introduction to islamic banking and finance pdf

Introduction to islamic banking and finance pdf

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1 Introduction

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Introduction to Islamic Banking and Finance

1 Introduction

Banking or banking activity that complies with sharia Islamic law —known as Islamic banking and finance , or shariah [1] -compliant finance [2] —has its own products, services and contracts that differ from conventional banking.

Some of these include Mudharabah profit sharing , Wadiah safekeeping , Musharakah joint venture , Murabahah cost plus finance , Ijar leasing , Hawala an international fund transfer system , Takaful Islamic insurance , and Sukuk Islamic bonds.

Sharia prohibits riba , or usury , defined as interest paid on all loans of money although some Muslims dispute whether there is a consensus that interest is equivalent to riba. To be consistent with the principles of Islamic law Shariah and guided by Islamic economics, the contemporary movement of Islamic banking and finance prohibits a variety of activities:. Money earned from the most common type of Islamic financing—debt-based contracts—"must" come "from a tangible asset that one owns and thus has the right to sell—and in financial transactions it demands that risk be shared.

Islamic banking and finance has been described as having the "same purpose" Institute of Islamic Banking and Insurance , [30] or having the same "basic objective" Mohamed Warsame , [31] as conventional banking but operating in accordance with the rules of shariah law. Benefits that will follow from banning interest and obeying "divine injunctions" [32] include an Islamic economy free of "imbalances" Taqi Usmani [32] —concentration of "wealth in the hands of the few", or monopolies which paralyze or hinder market forces, etc.

Other describe these benefits or similar ones as "principals" or "objectives" of Islamic finance. Nizam Yaquby, for example declares that the "guiding principles" for Islamic finance include: "fairness, justice, equality, transparency, and the pursuit of social harmony". Risk-sharing is lacking because profit and loss sharing modes are so infrequently used. Underlying material transactions are also missing in such transactions as " tawarruq , commodity murabahas , Malaysian Islamic private debt securities, and Islamic short-sales".

Others such as convert Umar Ibrahim Vadillo agree that the Islamic banking movement has failed to follow the principles of shariah law, but call for greater strictness and greater separation from the non-Muslim world. Banking makes up most of the Islamic finance industry. Banking products are often classified in one of three broad categories, [44] [45] two of which are "investment accounts": [46] [47] [Note 4].

Islamic non-banking finance has grown to encompass a wide range of services, but as of , banking still dominates and represented about four-fifths of total assets in Islamic finance. Other services include leasing, equity markets, investment funds, insurance takaful , and microfinance. These products—and Islamic finance in general—are based on Islamic commercial contracts aqad i.

While the original Islamic banking proponents hoped profit-loss sharing PLS would be the primary mode of finance replacing interest-based loans, [56] long-term financing with profit-and-loss-sharing mechanisms is "far riskier and costlier" than the long term or medium-term lending of the conventional banks, according to critics such as economist Tarik M.

Yousef and other observers note that musharakah and mudarabah financing have "declined to almost negligible proportions". A " mudarabah " profit sharing contract is a kind of partnership where one partner rabb-ul-mal gives money to another mudarib for investing in a commercial enterprise.

The "sleeping" rabb-ul-mal party provides percent of the capital. The mudarib party provides its expertise and management. If there is a loss, the first partner " rabb-ul-mal " will lose his capital, and the other party " mudarib " will lose the time and effort invested in the project. The structure of mudaraba is very similar to that of venture capital where the venture capitalist finances the entrepreneur who provides management and labor, so that both profit and risk are shared.

And that this would result in a balanced distribution of income and prevent financiers from dominating the economy. Musharakah is a relationship between two or more parties that contribute capital to a business and divide the net profit and loss pro rata.

Unlike mudarabah , there may be more than two partners and all the providers of capital are entitled but not required to participate in management. Like mudarabah , the profit is distributed among the partners in pre-agreed ratios, while the loss is borne by each partner in proportion to respective capital contributions.

This mode is often used in investment projects, letters of credit, and the purchase or real estate or property.

Musharakah may be "permanent" often used in business partnerships or "diminishing" often used in financing major purchases, see below. In Musharaka business transactions, Islamic banks may lend their money to companies by issuing "floating rate interest" loans, where the floating rate is pegged to the company's individual rate of return, so that the bank's profit on the loan is equal to a certain percentage of the company's profits.

Use of musharaka or at least permanent musharakah is not great. In Malaysia, for example, [Note 6] the share of musharaka financing declined from 1.

A popular type of financing for major purchases—particularly housing—is Musharaka al-Mutanaqisa literally "diminishing partnership". A musharaka al-mutanaqisa agreement actually also involves two other Islamic contracts besides partnership— ijarah leasing by the bank of its share of the asset to the customer and bay' gradual sales of the bank's share to the customer.

If default occurs, both the bank and the borrower receive a proportion of the proceeds from the sale of the property based on each party's current equity. This method allows for floating rates according to the current market rate such as the BLR base lending rate , especially in a dual-banking system like in Malaysia. El-Gamal complains that this violates the sharia principle that banks must charge 'rent' or lease payment based on comparable rents for the asset being paid off, not "benchmarked to commercial interest rate[s]".

Asset-backed or debt-type instruments also called contracts of exchange are sales contracts that allow for the transfer of a commodity for another commodity, the transfer of a commodity for money, or the transfer of money for money.

Murabaha is an Islamic contract for a sale where the buyer and seller agree on the markup profit or " cost-plus " price [87] [88] for the item s being sold. A contract with deferred payment is known as bai-muajjal in Islamic jurisprudence. Murabaha has also come to be "the most prevalent" [90] or "default" type of Islamic finance. Unlike conventional financing, the bank is compensated for the time value of its money in the form of "profit" not interest, [90] and any penalties for late payment go to charity, not to the financier.

Economists have questioned whether Murabahah is "economically indistinguishable from traditional, debt- and interest-based finance. In Bai' muajjal literally "credit sale", i. Bia'muajjal was introduced in by Bank Islam Malaysia Berhad. Because in Islamic finance the markup in murabahah is charged in exchange for deferred payment, bai' muajjal and murabahah are often used interchangeably, according to Hans Visser , [97] or "in practice Bai' al inah literally, "a loan in the form of a sale" , [] is a financing arrangement where the financier buys some asset from the customer on spot basis, with the price paid by the financier constituting the "loan".

Subsequently, the asset is sold back to the customer who pays in installments over time, essentially "paying back the loan". Since loaning of cash for profit is forbidden in Islamic Finance, there are differences of opinion amongst the scholars on the permissibility of Bai' al 'inah.

According to the Institute of Islamic Banking and Insurance, it "serves as a ruse for lending on interest", [] but Bai' al inah is practised in Malaysia and similar jurisdictions. This was a demonstration of "the philosophical differences" in Shariah between these "two centers of Islamic finance", according to Thomson Reuters Practical Law. Musawamah is the "most common" type of "trading negotiation" seen in Islamic commerce.

Istisna also Bia Istisna or Bai' Al-Istisna and Bia-Salam are " forward contracts " [] customized contracts between two parties to buy or sell an asset at a specified price on a future date. Istisna literally, a request to manufacture something is a "forward contract on a project" and unlike Bia-Salam can only be a contract for something manufactured, processed, or constructed, [] which would never exist were it not for the contract to make it.

Like istisna , Bai Salam also Bai us salam or just salam is a forward contract in which advance payment is made for goods in the future, with the contract spelling out the nature, price, quantity, quality, and date and place of delivery of the good in precise enough detail "to dismiss any possible conflict".

One contract is made with a seller and another with a purchaser to sell the good for a higher price. Ijarah , literally "to give something on rent" [] is a term of Islamic jurisprudence, [] and a product in Islamic banking and finance resembling rent-to-own.

In traditional fiqh Islamic jurisprudence , it means a contract for the hiring of persons or services or " usufruct " of a property generally for a fixed period and price. This involves two Islamic contracts very much like "Diminishing Musharaka" above :.

It is very important from the standpoint of shariah law for the Ijarah and Bai not to be combined , but to be two separate contracts. When the lease period expires, the second contract comes into effect, which enables the customer to purchase the car at an agreed price.

This type of transaction is similar to the contractum trinius , a legal maneuver used by European bankers and merchants during the Middle Ages to sidestep the Church's prohibition on interest bearing loans.

In a contractum, two parties would enter into three trinius concurrent and interrelated legal contracts, the net effect being the paying of a fee for the use of money for the term of the loan.

The use of concurrent interrelated contracts is also prohibited under Shariah Law. Ijarah wa-iqtina [] literally, "lease and ownership" [] also called al ijarah muntahia bitamleek [] also involves a ijarah followed by sale of leased asset to the lessee, but in an ijara wa iqtina contract the transfer of ownership occurs as soon as the lessee pays the purchase price of the asset—anytime during the leasing period. In a "forward ijarah" or ijara mawsoofa bi al dhimma Islamic contract literally "lease described with responsibility", also transliterated ijara mawsufa bi al thimma , the service or benefit being leased is well-defined, but the particular unit providing that service or benefit is not identified.

Thus, if a unit providing the service or benefit is destroyed, the contract is not void. This means the ijara mawsoofa bi al dhimma contract is combined with a Istisna contract for construction of whatever it is that will provide the service or benefit.

Also required by sharia is that the asset be clearly specified, its rental rate be clearly set although the rate may float based on the agreement of both parties. While tawarruq strongly resembles a cash loan—something forbidden under orthodox Islamic law—and its greater complexity like bai' al inah mentioned above mean higher costs than a conventional bank loan, proponents argue the tangible assets that underlie the transactions give it sharia compliance.

Islamic scholars have noticed that while there have been "billions of dollars of commodity-based tawarruq transactions" there have not been a matching value of commodity being traded. Taqi Usmani insists that "role of loans" as opposed to investment or finance in a truly Islamic society is "very limited", and that Shariah law permits loans not as an ordinary occurrence", but only in cases of dire need".

A shariah-compliant loan is known as Qardh-ul Hasan , also Qard Hasan , literally: "benevolent loan" or "beneficence loan". It is often described as an interest-free loan extended to needy people. However, other sources state that the borrower is allowed pay an extra if the extra is optional and not stipulated by contract. These contracts are intended to help individual and business customers keep their funds safe.

Hawala also Hiwala , Hewala , or Hundi ; literally transfer or sometimes trust is a widely used, informal "value transfer system" for transferring funds from one geographical area to another, based not on movement of cash, or on telegraph or computer network wire transfers between banks, but on a huge network of money brokers known as "Hawaladars" located throughout the Muslim world.

The hawala network operates outside of, or parallel to, traditional banking, financial channels, and remittance systems, but predates it by many centuries. In the first half of the 20th century it was gradually replaced by the instruments of the conventional banking system, but became a "substitute for many banking products", as Muslim workers began to migrate to wealthier countries to seek employment in the late 20th century, and sought ways to send money to or secure a loan taken out by their family back home.

Each hawala transaction takes place entirely on the honour system , and since the system does not depend on the legal enforceability of claims, it can operate even in the absence of a legal and juridical environment. Hawaladars networks are often based on membership in the same family, village, clan, or ethnic group, and cheating is punished by effective ex-communication and "loss of honour"—leading to severe economic hardship.

As illustrated in the box to the right, 1 a customer A, left-hand side approaches a hawala broker X in one city and gives a sum of money red arrow that is to be transferred to a recipient B, right-hand side in another, usually foreign, city. Along with the money, he usually specifies something like a password that will lead to the money being paid out blue arrows.

Then, the intended recipient B , who also has been informed by A about the password 2a , now approaches M and tells him the agreed password 3a. If the password is correct, then M releases the transferred sum to B 3b , usually minus a small commission. X now basically owes M the money that M had paid out to B; thus M has to trust X's promise to settle the debt at a later date.

Transactions may completed in as little as 15 minutes. Kafala literally "guarantee", [] "joining" or "merging" [] is called "surety" or "guaranty" in conventional finance. A third party accepts an existing obligation and becomes responsible for fulfilling someone's liability. Rahn collateral or pledge contract is property pledged against an obligation. It is used when the principal does not have the time, knowledge or expertise to perform the task himself.

Wakalah is a non-binding contract for a fixed fee and the agent or the principal may terminate this agency contract at any time "by mutual agreement, unilateral termination, discharging the obligation, destruction of the subject matter and the death or loss of legal capacity of the contracting parties".

Types of wakalh include: general agency wakalah 'ammah , specific agency wakalah khassah , limited or restricted agency wakalah muqayyadah , absolute or unrestricted agency wakalah mutlaqah , binding wakalah wakalah mulzimah , non-binding wakalah wakalah ghair mulzimah , paid agency, non-paid agency, etc.

An example of the concept of wakalah is in a mudarabah profit and loss sharing contract above where the mudarib the party that receives the capital and manages the enterprise serves as a wakil for the rabb-ul-mal the silent party that provides the capital although the mudarib may have more freedom of action than a strict wakil.

From the point of view of depositors, "Investment accounts" of Islamic banks—based on profit and loss sharing and asset-backed finance—resemble "time deposits " of conventional banks. At least in one Muslim country with a strong Islamic banking sector Malaysia , there are two main types of investment accounts offered by Islamic banks for those investing specifically in profit and loss sharing modes [] [] —restricted or unrestricted.

Some have complained that UIA accounts lack transparency, fail to follow Islamic banking standards, and lack of customer representation on the board of governors. Islamic banks also offer "demand deposits," i.

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Islamic Banks and Financial Institutions pp Cite as. Islamic Finance is the subject of growing interest as it provides an alternative banking system to the world economy. Islam considers trade a very important component of economic development and, therefore, the notion of investing finance in an ethical way is essential. On the one hand, interest is forbidden in Islam; on the other hand, the management of investment is a must, so Islam has developed an alternative financial system which encourages the promotion of trade without interest. In this system, therefore, risk is shared rather than being transferred while taking the business transactions into consideration. Unable to display preview. Download preview PDF.

JavaScript seems to be disabled in your browser. For the best experience on our site, be sure to turn on Javascript in your browser. On completion of the course you will have developed a good foundational understanding of the core principles, the various norms and prohibitions that govern activities and contracts in the Islamic financial system, the differences between the Islamic financial system and the conventional system, as well as the basic modes of Islamic finance. General practitioners working in banks, corporates, or financial institutions in functions such as relationship management, credit and compliance, but with an interest in trade finance. This eLearning course includes a self-assessment tool to help you recap what you have learned and embed your new knowledge.

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Introduction to Islamic Banking and Finance

The Qur'an prohibits riba , which literally means "increase". Technically riba is the increase when liquid or fungible assets cash, debt, grains, etc. In the late 20th century, as part of the revival of Islamic identity, [4] [Note 1] a number of Islamic banks formed to apply these principles to private or semi-private commercial institutions within the Muslim community. The industry has been lauded for returning to the path of "divine guidance" in rejecting the "political and economic dominance" of the West, [4] and noted as the "most visible mark" of Islamic revivalism, [13] its most enthusiastic advocates promise "no inflation, no unemployment, no exploitation and no poverty" once it is fully implemented.

The paper adopts a qualitative approach using 25 semi-structured interviews together with documentary analysis to analyse how Islamic banking has evolved in Nigeria. The paper demonstrates that the evolution of Islamic banking in Nigeria arose from a relationship between various human and non-human actors. The development was shaped by the Nigerian socio-economic environment, particularly the wealthy Muslim segment and the poor performance of the economy. The findings of this study suggest that publicising what the new practice or concept is in advance to the entire populace will enhance understanding and subsequent acceptance.

Introduction to Islamic Banking & Finance

Skip to search form Skip to main content You are currently offline. Some features of the site may not work correctly. Introduction to Islamic Banking and Finance is a succinct guide to the key characteristics of Islamic banking highlighting how these differ from conventional banking.

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Islamic Finance pp Cite as. Islamic banking has emerged as one of the most important alternate forms of funding in the financial world. There has always been a growing demand amongst Muslims for financial products and services that conform to the Syariah Islamic law. The basic principles underlying Islamic banking transactions are that it must not be tainted with elements of interest and that risk must be shared between banker and customer based on a profit and loss sharing PLS principle. Islamic banking is not a new phenomenon and its principle was practiced during the time of Prophet Saw.

Topic areas encompass:. The journal welcomes submission of material for consideration as main articles, notes or book reviews. Main articles should be broadly consistent with the "Aims and Scope" of Review of Middle East Economics and Finance, and be approximately 5,—7, words in length. They should include an abstract of no more than words. Notes on certain topics, especially policy issues, may be considered for publication and should be in the range of 2,—3, words.

Islamic Banking Controversies and Challenges

Banking or banking activity that complies with sharia Islamic law —known as Islamic banking and finance , or shariah [1] -compliant finance [2] —has its own products, services and contracts that differ from conventional banking. Some of these include Mudharabah profit sharing , Wadiah safekeeping , Musharakah joint venture , Murabahah cost plus finance , Ijar leasing , Hawala an international fund transfer system , Takaful Islamic insurance , and Sukuk Islamic bonds. Sharia prohibits riba , or usury , defined as interest paid on all loans of money although some Muslims dispute whether there is a consensus that interest is equivalent to riba.


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