Introduction to

Islamic Financial System

The current financial crisis

debunks the myths of
Capitalism, opening the way
for alternative economic
systems to emerge, among
which is the Islamic finance
and economy.

Musbri Mohamed
DIL; ADIL ( ITM )
Pursuing MBL ( UKM )

1
Scholars of Islamic economics ought to explain the concepts
and principles of the Islamic financial and economic system
and present its reference and applications to wider audience.

The basic framework for an Islamic financial system is a

set of rules and laws, collectively referred to as Shariah,
governing economic, social, political, and cultural
aspects of Islamic societies.

Shariah allows for a system of funding and investment based on

participation in both profit and loss and interaction between capital
and labor. Shariah calls on the parties involved in transactions to
behave in a truthful, honest, clear and transparent way by
prohibiting gharar, jahalah, cheating, gambling, lying, rumors,
exploitation and taking people's money unjustly.       
  
In a word, the only way out of this crisis can be found in the
principles and regulations of the Islamic economics.

2
Shariah originates from the rules dictated by the sources
of Islamic law. The sources refer are in sequence as follows:

• the Qur'an,
• the hadith texts (the words, actions, recorded statements
and practices of Prophet Muhammad (pbuh) and this
include hadith Qudsi),
• Ijma (consensus of the ulama) and qiyas (drawing analogies
deduction and reasoning from the Qur'an and hadith
texts), and
• Ijtihad (the scholar's own reasoning). Note that a scholar's
ijtihad only comes after the analysis of the other sources,
and remains within the parameters established by them.

3
The basic principles of an Islamic financial system can be
summarized as follows:

Prohibition of riba (usury) . Riba (usury), a term literally meaning

"an excess" and interpreted as "any unjustifiable increase of capital
whether in loans or sales". More precisely, any positive, fixed,
predetermined rate tied to the maturity and the amount of
principal (i.e., guaranteed regardless of the performance of the
investment) is considered riba and is prohibited. The general
consensus among Islamic scholars is that riba covers not only
usury but also the charging of "interest" as widely practiced. Allah
mentioned in many places in the Quran on the prohibition of Riba.

One of the ayah is stated below:

4:161. “ And their taking of Ribâ (usury) though they were

forbidden from taking it and their devouring of men's substance
wrongfully (bribery, etc.). And We have prepared for the
disbelievers among them a painful torment.”

4
Islam encourages the earning of profits but forbids
the charging of interest because profits, symbolize
successful business and creation of additional
wealth whereas interest, determined gambling, is a
cost that is accrued irrespective of the outcome of
business operations and may not create wealth if
there are business losses.

Social justice demands that borrowers and lenders

share rewards as well as losses in an equitable
fashion and that the process of wealth accumulation
and distribution in the economy be fair and
representative of true productivity.

5
Economic experts assert that the system of financial
derivatives can not bring about real development. Financial
derivatives create only money, with no real value, causing
inflation and price rise ,as well as moral decadence. For
example, financial derivatives caused quick collapse of East
Asian financial institutions.
In the Islamic financial system,
risk sharing, promotes
entrepreneurship, discourages
speculative behavior, and
emphasizes the sanctity of
contracts are being encouraged,
and it closes the door to the
concept of interest and precludes
the use of debt-based
instruments.

6
The financial products offer in the financial system by the
Islamic banking institution includes financing facilities for asset
acquisition, trade financing and corporate financing.

These different contacts i.e. Mark-up Sale (Murabahah), Sale

with Deferred Payment (Bai Bithaman Ajil), Leasing (Ijarah),
and Benevolent Loan (Qardhul Hasan) are some of the
products offer under the financing for assets acquisition.
Meanwhile letter of credit, letter of guarantee, accepted bills,
and working capital financing are offered for financing
purposes (trade and corporate). Different instruments are
offered by the market to satisfy providers and users of funds in
a variety of ways. These instruments serve as the basic building
blocks for developing a wide array of more complex financial
instruments, suggesting that there is great potential for
financial innovation and expansion in Islamic financial
markets.

7
Financial products offered by the Islamic banks,
just like the conventional banks, aims to gain
profit. However in the Islamic financial system,
the intermediaries are not allowed to deal with
interest or to engage in any business or trade
prohibited by Islam.

8
Shariah prohibits all forms of investment-based contracts of
funding that involve interest loans forbidding financial
transactions that involve gharar (risk-taking) and gahalah
(unawareness).

The most important difference between Islamic and

conventional practices is in the Islamic financial
activity the trading principle of buying and selling
must be on the fair basis and the profit is legitimate
and the monopoly and hoarding is prohibit in all
means. Usually in the Islamic financial system, it based
on equity whereas the conventional banking system is
loan based. Islam is not against the earning of money.
In fact, Islam prohibits earning that can cause harmful
to society or each other.

9
Al-Rahn (Rahnu)

Ar-Rahn means to hold a maal as a mortgage to a loan in such

a way that the loan can be settled from the value of the
mortgaged maal in case of default or inability to pay. Islamic
banks are like other conventional bank, which prefer to secure
a loan either through personal surety (guarantor) or a pledge.

Syariah Ruling

The Quran also supports the idea of furnishing a pledge

against a debt. It is laid down in Surah al- Baqarah 2:283;
“…And if you are on a journey and cannot find a scribe, pledges
(may be taken) in hand, but if trust one another, then let them who
is fulfill his trust, and let him be conscious of god, his sustainer…”

10
Al-Ijarah

It literally means to give something on rent. Technically, ijarah

means employing the services of a person on wages given to
him as a consideration for his hired services or transferring the
usufruct of a particular property to another person on a rent
claimed from him. There are two types of Ijarah, ijarah al-Ain
and ijarah al’amal.

Syariah Ruling
Surah Al-Qasas verse 26
“Trully the best men for you to employ is the man who is strong and
trusty.”(28:26)
Hadith:
Prophet Muhammad said that, “Give the employee his due wage before
his sweat dries.”

Al-Ijma’:
All scholars from sahabah time agree that ijarah is permissible since
people need benefits.

11
Syariah Rulling

Syariah disallows a bank to prescribe profit at the time of

contract. Hadith provides that, “Every loan which is draws benefit
is Riba”. Therefore, contract of loan in Islamic finance is called
benevolent loan (Qard al-hasan). But it is recommended for the
borrower to give something in return for the benevolent act of
the bank.

The hadith of the prophet are self-explanatory:

Hadith reported by Abu Rafi that the prophet was lent a young
female camel. He could not find a similar type of camel and
returned a pregnant camel instead. “Indeed a good person among
you is he who settles the loan with something better”.
Hadith narrated by Jabir, “ I had the right (of loan) on the prophet-
settled it made additional payment”.

12
Who’s to blame ?

Falling stock and home prices have wiped

out four years of gains in Americans' net
worth since the start of 2008, according to
new data from the Federal Reserve. Nearly
half of those losses occurred over the last
three months of the year, the biggest
quarterly decline since recordkeeping began
in 1952.

The new data underlined just how quickly

wealth created during the biggest credit
bubble in history has vanished, leaving
Americans without the college funds, nest
eggs and other reserves they had set aside.

13
President Obama, speaking at a gathering of chief
executives in Washington yesterday i.e 12 March 2009,
acknowledged that the nation had been lured by the
"illusion of prosperity," and he blamed "reckless speculation
and spending beyond our means on bad credit and inflated
home prices."

"Such activity . . . hurts us all in the end," he said.

While Obama outlined the steps his administration is taking

to pull the country out of recession, the task has become
more daunting in recent weeks. Americans continue to turn
to the government for help -- the number of people filing
continuous claims for jobless benefits jumped last week to
another all-time high -- and, according to a new survey,
foreclosure filings increased last month, despite foreclosure
moratoriums imposed by several states and major lenders.

14
 Solution

Islamic economic and financial system

is based on a set of values, ideals, and
morals, such as honesty, credibility,
transparency, clear evidence,
facilitation, co-operation,
complementarily ,and solidarity.

Islamic economy promotes
participation in profit, loss, and
actual exchanges of money and
assets. In fact, there should be real
interaction between the wealthy,
employers, the employees, and
financial experts. There is no party
who is a constant winner or a
constant loser; yet profit and loss is
mutually shared.

15