Islamic Financial

Instruments
MBF 709
By
Dr. Syed Zulfiqar Ali Shah
Ph.D (Finance), ACMA
Ref: Own, Md Noor Ul Islam, Book

Course Contents
Introduction to the Concept of Islamic Finance
Overview of Conventional and Islamic Banking
Islamic Economic System & Major prohibited Elements in Islamic Economy
Islamic Law of Contract & Business Transactions
Islamic Corporate Governance
Overview of Modes of Islamic Finance
Islamic Financial Instruments & institutions
Murabaha & Musharakah
Participatory Modes: Shirkah and its Variants
Salam A Trade Based Product
Istisna A Trade Based Product
Ijarah A Semi Debt based Product
Islamic Asset and Fund Management & Islamic Bond Market Sukuk
Islamic insurance Takaful
Risk Management in Islamic Finance & Appraisal of Common Criticism

Plan of Today's Lecture

Finance in General Perspective

General Decisions in Finance
Fundamental Principles of Islam:
Maqasid Al-Shariah:
The Strategy:
The Islamic World View:
Islamic Financial System(ifs):
Differences Between CFS & IFS
Principles of An Islamic Financial System
The Objectives Islamic Economics and Banking
Principles of Islamic Economics Systems:
Deposit Products of Islamic Bank:
Future of Islamic Banking

Finance
Decision Making
Four types of decisions
Investment Decision
Financing Decision
Asset Management Decision
Dividend Policy Decision

Investment Decision
Estimation of Cash Flows
Required rate of return
Tools and techniques to evaluate
proposal

Financing Decision
Three options of Financing
Own Money
Issuance of Equity/ Shares
Common Shares
Preferred Shares
Debt
Financial Institutions
General public

Asset Management Decision

Assets

Current Assets

Non Current Assets

Dividend Policy Decision

Why Dividend Policy
To avoid expected Risk
To have money for future
investments

Fundamental Principles
of Islam
Tawhid (Oneness And Unity of Allah
Allah is One, Unique & Supreme
Khilafah (Vicegerency)
The Concept of Khilafah has a Number of
Implications or Corollaries.
These are:
Universal Brotherhood
Resources are a Trust
Humble Life Style
Human Freedom
Adalah (Justice)
Need Fulfillment
Respectable Source of Earning
Equitable Distribution of Income & Wealth
Growth & Stability

Maqasid Al-Shariah:
Maqasid al-Shariah is to promote the welfare of the
people by safeguarding their Faith
Prosperity (descendant)
Life & intellect
Wealth
Maqasid (objectives of) al-Shariah
There have been efforts by jurists to add to the list of
these five requisites and also to change their sequence,
but it seems that these attempts have, in general, not
satisfied most jurists.
Imam Abu iIhaq-Al-Shatibi (d. 790/1388), writing a little
less than three centuries after Al-Ghazali, put his stamp of
approval on his list as well as the sequence, thereby
indicating that both of these are the most preferable in
terms of their harmony with the essence of the Shariah.

The Strategy
A socially agreed filter mechanism

A strong motivating system to induce the

individual to render his best in his own
Interest as well as the interest of the society

Restructuring of the whole economy with the

objective of realizing the maqasid in spite of
scarce resources.

A positive and strong goal-oriented role for

The government

The Islamic World View

Inability of the capitalist & socialist
countries as well as the developing
economies to realize simultaneously
the goals of both efficiency & equity

Social Darwinism, survival of the

fittest, class
struggle, maximum
want satisfaction, material condition of
life proved unsuccessful.

Maqasid Al-Shariah
Human well-being to be realized by ensuring the
enrichment of the following five ingredients for every
individual.
Din
Faith

Nafs
Self

Aql
Intellect

Mal
Wealth

Nasl
Posterity

Islamic Financial System

Islamic financial system(ifs):
A financial system that is based on Islamic principles and
values, which eliminates riba and ensure a profit sharing
mechanism in the financial system, may be called IFS.
It may be characterized by the absence' of interest based
financial institution & transactions, doubtful transactions or
gharar, stocks of companies dealing in unlawful activities,
unethical or immoral transactions such as market
manipulation, insider trading short-selling etc.
Differences between CFS & IFS
The conventional financial system is of two types.
1) socialistic financial system and
2) capitalistic financial system
- both systems have been proved inefficient to
establish
economic balance in the society.

Islamic Financial System

Basis of
Difference

CFS

IFS

1. Religious Belief

Secular & separates Religion from

Belief in unity of God & relates this

other Parts human life

belief to economic Life of a man

2. Freedom of Economic

In socialism govt. enjoys

Restrictive freedom is allowed in the

Activity

economic freedom but in

light of Shariah both by the govt. &/or

capitalism Individuals enjoys

individuals

freedom.
3. Ownership of means

4. Goals of financial System

Socialism-state ownership,

Allah is the exclusive owner. Man is

Capitalism-individual ownership

the caretaker of the property

Socialism-profit of the society

Welfare of both here and hereafter.

Capitalism-Individuals profit
5. Competition

Socialism-No competition

Logical Competition and financial co-

Capitalism- Logical & unethical

operation

competition
6. Wealth distribution

Socialism-Equal
Capitalism Unequal

Equitable

Islamic Financial System

CFS

Basis of
Difference

7. Basis of Economic System

Riba or Interest

IFS

Interest Free; PLS, Zakat &

Compensation based

8. Sources of the System

Intellects brain storming of the

Devine book Al-Quran &

economic problems of mens life

Prophets(SM) speeches

Capitalism concentration of

Maximum & equitable Distribution of

income & economic power in few

economic opportunities and higher

hands. Inefficiency

production in the society

10. Social & environmental

Do not consider the social &

Ensure social & environmental welfare

welfare

environmental welfare

11. Owners exception in respect

Dividend or part of profit in case

of respect of investment

of equity financing

12. Lender or Banks

Interest

Profit or Loss Sharing

Loan, Overdraft & Cash Credit

Mudarabah, Musharaka, Murabahah

9. Result

Part of Profit or Loss

expectation in terms of dept

financing
13. Modes of Investment

etc.

Principles of an Islamic
Financial System

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 originates from the rules dictated by the Quran
and its practices, and explanations rendered (more commonly
known as Sunnah) by the Prophet Muhammad. Further
elaboration of the rules is provided by scholars in Islamic
jurisprudence within the framework of the Quran and Sunnah.
The basic principles of an Islamic financial system can be
summarized as follows:

Prohibition of interest : Prohibition of Riba, a term literally

meaning "an excess" and interpreted as "any unjustifiable
increase of capital whether in loans or sales" is the central tenet
of the system. 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.

Islamic Financial System

This prohibition is based on arguments of social justice,
equality, and property rights. Islam encourages the earning
of profits but forbids the charging of interest because
profits,
determined
ex
post,
symbolize
successful
entrepreneurship and creation of additional wealth whereas
interest, determined ex ante, is a cost that is accrued
irrespective off the outcome of business operations and may
not create wealth if there are business losses. Social justice
demands that borrowers and lenders share rewards s 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.
Risk sharing: Because interest is prohibited, suppliers of
funds become investors instead of creditors. The provider of
financial capital and the entrepreneur share business risks
in return for shares of the profits.

Islamic Financial System

Money as "Potential" Capital: Money is treated as
"Potential" capital -that is, it becomes actual capital only
when it joins hands with other resources to undertake a
productive activity. Islam recognizes the time value of
money, but only when it acts as capital, not when it is
"Potential" capital.
Prohibition of speculative behavior: An Islamic financial
system discourages hoarding and prohibits transactions
featuring extreme uncertainties, gambling, and risks.
Sanctity
of
contracts:
Islam
upholds
contractual
obligations and the disclosure of information as a sacred
duty. This feature is intended to reduce the risk of
asymmetric information and moral hazard.
Shariah approved activities: Only those business activities
that do not violate the rules of Shariah qualify for
investment. For example, any investment in businesses
dealing with alcohol, gambling, and casinos would be
prohibited.

Islamic Financial System

The Objectives Islamic Economics and Banking
The Objectives of Shariah
The very objective of the Shariah is to promote the welfare of the
people which lies in safeguarding their faith, their life, their
intellect, their posterity, and their wealth. Whatever ensures the
safeguarding of these five serves public interest and is desirable.
(AI-Ghazali)
The-basis of the Shariah is wisdom and welfare of the people in this
world as well as the Hereafter. This welfare lies in complete justice,
mercy, well being and wisdom. Anything that departs from justice
to oppression, from mercy to harshness, from welfare to misery
and from wisdom to folly, has nothing to do with the Shariah (Ibn
AI-Quayyum).
Definition of Economics
Prof. L. Bobbins -Economics is a science which studies human
behavior as a relationship between ends end scarce means which
have alternative uses.

Islamic Financial System

1.

2.

3.

4.

5.

Definition of Islamic Economics

Islamic Economics is that branch of knowledge which helps realize human wellbeing through an allocation and distribution of scarce resource that is in
conformity with Islamic teachings without unduly curbing individual freedom or
creating continued macro-economic and ecological imbalances- Oman Chapra.
Islamic Economics aims at the study of human falah achieved by organizing the
resources of the earth on the basis of co-operation and participants
(Muhammad Akram Khan).
Islamic Economics is the Muslim thinker's response to the economic challenges
of their times. In this Endeavour they are aided by the Quran and the Sunnah as
well as by reason and experience- M Negatullah Siddiq.
Islamic Economics is the science of how man uses resources and means of
production to study his worldly needs according to a predetermined code given
by Allah (SWT) in order to achieve the greatest equity- Princes Muhammad AlFaisal Soud.
Islamic Economics is a social science which studies the economic problem of
the people imbued with the values of Islam. It is a composite social science
which studies the problem of production, distribution and consumption through
integrative system of exchange and transfer overtime and their social through
integrative system of exchange and transfer overtime and their social and moral
consequences in the light of Islamic rationalism. It assumes the presence of
Islamic man. M.A. Mannan.

Islamic Financial System

Objectives of Islamic Economics

1. To establish justice in the Economy (5:58) (16:90), Nahal, Nisa)

- Surely Allah enjoins justice and the doing good (to others) (16:90 Al-Nahal)
- Whenever you judge between people, you judge with justice 5:58 (An-Nisa)

2. To protect the interest of the deprived and the oppressed. (28:5)

(Kisas)
- And we desired to bestow a favour upon those who were deemed weak in
the land, and to make them the leaders, and to make them the Heirs 28:5
(Al-Qasas)

3. To establish good practices and institutions in the economy and

to eliminate bad practice and bad institutions from Economy (22:41)
- [Well aware of] those who, if we firmly establish them in the land (on
earth) will keep up prayer (remain constant prayer) and give in charity and
enjoin good and forbid bad 22:41 (Al-Hajj)

Islamic Financial System

4.

To make life easy and bearable (7:157)

5. To ensure full utilization of resources.

6.

7.

8.

9.

Proper of distribution of wealth and Resources.

Maximum production of useful production.
Bring stability in the value of money and exchange rates
Ensure economic efficiency and accelerated rate of
growth

10. Ensure broad based economic well being, balanced

monetary expansion and fill employment.

Islamic Financial System

Principles of Islamic Economics Systems:
1. Sole purpose is to obey and please Allah.
2. The wealth and asset in all their forms given under trust by
Allah.
3. Moral values and guiding factors for all Economic activities.
4. Maximum equitable utilization of human and material resources
given by Allah
5. Human dignity and respect of Labour.
6. 'Maximum freedom for economic activity within a just
framework.
7. Equitable distribution of wealth and income and disciplined
private ownership.
8. Simplicity economy and austerity in expenditure.
9. Adal and Ihsan (Justice and kindness).
10. Strict prohibition of Riba, Interest and Usury in all forms.

Islamic Banking
Modern banking system was introduced into
the Muslim countries at a time when they
were politically and economically at a low
ebb, in the late 19th century.
Governance structures are quite different from
these under Islamic banking because the
institution must obey a different set of
rules - those of the Holy Qur'an - and
meet the expectations of Muslim
community by providing Islamicallyacceptable financing modes.

The Islamic financial system employs the concept of

participating in Halal business opportunities, utilizing
the funds at risk on a profit-and-loss-sharing basis.
ISLAMIC BANKING MOVEMENT IN THE WORLD
The objective of Islam injunction is welfare of the
whole humanity. Islamic Banking, based on the
Islamic economic system, is not restricted to Muslims
only.
Malaysia is the first country to issue bonds on
Islamic basis.
In August 1983, the Iranian government had
passed the law for riba free banking
Islamic Banking and finance started in 1963
when Mit Ghambr Savings Bank began offering
interest free banking in Egypt.

Principles of Islamic
Banking
An Islamic bank is based on the Islamic faith and must
stay within the limits of Islamic Law or the sharia in all
of its actions and deeds. The original meaning of the
Arabic word sharia was 'the way to the source of life'
and it is now used to refer to legal system in keeping
with the code of behaviour called for by the Holly Qur'an
(Koran). Four rules govern investment behaviour:

the absence of interest-based (riba) transactions;

the avoidance of economic activities involving
speculation (ghirar);
the introduction of an Islamic tax, zakat;
the discouragement of the production of goods
and services which contradict the value pattern of
Islamic (haram)

What is Riba?

The word "riba" means excess, increase or addition,

which correctly interpreted according to Shariah
terminology, implies any excess compensation
without due consideration (consideration does not
include time value of money).
This definition of riba is derived from the Quran and is
unanimously accepted by all the Islamic scholars. There
are two types of riba, identified to date by these
scholars namely
'Riba an-Nasiyah' and 'riba al Fadl'.
'Riba an-Nasiyah' is defined as excess, which
results
From predetermined interest (Sood) which a lender
receives over and above the principle (Ras ul Maal).

'Riba al Fadl' is defined as the excess

compensation without any consideration resulting
from a sale of goods

Speculation
Another feature condemned by Islamic is
economic transactions involving
elements of speculation. Buying goods
or shares at low and selling them
for higher price in the future is
considered to be illicit. Similarly an
immediate sale in order to a void a loss
in the future is condemned. The reason
is that speculators generate their
private gains at the expense of
society at large.

Zakat

A mechanism for the redistribution of income and

wealth is inherent is Islam, so that every Muslim is
guaranteed a fair standard of living, nisab. An Islamic
tax, zakat (a term derived from the Arabic zaka,
meaning
"pure")
is
the
most
important
instrument for the redistribution of wealth. This
tax is a compulsory levy, one of the five basic tenets of
Islam and the generally accepted amount of the
zakat is one fortieth (2.5 per cent) of Muslim's
annual income in cash or kind from all forms of
assessed wealth exceeding nisab.

Haram

A strict code of 'ethical investment' operates. Hence it

is forbidden for islamic banks to finance
activities or items forbidden in islam, haram,
such as trade of
alcoholic beverage and pork
meat.

Profit-sharing agreements
Although the restriction against the use of
interest might seem to be a binding constraint
upon expansion, Islamic banks and financial
institutions have in fact grown rapidly.
As the use of interest rates in financial
transactions is prevented, Islamic banks
are expected to undertake operations
only on the basis of Profit and Loss
Sharing (PLS)
arrangements
or
other
acceptable modes of financing. Mudarabah
and musharaka are the two profit-sharing
arrangements preferred under Islamic law

Sources of funds
Besides their own capital and equity,
Islamic banks rely on two main sources
of funds,\
a) transaction deposits, which are risk
free but yield no return and,
b) investment deposits, which carry
the risks of capital loss for the promise of
variable. In all, there are four main types
of accounts:

Current accounts
Current accounts are based on
the
principle
of
Al-Wadiah,
whereby
the
depositors
are
guaranteed repayment of their
funds. At the same time, the
depositor
does
not
receive
remuneration for depositing funds in
a current account, because the
guaranteed funds will not be used for
PLS ventures

Savings Accounts
Savings accounts also operate under
the al-Wadiah principle. Savings
accounts differ from current deposits
in that they earn the depositors
income: depending upon financial
results, the Islamic bank may
decide to pay a premium, hiba, at
its discretion, to the holders of
savings accounts.

Investment accounts
An investment account operates under the
Mudarabah al-Mutlaqa principle, in which the
Mudarib (active
partner)
must
have
absolute freedom in the management of
the investment of the subscribed capital.

Special investment accounts

Special investment accounts also operate
under the Mudarabah principle, and
usually are directed towards larger
investors and institutions

The Basic Difference

between Capitalist and
Islamic Economy
The basic difference between capitalist
and Islamic economy is that in
secular capitalism.
Capital economy is based on the
market forces.
Islamic economy based on the
Principles of Quran and Sunah.

The Performance of the

Islamic Banks
Islamic banking has become today an
undeniable reality.
The number of Islamic banks and the
financial institutions is ever increasing.
New Islamic Banks with huge amount
of capital are being established.
Conventional
banks
are
opening
Islamic windows or Islamic subsidiaries
for the operations of Islamic banking.

Islamic Financial System

Deposit Products of Islamic Bank:
1.Al-wadeeah Current Deposits
2. Mudarabah Savings Deposits
3.Mudaraba Special Notice Deposits
4.Mudaraba Term Deposits
5.Mudaraba Hajj Savings A/c
6.Mudaraba Savings Bond
7.Mudaraba Special Savings Scheme
8.Mudaraba Monthly Profit Dep. Schemes(MMPDS)
9.MUDARABA MUHOR SAVINGS A/C
10.Mudaraba Waqf Cash Deposit A/C
11.Mudaraba Savings Deposits(RDS)

Islamic Financial System

UNDER CAPITALISM

UNDER ISLAM

1.

Economic Laws are like physical laws

1.

Economic laws are like natural laws

2.

Positivism: Economics is a positive

science as like as biology, physics which
have no value, value neutral

2.

Economics is value oriented. Permissible &

prohibition have to be observed

3.

Motive for More: Pecuniary interest. Man is

rational economic being. Survival of the
fittest, destruction of the poor

3.

Man does not work for only personal

interest. He has to secure the interest of
this world & the world hereafter.

4.

Market Oriented: Market can solve all the

problems. Poor's need is not reflected in
the market. Demand is backed by
purchasing power. Result is the mismatch
in resource allocation.

4.

Market can solve major problem but not all.

At least 20% economic problems to be
solved by the government. Communism
prescribes 100% solution by government.
Capitalists leaves it 100% to market.

5.

Little concern for poor humanity

5.

Major concern for poor. Poverty alleviation

by Zakat, Sadaqa & gives emphasis on
economic progress

6.

Nearly 100 corporate of countries control

the world economy in the name of
globalization.

6.

No concentration of wealth in few hand.

Wide dispersal of wealth & property

7.

18-20% people in Bangladesh live below

poverty line (not getting two meals a day)

7.

None can live below poverty line if Islamic

economic system is established

The Future of Islamic

Banking
Islamic banking is here to stay.
financial institutions predict that Islamic
finance will be the world's fastest-growing
banking sector for years.
with a predicted modest estimate of 20
percent annual increase in deposits.
bankers are realizing that Islamic banking
is big business that is only getting bigger
Japan is also planning to start Islamic
banking

THANK
YOU