TOPIC 2 Evolution of Islamic Financial Institutions and markets

1.

The Islamic System Shariah and Muamlat

2.

Sources of Laws Primary I. Secondary II. III. IV. V. VI. VII. Ijma (consensus) Qiyas (analogy) Istihsan ( juristic preference) Urf (customs) Al-maslaha al mursalah (public interest) Istihsab - continuity Quran and Sunnah

3.

Principles of Islamic Finance I. II. III. IV. V. VI. VII. VIII. Prohibition of riba Money as potential capital Risk sharing Sanctity of contracts Materiality of contracts Shariah approved activities Prohibition of excessive speculation Promotion of social justice

Islamic Finances :Shariah based :-

Conducting financial services in accordance with Shariah, offering financial products in a shariah compliant manner. Islamic banking is banking or banking activity that is consistent with the principles of sharia A financial system built from the bottom the bottom up based entirely on Islamic principles. No need to match any pre-existing products, pricing of products, or match demand for similar products. The argument is that the product offerings by these banks are simply shariah compliant (selling conventional methods in Islamic garb by tweaking its features so as to not violate any shariah rulings) instead of creating new products that doesn't have any semblance to conventional banking practices and hold true and dear to the very teachings of the Quran and Hadith

Shariah Compliant :-

A financial system that takes a pre-existing system based on conventional principles and systemically remove non-shariah compliant features from these products. Incomplete procesd as pressure exists to match existing products in terms of features and pricing. Islamicise existing products, infrastructure.

Fractional reserve banking :- conventional Existing banking system ASSETS Reserve % Loans Cost of funds
Earn Interest income from assets Pay Interest expense on assets

LIABILITIES Deposits

banks mobilize funds as loans

This system existed before Islamic banking came into existence Islamic banks subjected to Reserve Banking System (fractional)

ASSETS

LIABILITIES

RESERVES % FINANCING

DEPOSITS SAVINGS ACCOUNTS (WADIAH) CURRENT ACCOUNTS INVESTMENT ACCOUNT HOLDERS

FUNDS OF CURRENT ACCOUNTS AND SAVINGS ACCOUNTS CANNOT USED FOR INVESTMENT PURPOSES. BANKS BENEFIT FROM THIS DEPOSIT BASE, IN TERMS OF PRESTIGE, INCREASING PER PARTY LIMIT ETC. SO AS A BENEFIT TO THESE CUSTOMERS BANKS REWARD WITH A HIBAH OF GIFT. FUNDS OF INVESTMSNT ACCOUNT HOLDERS ARE INVESTED VIA MUDARABAH CONTRACTS WHERE IAH IS RAB UL MAAL AND THE BANK IS THE MUDARIB. INCOME ON SAVINGS AND CURRENT ACCOUNT HOLDERS IS ALSO GENERATED IN THE SHAPE OF INCOME FEES, ATM FEES, INTERNET BANKING FEES ETC .

ISLAMIC BANKS GIVE OUT FINANCING :- Fundamental difference in Islamic banks and conventional banks lies in the contracts for collecting deposits and for giving out financing. Receive deposits on basis of :1. 2. 3. Wadiah Mudarabah Qard ul Hassan

Give financing on the basis of :1. 2. 3. Mudarabah Musharikah Ijarah etc.

FUNDAMENTAL PROBLEM:1. 2. 3. Small customer base Lack of liquidity Mismatch between assets & liabilities.

From mind maps Overview of sources of laws in Islamic Finance. The Islamic System based on i. shariah, Sharia "legislation";is the moral code and religious law of Islam. Sharia deals with many topics addressed by secular law, including crime, politics, and economics, as well as personal matters such as sexual intercourse, hygiene, diet, prayer, and fasting. In its strictest definition it is considered the infallible law of Godas opposed to the human interpretation of the laws (fiqh). There are two primary sources of sharia law: the precepts set forth in the Quran, and the example set by the Islamic prophet Muhammad in the Sunnah. Where it has official status, sharia is interpreted by Islamic judges (qadis) with varying responsibilities for the religious leaders (imams). For questions not directly addressed in the primary sources, the application of sharia is extended through consensus of the religious scholars (ulama) thought to embody the consensus of the Muslim Community (ijma). Islamic jurisprudence will also sometimes incorporate analogies from the Quran and Sunnah through qiyas, though Shia jurists prefer reasoning ('aql) to analogy. ii. iii. iv. i. and i. ii. iii. iv. v. muamalat (economic activity) takaful, zakat, & wealth planning money & capital markets faith & belief ,(aqidah) morals & ethics (akhlaq) jinayah ibadah (worship) politics , education

Sources of Law : Primary Holy Quran and Sunnah

Secondary 1. Ijma , Consensus of scholars 2. Qiyas, Analogy 3. Istihsan, Juristic Preference 4. Urf, Customs or knowledge 5. istihsab, Issue of continuity 6. Masalah & Mursala or public interest

Istihsab presumption of continuity.. any cases decided before will remain valid till new evidence is found that contradicts it..

Principles of islamic finance:1. 2. 3. 4. 5. 6. 7. 8. Prohibit riba Money as potential capital Risk Sharing Sanctity of contracts Materiality of contracts Shariah approved activities Prohibition of excessive speculative behaviour Promotion of social justice

2) Discussion on Money as potential capital Keynesian view is that we use money for 3 things 1) 2) 3) For transactions where money is a medium of exchange As precautionary store of value for ill events For speculative purposes i.e. for making money from money

Example I have $100 $50 spent on satisfying needs and wants $20 save for a rainy day $30 is surplus, defer consumption and savings to invest from this money. Place funds in a savings account . low risk and low return for e.g. at 3% (conventional) Place funds in bonds and stocks high risks. In any case the opportunity cost for investing $30 is the b) c) Satisfaction obtained from buying goods and services from it Reward from the investment is at least the 3% you would get from the savings account reward for

Reward for any riskier investment must be at least 3%, > money creates money, or money is money. i.e. the 3% on the savings account. This interest is forbidden in Islam.

By placing money in an account which pays interest it means money can create money, this means money can act as potential capital. Definition of capital. In a fundamental sense, capital consists of any produced thing that can enhance a person's power to perform economically useful work

1)

Discussion on riba and profit sharing

In Islam we have risk sharing or mudarabah

Profits Capital owner or rab ul maal 2 players Entrepreneurs or mudarib no predetermined ROR Shared

Loss Shared

indicative ROR.

In case of profits, profits are shared as per a pre-agreed ratio (in proportion to risk) In case of losses rab ul maal loses expected profits and possibly all or some capital Mudarib loses expected cash flows from business and reputation.

4)

Risk sharing and risk transferring Originate and dispose credit is forbidden in Islam Returns are justified by taking risks, not avoiding them or passing them on to others.

5)

Sanctity of contracts

Fundamental in Islamic Finance to honour contracts. 6) Materiality of contracts bubbles.

All transactions must be backed by assets or real economic activity. Not based on 7) 8) Shariah approved activities all economic activity must be permissible. Excessive speculation :- Some institutions make a living from speculation.

Example day traders, or short term traders. buying stocks just for short term profits. Investments should be medium to long term investments Cannot buy stocks to drive the prices up. Assumption no single player can influence the market. E.g. Asian Financial Crises. Soros jacked up prices with his buy orders and then dumped his holdings to bring the prices crashing down.. Something to remember a:- In Islam debt is sold at par value. 9) Promotion of social justice Concept of pareto optimum additional benefit for 1unit is justifiable if it is not costing another unit any loss. In Islam additional benefit is meant for all.