Week 1: An Overview of Islamic Financial Systems

Week 1: An Overview of Islamic Financial Systems

“General Overview … Introduction to the Islamic Financial System … Principles of an Islamic Economic  … haracteristics of an Efficient Financial System & Role of FI’s … Types of Financial Markets … The Role of Ethics in an Islamic Financial System”
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Summaries

  • WeeK 1: An Overview of Islamic Financial Systems > Introduction to the Islamic Financial System > Unit
  • WeeK 1: An Overview of Islamic Financial Systems > Principles of an Islamic Economic System > Unit
  • WeeK 1: An Overview of Islamic Financial Systems > Characteristics of an Efficient Financial System & Role of FI's > Unit
  • WeeK 1: An Overview of Islamic Financial Systems > Types of Financial Markets > Unit
  • WeeK 1: An Overview of Islamic Financial Systems > The Role of Ethics in an Islamic Financial System > Unit
  • WeeK 1: An Overview of Islamic Financial Systems > Sources of Islamic Law & Types of Contracts in IF > Unit
  • WeeK 1: An Overview of Islamic Financial Systems > Types of Transactional Contracts > Unit
  • WeeK 1: An Overview of Islamic Financial Systems > Types of Financing Contracts > Unit

“WeeK 1: An Overview of Islamic Financial Systems > General Overview > Unit

  • Welcome to this introductory course on Islamic banking and finance.
  • This lecture will be an overview of Islamic finance and the main principles behind it.
  • Islamic finance, in general, is a set of moral principles supported by a comprehensive legal system governing and guiding economic and financial activities.
  • Islamic finance provides the necessary principles and guidelines that would help balance these two domains of activities.
  • If you look at modes of finance in Islamic finance we will find for example deferred sale or mark up sale.
  • In this manner at least in principle wealth creation and debt creation they are in harmony, they go hand in hand.
  • Debt is not allowed to grow on it’s own, because the moment we allow debt to grow on it’s own it will go beyond wealth and income and therefore it will be a burden on the economy.
  • The same thing for other instrument of Islamic finance for example leasing and Salam, which is the reverse of deferred sale.
  • Time value is important, is acknowledged in Islamic finance as long as it is coupled and integrated with economic value, so time value and economic value they have to go hand in hand.
  • So we have two types of debt, good debt and bad debt.
  • Economies collapse because of debt, wars were raged because of debt, and catastrophes happened because of debt, but on the other hand the economy cannot function without debt.
  • So we have two kinds of debt, good debt and bad debt.
  • So debt would be good if it is used to finance real economic activities.
  • As long as debt creation and wealth creation are synchronized and going hand in hand this will be…in principle at least…good debt.
  • So let me summarize this overview of Islamic Finance.
  • It emphasizes the balance between market and non-market activities, it integrates finance with real economic activities to achieve sustainable wealth creation.
  • It tells us where to draw the line between good debt and bad debt, it puts finance in its proper position.
  • Everybody agrees that finance is a means to facilitate trade and production.
  • So the question is, how to keep finance truly within its limits and truly to function or to serve its own function properly? In reality, finance is not always a means.
  • Many commenters and many economists and analysts and officials realized that finance became an end of itself rather than a means to facilitate trade and production.
  • So to keep finance within its own boundaries, we have to be sure that finance is integrated with real economic activities.

WeeK 1: An Overview of Islamic Financial Systems > Introduction to the Islamic Financial System > Unit

  • The additional and vital factor is the Shari’ah rules, i.e., the rules of Islamic law which are designed by Allah, the one true God, and operationalized through the Sunnah, which is the prophetic tradition, and made contemporary by Ijtihad, which is independent scholarly reasoning.
  • Upon completing this chapter, you will be able to describe the core principles of the Islamic economic system, identify the characteristics of an efficient financial system, describe the roles of financial institutions themselves, explain the two main tasks for financial institutions, identify the different types of financial markets, and, importantly, explain the role of ethics and how differences, areas of conflict and priorities are managed in the Islamic financial system.
  • They are 1) property rights, 2) property obligations, 3) contracts, 4) trust, 5) individualize rights and obligations, 6) work, 7) wealth, 8) the concept of Barakah, 9) risk sharing, and lastly, competition and cooperation.

WeeK 1: An Overview of Islamic Financial Systems > Principles of an Islamic Economic System > Unit

  • The modern western concept of property rights defines the right to property as the right of an individual to exclude others from using, enjoying, and disposing of material assets.
  • The right to public property, that is the right of an individual not to be excluded by others from the right to use or enjoy material assets, has diminished as market principles have taken over.
  • Islam differs from this concept in two basic principles derived from the need to be just toward the individual and the society.
  • It is he that has given the right of possession of property to humans to enable them to perform their duties and obligations.
  • An individual has rights to the resources owned collectively and the products created by his or her own creative use of those resources without impinging on the collective rights of those resources or products.
  • Individuals may gain property through their own labor or by transfer from another entity.
  • Everyone has the right and obligation to use natural resources to produce goods and services.
  • Every individual has equal rights on the natural resource before these are transformed through work.
  • The individual only gains priority over collective resources in using and enjoying assets created by their own labor.
  • The Shari’ah described two private property obligations that are aligned with its definition of property rights.
  • The second obligation is to avoid a destruction, wastage, squander and misuse of the property.
  • Islam recognizes that some individuals are capable of earning more assets and properties using their greater mental and physical capacities compared to others.
  • These individuals have greater responsibility and obligations than others.
  • Their property rights are considered inviolate when they have been shared their assets and property in the recommended manner.
  • In an economic system, individuals interact with others through transactions facilitated by contracts that may be explicit or implicit.
  • It is the foundation of an individual’s relationship with Allah and with others.
  • Even when we look at the life of the prophet Muhammad, peace be upon him, it also illustrates the importance of trustworthiness in both individuals and within the community.
  • The fifth core principle concerns individual rights and obligations.
  • The Shari’ah holds that the rights of an individual are gained not intrinsically but as a consequence of meeting obligation to Allah, nature, self, and to others.
  • For an individual pursuing one’s economic interests in an obligation, a duty, and finally, a right no one can abrogate.
  • When the ability of an individual increases, his obligation and rights also increases.
  • If an individual lacks the skill to pursue one’s economic interests, the right to economic benefits is not negated.
  • It is negated only if the individual is able but does not perform his obligation.
  • Work is regarded as a right, as a duty, and also as an obligation.
  • The selection of work by an individual should be based on natural skills and talents, technology and personal inclination.
  • Every individual has different talents, so the productivity may differ for everyone.
  • Justice calls for the commensurate return for each and every individual’s work to be based on their productivity.
  • Acquiring wealth can be an individual’s ultimate objective.
  • These include the recognition of rights of others in that wealth, which results from the principle of invariant claim to ownership.
  • Any inability on his part to use the wealth and property can be used to enforce forfeiture of his right to this wealth.
  • Such a structure helps to determine if the individuals will follow the rules or not.
  • It covers all aspects of the individual’s conduct, which includes economic behavior.
  • The tenth and last core principle concerns competition and cooperation.
  • Islam guides individuals to direct their actions and participate responsibly in economic affairs to improve the well-being of society.
  • The individual is responsible for the moral effect of their social actions, including their economic actions.
  • Humans can cooperate and compete amongst themselves for good or for evil.

WeeK 1: An Overview of Islamic Financial Systems > Characteristics of an Efficient Financial System & Role of FI’s > Unit

  • Let us now look at the characteristics of an efficient financial system.
  • The efficiency of a financial system is measured based on how well the savings from surplus saving units are allocated to surplus deficit units that need the funds.
  • Efficiency in mobilization of funds improved on increasing the range of financial assets and instruments.
  • On the basis of this risk return expectations, we can classify the financial system’s efficiency into four categories.
  • Such higher value projects issue financial instruments are involved a lower cost of funds for the issuer.
  • If an instrument or a project is more valuable, the price of the instrument linked with it also increases, a high price for financial instrument, in the case low cost of funds or low rates.
  • If the financial system is working fine, your investment will receive the highest possible return for your tenure, and for the businessman would have received his loan at the lowest possible rates.
  • If a financial institution had adequate information on the project, then the prices and rates will indicate the intrinsic value of financial assets.
  • Let us now look at the roles keyed up by financial institutions.
  • Apart from these roles, there are many different players that help to accomplish the financial system’s overall objectives.
  • Coming to look at the facilitator role of financial institutions.
  • In well-developed financial systems, the surplus deficit units are able to directly offer their investment products to the surplus saving units.
  • In these systems, financial institutions act as facilitators in the flow of funds and help governments and companies to raise funds from their households.
  • Financial institutions help surplus deficit units to design and create securities and then price them and eventually market them to the surplus saving units.
  • In well-developed financial systems, surplus defect units are able to directly offer their investment products to the surplus saving units.
  • In these systems, financial institutions act as facilitators in the flow of funds and they help governments and companies to raise funds from households.
  • Financial institutions who play this facilitating role are also known as investment banks.
  • In less developed financial systems whereby the surplus deficit units do not have direct access to the surplus saving units, financial institutions fill the funding gap by performing the role of an intermediary.
  • Such intermediary financial institutions are commonly known as commercial banks.
  • The two main tasks for commercial financial institutions are that first they mobilize funds from the surplus saving units.
  • Financial institutions offer a variety of financial products to the surplus saving units that align with their requirements and their expectations.
  • In an Islamic financial system, the surplus saving units always need to conform to the Shari’ah.
  • Financial institutions design financial products and services based on the requirements and needs of the governments and companies.
  • Again, the financial products that a bank develops must not include interest.
  • Financial institutions can price their products to surplus deficit units, to factor in the risk that they bear.

WeeK 1: An Overview of Islamic Financial Systems > Types of Financial Markets > Unit

  • Financial intermediaries trade products and securities in different types of financial markets.
  • They are primary and the secondary market, money and capital market, spot and futures market, options market and a foreign exchange market.
  • In the primary market, it trades new and fresh financial products and securities.
  • In the secondary market the primary market buyers sell the products and security they possess before these reach maturity.
  • Secondary markets provide the liquidity for these products.
  • Participants in a spot market trade products for immediate delivery and payment.
  • The spot market is also known as the cash market.
  • On the other hand, the capital market involves long term debt instruments and equity instruments.
  • In the options market, participants in the options market trade stocks, commodities or currencies for conditional future delivery.
  • This market trades either for spot or future delivery.

WeeK 1: An Overview of Islamic Financial Systems > The Role of Ethics in an Islamic Financial System > Unit

  • It does not imply unrestricted freedom to contract.
  • The freedom to contract is subordinate to these other norms, which require specific injunctions.
  • Any contract that involves coercion is, by default, invalid.
  • All forms of transactions and contracts must be free from interest.
  • No form of contracts and transactions must involve excessive Gharar, or uncertainty.
  • Contracts are disallowed under conditions and situations that involve high uncertainty in the view of Islamic scholars.
  • Contracting under excessive uncertainty or Gharar, and uninformed speculation are closely related to gambling.
  • While all business decisions are speculative to some extent, the lack of relevant information or conditions of excessive uncertainty make business speculation closely related.
  • Islam conceives of a free market in which the forces of demand and supply determine prices.
  • Even the regulators should not hinder the process of price formation.
  • Any attempt to affect the prices by creating an artificial surplus/shortage, or Ihtikar , is not permissible by Islam.
  • Attempts to increase prices through the creation of artificial demand, Najash is also not permissible.
  • Historically, there was an oversight inspection team known as al-Hisbah, which would intervene to ensure that the market produced fair and just prices.
  • Darar is a chance that a third party will be adversely affected by the contract between two parties.
  • Sometimes a contract executed with mutual consent between two parties affects the interest of a third party unfavorably.
  • In such a case, the third party is entitled to certain rights and options.
  • Prices are believed to be fair when they result from free interplay of forces of demand and supply.
  • Sometimes the pricing is based on valuation by experts and may be manipulated.
  • In these instances, the gap between the transaction price and the fair price is termed Ghubn Faahish.
  • The right to equal, adequate and accurate information.
  • Islam considers equal, adequate and accurate information as vital for proper functioning of the financial market.
  • Releasing wrong information, hiding vital information, in Arabic as Gish, was misrepresenting parties in a transaction, also known as Jahalah, violates the norms of Islamic ethics.
  • Whilest the Hadith refer to these malpractices refers specifically to commodity transactions.
  • Islamic ethics also requires that this relate to information on expected cashflow and asset valuation as well.
  • Because these are revised continuously with events, Islamic ethics require that all such information should be available equally to all investors.

WeeK 1: An Overview of Islamic Financial Systems > Sources of Islamic Law & Types of Contracts in IF > Unit

  • Maslahah comprises of considerations which are in line with the objectives of Shari’ah and provide benefit or prevent harm.
  • Apart from these potential conflicts in Islamic jurisprudence, there can be a fundamental complex between ethics and the efficiency in the financial systems.
  • Here we find a key difference between Islamic finance and conventional finance.
  • Let us examine now the different types of contracts in Islamic finance.
  • Contracts can be classified into four different categories according to their function and purpose.
  • Transaction contracts, financing contracts, intermediation contracts and social welfare contracts.
  • They are more about the real economic transactions, such as exchange, trade of goods and services.
  • Such contracts generate assets that can further create financing opportunities.
  • They help to generate and extend credit from transactional contracts, provide means to form capital and transfer resources between the investors and entrepreneurs.
  • Financing contracts can be used to provide capital for equity partnerships.
  • They provide the mechanism to execute transactional and the financial contract efficiently and transparently.
  • In these contracts economic agents perform the financial intermediation and other fee-based services for economic activities.
  • These are between individuals and the society.

WeeK 1: An Overview of Islamic Financial Systems > Types of Transactional Contracts > Unit

  • Basic transactional contracts are the exchange and sale of an asset, and the sale of the rights to utilize an asset.
  • These contracts facilitate cash sale, deferred payment sale, deferred delivery sale, sale on order, sale on debt, sale on currency and so on.
  • The contract of sale can be classified using subject or sale and mode of payment.
  • Sale contracts can be of six types when viewed from the subject matter of sale.
  • First one being Bai, the sale of an asset to others for a price.
  • Second one is Sarf, sale by exchange of money for money on the spot.
  • Third, sale by barter, the exchange of goods for goods.
  • The fourth is Bai al Dayn, the sale of debt or liability.
  • The fifth is Bai al Salam, the sale of immediate payment against a future delivery.
  • Lastly number six, Bai al Istisna’a, the sale on order.
  • Sale contracts can be of five types when viewed from the perspective of the mode of their payments.
  • Except for Bai al Salam, this type of payment is applicable to all types of sales.
  • Let us look at the sale of rights to utilize an asset, Ijarah, or a lease.
  • It’s an example of a sale of the rights to utilize an asset.
  • It also means a sale of the usufruct for a specified period.

WeeK 1: An Overview of Islamic Financial Systems > Types of Financing Contracts > Unit

  • Let us now look at the different types of financing contracts.
  • Financing contracts comprise on one hand, of low-risk asset-backed securities, and on the other hand, risky equity financing.
  • Financing contracts are classified into four major contracts.
  • Based on this contract, the financier purchases the goods and supplies them to the entrepreneur.
  • For Murabaha to be valid according to Shari’ah, that contract should involve the original sale, not any existing inventory.
  • In some Islamic countries, the payment of a Murabaha contract is made in installments after delivery of the goods.
  • In this contract also, the financier purchases goods and resells them to the entrepreneur at a higher price.
  • Tawarruq is also known as reverse Murabaha, and this contract involves two separate transactions.
  • It is existing in pre-Islamic times, a contract that was commonly and widely accepted and promoted by the Profit Muhammad, peace be upon him.

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