Introduction to Islamic Banking and Finance:

Chapter 1

Introduction to Islamic Banking and

Finance
 Subject Aims:
The key aim of this subject is to assist students in
understanding the theory and practice of Islamic banking,
based on the contemporary situations. At the end of the
course, students will be able to:
1. Understand the theory of Islamic banking,
2. Understand the operation of Islamic banking,
3. Identify the products offered by Islamic banks,
4. Evaluate the performance of Islamic banks, and
5. Analyse current issues and problems faced by Islamic banks.
 What is Islamic Banking?
Definition:
“an Islamic bank is a financial institution whose statutes, rules
and procedures expressly state its commitment to the principle
of Shariah and to the banning of the receipt and payment of
interest on any of its operation…” (OIC)
Moreover, the Malaysian Islamic Banking Act 1983, defines an
Islamic bank as
“… a company which carries on Islamic business. Islamic
business means banking business whose aims and operations
do not involve any element which is not approved by the
religion of Islam…”
Thus, Islamic banking is banking that complies with Shari’ah or
Islamic law.
 The Banking Business
1. Bank is an authorized deposit-taking institution (ADI)
2. Facilitates intermediation between savers and investors.
3. Transfer funds from surplus units to deficit units.
4. It manages payments and clearing systems.
Islamic and conventional banking (1 to 4 above + …)
• The prohibition of riba (interest, usury), gharar (excessive
uncertainty) and haram (impermissible) activities.
• The implementation of profit and loss sharing (PLS) principle.
• The emphasis on productivity and real economic activity
(rather than credit worthiness).
 Basis of Islamic Banking and Finance

Figure 1.1: Shari’ah as the Basis of Islamic Banking and

Finance
 Basis of Islamic Banking and Finance
Learning Objective 1.1
Describe the conceptual
basis of the modern
The Qur’an practice of Islamic banking
and finance.
• The first source of the Shari’ah
• General and specific rules on religious, commercial,
political, economic, legal and social norms
• Emphasis on mutual consent and consensus among
consenting parties
• Prohibits exploitative measures:
• Excessive risk or uncertaintly (gharar)
• Usary or interest (riba)
• Prohibits cheating and corrupt practices in the
management of funds
• Does not allow dealings in prohibited products
 Other sources for Shari’ah are Ijma’ (consensus)
and Ijtihad (juristic decision).
• Ijma’ (Consensus) – This refers to teachings in Islam that have
been agreed upon by the early generations of Muslims or
Muslim scholars. These are matters that are established and
leave no room for disagreement in the Shari’ah.
• Ijtihad (Juristic decision) – Ijtihad is applied by the Mujtahid
(Muslim Jurist/Scholar) who does not find the answer clear
cut from the Qur’an or Sunnah. Therefore, they explore into
the Primary sources to find the answer based on their skills of
judgment -maintaining the aims of the Shari’ah- and trying
their best to interpret the intent of the Law Maker.
• Sometimes the word Qiyas (analogy) is used to refer to
ijtihad. Qiyas is used to figure out rulings based on similar
existing rulings by way of analogy.
 Learning Objective 1.2
Explain the historical
development and
Origins and Historical Overview of Islamic conceptual arguments of
Islamic banking and

Banking and Finance finance

• Islamic finance is both a new and old

phenomenon. The history of Islamic finance is
divided into two general aspects:

– The early days transactions (The guiding principles of Islamic

Finance originate from the early days of Islam).

– The modern-day experiments (Experiments in Islamic finance in

Egypt, Malaysia, and Pakistan: the basis of modern Islamic banking and finance ) .
 Learning Objective 1.2
Explain the historical
development and
Origins and Historical Overview of Islamic conceptual arguments of
Islamic banking and

Banking and Finance finance

The Era of the Prophet

The prevailing modes of transactions during this era include:
• Shirkah (partnership) based on profit-and-loss sharing (PLS)
• Al qard Al hasan (benevolent loan)
• Salam (Forward) contract
• Sarf (exchange of money), i.e. gold for gold and silver for
silver at the same sitting
• Ijarah (leasing)
• Trans-regional trade involved trade caravans from Mecca to
Syria and vice versa
 Origins and Historical Overview of
Islamic Banking and Finance
Timeline of Modern-day Experiments of
Islamic Banking and Finance from 1962 to
1975
• Initial Reforms in the Banking Industry in Pakistan in 1962

• Mit Ghamr Local Savings Bank in Egypt of 1963 (“the first modern-day trial of Islamic baking”)

• The Malaysian Pilgrims Savings

Board, Tabung Haji of 1969
(managing savings of prospective
pilgrims by investing in Sharī’ah-
compliant investments)

– The new birth of modern Islamic finance took place in Dubai in 1975 through Dubai Islamic
Bank as the first Islamic commercial bank in the world. At the same time, IDB established and
started Islamic Finance.
 The Islamic Development Bank
Islamic Banking and Finance
The functions of the IDB are:
• To participate in equity capital and to grant loans
• To provide financial assistance to member countries
• To establish and operate special funds for specific
purposes
• To accept deposits and to mobilize financial resources
through Sharī’ah compatible modes
• To promote foreign trade, especially in capital goods,
among member countries
 The Islamic Development Bank
Islamic Banking and Finance
5 pillars of activity
1- Building partnerships between governments, the private sector and civil
society through Public Private Partnerships (PPP).
2- Adding value to the economies and societies of developing countries
through increased skills and knowledge sharing.
3- Focusing on science, technology and innovation led solutions to the
world’s greatest development challenges, through boosted connectivity and
funding, and a focus on the UN’s Sustainable Development Goals.
4- Promoting global development that is underpinned by Sharia complaint
long term sustainable and ethical financing structures, as global leaders in
Islamic Finance.
5- Fostering collaboration between our members nations in a uniquely non-
political environment, as we come together to focus on the betterment of
humanity.
 Origins and Historical Overview of
Islamic Banking and Finance
Dubai Islamic Bank (DIB)
The first fully-fledged Islamic world commercial bank
in 1975. Operates five main business groups:
• Retail banking

• Corporate banking

• Real estate

• Investment banking – Financial advisory to corporations and government.

1. Investment bankers help companies and other entities raise money for expansion and improvement.
2. They may be brought in to manage a company's initial public offering (IPO).
3. They may also prepare a bond offering, negotiate a merger, or arrange a private placement of bonds.

• Proprietary trading investments - Meaning of Proprietary Trading

Also known as "prop trading," this type of trading activity occurs when a financial firm chooses to take advantage
of market activities rather than thin-margin commissions obtained through trading with clients.
 Key 6 principles of Islamic banking
1. Prohibition of predetermined loan repayments as interest
(riba)
2. Profit and loss sharing, which is at the heart of the Islamic
finance system
3. Making money out of money as being unacceptable, with all
financial transactions needing to be asset-backed
4. Prohibition of speculative behavior
5. Only Shariah approved contracts being acceptable
6. The sanctity of contracts

In the News: The Vatican says Islamic Finance

May Help Western Banks in Crisis
“The ethical principles on which Islamic finance is based may
bring banks closer to their clients and to the true spirit which
should mark every financial service,” (the Vatican’s official newspaper
 Sukuk
• Definition of Sukuk: Sukuk are financial instruments similar to
bonds and also shares that are compliant with Islamic law.
• Since their inception in 2002, Sukuk markets have
experienced dramatic growth rates attracting the attention of
investors, analysts and researchers alike.
• Accounting and Auditing Organization for Islamic Financial
Institutions (AAOIFI) defines Sukuk as being: “Certificates of
equal value representing undivided shares in the ownership of
tangible assets, usufructs and services or (in the ownership)
the assets of particular projects or special investment
activities.”
 Sukuk
• Sukuk can play an important part in the development of an Islamic market
and banking system.

• The main advantage of sukuk is to comply with Sharia while boosting the
standard of living in Islamic society and developing these societies’
economies.

• Broadly speaking, compliance with sharia means that:

• any profits derived from these funding arrangements must be derived from
commercial risk-taking and trading only.
• all forms of conventional interest income is prohibited.
• the assets that are subject to the funding arrangement must, themselves,
be permissible (halal).
 Sukuk
• There are three requirements for a Sukuk to be considered in
compliance with the Sharia law .

• First, the certificates must represent ownership in tangible

assets, usufructs or services from revenue-generating firms.

• Second, payments to the investor come from after-tax profits.

• Third, the value repaid at maturity date should follow the

current market price of the underlying asset and not the
original invested amount.
Islamic Banking and Finance around the
world

And many more....

 Islamic Banking and Finance in
Australia

"The LM Australian Alif Fund has been awarded 'Best New Product
2009' at the world's leading Islamic Banking and Finance awards in
Dubai for its innovative approach to Shariah-compliant investment,
beating a shortlist of prominent international Islamic institutions'‘
http://www.lmaustralia.com
Why so much interest in “No Interest” banking? Open Discussion