Chapter 8 Islamic Finance

Chapter 8 Islamic Finance

Chapter 8 – Islamic Finance

Chapter 8

Islamic Finance

Islamic finance may be viewed as a form of ethical investing, or ethical lending, except that no loans are possible unless they are interest-free. Among the ethical restrictions is the prohibition on alcohol and gambling and the consumption of pork. Islamic funds would never knowingly invest in companies involved in gambling, alcoholic beverages, or porcine food products. The economic system of Islam tends to ensure that individuals satisfy basic needs without any distinction. Individuals and society are both important to make a contented and happy economy and society.

Islam prohibits Muslims from taking and giving interest (riba) on any form of loan.

Islam professes to help one another according to principles of goodness and piety (but not to cooperate in evil or malice). In essence, it aims to eliminate exploitation and to establish society by the application of the Shari'ah or Islamic law to the operations of banks and other financial institutions. To ensure compliance to the Shari'ah, Islamic banks use the services of religious boards comprised of Shari'ah scholars.

Islamic finance is a new phenomenon that has proliferated both in Muslim and non-Muslim countries. It has found acceptance from many sections of the society for its interest free and non-exploitative nature. The whole banking system has been Islamized in both Iran and Pakistan. There are some thirty Islamic banks in operation in other parts of the globe, including the Jeddah-based Islamic Development Bank. In addition; there are numerous non-bank Islamic financial institutions. The Islamic Financial System consists of the following:

  1. Islamic Banks – It is a deposit taking and financing institutions, including full-fledged Islamic banks, Islamic subsidiaries and “windows” of conventional banks such as onshore and offshore commercial and investment banks. (an Islamic window is generally defined as part of a conventional financial institution that undertakes Shari’ah compliant deposit-taking, financing, investment and/or fund management activities)
  2. Islamic non-bank financial institutions, including Islamic leasing and factoring companies, finance companies, ijarah and mudarabah companies, Islamic housing cooperatives, Islamic microfinance institutions, credit sale subsidiaries of trading companies and other similar institutions, and private equity/venture capital, as well as institutions managing hajj funds, awqaf, zakah and sadaqah.
  3. Islamic insurance and re-insurance or takaful and re-takaful, operators;
  4. Islamic capital markets and their players, such as brokerage houses, investment banks, etc., as well as fund management institutions including Islamic asset management companies (such as mutual funds/unit trusts, hedge funds, etc.); and
  5. Islamic financial architecture and infrastructure

Islamic Economics

Islamic economics is based on Shari’ah, the Islamic law, which governs secular as well as religious activity. The basic objective of Shari’ah is to ensure general human well-being and socio-economic justice. It teaches that all wealth belongs to Allah and that humans are merely trustees of this wealth, entrusted with it to realize the above –mentioned objectives (Quran: 57:7). The Islamic economic system is based on the teaching that “no one should claim for himself what is basically the creation of Allah or the product of another man’s efforts and skills”. The system is therefore grounded heavily towards social justice. This is the basic difference between Islamic and Western economics. One of the important aims of Islamic economics is that wealth, instead of becoming concentrated in the hands of a few, should be allowed to circulate in society as widely as possible, so that the distinction between the rich and the poor is narrowed down as far as it is natural and practicable.

Islamic Banking

Islamic Banking, popularly known as Interest-free banking is a new system of banking based on the principle that interest would not be charged or paid and the returns would be in the form of profits from trade in which the money lent or borrowed in invested. In order to promote this new form of banking, Islamic Development Bank (IsDB) was set up in 1974 by the Organisation of Islamic Countries in Jeddah, Saudi Arabia.

Islamic banking practices differ from the conventional banking system in the following ways:

(1) The main function of an Islamic bank is investment financing

(2) No fixed interest bearing deposits are available with Islamic banks

(3) Islamic banks do not grant any overdrafts on current accounts

(4) They are permitted to purchase stock on behalf of a client and sell it to him at a profit over the purchase price

(5) Islamic banks would pay an annual wealth tax known as Zakat at some percentage of current assets and other modes of income as determined by the Shari’ah Supervisory Board.

The application and practice in finance based on Islamic principles began in Egypt and Malaysia. The landmark events include the rise and fall of Mitghamr Saving Association based on profit-sharing in a small town in Egypt during 1961-1964 period and the establishment of Malaysia’s Tabung Haji in 1962. Tabung Haji has since flourished and has become the oldest Islamic financial institution in modern times. Islamic banks emerged with the establishment of the Islamic Development Bank (IsDB) in 1974 and Dubai Islamic Bank in 1975.


In Conventional System / In Islamic System
Borrows funds from the depositors paying interest on the liability side of its balance sheet. / Partnership (Mudarabah) or profit and loss sharing arrangement between the bank and the depositors
Lends the funds to the borrowers, charging higher interest on the asset or investment side. / Profit and loss sharing (Musharaka) or trade based financing arrangement (Mubadalah) between the bank and its investment clients
Between the depositors and the bank, there is an iron wall. / Islamic bank entitles the depositors,
(a). To be informed of what the bank does with their money
(b). To have a say in where their money would be invested (Mudarabah-e-Muqayyidah)
The interest or the return is predetermined or fixed in advance / The profit or the return is based on the actual investment outcome
Transactions are financial asset based / Transactions are real asset based

Types Islamic Financing

1. Mudarabah (Passive Partnership): This is a contract between two parties; a capital owner (rabb-al-mal) and an investment manager (mudarib). Profit is distributed between ther two parties in accordance with the ratio that they agree upon at the time of the contract. Financial loss is borne by the capital owner; the loss to the manger being the opportunity cost of his own labour, which failed to generate any income for him.

2. Musharakah (Active Partnership)

A musharakah contract is similar to that of the mudarabah, with the difference that in the case of musharakah both partners participate in the management and provision of capital and also share in the profit and loss. Profits are distributed between partners in accordance with agreed ratios, but the loss must be distributed in proportion to the share of each in the total capital.

3. Diminishing Partnership

This is a contract between a financier (the bank) and a bendficiary in which the two agree to enter into a partnership to own as asset, as described above, but on the condition that the financier will gradually sell his share to the beneficiary at an agreed price and in accordance with an agreed schedule.

4. Murabahah (Sale contract at a Profit Markup)

Under this contract, the client orders an Islamic bank to purchase for him a certain commodity at a specific cash price, promising to purchase such commodity from the bank once it has been bought, but at a deferred price, which includes an agreed upon profit margin called markup in favour of the bank.

5. Ijarah (Leasing)

The subject matter in a leasing contract is the usufruct generated over time by an asset, such as machinery, airplanes, ships or trains. This usufruct is sold to the lessee at a predetermined price. The lesser retains the ownership of the asset with all the rights as well as the responsibilities that go with ownership.

6. A Lease Ending in the Purchase of the Leased Asset

Leasing that ends in the purchase of the leased asset is a financing contract which is intended to transfer ownership of the leased asset to the lessee at the end of the lease agreement. This transfer of ownership is made through a new contract, in which the leased asset is either given to the lessee a gift or is sold to him at a nominal price at the end of the lease agreement. According to a decision of the OIC Fiqh Academy, this second transfer-of-ownership contract should be signed only after termination of the lease term, on the basis of an advance promise to affect such a transfer of ownership to the lessee. Rent installments are calculated in such a manner as to include, in reality, recovery of the cost of the asset plus the desired profit margin.

7. Istisna

Al-Istisna is a contract in which a party orders another to manufacture and provide a commodity, the description of which, delivery date, price and payment date are all set in the contract. According to a decision of the OIC Fiqh Academy, this type of contract is of a binding nature, and the payment of price could be deferred.

8. Salam

Salam is a sales contract in which the price is paid in advance at the time of contracting, against delivery of the purchased goods/services at a specified future date. Not every commodity is suitable for a salam contract. It is usually applied only to fungible commodities.


I / Deposits
Current deposits / Amanah – no return payable
Saving deposits / Mudarabah
Special investment deposits / Mudarabah
II / Trade Finance
Project Finance / Musharakah – Mudarabah - Ijarah
Working Capital Finance / Murabha – Musharakah
III / Agriculture, forestry and fisheries
Production finance for input / Murabha – Salam
Machinery and transports / Ijarah - Murabha – Salam
IV / Treasury
Money market – Liquidity management / Mudarabah with or without allocation of assets – sale or purchase of permissible securities
Fund management / Mudarabah – trading in permissible stocks and Sukuk
V / Personal advances
Consumer durables / Murabha
Automobiles / Ijarah – Murabha
Housing Finance / Diminishing Musharakah – Murabha
Providing cash for personal needs / Salam

Some Special Terms in Islamic Finance

Qard or Qard Al-Hassan: Financing extended without interest or any other compensation from the borrower. The lender expects a reward only from God.

Riba: Literally, increase or addition or growth. Technically, it refers to the” premium” that must be paid by the borrower to the lender along with the principal amount as a condition for the loan or an extension in its maturity. Interest as commonly known today is regarded by a predominant majority or fuqaha to be equivalent to riba.

Sadaqah: An act of charity.

Sukuk: A financial paper showing entitlement of the holder to the amount of money shown on it. The English word “cheque” has been derived from it. Technically, Sukuk are financial instruments entitling their holders to some financial claims.

Takaful: An equivalent to the contemporary insurance contract whereby a group of persons agree to share a certain risk (for example, damage by fire) by collecting a specified sum from each. In case of loss of any one of the group, the loss is met from the collected funds.

Amanah, which refers to deposits in trust. A person can hold a property in trust for another, sometimes by express contract and sometimes by implication of a contract. Amanah entails ‘absence of liability for loss except in breach of duty. Current Accounts are regarded as Amanah (trust). If the bank gets authority to use Current Accounts funds in his business, Amanah transforms into a loan. As every loan has to be repaid, banks are liable to repay full amount of the Current Accounts’.



University of Nizwa / CEMIS / Department .of Management Studies / BUSINESS FINANCE / Dr.Ayoob / Page