Introduction to Islamic Finance

Sami Al-Suwailem
IRTI, IDB 1429H - 2008

Objectives of Islamic Finance

Wealth creation Justice Benevolence

Introduction to IF

Principles of Islamic Finance

Economic transactions are generally acceptable unless otherwise stated Origins of prohibited dealings:
Injustice: Riba Ignorance: Gharar

Introduction to IF

Economic Transactions

Prohibited

Acceptable

Introduction to IF

Riba
All religions prohibit riba Most legal systems put restrictions on interest:
Interest ceiling Ban on compound interest Why?

Introduction to IF

Whats wrong with Riba?

Interest grows faster than wealth
Why?

Debt burden destroys the economy Impossibility of repayment

Introduction to IF

$1 Borrowed at 5% in 1 AD
1000 1,546,318,920,731,950,000,000

1500

60,806,303,788,323,700,000,000,000,000,000

2000

2,391,102,204,613,620,000,000,000,000,000,000,000,000,000

Introduction to IF

Borrow 1 pence at 4% in 1 AD

In 1750 debt equals weight of the globe of gold In 1990 it equals 8190 globes!
Introduction to IF 8

Money & Debt in the U.S.

35,000 30,000 25,000

$billions

20,000

15,000

10,000

5,000

0 1976 1980 1985 1990 1995 2000 2005 2007

M2

Total debt

Introduction to IF

Debt Repayment
Debt exceeds available money Repayment only with new debt Economy is servicing debt
Interest exceeds 70% of exports African countries pay for debt services twice as health-care

Introduction to IF

10

Debt Inverted Pyramid

Debt

wealth

Introduction to IF

11

Restrictions on Debt
E.U. requirements:
Deficit < 3% of GDP Debt < 60% of GDP

Intertemporal Budget Constraint:

The present value of debt go to zero Prevents Ponzi financing

Why this wont work?

Introduction to IF 12

Islamic Solution
Finance is tied to real transactions Finance always serves real economy Return on financing is paired with wealth creation Address debt creation from the start

Introduction to IF

13

Debt in Islamic Economy

Debt

Wealth

Introduction to IF

14

Finance in Islam
Finance is embedded in real transactions Islamic contracts:
Deferred sale, leasing, Salam, Musharakah

Time value is in line with real value Lending is strictly a non-profit activity
Lending vs. financing?

Introduction to IF

15

Riba vs. Deferred Sale

Def. Sale Riba
Not tied to real exchange Not compensated

Debt
Time Value
Introduction to IF

Tied to real exchange Compensated by gains from trade

16

Types of Riba
Debt riba: riba naseeah Incremental riba: riba al-fadhl

Introduction to IF

17

Riba al-Fadhl
Debt Riba consists of: unequal amount + delay Unequal amount = riba al-fadhl Delay = riba al-nassa Each component is prohibited to prevent any possibility of debt riba

Introduction to IF

18

Riba al-Fadhl
Specific types of commodities:
Gold and silver (money) Wheat, barley, date, and salt (staple food)

Introduction to IF

19

Gold Gold
Silver Wheat Barley Dates Salt

Silver Wheat Barley Dates

Salt

20

Introduction to IF

Range of Riba al-Fadhl

Applies to any fungible and necessary commodity
Contemporary example?

What about water?

Introduction to IF

21

Reasons for Riba al-Fadhl

Prevents the possibility of debt riba How? Protects necessary commodities and goods

Introduction to IF

22

The Principle of Similarity

Similarity negates gain from trade Variety allows mutual benefit Diversity is essential for prosperity Stronger similarity imposes stronger restrictions of exchange Riba: imbalanced exchange of similars

Introduction to IF

23

Similarity

Low

High

Locate sale and riba

Introduction to IF 24

Conclusion
Roots of prohibited transactions:
Riba Gharar

Islamic principles promote better growth and more balanced wealth

Introduction to IF

25