Islamic Financial System

Abdur Rashid Mirza Lecture no.03 Financial Engineering and Islamic Finance (Product and Services) University of Lahore School of Accountancy and Finance

The Concept of Money

Money is essential for the activity of IFIs. Definitions of money:
Based on fiqh, money is synonym of nuqud, which is defined as a medium of exchange or transaction as well as a measurement of the value of goods or services. Its defined as

everything that performs the functions of money included as a

medium of exchange, a mode of payment, a value store and as a unit of measurement.

The Forms of Money

Commodity
refers to money whose value comes from a commodity. Examples of commodities that have been used as money include gold, silver, large stones. This is basically how it worked: two individuals each possessing a commodity the other wanted or needed would enter into an agreement to trade their goods.

money

Fiat money, any money declared by a government. Most of the world's paper

money is fiat money. Because fiat money is not linked to physical reserves.

Commodity Money
Gold and silver Applied in the Islamic State period In the next development, modified as a gold reserve standard
paper money supported by gold and silver printed only if gold/silver is provided gold standard

Fiat Money
Paper money Not supported by commodity Only supported by government policy Managed money standard Government responsible for the maintaining of the paper value The paper its self has no value actually

Forms of Fiat Money

Cash Non cash

Financial System
Subsystem of economic system; Allows the transfer of money between savers and borrowers; Includes a set of complex and closely interconnected financial institutions, markets, instruments, services, practices, and transactions.

The Importance of Financial System

Crucial to the allocation of resources in a modern economy; Channels household savings to the corporate sector and allocate investment funds among firms; Allows smoothing of consumption by households (Family Unit) and expenditures by firms; Enables households and firms to share risks Has impact on saving, investment, technology innovation, and economic development; Controlling and monitoring managers of firms.

Islamic Financial System

A set of rules and laws, collectively referred to as shariah, governing economic, social, political, and cultural aspects of Islamic societies (Iqbal, 1997); Includes of:
Islamic Financial Islamic Financial Islamic Financial Islamic Financial Supervision Instruments Institutions Rules and Regulations Control and

Basic Principles of Islamic Financial System

Syari principles Tabii principles

Based on Al Quran and As Sunnah Based on the ijtihad and ijma Related to modern issues such as risk management, cash flow management, technical analysis, capital management and so forth.

Syari principles
Prohibition of interest (riba) Prohibition of speculative behavior (maisir) Prohibition of uncertainty (gharar) Risk sharing between suppliers of fund (investor) and entrepreneur Money as potential capital

Purity of contracts

Money becomes actual capital only when it joins hands with other resources to undertake a productive activity
Disclosure of information and maintenance the responsibility contract is duty To reduce information unequal and moral hazard

Shariah-approved activities

Riba
Usury Excess, increase or addition Types:
Riba Riba Riba Riba Riba Riba Al Al Al Al Al Al

Buyu Like Barter System qard Like Banks Loans Jahiliyah Fadhl Nasa Nasia

Riba Al Buyu
Usury of trade Referring to instances where the usury is achieved through a trading transaction as opposed to a loan transaction

Riba Al Qard
Usury on a loan Analogous to the charging of interest on the loan of an asset
Any excess for precondition to the borrower

Riba Al Jahiliyah
The kind of usury practised during the pre-Islamic times among the Arabs Involving a delay in payment of a debt in return for an increase in its amount
Debt payment above the actual amount of the debt because the debtor fails to pay on time

Riba Al Fadhl
Usury of surplus

The usury is achieved unequal exchange of quantity

through quality

an or

An exchange of unequal qualities or quantities of the same commodity simultaneously

The exchange of commodities at the different quality and or quantity

Riba Nasa
Usury of postponement A form of usury in which an exchange of two equal qualities or quantities occurs, but where the exchange is not completed on the spot (i.e. hand to hand). There is thus a postponement in the completion of the exchange. The term is sometimes used interchangeably with 'riba al-nasia'

Riba Nasia
Usury of waiting Used variously by scholars:
some regarding it as being that usury which is achieved solely by effecting a delay in the exchange of two countervalues in a transaction others regarding it as a combination of riba al-fadl and riba al-nasa thus giving rise to both a delay and an unequal exchange of quality or quality

Differences/excess/additional to the exchanged commodity because of the different time of delivery/payment

The Implication of Riba to the Sale and Purchase Transaction

Sale and purchase of similar ribawi commodities should be performed at the same quantity and quality and must be hand to hand. Sale and purchase of different ribawi commodities at the different quantity and quality is permissible but it should be performed on the spot. The exchange of ribawi commodities to non ribawi commodities may not be at the same quantitiy as well as quality. The commodities should be transferred at the same time of aqad. The exchange of non ribawi commodities at the different quality and quantity is permissible but must be delivered on the spot.

Characteristics of Islamic Financial System

Chapra (2000) To achieve the economic welfare through utilizing resources efficiently;
Without producing unlawful product Without great gap between the poor and the rich (Equitable distribution) Without harming current/next generation as well as environment

Stability of currency value Mobilization of saving investment to encourage productive activity To provide effective financial services.