Alhozaimy

The Islam
T misation of
o Saudi Arabian n Moneta
ary Agenccy (SAMAA)
and the Financia
al System
m in the Kingdom
K m of Saud
di Arabia,,
E
Experienc
ce from Selected
S Muslim Countriees
By
Yo
ousef Alh
hozaimy – 500204265
MSc. Disserttation to be
e Submitted in Fulfilllment of th
he Requirem
ments for the
t
Deggree of Masster of Scien
nce in Islammic Bankin
ng and Fina
ance
Su
upervised by
Prof. Philip
P Mollyneux
Bangorr Businesss School
Bang
gor Unive
ersity
Bangor,, United Kingdom

K
2009
Electronic
Electroniccopy
copyavailable
availableat:
at:https://ssrn.com/abstract=1572758
http://ssrn.com/abstract=1572758
The Islamisation of Sa
audi Arabian Moneetary Agency (SAMMA) and the Financcial System in the Kingdom
K of Saudi A
Arabia, Experience from
Seleected Muslim Coun
ntries
In the Na
ame of Alllah, the Most Grracious, the
t Mostt Mercifu
ul
|P a g e 2
Youseef Alhozaimy – 500
0204265 14 Septembeer 2009
Bangoor Business Schooll – Bangor Universsity
Electronic
Electroniccopy
copyavailable
availableat:
at:https://ssrn.com/abstract=1572758
http://ssrn.com/abstract=1572758
The Islamisation of Saudi Arabian Monetary Agency (SAMA) and the Financial System in the Kingdom of Saudi Arabia, Experience from
Selected Muslim Countries
Abstract:
One of the most important factors for economic growth, development and stability is
the financial system. The more stable, strong and developed is the financial system in a
country; the more likely is that country's economy to be solid and able to maintain
long‐term growth. This research will seek to establish a link between the theory of the
financial development importance for economic growth and stability on one hand and
the idea of profit‐loss‐sharing (PLS) as an alternative tool to the interest‐based
economy on the other hand. In addition, this research analyses the Saudi Arabian
financial system, its history, features, strengths and weaknesses. Finally, the research
highlights other Muslim countries' experiences with Islamising their financial systems
and economies; as well as the instruments that they have created in order to replace
the traditional economic and financial methods.
Keywords:
Central Bank, Economy, Growth, Islamisation, Islamic Banking and Finance, Islamic
Economics, Islamic Finance, Kingdom of Saudi Arabia, Macro‐Economic, Micro‐
Economic, Muslim Countries, Regulation, Socio‐Economic, and Stability.
|P a g e 3
Yousef Alhozaimy – 500204265 14 September 2009
Bangor Business School – Bangor University
Electronic copy available at: https://ssrn.com/abstract=1572758

Acknowledgements:
In the name of Allah (God), the most Gracious, the most Merciful
Praise is to Allah, the lord of the worlds. And the blessings and the peace be upon the last
messenger of Allah, Mohammed (peace be upon him).
First and foremost, thanks and praise to Allah, the most Gracious and most Merciful.
The research on which this dissertation is based was undertaken at Bangor Business
School, Bangor University, under the supervision of Professor Philip Molyneux. The
author is deeply indebted to Professor Molyneux for having provided this research
opportunity and for his enthusiastic supervision, enlightening inspiration, continuing
encouragement and invaluable technical suggestions throughout the course of this
study.
My special thanks and appreciation are extended to my parents, my wife, my brothers

and sisters, my family and my friends for their prayers, love, encouragement and
support. Without you, my success would not have been possible, thank you all I am
very grateful.
Also, special thanks goes to all the academic and administrative staff and students at
Bangor Business School and Bangor University, my classmates and colleagues.
Last but not least, special thanks are due to the Ministry of Higher Education ‐ Saudi
Arabia and the Saudi Arabian Cultural Bureau ‐ London for your supports and for
provided me this opportunity to continue my Master study.
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Table of Contents
Abstract ..................................................................................................................................... 3
Keywords ................................................................................................................................... 3
Acknowledgements .................................................................................................................. 4
Table of Contents...................................................................................................................... 5
List of Charts, Diagrams and Tables ....................................................................................... 7
List of Abbreviations ................................................................................................................ 8
Chapter One .............................................................................................................................10

Introduction .............................................................................................................................10
1.1. Introduction ................................................................................................................ 10
1.2. The Reasearch Question ............................................................................................ 11
1.3. The Objectives and the Purposes of the Research ................................................... 11
1.4. Research Methods ...................................................................................................... 11
1.5. Research Structure ...................................................................................................... 11
1.6. Conclusion ................................................................................................................. 12
Chapter Two ............................................................................................................................. 13

Overview of the Islamic Economic System and Relevant Literature Review ...................... 13
2.1. Introduction ................................................................................................................13
2.2. Financial Development and Economic Stability......................................................13
2.3. Islamic Economic System ......................................................................................... 14
2.3.1. Interest (Riba, Usury) and Other Prohibitions ..................................................... 14
2.3.2. The Stability and Superiority of the Islamic Financial System ........................... 16
2.4. Issues, Challenges and Other Muslim Countries' Experiences ............................. 18
2.5. Conclusion ................................................................................................................. 21
Chapter Three ......................................................................................................................... 22

Financial Development and Economic Stability .................................................................. 22
3.1. Introduction ............................................................................................................... 22
3.2. The Relationship between Financial Development and Economic Stability ........ 22
3.3. The Impact of Financial Development on the Reduction and the Prevention of
Poverty ..............................................................................................................................24
3.4. Islamic Economic System ......................................................................................... 25
3.4.1 Interest (Riba, Usury) and Other Prohibitions......................................................26
3.5. The stability and Superiority of the Islamic Financial System .............................. 27
3.6. The Role of Islamic Economic and Islamic Financial Institutions on the
Elimination of Poverty......................................................................................................31
3.7. Conclusion ................................................................................................................. 33
Chapter Four ........................................................................................................................... 34

The Economy and Financial System of the Kingdom of Saudi Arabia ............................... 34
4.1. Introduction ...............................................................................................................34
4.2. Economic Background..............................................................................................34
4.2.1. Macro‐Economic Indicators ..................................................................................36
4.3. The Financial Market Structures .............................................................................38
4.3.1. The Saudi Arabian Monetary Agency (SAMA) .....................................................38
4.3.2. The Capital Market Authority (CMA) ..................................................................43
4.3.3. Special Purpose Government Funds .................................................................... 44
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4.4. The Financial Markets ............................................................................................. 44

4.4.1. Saudi Stock Exchange TADAWUL ....................................................................... 44
4.4.2. Sukuk and Bond Market ........................................................................................45
4.5. Banking Sector ......................................................................................................... 46
4.6. Islamic Banks in Saudi Arabia .................................................................................47
4.7. Historical Challenges in the Saudi Banking System.............................................. 48
4.8.Conclusion ................................................................................................................ 49
Chapter Five ............................................................................................................................ 50

Issues, Challenges and Other Muslim Countries' Experiences ........................................... 50
5.1. Introduction ...............................................................................................................50
5.2. Issues and Challenges ...............................................................................................50
5.2.1. Islamic Money Market ............................................................................................ 51
5.2.2. Regulating and Supervising ................................................................................... 51
5.2.3. Shariah Supervisory Board (SSB) .......................................................................... 52
5.2.4. Islamic Liquidity Instruments ............................................................................... 53
5.3. Other Muslim Countries' Experiences.....................................................................54
5.3.1. Malaysia ................................................................................................................... 55
5.3.1.1 The Islamic Money Market ...................................................................................56
5.3.2. Bahrain .................................................................................................................... 61
5.3.3. Sudan ....................................................................................................................... 61
5.3.4. Pakistan...................................................................................................................63
5.3.5. Iran ..........................................................................................................................67
5.4. Islamic Organisations .............................................................................................. 69
5.5. Conclusion ................................................................................................................. 71
Chapter Six .............................................................................................................................. 72

Conclusions and Recommendations ..................................................................................... 72
6.1. Introduction ............................................................................................................... 72
6.2. Conclusions and Recommendations ....................................................................... 72
6.3. Limitations and Further Research ........................................................................... 75
References ............................................................................................................................... 76
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List of Charts, Diagrams and Tables:
Chapter 3
Diagram 3.1 The Flow of Funds among the Islamic Financial System 33
Chapter 4
Chart 4.1 Saudi Export of Crude Oil by Destinations 2007 36
Chart 4.2 The Saudi Arabian Liquidity and Risk Detector 46
Islamic Banks Vs Conventional Banks in Saudi Arabia 2008 (billion
Chart 4.3 49
US$)
Diagram 4.1 Domestic Money Creation Process in Saudi Arabia 44
Diagram 4.2 Banks in the Kingdom of Saudi Arabia 47
Selected Macro‐Economic Indicators for Saudi Arabia from 2000 to
Table 4.1 38
2008
Table 4.2 Saudi Arabia Bank Supervisory Guiding Policies 41
Table 4.3 Saudi Banking Regulatory Checklist 42
Table 4.4 SAMA's Monetary Policy Instruments: Comparative Analysis 43
Saudi Arabian Market's Capitalisation and the Index Movements
Table 4.5 46
from 2000 to 2008
Consolidated Balance Sheet of Commercial Banks in Saudi Arabia
Table 4.6 48
(billions US$)
Chapter 5
Saudi Arabia and Selected Muslim Countries' GDP, Constant Prices
Chart 5.1 56
(annual percentage change)
Diagram 5.1 The Islamic Interbank Money Market within the Financial System 58
SBP's Modes of Financing for Various Transactions 66
Table 5.1
67
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List of Abbreviations:
AAOIFI Accounting and Auditing organization for Islamic Financial Institution

ATM Automated Teller Machine
BCD Banking Control Department
BIMB Bank Islam Malaysia Berhad
BMA Bahrain Monetary Agency
BNM Bank Negara Malaysia
BNNN Bank Negara Negotiable Notes
Cap Capitalisation
CBI Central Bank of the Islamic Republic of Iran
CII Council of Islamic Ideology
CMA Capital Market Authority
CMC Central Bank Musharakah Certificate
CMP Commodity Murabahah Program
CPO Crude Palm Oil
CRR Cash Reserve Ratio
etc et cetera
FAO Food and Agriculture Organization of the United Nations
FDI Foreign Direct Investment
FRS Fixed Return Scheme
FSC Federal Shariah Court
FSD Financial Sector Development
GCC Gulf Cooperation Council
GCIBFI General Council for Islamic Banks and Financial Institutions
GDP Gross Domestic Product
GIC Government Investment Certificates
GII Government Investment Issue
GMC Government Musharakah Certificate
HBFC House Building Finance Corporation
IAB Islamic Accepted Bills
IBA Islamic Banking Act
IBS Islamic Banking Scheme
ICCS Islamic Cheque Clearing System
ICP Investment Corporation of Pakistan
IDB Islamic Development Bank
IFSB Islamic Financial Services Board
IIFM International Islamic financial Market
IIMM Islamic Interbank Money Market
IIRA Islamic International Rating Agency
IMF International Monetary Fund
INDC Negotiable Islamic Debt Certificate
INI Islamic Negotiable Instruments
INID Islamic Negotiable Instruments of Deposit
|P a g e 8

IPDS Islamic Private Debt Securities

IS‐LM Investment Saving / Liquidity preference Money supply
KSA The Kingdom of Saudi Arabia
LIBOR London Interbank Offered Rate
LLR Lender of Last Resort
LMC Liquidity Management Centre
M3 Broadest Type of Money
MII Mudarabah Interbank Investment
MOF Ministry of Finance
n.d. No Date
NCB The National Commercial Bank
NHM Nederlands Handel‐Maatschappij
NIT National Investment Trust
ODA Open Deposit Account
ORR Official Repurchase Rate
PIRI Prudential Information and Regulatory Framework
PLS Profit Loss Sharing
PTC Participation Term Certificates
REPO Repurchase Agreement
RRR Reverse Repos Rate
RRR Reserve Requirement Ratio
SAGIA Saudi Arabian General Investment Authority
SAIBOR Saudi Arabia Interbank Offered Rate
SAMA Saudi Arabian Monetary Agency
SAR Saudi Arabian Riyal
SBBA Sell and Buy Back Agreement
SBP State Bank of Pakistan
SLR Statutory Liquidity Ratio
SPTF Skim Perbankan Tanpa Faedah
SSB Shariah Supervisory Board
TADAWUL Saudi Stock Exchange
TASI Tadawul All‐Share Index
UAE United Arab Emirates
US$ United States Dollar
VRS Variable Return Scheme
WEO World Economic Outlook
WTO World Trade Organisation
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1. Chapter One – Introduction
1.1. Introduction:
Since the mid 1990s, financial and economic crises have been as ghosts chasing,
threatening nations' economies, and the welfare of people. Dozens of economists,
finance and business scholars or researchers have strived to build the perfect system to
achieve the aim of economic stability. Although, the world has all the factors and the
theories required for success, indecision and the failure to co‐operate appear to
prevent that achievement. The world is suffering from economic crises which
sometimes lead to political conflicts, wars, famine and poverty. According to the FAO
(2009), "one sixth of humanity is undernourished ‐ more than ever before." In
addition, the consequences of financial failure lead to instability and imbalance in
economies; increases or decreases inflation which affects the value of money and
people's wealth; changes exchange rates, changes commodity and stock prices; and
influences the level of unemployment, all of which affect countries' security. In
addition, society suffers other crises such as low income for individuals which might
lead to a rise in crime rates, high rates of divorce, mental illness, drug addiction and
suicide among other social problems.
Current economic theories have resulted in the vast majority of economies operating
banking systems which are mainly based on the principle of paying interest (usury,
riba). However, greed, the desire to increase wealth and competition are the main
driving forces behind this system. All too often economic boom would instigate a
scenario in which a financial disaster loom on the horizon to destroy all of the success.
This is essentially the situation faced in 2009, as one of the biggest and worst financial
crises affects the whole world, driving the world into the worst recession and economic
slowdown since the 1930s. Despite the fact that the financial crisis has affected most of
the various financial and industrial sectors, there remains one financial sector that has
not been affected to the same extent as the rest. That is the Islamic banking sector,
which is based on the principles of the Islamic law (Shariah). Islamic law or Shariah
prohibits anyone to benefit from various forms of usury and forbids many other
transactions that were among the reasons behind the financial collapse, such as deals
with debts, speculation, gambling and uncertainty among others. The Islamic financial
idea is not a new or invented knowledge; from the earliest time of Islam, it has been
| P a g e 10

used in business based on the Quraan and the prophet's Sunnah. However, the new
idea of Islamisation traditional financial activities were founded in the 1970s; in Egypt
where the first Islamic bank was set up in a small village, which known as Bank Faisal.
Today, the whole world has begun to pay attention to the opportunities afforded by
Islamic banks. At present, they have over $500 billion in total assets. Islamic banks and
the idea of the Islamic economy are based on the principle of profit‐loss‐sharing as a
real and major alternative to interest payments.
1.2. The Research Question:
Should we continue with the traditional (conventional) central bank system and
financial system in the Kingdom of Saudi Arabia or change it into a fully‐fledged
Islamic or dual system by adopt Islamic principles?
1.3. The Objectives and Purposes of the Research:
The objectives behind this thesis are to answer the research question, and firmly
establish what the best and most stable option is for the economy. Also, the study aims
to understand the real relationship between the financial system and the economy.
Finally, the research finds alternative methods that comply with the Islamic law that
may be used instead of the traditional methods in the financial and economic systems.
1.4. Research Methods:
The research is based mainly on extensive theoretical research, drawing on the

previous related literatures. In addition, selected Muslim countries' financial and
economic profiles are featured in addition to that of Saudi Arabia.
1.5. Research Structure:
The structure of this research is as follows: Chapter 2 provides a review of the

empirical literature. Chapter 3 introduces the concepts of financial development and
economic stability. Chapter 4 introduces the specific features of the economy of the
Kingdom of Saudi Arabia. Chapter 5 addresses the core issues and challenges, before
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considering the experiences of other Muslim countries with Shariah‐based finance.

Chapter 6 summarises the findings and offers conclusions.
1.6. Conclusion:
This chapter has introduced the research topic and the aims of this study. The research
question was given, followed by the objectives and the purposes of the research. The
research methods and research structure were then briefly discussed. The following
chapter will provide a review of the relevant empirical literature upon which this
dissertation is built.
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2. Chapter Two – Overview of the Islamic Economic System and Relevant

Literature Review
2.1. Introduction:
Only a relatively small number of studies have focused specifically on the subject of
Islamisation. Therefore, this chapter presents an overview of Islamisation through an
intensive analysis of the relevant empirical and theoretical literature reviews as
follows.
2.2. Financial Development and Economic Stability:
Both theoretical and empirical researches have illustrated the importance of financial
sector development (FSD) for a country's economy. Also, studies have provided
evidence regarding the relationship between financial system development and
economic stability and growth; those studies have included both time series and cross
section data. The Department for International Development in the UK introduced
papers about the importance of FSD for economic growth and the impact that FSD can
play in the reduction and the prevention of poverty. (Seers, 1969; Levine and Zervos,
1996; Sen, 1999) did similar works; all of which described the chief purpose of any
financial system in any country as being to diminish poverty. The financial sector team
has shown results of the theoretical and the empirical side also. (The Department for
International Development, 2004) defined the meaning of the financial sector, drawing
on previous research papers on many studies such as that by (Levine, 1997).
Likewise, other studies have shown a positive relationship between financial sector
development and economic growth. First, (Goldsmith, 1969) took around 35 countries
for the period between 1860 and 1963 to prove the relation between economic and
financial development over the long‐term horizon. (King and Levine, 1993a, b, c; Gelb,
1989; Gertler and Rose, 1994; Roubini and Martin, 1992; Easterly, 1993; Cameron, 1976)
among others, found a positive relation, especially in the long‐term. Furthermore,
(Levine et al., 2000) conducted research which supported the earliest studies. In
addition, (Zingales, 2003) observed a positive effect on economic growth. Moreover,
the quality of the financial system could save the country's economy from economic
and financial shocks. That is what the Vice Chairman and President of Citigroup
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International, Stanley Fischer, suggested at a presentation. He said, "a weak financial

system not only makes a country open to international capital flows more vulnerable
to crisis, but also exacerbates the costs of any financial crisis that does occur." Fischer
(2003, p.1). Besides, he gave an example of how the Brazilian financial system's
strength had helped the country's economy to ride out the 2002 crisis.
Furthermore, historical studies confirm the relationship between the financial system
and economic development. (Bagehot, 1873) wrote that the reason behind the
manufacturing revolution in England was the country’s well organised capital markets.
Next, one of the most important studies was Schumpeter's contribution on the same
topic. His basic idea said that what caused economic growth was financial
development, "the banker… is not so much primarily a middleman in the commodity
purchasing power as a producer of this commodity… he stands between those who
wish to form new combinations and the possessors of productive means. He is
essentially a phenomenon of development, though only when no central authority
directs the social process. He makes possible the carrying out of new combinations,
authorises people, in the name of society as it were, to form them. He is the ephor
(overseer) of the exchange economy." Schumpeter (1934, p. 74). More to the point,
(McKinnon, 1973; Shaw, 1973) published their books about financial repression which
means a government buy foreign bonds in an effort to sterilise currency. It affects the
size and quality of investments. The foundation for it is that decreased interest rates
will improve investment, savings, and therefore growth. Based on this idea a study was
published by (Fry, 1995).
2.3. Islamic Economic System:
2.3.1. Interest (Riba, Usury) and Other Prohibitions:
Above and beyond, one of the key elements in the financial sector is the interest
payments that the traditional financial or economic system is predominately based on.
This has been defined by religious Muslim scholars as well as people with a
background in economics and finance such as, (Maudoodi, 1961; Siddiqi, 1980) as Riba
or Usury. In addition, Western religious scholars and scientists have written about
interest and defined it as usury including (Mills and Presley, 1999). In addition, other
religions had condemned it. According to (Chapra, 2007), the world's four major
religions have prohibited interest riba, collectively representing more than 68 per cent
| P a g e 14

of the world's population. On the other hand, quite a number of theorists argue in
favour of treating interest as riba as mentioned in the Quraan such as (Rahman, 1969).
Alternatively, El‐Gamal (2001a, pp.3‐4) gave another angle about riba, "not all interest
is the forbidden riba and not all riba is interest." He also illustrated the reasons
empirically. Since, Shariah prohibited dealings in any shape with interest (riba) in
addition to other things such as uncertainty (Gharar), speculation or gambling (Maisir)
and Haram industries (Iqbal and Molyneux, 2005a).
Furthermore, in addition to the religious reasons there are other reasons behind those
prohibitions and definitions. First, (Chapra, 1985) has offered several reasons and
definitions for the various types of riba. Again, he debated interest and how it could
harm the economy in one way or another and other socio‐economic reasons. Besides,
many other Islamic researchers mentioned the same idea. For instance, (Siddiqi, 2004)
wrote about five reasons for the riba prohibition. In Chapra's discussion, he mentioned
other views that could be the causes of the one hundred financial economic crises in
the past 35 years such as "something is wrong with the global financial system." Stiglitz
(2003, p.54). However, Dr. Chapra's statement regarding interest or riba as a reason
behind financial system collapses was "the result may be even better if credit is
confined primarily to the purchase or lease of real goods and services." Chapra (2007,
p.181). (Khan, 1989) looked into the influence of the prohibition of interest on the
economy and what problems could it cause. Using mathematical methods, he
compared the Islamic financial system based on a variable return scheme (VRS) with
the conventional financial system based on a fixed return scheme (FRS). His results
demonstrated that the Islamic financial system is superior to a conventional financial
system. Second, the reasons behind the prohibition of uncertainty (Gharar), according
to (Iqbal and Molyneux, 2005a) there are three views in the definition of Gharar,
(Dhareer, 1997) which supported Ibn Abidin's definition, the Zahiri School that
supported Ibn Hazm and the third is a combination between the two views as Al‐
Sarakhsy defined it. Additionally, some identified Gharar as the way to trade in risk
(El‐Gamal, 2001b), linking it with an economic explanation. Al‐Suwailem (1999, p.61)
endeavoured to set the idea to identify and measure gharar in exchange, as "a gharar
transaction is equivalent to a zero‐sum game with uncertain payoffs."
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2.3.2.The Stability and Superiority of the Islamic Financial System:
An Islamic financial or economic system is defined as a system not based on interest

(riba) and instead of that, replaces the interest component with a profit‐loss‐sharing
(PLS) scheme. From the early stage of the appearance of Islamic banking and finance
knowledge Muslim scholars and people with Islamic finance background such as
(Maudoodi, 1961; Siddiqi, 1980; Uzair, 1978), have been supporting the idea of using
and establishing the Islamic financial system under the two tiers PLS concept.
According to Siddiqui, the PLS model based on Mudarabah and Musharakah, that
between financial institutions and fund suppliers on the one hand, and on the other
hand between financial institutions and fund users. Thus, different Muslim countries
had taken this suggestion and converted their economies and financial systems into
the Islamic system such as Pakistan, Sudan and Iran. Other countries enhanced their
systems by setting up an Islamic financial system in addition to their original
traditional systems, such as Malaysia and Bahrain.
Nevertheless, the issue to confirm that interest affects the economy as a tool in the
conventional financial system is one of the challenges facing Islamic financial system
researchers. Moreover, (Allais, 1993) noted interest payments as a reason for instability
in the financial system. (Fardmanesh and Siddiqui, 1994) applied a new approach to
show the effects of interest on the actions of commercial financial institution, which
make the conventional system instable. They argued that a PLS system would be more
stable by influencing the actions of financial institutions. They depend in their study
on Lavoie’s (1986‐87) model based on Hyman Minsky’s hypothesis. All these concerns
have come true in the ongoing turmoil and today we face one of the worst economic
slowdowns in history.
Other Islamic researchers have striven to develop models for the Islamic financial
system, Islamic banking and macroeconomic models for an Islamic economy.
Generally, PLS models were based on similar lines to the IS‐LM model or other related
conventional macro and monetary economics. The leaders to adopt this idea were
(Khan, 1986; Khan and Mirakhor, 1986; Siddiqui and Zaman, 1989a, b; Anwar, 1987;
Zangeneh, 1995). Despite the fact, Western economists mentioned such alternative
system for the current traditional system, therefore such idea is not an alien them,
(Fisher, 1945; Simons, 1948; Friedman, 1969), all of them had mentioned such system
| P a g e 16

(Khan, 1986; Siddiqui, n.d.). To sum up, out of these models a financial system founded
in a profit and loss sharing model would not create any difficulty for carrying out the
conventional monetary policies of controlling the money supply for price stabilisation
or other macroeconomic goals. Further, the Islamic financial system based on a profit
and loss sharing method would be more stable, secure and steady. Plus it has been
shown that the Islamic financial system leads to a more desirable distribution of
income. On the other hand, according to Shamim Ahmad Siddiqui Islamic countries
that supposedly took steps to Islamise their economies and financial systems instead
have become more reliant on the traditional financial system and the Western
economical theories. "There has been a phenomenal growth in the number of Islamic
banks all over the world but the lack of a profit and loss sharing Islamic banking (that I
prefer to popularise with the acronym PALSIB) failed to necessitate any significant
change in monetary policy and the required research to formulate or evaluate new
policies." Siddiqui (n.d., p.236).
Emphasis on the stability of the Islamic financial system was the key point that all the
Islamic researchers pointed out. For example, (Iqbal and Khan, 1981), stressed that the
Islamic economic system has inbuilt forces to ensure stability. Also (Siddiqi, 1982)
confirmed that replacement of the rate of interest by profit‐sharing ratios will not
undermine the economy; he proved that to create that system will also guarantee and
improve resource allocation which should drive justice and fairness of wealth
distribution. Nevertheless, the opposite point of view was addressed by (Khan, 1981),
who argued that there is no need to adjust the current financial system or to doubt the
stability of the economic system. Also, (Uzair, 1980) pointed to the issues of using PLS
ratios in Islamic system. For that reason, (Siddiqui, n.d.; Iqbal and Khan, 1981), clarified
and gave justification for the success of the newly introduced system.
Recently, (Al‐Suwailem, 2007) has prepared research papers about Islamic economics,
a framework and a research tool. He has shown the framework of an Islamic economy
based on the complexity theory with the tool of agent‐based simulation, and how such
a framework related to the neoclassical theory could be more stable for an Islamic
economy than the traditional economy. He also has shown examples of how riba,
markup finance and Zakah could affect economic performance. In addition, Čihák and
Hesse (2008, p.2) prepared an empirical analysis to examine Islamic banks and
financial stability. In their paper, they found "evidence covering individual Islamic and
| P a g e 17

commercial banks in eighteen banking systems with a substantial presence of Islamic

banking. They found that (i) small Islamic banks tend to be financially stronger than
small commercial banks; (ii) large commercial banks tend to be financially stronger
than large Islamic banks; and (iii) small Islamic banks tend to be financially stronger
than large Islamic banks, which may reflect challenges of credit risk management in
large Islamic banks. It was also found that the market share of Islamic banks did not
have a significant impact on the financial strength of other banks." Last but not least,
(Zubair, 1985) investigated the economics of the PLS ratio at the macro level.
Finally yet importantly, other areas covered by many researchers regard the new
system the PLS system. First, savings and investment under the PLS system, (Haque
and Mirakhor, 1987a, b) produced brilliant attempts to show the impact of the PLS
system on investment and saving. In addition, (Siddiqui and Zaman, 1989a) had results
suggested that saving and investment under the PLS system are higher than with the
traditional system. Others showed more research related to this subject and their
results were the same such as, (Bashir and Darrat, 1992; Bashir, et al., 1993). However,
the effect of the PLS system on saving and investment was mentioned by (De Rosa,
1986), who argued that the lack of a risk‐free asset class may lead to high risk that
could be harmful to public saving and investment, thereby hindering the country's
economic development. Second, how capitalism, socialism and Islamic economic
systems address the basic economic problems; determination of priorities, allocation
of, distribution of income and development.
According to Zaman who commented on Dr. M. Iqbal’s contributions, the major

difference between conventional finance and Islamic financial systems and their role in
the economy is that the first is mainly based on greed and competition. Nevertheless,
the Islamic system is founded on generosity and cooperation. Conventional banks
focus specifically on credit worthiness, while Islamic banks are more concerned about
the soundness of the project in which they invest (Zaman, n.d.).
2.4. Issues, Challenges and Other Muslim Countries' Experiences:
Generally, one of the duties for conventional or Islamic central banks is to guarantee
the stability of the country's financial system. Although, unlike conventional financial
institutions, Islamic financial institutions do not need the same level of supervision.
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This idea based on research conducted by (Errico and Farrahbaksh, 1998; El‐Hawary et
al., 2004) both of which listed features of Islamic financial institutions that mimic the
conventional financial institutions' regulations, "moral hazard considerations,
safeguarding the interests of demand depositors, systemic considerations and Shariah
compliance." Solé (2007, pp.15‐16). More to the point, the functions of Islamic central
banks are "the Islamic central bank should be responsible for the issue of currency and,
in coordination with the government, for its internal and external stability." Chapra
(1985, p.147); he also mentioned other duties. However, the need for an Islamic body in
the financial system is one of the urgent needs; many authors have written about this
subject. According to El‐Hawary et al. (2007, p.789), "El Sheikh (2000) mentions,
among others, the widely held view by Islamic jurists . . . that Islamic banks should not
be regulated or supervised by any authority". Also, (Chapra and Khan, 2000) argued for
it and they advised four reasons for the regulation of Islamic financial institutions:
systemic considerations, protecting the interest of depositors, ensuring compliance
with Shariah and the integration of IFIs in the international financial system. On the
other hand, there are risks from the absence of Islamic regulators, according to El‐
Hawary et al. (2007, p.785) "five broad risk categories: transaction, business, treasury,
governance, and systemic risks. The following focuses on risks specific to IFIs: (a)
displacement risk; (b) quality of management; (c) harmonization of the institutional
environment; (d) liquidity management, and (e) counter‐party risk."
Turning to the implications of Islamic central bank based PLS system in an open
economy and open market operations, among the first to explore this area were,
(Mirakhor and Zaidi, 1992) who sought to examine the case of PLS working in an open
economy without a fixed rate of interest. Second, (El‐Gamal, 1999) discussed in his
paper the differences between Islamic jurists in different Muslim countries and how
this issue affects the acceptance of government papers, as one of the tools for the
central bank to control the financial system in a country. Also he mentioned the
related laws in Islam which rule the trade of government papers, the different
government papers that are accepted in Islamic countries, and their effectiveness in
carrying out open market operations.
On the subject of types of financial systems, there are three types operational in
Muslim countries. The first of these is the fully‐fledged Islamic financial system such
as that in Iran, Pakistan and Sudan. Those countries have converted their systems into
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interest‐free economies. Secondly, there are those countries that operate with dual
financial systems both conventional and Islamic, such as Bahrain and Malaysia. They
have established Islamic institutions to supervise and regulate the financial activities in
their countries side by side with the regular institutions. Thirdly, the majority of
Muslim countries such as Saudi Arabia, UAE, Egypt and others are using the
conventional financial system. They still have the traditional systems and there are no
special Islamic bodies in their system. However, even those countries without the
presence of an official Islamic authority in their financial system do host Islamic
financial institutions, which are supervised by the central bank under the traditional
system. Some of these are among the largest Islamic banks, for example Saudi Arabia
with one of the largest Islamic banks in the world, Al Rajhi Bank (Schmith, n.d.).
As with any financial system, Islamic financial systems need three fundamental
elements in order to be viable (Iqbal and Molyneux, 2005a). First, "Iran’s transition
towards a fully Islamic financial system started with the enactment of the 1983 Usury
Free Banking Law, which abolished interest‐based banking operations." Solé (2007,
p.13). Second, "Sudan pursued the full Islamisation of its financial system with the
promulgation of the 1992 Banking Law, which aimed to eliminate interest from
banking, as well as from all government transactions." Solé (2007, p.13). Third, "in
some instances, the results of this coexistence have been remarkably beneficial, such as
in Bahrain and Malaysia. In both cases, the presence of a dual system has given these
nations a substantial competitive edge to establish themselves as well‐diversified
international financial hubs, appealing to both Islamic and conventional investors."
Solé (2007, p.13). Finally, in 1977, Islamisation of the banking and financial system of
Pakistan was started with the aim of eliminating interest payments from the
operations of financial institutions and the country's financial system. Other authors
wrote about each country's experiences, the advantages and disadvantages of their
respective stances, and the instruments that they employ in their system.
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2.5. Conclusion:
This chapter has presented an overview of the subject through an intensive analysis of
the relevant empirical and theoretical literature, which involved firstly, literature
regarding the relationship between financial development and economic stability and
growth. Secondly, literature regarding the Islamic economic system that covered the
prohibition of interest payments and other prohibitions with the reasons behind those
prohibitions, as well as the stability and superiority of the Islamic financial system
were addressed. Whereby, the need to have an alternative system to the conventional
system is needed due to the instability affection that might caused by the interest as a
tool. On the same time, the Islamic system has been superior to the traditional system.
Finally, the chapter covered the literature regarding the key issues, challenges and
other Muslim countries' experiences. The following chapter discusses the main theory
of the relationship between financial development and economic stability and growth
in detail and shows why some believe that the Islamic economic system should replace
the current economic system.
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3. Chapter Three – Financial Development and Economic Stability
"Now the company of those who believed were one of heart and soul, and no one said
that any of the things which he possessed was his own, but they had everything in
common" Acts of the Apostles 4:32, Holy Bible.
"Economics is about people not curves." Laibman (2001).
3.1. Introduction:
There are differences between the conventional and Islamic financial systems, both at
the micro and macro levels. Therefore, the first phase of this chapter discusses two
ideas, vis., the relationship between financial development and economic growth and
stability; and the impact of financial development in the reduction and the prevention
of poverty. The second phase of this chapter is linked to the first phases' ideas with the
ideas of the Islamic financial system and the Islamic economy, as the appropriate,
stable, secure and superior system; through covering the meaning, the objectives, and
the role of the Islamic financial system within the economy.
3.2. The Relationship between Financial Development and Economic

Stability:
The literature review in Chapter 2 identified three core different views concerning this
matter. The first view goes to put a positive relationship, to consider that there is no
economic growth without financial development. This set of ideas dates back to
Bagehot (1873, pp.3‐4) who started the fundamental foundation to this view as the first
and the oldest study. "We have entirely lost the idea that any undertaking likely to pay,
and seen to be likely, can perish for want of money; yet no idea was more familiar to
our ancestors, or is more common in most countries. A citizen of London in Queen
Elizabeth’s time … would have thought that it was no use inventing railways (if he
could have understood what a railway meant), for you would have not been able to
collect the capital with which to make them. At this moment, in colonies and all rude
economies, there is no large sum of transferable money; there is no fund from which
you can borrow, and out of which you can make immense works." Subsequent studies
supported his beliefs, including those of (Schumpeter, 1911; Goldsmith, 1969;
McKinnon, 1973; Shaw, 1973; Cameron, 1976; Gelb, 1989; Roubini and Martin, 1992;
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Easterly, 1993; King and Levine, 1993a, b; Gertler and Rose, 1994; Odedokun, 1996;
Levine et al., 2000; Zingales, 2003).
The Department for International Development (2004, p.6) defined the meaning of the
financial sector as, the whole‐sale market, all banks and financial institutions,
governmental financial institutions (including the central bank), stock exchanges and
other financial institutions; and one of their descriptions to the word develop is "the
regulation and stability of the financial sector may improve." They have relied in their
papers on many studies such as (Levine, 1997), who classified the identification of the
five basic functions of financial intermediaries, and how they play their role in
achieving wider economic growth. Those five basic functions are:
1) Savings mobilisation,
2) Risk management,
3) Acquiring information about investment opportunities,
4) Monitoring borrowers and exerting corporate control,
5) Facilitating the exchange of goods and services.
An alternative view is that financial development is regarded as a relatively

unimportant element in economic growth. This was the finding of research conducted
by (Robinson, 1952; Lucas, 1988; Stern, 1989). "I will also be abstracting from all
monetary matters, treating all exchange as though it involved goods‐for‐goods. In
general, I believe that the importance of financial matters is very badly over‐stressed in
popular and even much professional discussion and so I am not inclined to be
apologetic for going to the other extreme. Yet insofar as the development of financial
institutions is a limiting factor in development, more generally conceived I will be
falsifying the picture, and I have no clear idea as to how badly. But one cannot theorise
about everything at once. I had better get on with what I do have to say." (Stern, 1989
p.6).
The third view contrasts sharply with the first view, suggesting a negative relationship
between financial development and economic growth. Examples of those who follow
this aspect are (Van Wijnbergen; 1983; Buffie, 1984). Similarly, (Xu, 2000) showed on
empirical base that there is no positive relationship for financial development on
economic growth. Finally, (Neusser and Kugler, 1996; Berthelemy and Varoudakis,
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1998; Ram, 1999; Sinha and Macri, 2001), found that it was not possible or easy to state
the relationship between those two variables due to independent factors’.
"Saudi Arabia’s economy ranks third in the world in terms of macroeconomic

stability." SAGIA (n.d.a). Based on the economic theories concerning the relationship
between financial services development and economic growth, theorists argued
whether the growth of financial institutions was just for the reason to supply the needs
and demands of society and their financial needs, or because financial institutions
were prompting changes themselves. Therefore, "earlier literature on Saudi banking
development suggested that Saudi banking followed the passive or demand‐following
approach, but that more recently Saudi banks have been following a supply‐leading
approach, especially by introducing electronic banking and investment products."
Ramady (2005, pp.111‐112).
3.3. The Impact of Financial Development on the Reduction and the

Prevention of Poverty:
Poverty reduction is one of the fundamental anxieties in all countries worldwide

regardless of whether the country concerned is developed or not. Thus, the wealthy are
expected in some way to help the others to live in a sustainable manner, sharing their
wealth with them and creating the business opportunities to give them jobs. The
Department of International Development in the UK has an approach to inspiring
their policy framework that is called Pro‐Poor Growth, which has four pillars all aimed
at reducing or preventing poverty. They rely on studies performed by (Seers, 1969;
Levine and Zervos, 1996; Sen, 1999), who agreed that the chief purpose of any financial
system and economy in any country is to diminish poverty. The DFID (2004, p.1)
explains the meaning and the aim of financial development as "particularly important
from a poverty reduction perspective, more of the population may gain access to
financial services." Moreover, how could financial development play a part of
diminishing poverty? It could be done directly or in‐directly through numerous ways:
• By assurance of credit availability which "can also be an important factor in the

creation or expansion of small businesses, thus generating employment and
increasing incomes" DFID (2004, p.2).
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• By reducing the vulnerability and risks within the financial system, to enable
the poor to save in a sound system; and also to let them have a buffer against
financial shocks and crises.
3.4. Islamic Economic System:
"Islam has a set of goals and values encompassing all aspects of human life including
social, economic and political." Chapra (1979, p.2).
"It is event that, unlike both capitalism and socialism, the goals of Islam are absolute
and a logical outcome of its underlying philosophy" Chapra (1992, p.213).
The Islamic economic system basically, is an economic system which is based on the
rules of the Islamic law which is known as Shariah. The comprehensive definition is an
economic system includes all societies (both Muslim and non‐Muslim) and other
aspects of life, it studies economic behaviour, institutions, policies, production,
distribution and consumption of goods and services; it also includes the economic
explanation of the Islamic principles, implementations and policy implications. Al‐
Suwailem (2007, p.53) outlined the Islamic principles as the following:
• Material interest shall be balanced with spiritual and social interests,
• Time horizon is extended beyond this world to include the hereafter,
• Zakat or obligatory charity is an essential duty,
• Riba or interest on loans is strictly prohibited,
• Gambling and wagering, or Gharar in general, is also prohibited.
Chapra (1992, p.3) wrote "goals of general need fulfilment, full employment, equitable
distribution of income and wealth, and economic stability." These are the key goals of
the Islamic economic system. Therefore, this makes the Islamic economic different
from the any other Economic system such as capitalism or socialism. The Islamic
economy does not include commercial activities only, but it reflects the socio‐
economic values of society, justice and equitable distribution of income. Moreover,
regarding how money is used "in economic terms money has no intrinsic value; it is
only a medium of exchange, therefore earning interest on a medium of exchange
without bearing any risks does not sit well in the Islamic system." Rahman (1994, p.14).
The Islamic system has real assets with intrinsic value and usually Islamic finance deals
with asset‐backed finance especially in the profit‐loss‐sharing instruments (Usmani,
M.T. 1998).
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3.4.1. Interest (Riba, Usury) and Other Prohibitions:
". . . Allah (God) has permitted trading and forbidden Usury." Quran:2:275.
"O you who believe! Eat not Riba (usury) doubled and multiplied but fear Allah that
you may be successful." Quran:3:130.
"Love your enemy and do good; lend without expecting repayment. Then will your
reward be great. You will rightly be called sons of the Most High; since He Himself is
good to the ungrateful and the wicked." Luke 6:35.
"If thou lend money to any of my people, even to the poor with thee, thou shalt not be
to him as a creditor; neither shall ye lay upon him interest." Exodus 22:24.
"Thou shalt not lend upon interest to thy brother: interest of money, interest of
victuals, interest of anything that is lent upon interest. Unto a foreigner thou rnayest
lend upon interest; but unto thy brother thou shalt not lend upon interest; that the
Lord thy God may bless thee in all that thou puttest thy hand upon." Deuteronomy
23:20‐21.
The core contrasts between the traditional economies and the Islamic economies are
that the first is based on interest payments as a main key element in its composition;
whereas the Islamic law completely prohibits its use. All Muslim scholars as well as
others with backgrounds in economics and finance have defined and agreed on
interest as Riba or Usury (Maudoodi, 1961; Siddiqi, 1980). In addition, several Western
religious scholars and scientists have written about interest, defining it as usury, and
condemning it. Usury was mentioned and prohibited in Judaism, Christianity and
Hinduism (Mills and Presley, 1999). In addition, the reasons behind the prohibition are
as Siddiqi (2004, p.41) listed, "riba corrupts society, riba implies improper
appropriation of other people's property, riba's ultimate effect is negative growth, riba
demeans and diminishes human personality and riba is unjust."
Furthermore, to let us understand the Islamic financial and economic system we have
to distinguish between profit and interest. In a capitalist system there are both capital
and entrepreneurs, they are considered as separate different parts for any business
productivities. The return on capital is interest that is fixed while profits or losses are
the returns for entrepreneurs, whereas profits can only be earned after distributing the
fixed return to land, labour and capital or in case of rent, wages and interest. On one
hand, "a capitalist economy would have to make fixed interest repayments even when
the venture is making a loss." Rammal and Zurbruegg (2007, p.73). On the other hand,
the Islamic financial and economic system takes an opposite approach to that of the
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capitalist system; (Siddiqui, 2004) defined the beliefs of the Islamic economic system
that all the parties, including the capital providers are subject to the risk of loss and
they are subject to share the profits. (Usmani, M.I., 2002) mentioned that
entrepreneurs in the capitalist economy have to pay a fixed interest fee even when the
business is making loss, while in the Islamic economy he is protected from such a
thing. Generally, even without fixed interest, the rate of return and profit in an Islamic
economic system is considerably higher than in a capitalist economic system. In
addition, the Islamic economic system, as opposed to the capitalist one, has
relationship with several parties since it involves other parties such as in the case of
financing through commodities.
Siddiqi (2004, p.57), wrote a summary of twelve arguments for those who validate
interest. The third argument was, "interest is an essential part of the modern system of
money and finance without which the whole system would collapse." This is a fallacy
because the empirical literature has shown that the Islamic economic system is not
based on interest and can function better than the traditional system (Siddiqi, 1980,
pp.64‐66; Siddiqi, 1983, pp.167‐76; Zarqa, 1982; Chapra, 1985, pp.107‐39; Khan and
Mirakhor, 1987 pp.125‐39; IIBI, 1995).
Likewise, other prohibitions distinguish the Islamic economic system. Firstly,

uncertainty or Gharar is one of the prohibitions in the Shariah. "Literally, Gharar
means to unknowingly expose oneself or one’s property to jeopardy." Iqbal and
Molyneux (2005a, p.30). Secondly, the prohibition of gambling or Maisir, whereby it is
important to distinguish between chance as speculation activities and activities with
uncertainty as a part of their nature. One of the major features of Islamic banking and
finance is the profit‐loss‐sharing that includes uncertainty but is in the nature of the
business.
3.5. The stability and Superiority of the Islamic Financial System:
The natural question that emerges when discussing the Islamic financial system Vs the
conventional financial system is which financial system would be better? Which
system is more stable, superior and improves the economy? To answer all of these
questions it is necessary to first look to the influence of interest elimination since it is
prohibited in Islam. Indeed, such an idea about the replacement of an interest‐based
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system is not outlandish to the Western economic school. (Fisher, 1945; Simons, 1948;
Friedman, 1969; Allais, 1993; Fardmanesh and Siddiqui, 1994) have all discussed it; they
thought that the current one‐sided liability, interest‐based financial system could be
basically unstable and harm the economy. For instance, many crises and economic
collapses such as, the German hyperinflation of the 1920s, oil shock inflation in Europe
during the 1970s, East Asia crisis 1997, California, banking crises in Japan, post war
hyperinflation in South America, the BCCI debacle in the 1980s, and the recent global
financial crisis. According to Tlemsani and Matthews (2002, p.3), "the occurrence of
crises is the result of complex factors emanating from over exuberance, greed
underestimation of risk, overexposure, currency failures, asset depreciation, faulty
regulation, illiquidity, macroeconomic shocks."
(Minsky, 1975, 1977, 1980, 1982, 1986) has argued that the instability of the economy as
for Keynes, instability and financial crises are the results of a modern capitalist
economic system. The basic idea is that the capitalist economic system is based on
debt creation which could lead to insolvency for many financial intermediary
institutions, resulting in the collapse of the financial system and economy. Minsky, as
a follower to Keynes blamed the traditional economic system, the government and the
US Federal Reserve System for the Great Depression. Instability in the capitalist system
is due to the payment of interest as a key element in that system.
The alternative to the conventional system is the profit‐loss‐sharing (PLS) based

system which will curb the economy and financial system, thereby making it more
secure, stable, and superior than it is now with the capitalist system. Researches has
been conducted that demonstrates the stability and superiority of the PLS system as
was mentioned in the literature review chapter. Macroeconomic stability could be
achieved through the PLS system in addition to modifying banking and government's
economic role. This idea has been supported by (Maudoodi, 1961; Uzair, 1978; Siddiqi,
1980; Zarqa, 1983; Khan, 1986; Abdul Gafoor, 1997; Chapra, 2000; El‐Gamel, 2000).
Moreover, the PLS system leads to stability within the financial system and economy
and monetary sector that affects the economy to make it stable and able to continue
its growth. On the contrary, the current capitalist system with interest payments at its
core has been proven to induce instability in the financial system as (Lavoie, 1986,
1987) formulated Minsky's hypothesis. "He argued that Minsky's thesis relies on two
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crucial phenomena. First, the economy naturally moves towards a more fragile
financial system. Second, under such circumstances interest rates will eventually rise."
Fardmanesh and Siddiqui (1994, p.76). "Investment booms characterised by increasing
growth rates of capital accumulation might require a constant rate of growth of the
share of profits in national income, which implies ceteris paribus, an increasing rate of
growth of prices. He then refers to the standard Fischer relation to conclude why
interest rates may eventually increase resulting in financial instability in accordance
with Minsky's thesis." Fardmanesh and Siddiqui (1994, p.77). Furthermore, the
consequences of an investment boom in the capitalist economy can be summarised as
follows.
• A higher level of utilization of capacity,

• A larger leverage ratio,
• A higher retention ratio,
• A larger profit margin,
• A constant rate of growth of the share of profits involving a period of inflation
and higher nominal interest rates.
Thus, if the leverage ratio is escalated, it will cause the financial system to be in risk of
fragility; because such action will raise the institutions' uncertain future obligations
which is in fixed income or outcome. Therefore, the fixity of future commitments or
interest will cause capitalism to be unstable.
Despite these facts, interest remains one of the key elements of conventional economic
theory and it is accepted by almost all the Western economists. (Fardmanesh and
Siddiqui, 1994) argued about Keynes's views about interest, Keynes had changing his
views on it. For example, "the rate of interest at any time, being the reward for parting
with liquidity, is a measure of the unwillingness of those who possess money to part
with their liquid control over it. The rate of interest is not the price which brings into
equilibrium the demand for resources to invest with the readiness to abstain from
present consumption. It is the “price” which equilibrates the desire to hold wealth in
the form of cash with the available quantity of cash…." Keynes (1936, pp.166, 167). In
addition, he thought there is no reason instance to exist in the long term, "interest
today rewards no genuine sacrifice, any more than does the rent of land. The owner of
capital can obtain interest because capital is scarce, just as the owner of land can
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obtain rent because land is scarce. But whilst there may be intrinsic reasons for the
scarcity of land, there are no intrinsic reasons for the scarcity of capital. An intrinsic
reason for such scarcity, in the sense of a genuine sacrifice which could only be called
forth by the offer of a reward in the shape of interest, would not exist, in the long run,
except in the event of the individual propensity to consume proving to be of such a
character that net saving in conditions of full employment comes to an end before
capital has become sufficiently abundant. But even so, it will still be possible for
communal saving through the agency of the State to be maintained at a level which
will allow the growth of capital up to the point where it ceases to be scarce." Keynes
(1936, p.376).
Finally, a financial system with high interest rates usually drives to a low level of
investment and unemployment, which put the economy in an unstable situation.
Keynes again saw that the violent nature of the marginal efficiency of capital is behind
the instability of the capitalist system. "Now we have been accustomed in explaining
the crisis to lay stress on the rising tendency of the rate of interest under the influence
of the increased demand for money both for trade and speculative purposes. At times,
this factor may certainly play an aggravating and, occasionally perhaps an initiating
part. But I suggest that a more typical, and often the predominant, explanation of the
crisis is, not primarily a rise in the rate of interest, but a sudden collapse in the
marginal efficiency of capital." Keynes (1936, p.315).
Thus, an alternative PLS system would be dissimilar in two ways. "First, it would
increase lenders' scrutiny of business undertakings by denying them a fixed positive
return. Second, it would distribute the risk of investment between lenders and
borrowers by assigning both sides a predetermined share of the profits and losses. The
entrepreneurs and the provider of funds would not be carried away by the market
sentiment as easily. Not only would fluctuations in the level of investment decline, but
also a sudden decrease in the marginal efficiency of capital would not render the
indebted units insolvent, as a reduction in borrowers' profits (loss) would be shared by
lender and is speared over larger group. The result would be a more stable level of
investment and financial structure." Fardmanesh and Siddiqui (1994, pp.79‐78).
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3.6. The Role of Islamic Economic and Islamic Financial Institutions on the
Elimination of Poverty:
"And that which you give in gift (to others), in order that it may increase (your wealth
by expecting to get a better one in return) from other people’s property, has no
increase with Allah: but that which you give in Zakat (charity) seeking Allah’s
countenance, then those, they shall manifold increase." Quraan: Ar‐Rum (30), verse 39
Part 21.
As mentioned in the impact of financial development in the reduction and the

prevention of poverty, one of the most fundamental anxieties on the top of a county's
agenda is poverty elimination. From the above Quraan verse, God orders wealthy
people to spend and share their wealth with other people whom are in need. This is
one of the Islamic religion's primary roles and objectives, whereby, it is the duty of the
individuals as well as the State to ensure they consider the other poor people within
their budget and system. According to Azam (n.a.), "whether separately or jointly,
individuals are expected to be sensitive to the needs of those who are near and close to
them, physically or in terms of kinship. While managing the allocation of its resources;
redistribution of its income; and achieving higher levels of development, the state is
expected to take into consideration the needs of the poorest segment of society."
Two financial sources for welfare activities and the cornerstones in the Islamic religion
are Zakah and charity. They are compulsory for individuals and at the State level to
present the responsibility of the rich for the poor. Zakah on the wealth of the rich is
considered as the right of the poor. Additionally, charity could be in many actions
where in Islam there is Waqaf, which means donations. They help in reallocate the
wealth and equitable income distributions. Moreover, Azam (n.a.) discussed four core
terms for the Islamic economic system to approach poverty elimination. "a) The design
of fiscal and monetary policies ensures the flow of resources to the poor, b) the design
of the legal and institutional systems assures that wealthy people transfer regularly the
due Zakah to the poor and the needy, c) financial sources for poverty alleviation
include voluntary transfer as well as compulsory regular transfer from the well‐off to
the poor, and d) the provision of interest‐free loans is necessary to make funds
available to the needy."
Nowadays, the nations are struggling in the face of challenges to eliminate poverty;
these challenges are mainly related to the difficulty as the World Bank (2005)
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described them: "a) identifying the most financially‐sustainable programs that reach
the poor, b) rationalising the existing programs and improving their cost‐efficiency
through better management and targeting, and c) designing and implementing a
monitoring system which ensures the effectiveness of these poverty alleviation
programs." Moreover, Islamic financial institutions play an essential role by providing
the needed products and instruments that help the poor people to increase their
income, invest their surplus funds and borrow funds to finance their needs. The
following diagram shows the flow of funds among the Islamic financial system.
Diagram 3.1: The Flow of Funds among the Islamic Financial System
Source: Obaidullah 2003, p.16.
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3.7. Conclusion:
To sum up, this chapter has linked the literatures which regarding relationship
between financial development, and economic stability and growth. There is no doubt
that financial development is the main cause for economic stability and growth. In
addition, the impact of financial development in the reduction and the prevention of
poverty, if we compare between Azam's four conditions for poverty elimination and
the World Bank's set of challenges, we find that the solution is the Islamic economic
system. Beyond this, since macroeconomic policies affect growth, monetary and fiscal
policies, investment policy, private sector development, human and financial capital,
etc; thus, the choice of a country's economic system could lead to improvements in
poverty or could make it worse.
Moreover, this chapter has discussed the Islamic economy, the definition, objectives
and the differences with the current conventional economic system, the forbidden
activities in the Islamic system with the reasons behind those prohibitions.
Furthermore, this chapter has provided a clear explanation of the alternative system
with the reasons. The next chapter discusses in detail the Saudi Arabian economic and
financial systems, the history, future, structures and main characteristics.
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4. Chapter Four ‐ The Economy and Financial System of the Kingdom of Saudi
Arabia
"Saudi Arabia has changed dramatically over the past three decades ‐ economically,
socially and demographically. This would be a short period in the lifespan of many
nations; but for the Kingdom, it has been a long time." Ramady (2005, p.1).
4.1. Introduction:
This chapter outlines the main characteristics of the Kingdom of Saudi Arabia's
economy and financial system. It includes the history, the development and the
performance of the Kingdom's financial and economic systems. In addition, it
discusses the central bank's functions, policies and the banking sector profile. The aim
is to give a clear understanding of the Kingdom's economic and financial profile.
4.2. Economic Background:
The first bank in the Arabian Peninsula was the Ottoman Bank, it was established in
1912 to act as an agent for the Turkish troops in the region. After that, the Sharif of
Makkah established the Arabian National Bank of Hejaz in 1924, forbidding any
dealings involving interest payments, also there was another Egyptian bank operating
in the region. However, both of the banks have subsequently closed. On 23 September
1932, the Kingdom of Saudi Arabia was established and unified by King Abdulaziz Al
Saud. Prior to that, the Kingdom as a part of the the Arabian Peninsula was something
of a backwater. The country's economy in that early stage was poor, basic, and simple;
with few foreign‐based trading houses and moneychangers to serve and provide basic
financial services to locals and the pilgrims, who were the major sources of finance in
the country's economy. However, the emergence of a modern day unified state has
been supported by the discovery of oil in 1938, and the kingdom's transformation has
been astonishing. Since that time, the country's revenues grew and foreign banks
started to be interested to entering the country's market through de novo entry.
The first foreign bank to enter Saudi Arabia was Nederlands Handel‐Maatschappij
(NHM) in 1926, even before the country's unification. The bank was the only bank in
the country without any competitors, it served on that time as the country's central
bank and it maintain the country’s gold stock and processed oil royalty payments. In
1948, The French Banque de L’Indochine and Arab Bank started to operate by opening
| P a g e 34

K of Saudi A
ntries
bran
nches in Jed
ddah. Then
n in 1950, th
he British Bank of Mid
ddle East, N
National Ban
nk of
Pak
kistan and Bank
B Misr off Egypt enteered the maarket. Moreover, the Kiingdom did
d not
havee a financial system or authority bodies
b at thaat time and currency no
otes had not yet
been
n issued. In
nstead, foreign currenciies and Saud
di silver coin
ns were thee only circullated
mon
ney in the Kingdom
K (BIIS, n.d.).
As previously
p m
mentioned, o was discovered in th
oil he Kingdom
m in 1938. To
oday, it is sittting
on top
t of morre than a qu
uarter of th
he world's proven
p oil reserves; it has 261 billion
barrrels of proveen oil reservves and up to 1 trillion
n of ultimateely recoveraable, oil maaking
the country on
ne of the weealthiest in the world. Additionallly, it gives tthe countryy the
lead
ding position
n in the exp
port of oil, with
w total oiil productio
on of 3217.777 million baarrels
in 2007,
2 of whiich 2541.16 million
m barrrels were exp
ported. Thee following cchart showss the
desttinations off the Saudi export
e of cru
ude oil in th
he year 20077.
Chart
C 4.1: Sau
udi Export of
o Crude Oil by Destinattions 2007
%57 %0 Norrth America

Sou
uth America
Western Europe
Mid
ddle East
%23
Afriica
Asiaa and Far Eastt
Oce
eania
%1
%3 %4 %12
Sourcce: Ministry of Petroleum

P & Min
neral Resources,, n.d.
According to Dr.
D Hamad Aljasser th overnor, "Saudi Arabiaa is a resou
he SAMA go urce‐
baseed open eco
onomy. Its GDP is equ
ual to appro
oximately on
ne per cent of global GDP,
G
but it plays an important systemic ro
ole in ensurring global economic
e sttability thro
ough
the way it manages its oil reserves.
r Saaudi Arabia, which has an
a estimateed 25 per cen
nt of
the world's reseerves, has a pragmatic policy
p of meeeting globaal oil deman
nd. Saudi Arrabia
is not
n only thee larggest oil
o exporter,, but also the
t sole sou
urce of liqu
uidity in thee oil
marrket due to its significaant spare caapacity. Effeectively, Sau
udi Arabia p
plays the role of
the Federal Reeserve for oil."
o AlJasserr (2009). Th
hus, the co
ountry's eco
onomy could
d be
desccribed as oill‐based, witth more thaan 85 per cen
nt of total Saudi
S govern
nment reven
nues
| P a g e 35
0204265 14 Septembeer 2009

coming from oil and its derivative products. For instance, in 2007 total government
revenues were US$171.4 billion and total government expenditure was US$124.3 billion.
In addition, the Kingdom has a leading position in natural gas reserves.
However, the Saudi government strives to change the economic dependency by

diversification and creating alternative sources of income for the country. Some of
these actions include: 1) when the Kingdom joined the (WTO) the World Trade
Organisation in 2005 to open the country's economy, 2) started a domestic
privatisation programme in 2002 to privatise some government services, 3) the set off
the foreign investment law by set up the Saudi Arabian General Investment Authority
(SAGIA) to supervise the Foreign Direct Investment (FDI), 4) the cooperation between
the Gulf Cooperation Council (GCC) countries when the tariffs were lowered to five
per cent in 2002, then the full customs union for the GCC took action in 2003
(Ramady, 2005), 5) recently, the decision taken by the GCC Monetary Union to place
the GCC central bank in Riyadh and then to join the joint GCC single currency by 2010
after more than 45 years, when the Saudi Riyal was officially pegged to the US dollar at
3.75; this was one of the aims behind the idea of the GCC when the Kingdom and the
other five member countries decided to set up the council in 1981 (gccsg, n.d.), 6) the
Saudi government set up five economic cities to promote balanced regional
development, to achieve economic diversification, to create jobs and to upgrade
competitiveness. They are King Abdullah Economic City, Prince AbdulAziz bin
Mousaed Economic City, Knowledge Economic City and Jazan Economic City (SAGIA,
n.d.b).
4.2.1. Macro‐Economic Indicators:
The global economic slowdown did affect the Saudi economy, especially when oil
prices dropped from their peak of US$146.61 per barrel in mid 2008 to US$67.97 per
barrel as of the beginning of June 2009 (FT, 2009b). Furthermore, the following table
shows some selected macro‐economic indicators for the Kingdom from 2000 to 2008.
| P a g e 36

Table 4.1: Selected Macro‐Economic Indicators for Saudi Arabia from 2000 to 2008
2000 2001 2002 2003 2004 2005 2006 2007 2008

Estimated Population (millions) 20.47 20.98 21.49 22.02 22.67 23.1 23.68 24.24 24.81
GDP Growth at Current Prices 17.08 ‐2.88 3.03 13.80 16.67 25.96 12.94 7.64 21.97
GDP at Current Prices (billion US$) 188.45 183.01 188.56 214.56 250.35 315.33 356.16 381.47 467.60
GDP at Constant Prices of 1999 166.19 169.71 169.92 182.93 192.59 203.28 209.68 216.80 223.20
(billion US$)
Non‐Oil GDP Deflator 99.33 99.70 99 102.10 105.90 110.30 114.40 115.80 118.70
Inflation Rate (Consumer Prices) ‐1.10 ‐1.14 0.20 0.60 0.30 0.70 2.20 4.10 9.90
Aggregate Money Supply M3 85.12 90.72 104.11 111.33 132.30 147.65 176.16 210.613 247.76
(billion US$)
Price of Arabian Light Oil 20.30 18.90 26.72 27.05 31.68 50.86 55.94 91 38.35
(US$/barrel)
Interest Rates on Domestic 6.67 3.92 2.23 1.63 1.73 3.75 5.02 4.79 2.89
Currency Deposits (3 months)
Banks Capital Adequacy Ratio 20.3 20.3 21.3 19.4 17.8 17.8 21.9 20.6 16
(Basel Standard)
Actual Government Revenue 68.83 60.85 56.80 78.13 104.61 150.48 179.65 171.41 109.33
(billion US$)
Actual Government Expenditure 62.75 68.03 62.27 68.53 76.05 92.40 104.88 124.32 126.67
(billion US$)
Ratio of Budget Deficit / Surplus to 3.20 ‐3.90 ‐2.90 4.50 11.40 18.40 21 12.30 33
GDP
Exports of Goods (billion US$) 77.49 67.97 72.45 93.25 126 177.89 211.01 234 313.44
Import of Goods CIF (billion US$) 30.19 31.20 32.29 36.91 44.75 59.47 69.71 90.16 115.09
Ratio of Current Account Surplus 7.50 5.10 6.30 13.10 20.70 28.50 27.80 24.90 28.80
to GDP
Current account (billion US$) 14.34 9.36 11.87 28.05 49.31 90 98.93 95.01 139.04
Central Bank Own Gross Foreign 57.34 58.94 55.89 70.44 98.97 157.32 239.94 312.26 449.02
Reserve (billion US$)
nd rd th th
Source: SAMA 42 , 43 , 44 and 45 annual reports.
The Kingdom's economic outlook figures for 2009 are: real GDP of ‐0.9% compared to
4.6% in 2008; the consumer prices inflation of 5.5% compared to 9.9% in 2008; and a
current account balance of ‐1.8% of total GDP which contrasts with 28.9% in 2008.
Additionally, the official inflation rate as of the end of 2008 was 9.9% while the interest
rate by the end of the fiscal year 2008 was 2.5%. The main factors influencing inflation
are, government and private expenditures that increased by 11.5% and 8.7% in 2007
and 2008 respectively; and the money supply (M3) which increased by 17.6% in 2008
compared with 19.6% in 2007.
On the other hand, the Saudi budget had a fiscal deficit for this year 2009 of US$17.3
billion compared with a historical budget surplus in 2008, which is the first time for
the Saudi government to have a deficit budget since 2004. The 2009 forecast for the
| P a g e 37

Kingdom's budgeted expenditure decreased by 7.4% compared with 2008. In addition,

the current account surplus rose to US$150.66 billion.
4.3. The Financial Market Structures:
There are two authority bodies that control and supervise the banking and the
financial activities in the Kingdome of Saudi Arabia.
4.3.1. The Saudi Arabian Monetary Agency (SAMA):
The genesis of the banking system in the Kingdom of Saudi Arabia has its roots in the
establishment in October 1952 of the Saudi Arabian Monetary Agency SAMA. SAMA
plays the role of the country's central bank; when the government with the help of the
International Monetary Fund (IMF), founded a programme to develop a monetary
system for the country. In 1953, SAMA issued its first pilgrim receipts, which were at
first in the denomination of 10 Riyals only. In 1962, the Kingdom of Saudi Arabia issued
its first official bank note the Saudi currency, which has been known as Saudi Riyal
(SAR). SAMA also supervises the insurance companies. As of the end of 2008 there
were 43 insurance companies operating in Saudi Arabia, 21 of which are listed on the
Saudi stock market TADAWUL (SAMA, 2008b). SAMAs' main functions are to:
• Issue the national currency,

• Act as a government bank,
• Supervise commercial banks,
• Manage foreign exchange reserves,
• Conduct monetary policy for promoting price and exchange rate stability,
• Remote the growth and ensures the soundness of the financial system.
Moreover, in 1966 the banking control law was issued that gave SAMA the power to
regulate banking by setting the level of capital adequacy, liquidity, reserves , the
lending credit limit, and permitting the entry for banks, etc. Unlike Western central
banks, SAMA is considered as a semi‐independent central bank because it is very
much influenced by the Saudi government. It behaves like most central banks, except
that because of Islamic constraints it cannot use open market operations to control the
money supply. Instead, government spending regulates the money supply.
| P a g e 38

Saudi Arabia is the oldest Islamic nation in the world and is home to the Islamic holy
cities of Makkah and Medina. The law of the Kingdom is the Shariah, the kingdom is
generally considered the most adherent of Quraanic law. However, it is also the most
laissez‐faire in terms of economics. Interest is forbidden, as it is considered Riba.
However many independent financial institutions deal with interest which, much to
the chagrin of Islamic purists, is effectively interest. Moreover, even when the banking
system means more than a financial system to serve and supply the people and the
market demands, it reflects the commonly traditional social environment of the
Kingdom; especially on issues relating to interest and Riba or usury. Although, SAMA
was based on the Islamic law, according to Ramady (2005, p.81), "it could not be a
profit‐making institution and could neither pay nor receive interest. There were
additional prohibitions, including one against extending credit to the government, but
this was dropped in 1955 when the government needed funds and SAMA financed
about one‐half of the governmental debt that accrued in the late 1950s." Therefore,
Shariah supervision is not identified among SAMA's responsibilities, thus Islamic
banks in Saudi Arabia have the same rules applied to them as any other conventional
banks. Nevertheless, "SAMA became a founding member of the Islamic Financial
Services Board (IFSB) in late 2002." IMF (2006a, p.11).
The main thrust of the supervisory policies of Saudi Arabian banking throughout the
evolution of the banking system to date seems to have been guided by certain
objectives summarised in the following table.
| P a g e 39

Table 4.2: Saudi Arabia Bank Supervisory Guiding Policies
Guiding Policy Observation
• Maintain open and liberal financial market • Effectively carried out, including minimal
with minimal restriction on capital flow. restrictions on capital flow.
• Strong and healthy banking sector to • Saudi bank profitability is one of the highest in
maintain sustainable economic growth. the world and its banking system has grown and
adopted as the economy evolved.
• Promote fair competition in financial and • More competition needed due to excessive bank
banking services. concentration; foreign bank presence could
promote more competition.
• Benefit from participation of foreign banks • Achieved with Saudization of banks in a smooth
and foreign shareholders to transfer manner; Saudi banking personnel are in key
technology, training of Saudi personnel and positions and Saudi banks are positively rated
improve risk management practices. by credit rating agencies.
• Ensure Saudi financial markets are at cutting • Achieved, for Saudi banking is one of the most
edge of communication and IT. technologically advanced in the world.
• Pursue the adoption and implementation of • Achieved thorough SAMA supervision and the
global standards, principles and practices. adoption of joint venture best banking
practices.
Source: Ramady, 2005, p.112.
| P a g e 40

In addition, the following table shows the Saudi banking regulatory checklist.
Table 4.3: Saudi Banking Regulatory Checklist
Category Availability Non‐ Observations

Availability
Government safety net Not No formal deposit insurance scheme exists.
available
Restriction on bank Not No restrictions, large concentration in few
holdings available hands.
Capital adequacy Available Basle BIS capital adequacy ratios exceeded.
requirement
Disclosure requirements Available Large loans need SAMA approval.
Chartering and bank Available SAMA makes onsite and off‐site audits and
examination approves new bank licenses.
Consumer protection Available Maximum SAMA imposed commissions and
charges.
Restriction on Not No formal regulatory restrictions exist as to
competition available branch network numbers or to type of banking
activities to be carried out.
| P a g e 41

Moreover, SAMA does not have the same range of tools that are used in any other
central banks in the world. It controls the money supply in the country through
conventional monetary police tools as follows.
Table 4.4: SAMA's Monetary Policy Instruments: Comparative Analysis

Policy Instrument Tool Rationale, and Operational Usage Effectiveness
Cash Reserve Ratio (CRR) or To insure banks have adequate • Used for implementing structural
Reserve Requirement Ratio: liquidity to cover clients deposits, changes in bank liquidity (credit
which are 7% on current accounts creation control) and for fine‐tuning
and 4% on saving\time deposits. short‐term liquidity.
• Produces strong signal effects but
infrequently used.
• Not imposed on inter‐bank
transactions.
Statutory Liquidity Ratio (SLR):

Banks required to maintain • "Free liquidity" at disposal of banks is
minimum amount of specified liquid reduced and can influence overall
assets equal to 20% of demand and bank lending structure (short/long
time deposits. term).
Official Repurchase Rate (ORR) SAMA alters liquidity position of • Allows for short‐term injection of
or Repos (Interest Rate): banks by dealing directly in the reserves and automatic withdrawal
market to make temporary additions upon repo maturity.
to bank reserves through short‐dated • Efficiency depends on SAMA's holding
repurchase agreements (overnight), of securities and size and depth of
which is 2%. market.
Reverse Repos Rate (RRR): Need for banks to place excess • SAMA can absorb rather than provide
liquidity with SAMA through bank reserves.
overnight matched sale‐purchased • A definitive purchase of financial
operations, which is 0.25%. assets reversible at short notice not
affecting prices in bond market; serves
to regulate the money market.
Foreign Exchange Swaps: Intention to influence capital • More flexible than repos/ reverse
outflows, avoiding disruptions to repos in terms of their maturity and
monetary policy from foreign volume per deal.
exchange markets. Also, used for • Affect liquidity but do not generally
liquidity management and currency exercise influence on foreign
speculation. exchange rate.
Placement of Public Funds: At SAMA's discretion to place • A "rough tuning" instrument
governmental institutions' funds providing banks with long term
with selected banks. liquidity support.
• Can signal crises management and
problems in banks.
Sources: SAMA annual report 2007 and Ramady, 2005, p.86
| P a g e 42

Finally, the next diagram illustrates the process of money supply creation in Saudi
Arabia.
Diagram 4.1: Domestic Money Creation Process in Saudi Arabia
4.3.2. The Capital Market Authority (CMA):
The Capital Market Authority (CMA) was established in 2003. Today, there are 113 local
and foreign financial institutions providing investment and other non‐banking
financial services supervised by CMA (CMA, n.d.b). The main functions of CMA are to
(CMA, n.d.a):
• Regulate and develop the capital market,

• Protect investors and the general public from unfair and unsound practices
involving fraud, deceit, cheating, manipulation and insider trading,
• Achieve fairness, efficiency and transparency in securities transactions,
• Develop measures to reduce the risks pertaining to securities transactions,
• Develop, regulate and monitor the issuance and trading in securities,
• Regulate/ monitor the activities of entities subject to the control of the CMA,
• Regulate/ monitor full disclosure of information related to securities and their
issuers,
• Regulate proxy and purchase requests and public share offerings.
| P a g e 43

Moreover, CMA supervises and regulates investment funds in the banks and the
financial institutions in the Kingdom, where the total size of investment funds both
local and foreign by the end of 2008 was US$19.95 billion (SAMA, 2009b).
4.3.3. Special Purpose Government Funds:
During the 1970’s the Saudi government created five special purpose government funds
mainly for lending. These funds or institutions are:
Saudi Credit Bank,

Saudi Agricultural Bank,
Public Investment Fund,
Saudi Industrial Development Fund,
Real Estate Development Fund.
The purpose of these institutions mainly is to provide medium and long term
development finance to supplement the short‐term funds provided by commercial
banks. These institutions are important players in supporting the medium and long
term capital needs of the industrial and private sectors (MOF, n.d.).
4.4. The Financial Markets:
There are two financial markets in the Kingdom that are supervised by CMA:
4.4.1.Saudi Stock Exchange TADAWUL:
The history of the first Saudi joint stock companies goes back to the mid of 1930's,
when the Arab Automobile Company was established. Because of the rapid economic
expansion and the oil boom, the number of Saudi joint stock companies had grown to
14 public companies in 1975. However, there was no official market in the country up
until 1984 when the market was founded. SAMA was the government body to
supervise and regulate the market until the CMA was created. Today, the market is
well organised and the number of listed companies is close to 128 structured within 15
sectors. The market's index is called TASI or the Tadawul All Share Index. The
following table shows the market's capitalisation and the index movements during the
period from 2000 to 2008. It's clear that oil prices affected the market crash in
February 2006 and the global financial crisis in August 2007.
| P a g e 44

Table 4.5: Saudi Arabian Market's Capitalisation and the Index Movements from 2000 to 2008
2000 2001 2002 2003 2004 2005 2006 2007 2008 Growth Growth
8Yrs Avg/Yr
Market Cap 67.86 73.21 74.86 157.31 306.29 650.19 326.90 519.03 246.54 263% 33%
(billion
US$)
% Change 11.32% 7.89% 2.26% 110.14% 94.70% 112.28% ‐49.72% 58.77% ‐52.50%
TASI 2,258.29 2,430.11 2,518.08 4,437.58 8,206.23 16,712.64 7,933.29 11,038.66 4,802.99 113% 24.17%
(points)
% Change 11.33% 7.61% 3.62% 76.23% 84.93% 103.66% ‐52.53% 39.14% ‐56.49%
Source: Tadawul n.d.a
4.4.2. Sukuk and Bond Market:
On 13 June 2009, the Saudi Arabian Capital Market Authority launched the first Sukuk,
bonds markets to be the secondary market to trade Sukuk and Bonds (Sukuk.net,
2009). There are only four listed Sukuk in the market as it is still in nascent stage.
However, this initiative is considered to continue the way in developing the Saudi
capital market and to support credit in the country especially as the world is suffering
from a slowdown in the appetite for lending and credit because of the financial crisis
which affected liquidity in the country and in the wholesale market. The following
chart shows Saudi Arabian liquidity and the risk detector.
Chart 4.2: The Saudi Arabian Liquidity and Risk Detector
Source: NCB market review and outlook 21 June 2009
Indeed, Sukuk and bonds are important alternative instruments for the government
and companies to finance their projects and to access the necessary liquidity.
Moreover, this step will enhance debt issuance and trading, which could lead to the
establishment of the much needed Islamic money market, which is covered in more
detail when the Malaysian experience with the Islamic money market is discussed later
in this study.
| P a g e 45

4.5. Banking Sector:
The first locally registered bank in the Kingdom was the National Commercial Bank
(NCB), which was established in 1953 (NCB, n.d.). Meanwhile, the first Islamic bank
was Al Rajhi Bank which was established in 1957 (Al Rajhi, n.d.). Today after 57 years of
SAMA, the banking system consists of 23 retail and commercial banks including
domestic GCC and Western banks registered and operating in the country. Of these, 11
are listed on the Saudi Stock Market TADAWUL (SAMA, n.d.); the following diagram
shows the banks and their ownership.
Diagram 4.2: Banks in the Kingdom of Saudi Arabia
Source: SAMA, c, d n.d.
Because of favourable macro‐economic conditions for the Kingdom of Saudi Arabia,

supported by the growth rates of the domestic economy especially the private sector
and the increase in the oil prices in addition to other economic domestic factors, banks
continued their record good performance from 2000 to 2008. Indeed, the total number
of bank branches in the Kingdom had reached 1410 as of 2008 with 8993 ATMs
distributed around the Kingdom (SAMA , 2009). Moreover, the table below illustrates
the banks' performance for the last eight years.
| P a g e 46

Table 4.6: Consolidated Balance Sheet of Commercial Banks in Saudi Arabia (billions US$)
2000 2001 2002 2003 2004 2005 2006 2007 2008 Growth Growth
8 Yrs Avg/Yr
Capital & Reserves 11.61 11.68 12.61 12.54 13.93 17.76 21.32 28.27 35.15 203% 15%
Growth % 1% 8% ‐1% 11% 28% 20% 33% 24%
Deposits 71.52 77.60 90.16 96.54 116.26 130.50 157.67 191.35 225.63 215% 16%
Growth % 8% 16% 7% 20% 12% 21% 21% 18%
Assets/Liabilities 120.87 125.98 135.53 145.39 174.77 202.42 229.62 286.73 347.27 187% 14%
Growth % 4% 8% 7% 20% 16% 13% 25% 21%
Profits 2.36 2.68 2.81 3.24 4.42 6.83 9.24 8.07 7.98 238% 18%
Growth % 14% 5% 15% 36% 55% 35% ‐13% ‐1%
Source: SAMA 42nd, 43rd, 44th annual reports and SAMA Monthly Statistical Bulletin Apr 2009
While much of the world has had to contend with a severe financial crisis since August
2007. The situation in the Kingdom is little‐changed. The Saudi banks have not yet
faced the same difficulties as in other countries, even countries in the GCC such as
Kuwait or the UAE. SAMA succeeded in its mission to supervise the banking system by
set the needed rules and regulations and assure that the banks apply them.
4.6. Islamic Banks in Saudi Arabia:
Many Saudi economists deem that the reasons behind the evolution of Islamic banking
in the Kingdom of Saudi Arabia are because of 1) an influence from other Islamic
countries, 2) advances in Islamic financial engineering worldwide and 3) the growing
local demand and sophistication of investors (Asaad, 2007). Moreover, the first Islamic
bank in the Kingdom was Al Rajhi Bank which was set up in 1957. The bank is the
world's largest private Islamic bank in terms of market capitalisation with total assets
of US$33 billion and a market capitalisation of US$4 billion (FT, 2009a). Today,
although the word Islamic does not appear in Saudi banks names, the total number of
Islamic banks working in Saudi Arabia is four purely Islamic banks. They are: Al Rajhi
Bank, Alinma Bank, Bank AlJazira and Bank AlBilad. In addition to the biggest bank in
the Middle East in terms of total assets, the National Commercial Bank, which
announced in 2005 plans to converts the bank into the Islamic framework and today
more than 75% of the bank's divisions are already converted to the Islamic structure.
With regards to Islamic banks Vs conventional banks in Saudi Arabia, Islamic banks
account for more than 50% of bank market share. Saudi Arabia is the biggest market
for Islamic finance and is host to the biggest Islamic bank in the world. Nevertheless,
there is not yet a dedicated government organisation to regulate Islamic banking in
| P a g e 47

K of Saudi A
ntries
Saudi Arabia. The follow

wing chart gives a cleear compariison betweeen Islamic and
convventional banks at the end of 2008
8.
C
Chart 4.3: Isllamic Bankss Vs Conven
ntional Bank
ks in Saudi Arabia
A 2008
8 (billion US
S$)
250
0
228.37
200
0
150
0 140.1
17
118.90
Isllamic Banks
100
0 85.46 Co
onventional Ba
anks
50
0
20.6
65
14.50
5.59 2.39
0
Proffits A
Assets/Liabiliti
ies Deposits Capital & Rese
erves
Sourrce: SAMA Mon

nthly Statistical Bulletin
B Apr 200
09 and Banks an
nnual reports 200
08.
4.7. Historrical Challe

enges in the Saudi Ban
nking System:
m the earlly years of the Saudi financial system

From s it has
h remain
ned stable, well
deveeloped and strong. Theere were problems faceed by SAMA
A; the first o
of which waas in
1960
0 when Riyyadh Bank and Al‐Waatany Bank both had serious liqu
uidity probllems
caussed by mism
managemen
nt and the granting
g of improper
i loans by the b
board mem
mbers
in both
b bankss. Thereforee, SAMA liquidated Al‐Watany
A B
Bank and m
merged it with
Riyaadh Bank. SAMA
S also forced
f Riyad
dh Bank to reorganise
r a restructture its boarrd of
and
direectors and system.
s Thee second pro
oblem was in
i 1982 in which
w SAMA
A faced ano
other
challlenge when
n irregularitties appeared at the Sau
udi Cairo Baank. The maanaging direector
and
d the treasurrer were invvolved in illeegal trading
g that caused the bank to record lo
osses
thatt exceeded capital reserves. Therrefore, SAM
MA forced the
t bank to
o reappointt the
board of directtors and issu
ued additional capital to
t the doub
ble. In addittion, there were
w
also
o mergers an
nd restructu
uring betweeen Saudi baanks in the 1980s and 19
990s.
Also
o, the system
m suffered from system
mic challeng
ges due to the declinin
ng oil price and
reveenue in 19
982 that drove
d the economy into a slo
owdown an
nd imbalan
nced
maccroeconomic situation.. This causeed asset quality and bank profits to decline and
non
n‐performing loans to increase.
i Ass a result, SA
AMA with other
o goverrnmental bo
odies
| P a g e 48
0204265 14 Septembeer 2009

gave additional guidance with the aim of strengthening banks and their financial
position. Some of these regulations including, "retention of capital reserves, tax write‐
offs for loan provisions, extension of the tax holiday for foreign investors,
encouragement of bank recapitalisation, provision of liquidity through repos, and
investment in new technologies." Al‐Suhaimi (n.d., p.131). Finally, yet importantly the
Gulf war in 1990 was a good test to judge the stability and strength of the Saudi
banking system and SAMA's capability as a central bank. SAMA succeeded in
providing the required additional liquidity to cover deposit withdrawals and managing
foreign currency exchanges.
4.8. Conclusion:
To sum up, in this chapter the economic and financial history of the Kingdom has
been presented. This was followed by, the oil discovery evolution and its affect on the
country's micro‐economy and macro‐economy. The chapter continued by explaining
the Kingdom's plans in diversifies its sources of income to develop its economy, and
illustrate the macroeconomic indicators.
Moreover, the chapter identified the Kingdom's financial market structure. Also, this
chapter detailed SAMA's and CMA's policies, roles, histories and the tools that the
central bank currently use in controlling the financial system. Next, the financial
markets were analysed to clarify the level of development that the country has reach.
Finally, the banking sector and the Islamic banking futures, volumes and performances
were provided to present a full picture regarding the financial system in the Kingdom.
Generally, the economy and financial system in the Kingdom is strong that is because
of the government supports, especially for the banking system. However, if the
banking system left without that government supports and funds the picture will be
totally different; therefore, the Islamise is needed. The next chapter will highlight the
issues and challenges that are facing Islamic banking and finance, and the other
Muslim countries experiences with Islamisation and Islamic banking and finance.
| P a g e 49

5. Chapter Five – Issues, Challenges and Other Muslim Countries' Experiences
"The country can benefit largely from the experience of other Muslim countries
making attempt to eliminate Riba from the economy." Khan (2002).
"I shall watch with keenness the work of your organization in evolving banking
practices compatible with Islamic ideas of social and economic life. We must work
towards our destiny in our own way and present to the world an economic system
based on the true Islamic concept of the equality of manhood and social justice."
Jinnah (1948).
5.1. Introduction:
There are a number of issues and challenges facing Islamic banks and economies at
present. For instance, too much effort has been giving to boost credit and liquidity in
the financial markets. Therefore, several Muslim countries have been developing
solutions to replace conventional inter‐bank or wholesale markets with an Islamic
alternative. This chapter outlines those issues and challenges which are facing Islamic
economies, in addition to tracing Muslim countries' experiences with the Islamisation
and the types of solutions that they have established in the aim to mimic the
traditional financial system with their Islamic financial system. In addition, at present
different organisations are working to achieve international harmonisation in Islamic
banking and finance. The objective in the end is to enable the Kingdom to benefit from
these experiences to convert the financial system or at least establish Islamic bodies
within the system as a start by adopt Islamic principles.
5.2. Issues and Challenges:
Any financial system has elements to operate and success as a doable system, where if
in somehow one of these elements is missed or failed, the whole system will be prone
to collapse. "Recognising that like any banking system, an Islamic banking system
requires three vital elements to qualify as a viable system i.e. a large number of players;
a broad variety of instruments; and an Islamic money market." Iqbal and Molyneux
(2005a, p.69). Moreover, there is no problem with a large number of players since the
size of the current Islamic finance is sufficiently large and increasing day by day. The
other issues and challenges are as follows.
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5.2.1. Islamic Money Market:
Islamic money markets or Islamic interbank markets assist with liquidity management,
credit issuances, monetary operations, etc. Where countries such as Malaysia and
Bahrain have created the needed markets as the following pages show; other countries
have only recently started such as Saudi Arabia. However, creating Islamic instruments
with noninterest‐bearing features was difficult, but it is not anymore, as other Muslim
countries developed the methods to create such a market.
5.2.2. Regulating and Supervising:
The significance of the monetary body within the financial system is critical as it is
important to regulate, supervise and control that system, since the financial sector
affects the economy. The main three features of any central bank to successfully
regulate and supervise its financial system are: 1) transparency within the system, 2)
soundness of the financial system and 3) efficiency of monetary policy (El‐Hawary et
al., 2004). Thus, an Islamic central bank must have the same features and additional
features relating to Shariah compliance. Moreover, similar to conventional central
banks an Islamic central bank has to have instruments to play its role in regulating and
supervising Islamic financial institutions and the country's financial system overall.
However, the Islamic central bank should use different instrument since the Islamic
financial institutions are based on the Islamic law, which prohibited interest that is the
main key in conventional monetary policy tools. Zaman (1986) classified those tools
under five categories:
1. Changes in reserve requirements,

2. Open market operations,
3. Discount rate policies,
4. Credit rationing,
5. Moral suasion (obligation urged by the central bank).
He added more five tools in the case of an Islamic monetary system:
6. Regulation of High‐Powered Money,

7. Profit ratio,
8. Lending ratio,
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9. Demand deposit ratio,

10. Refinance ratio.
Furthermore, the basic tools of fiscal policy in the Western system are taxes,
borrowing, and deficit financing. While, in the Islamic system there are Zakah that
would replace taxes.
Despite this fact, the majority of Muslim countries organise Islamic banks that operate
in their countries under the supervision and regulation of conventional central banks
as with any other conventional bank; excluding some of them such as Malaysia,
Pakistan, etc, as the follow pages will show. In addition, those countries usually are
using Islamic concepts as Billah (2006) categorized the financial contracts under
Islamic concept as follows:
1. PLS Contracts, consists of

a. Mudarabah Contract (Co‐partnership),
b. Musharakah Contract (Partnerships).
2. Non PLS Contracts, consists of various trading contracts such as:
a. Murabahah Contract (Sales),
b. Salam (Purchase by Order),
c. Istisna. (Manufacturing),
d. Ijarah (Lease),
e. Wadiah (Safe Custody),
f. Wakalah (Agency),
g. Kafalah (Surety), etc.
5.2.3.Shariah Supervisory Board (SSB):
The Shariah Supervisory Boards or as known as the Religious Supervisory Board/

Committee. Its core mission is to ensure that Islamic financial institutions are
compliant in their day‐to‐day operations, dealings and contracts with the Islamic law.
One of the challenges facing Islamic banking and finance is to have one Shariah board
regulated and supervised by the central bank with the aim of unifying all of the
Muslim countries under one concept of Islamic law. Moreover, there are differences in
the composition and authorities of these boards; some boards work as consultants to
the management while at other financial institutions, the boards have the final
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decision and the management has to follow it. If there are any arguments between the
institution and its clients, the board has the final decision (Ray, 1995).
Furthermore, the role of Shariah supervision is necessary for any Islamic financial
institution. There are two categories of Islamic financial institutions. The first type is
institutions that were set up to operate under the Islamic law and were forbidden from
having any of their activities out of the Islamic frame; most of them have a shariah
board. On the other hand, the other type includes institutions that have been forced
by the regulators to convert from conventional to Islamic banking and most of these
do not have a shariah board, it happened in three Muslim countries, namely, Pakistan,
Iran and Sudan (Shaikh, 1997).
The views of boards are usually based on the Quraan or Sunnah, and if there were no
available dictate then their views would be based on early jurists. They also rely on the
Islamic jurisprudence for alternative solutions to the modern banking and financial
transactions. In addition, although all Islamic financial institutions' activities have to
comply with Shariah, they have to follow the country's financial regulations (Saeed,
1996).
5.2.4. Islamic Liquidity Instruments:
Liquidity to financial system resembles the blood of human body. Generally, liquidity
means the ease with which an asset can be converted into cash within a short period.
In the financial institution framework, it means the institution's ability to meet its
commitment between liabilities and assets. In addition, liquidity is an important
subject to the central bank that acts as the lender of last resort in the financial system,
where it is one of its core functions to monitor financial institutions' activities and
ensure that they have sufficient liquidity and the whole system remains liquid.
Moreover, liquidity management is a part of the risk management framework of any
institutions whether they are governmental or private in the financial industry.
Conventional and Islamic banks both need the presence of the secondary market in
order to ensure that they have sufficient liquidity to manage their required liquidity
and finance their projects in addition to the ability to have a tradable source to trade
the liquidity instruments such as Sukuk. Indeed, for the Islamic finance industry,
liquidity management is critical and unique because most of the available instruments
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that are used to manage liquidity are conventional and interest based; which are not
complaint with the Islamic law or Shariah. Therefore, limited development has been
done in the Islamic interbank market or the Islamic money market matters. According
to Abdulrais Abdulmajid the Chief Executive Officer of the International Islamic
Financial Market, the causes of liquidity problems in Islamic banks and financial
institutions could be summarised as the following: "small number of participants, the
slow development of Islamic financial instruments, no Islamically acceptable inter‐
bank bank market, the absence of a liquid Islamic secondary market, no lender of last
resort facilities, and different Shariah interpretation." Abdulmajid (2003, p.6).
Usually, Islamic banks and institutions rely mainly on commodity Murabahah for their
short‐term investment and liquidity management; which could drive to inefficient rate
of returns. Thus, there is a need for alternative instruments to comply with the Islamic
law. There are several ways or techniques that could provide the needed solution, for
instance, Sukuk or Islamic bonds. But there are other problems that remain. First of
these is trading instruments in the secondary market and making them liquid to
attract the financial institutions and capital. Second, Islamic law place conditions and
rules on the Islamic money market that hinders its operation when compared with the
conventional money market. For instance, Shariah forbids trade or discount debt and
prohibit deal with interest.
5.3. Other Muslim Countries' Experiences:
Yet, there remain no agreement between Muslim countries on the matter of whether
they have to have an Islamic financial system or conventional. There are three types of
Muslim countries' financial systems: The first of these is a fully‐fledged Islamic
financial system such as Iran, Pakistan and Sudan; those countries have converted
their financial systems into an interest‐free system. Second, countries that use the
dual financial system both Islamic and conventional, such as Bahrain and Malaysia;
they have established Islamic institutions to supervise and regulate their financial
system activities side by side with the regular institutions. Thirdly, the majority of the
Muslim countries including Saudi Arabia, UAE, Egypt and others are using the
conventional financial system; although, they have Islamic financial institutions in
their system, they still have the traditional systems and there are no special Islamic
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bodies in their system. For example, Saudi Arabia has one of the largest Islamic banks
in the world in term of market capitalisation, Al Rajhi Bank (Schmith, n.d.).
The Islamisation of the Kingdom's financial system will be based on other Muslim
countries' experiences. Although, each country has different financial, economic and
political characteristics; additionally, each country has its own interpretation of the
Islamic law since each country follows different schools of jurisprudence. Four main
schools have been founded within the orthodox Sunni, viz., Hanbali, Shafii, Maliki and
Hanafi. While the Shiaa Muslims have their own separate schools (Warde, 2000). The
following chart illustrates the annual percentage changes in the GDP of those
countries (Malaysia, Bahrain, Sudan, Pakistan and Iran) with Saudi Arabia for the
period from 2000 to 2008.
Chart 5.1: Saudi Arabia and Selected Muslim Countries' GDP, Constant Prices (annual
percent change)
12
10 Saudi Arabia
8 Malaysia
Bahrain
6
Sudan
4 Pakistan
2 Iran
0
2000 2001 2002 2003 2004 2005 2006 2007 2008
Source: IMF, WEO Database, 2009b
5.3.1. Malaysia:
Malaysia is one of the two Muslim countries which operates a dual financial system;
where the Malaysian central bank runs on a parallel basis both the Islamic and the
conventional financial systems in the country. On 26 January 1959, Bank Negara
Malaysia (BNM) was established the country's central bank (BNM, b n.d.). Moreover,
in 1983 the country experienced the first official presence of Islamic banking, when the
government set up the Islamic Banking Act (IBA), to provide the needed regulations
and policies to supervise the Islamic banking business (BNM, a n.d.). In the same year,
Bank Islam Malaysia Berhad (BIMB) was founded as the first fully‐fledged Islamic bank
to start the first step in Malaysia's Islamic bank evolution. Today, the number of
financial institutions operating in Malaysia is 65 financial institutions, of which 19
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banks are Islamic (BNM, c n.d.). Regarding the liquidity issue, the Malaysian authority
has been presenting solutions to help the Islamic financial system and to find the
needed Islamic instruments to be used by Islamic central banks as a tool to control and
supervise the financial system, the money supply and credit allocation in a country.
5.3.1.1. The Islamic Money Market:
The Malaysian government introduced the guidelines of the Islamic interbank money
market (IIMM), and the market operated in 1994. There are no differences between
both the interbank market and the money market, where the first is dominated by
banks. Generally, "the money market is securities based with funds being channelled
through use of short‐term securities such as Treasury Bills and commercial paper. In
the interbank markets, funds are moved through use of bank deposit instruments such
as Bankers Acceptances and Certificates of Deposit." Bacha (2008, p.4).
Moreover, the simple structure of the Malaysian interbank market was based on the
conventional interbank market by mimicking and forming it under Islamic law rules;
where the IIMM has three components: 1) a Mudarabah based interbank market for
deposits; that allow surplus Islamic banks to lend and invest their funds to the deficit
Islamic banks, which known as Mudarabah Interbank Investment Scheme (MII). This
scheme is based on Mudarabah with a negotiated profit loss sharing ratio PLS. 2) A
platform for issuing and trading short term Islamic financial instruments and 3) an
Islamic Cheque Clearing System (ICCS) which works on the basis of Mudarabah, which
was initially created for Islamic banks under two conditions. First, Islamic banks must
maintain a current account with the central bank, which is known as Alwadiah or safe‐
custody. Second, Islamic banks must give power to the central bank to place the
funding position between surplus and deficit banks during the automatic cheque
clearing process at midnight. In addition, not only Islamic banks who participate in the
market, but also others have access to the market such as Takkaful companies,
insurance companies, conventional banks and non‐bank financial institutions. For a
better understanding for the role of the market within the country's financial system
the follow diagram shows how the steps would be (Bacha, 2008).
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Diagram 5.1: The Islamic Interbank Money Market within the financial system
Source: Bacha, 2008, p.6.
Furthermore, the Malaysian central bank BNM continued pioneering instruments that
comply with Shariah to develop the Islamic interbank money market, by mimicking
the traditional instruments that are usually used in any conventional interbank money
markets removing interest and replacing it with either a PLS rate or a mark‐up. For
instance, one of the common tools for any conventional central bank in the world is
the repos. The Malaysian central bank instead opted for Sell and Buy Back Agreements
(SBBA). These instruments could be used as tools to Islamise financial system or
create a dual system. The instruments and their explanations are as follows:
Government Investment Issue (GII):
The GIA was approved by the Malaysian Parliament in 1983. The objective behind it
was to facilitate government finance through the issuance of non‐interest bearing
certificates that complied with Islamic law since it was based on Qardh Hasan
(benevolent loans), which are known as Government Investment Certificates (GIC)
and the Government Investment Issuance (GII). In addition, the main reason behind
the idea of GII was to provide Islamic banks with the required statutory liquidity as
well as to invest their surplus funds in an Islamic way (Iqbal and Molyneux, 2005).
Moreover, if Islamic financial institutions had surplus funds, they could buy the GICs
or GIIs from the Malaysian central bank and they will sell them when the central bank
is in need for liquidity. With the same techniques, the government could control the
money supply in the system. If they wanted to increase the money supply for any
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reason, they would buy those certificates and the opposite when they want to reduce
the money supply (Bacha, 2008).
Moreover, "a Qard Hasan is based instrument would not have a predetermined fixed
face value at maturity, it would not be suited for secondary market trading" Bacha
(2008, p.28). Therefore, in 2001 it was changed to be issued under a new concept of Bai
Alinah (debt trading). Despite the fact, it has created debates over this issue, since the
Shariah schools of thought in Malaysia are different. They have their opinion about a
couple of Islamic finance issues, where other Shariah schools of thoughts do not agree
with the Malaysian opinion and they restricted and not agree with it.
Bank Negara Negotiable Notes (BNNN):
BNNN are short‐term money market instrument issued for the first time by BNM in
2000, where it is based on Bai Alinah to be used as a liquidity management instrument.
It is traded within the secondary market, where its price is determined on a discounted
basis with tenure of up to one year (Bacha, 2008).
Cagamas Mudarabah Sukuk:
The Cagamas Mudharabah Sukuk was a tool to finance the deal to purchase Islamic
mortgages from financial institutions in 1994 by Cagamas Berhad, the National
Mortgage Corporation, and the concept behind it was Islamic bonds structured under
the Mudarabah modes. Sukuk holders and Cagamas shared the profits accrued
according to the predetermined profit‐loss‐sharing ratios. Simply, this idea will help
the real estate market in Saudi Arabia to boom since the Saudi Consultative Council
approved the mortgage bill in July 2008; on the other hand it will be a good solution
for the Saudis to have a mortgage that is compliant with Shariah (Bacha, 2008).
Islamic Accepted Bills (IAB):
The IAB was launched in 1991. Its objective was to meet the demand for a shariah
compliant instrument for trade financing. It's based on the Islamic principles of
Murabahah (deferred lump‐sum sale or cost‐plus). The secondary market trading of
the instrument is based on Bai ad‐Dayn (debt‐trading). Moreover, there are two types
of financing under the IAB as follows:
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a) Trade Financing/ Imports: It is a Murabahah based working capital financing

mechanism. "The Islamic bank appoints the customer as its purchasing agent
for the underlying goods. As agent, the customer purchases the needed goods
from the seller (foreign exporter) on behalf of the bank, which pays the seller
/exporter and resells the goods to the customer at a marked up price. The
customer is typically allowed a deferred payment of up to 200 days. Since, the
sale of goods by the bank to the customer on deferred payment constitutes a
debt; the debt is securitised in the form of a bill of exchange drawn by the bank
and the customer for the full amount of the selling price. The bank can then
decide to sell the IAB to a third party on a Bai al‐Dayn basis." Bacha (2008,
p.29).
b) Trade Financing/ Exports: "An exporter, with an approved IAB facility,
prepares the export documentation as required under the sale contract or letter
of credit. The export documents shall be sent to the importer's bank. The
exporter then draws on the foreign commercial bank a new bill of exchange as
a substitute bill and this will be the IAB. The bank shall purchase the IAB at a
mutually agreed price using the concept of Bai al‐Dayn and the proceeds will
be credited to the exporter's account." Bacha (2008, p.29).
Islamic Negotiable Instruments (INI):
There are two varieties for the INIs: First, Islamic Negotiable Instruments of Deposit
(INID) that are based on Mudarabah; where a sum of money is deposited with an
Islamic banking institution and repayable to the holder on a specified future date is
usually the underlying asset for them. Second, Negotiable Islamic Debt Certificate
(NIDC) that involves the sale of an Islamic bank’s assets to a client at an agreed cash
price and then the same client sells again the same asset to the same bank at the
original sale price plus a profit. Next, the bank will pay the client this new amount at
an agreed future date (Bacha, 2008).
Islamic Private Debt Securities (IPDS):
They are Corporate Sukuk; they shape the backbone of the Malaysian Sukuk market
was and were introduced in 1990. Nowadays, most of the IPDS outstanding were issued
based on modes of Bai Bithaman Ajil, Murabahah, Mudarabah and Ijarah; where the
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last has increased worldwide to dominate more than 50% of total Sukuk issuances
(Bacha, 2008).
Sell and Buy Back Agreement (SBBA):
SBBA is a replication of the conventional REPO to replace it with an Islamic money

market transaction. "A bilateral agreement in which an SBBA seller (seller), first sells
assets to an SBBA buyer (Buyer) at an agreed price. Subsequently, both parties enter
into a separate agreement in which the buyer promises to sell back the asset to the
seller at an agreed price." Bacha (2008). There is also the reverse SBBA which is akin to
the reverse REPO.
The Commodity Murabahah Program (CMP):
Presently, it is introduced to the Malaysian IIMM in 2007. Simply, it is a liquidity

management instrument which is based on commodities. The underlying commodity
is Crude Palm Oil (CPO). "Under the programme, an Islamic bank purchases CPO
from a broker and sells it to BNM at cost‐plus. BNM agrees to pay the bank the said
amount on a deferred basis and appoints the bank as its agent to sell the commodity.
The bank then sells the commodity to another broker and credits the amount to BNM.
What has effectively happened is that, as a result of this transaction, the bank has
placed out its excess funds with BNM. The same transaction can be done in reverse if a
bank is short of funds and needs liquidity. The CMP however, is not currently available
in the secondary market." Bacha (2008, p.30).
Besides, the Malaysian authority in aim to ease corporation between Islamic banks and
conventional banks in its dual financial system, introduced other projects. For
example, the Islamic banking scheme (IBS) was lunched to let the conventional banks
offer and participate in Islamic banking products and services through their own
branches (Kaleem and Md Isa, n.a.). Also, the Malaysian government lunched on 4
March 1993 an Interest‐free Banking Scheme known as Skim Perbankan Tanpa Faedah
(SPTF). The objective behind it was to enhance the number of financial institutions
who offered products compliant with the Islamic law within the lowest cost and the
shortest time frame (Iqbal and Molyneux, 2005a).
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5.3.2.Bahrain:
The Kingdom of Bahrain is the second Muslim country which operates a dual financial
system. The first Islamic bank was introduced in 1979, where the central bank of
Bahrain was established shortly after the country gained full independence from Great
Britain in 1973 (CBB, n.d.). Currently, Bahrain plays a significant role in the region and
in the Islamic banking and finance industry as a leading international Islamic financial
hub. It has the largest number of Islamic financial institutions worldwide with 24
Islamic banks and 11 Takaful institutions. Moreover, the government of Bahrain,
specifically the Bahrain Monetary Agency (BMA) founded in 2000 the Prudential
Information and Regulatory Framework (PIRI), which is a framework for the Islamic
financial institutions in the country to supervise and regulate them (Iqbal and
Molyneux, 2005a).
Regarding the efforts of the Bahrain government on the matter of liquidity, the
Bahrain Monetary Agency on July 29 2002 set up the Liquidity Management Centre
(LMC) to facilitate Islamic financial institutions in Bahrain and the GCC to manage
their liquidity mismatch through short and medium term liquidity investment
products that comply with the Islamic law standards (LMC, n.d.). Mainly, those
products are Sukuk.
5.3.3. Sudan:
The first appearance of Islamic banking and finance in Sudan dates back to 1977 when
the first Islamic bank began to operate in the country namely Faisal Islamic Bank of
Sudan. Then the government took the initial step towards developing Islamic banking
and finance in the country when they decided that the whole country's financial
system and economy should adhere to Islamic law by eliminating interest payments in
the entire finance system in 1984. "A presidential decree was issued directing all
commercial banks to stop interest‐based dealings with immediate effect and to
negotiate the conversion of their then existing interest‐bearing deposits and advances
into Islamically acceptable forms." Iqbal and Molyneux (2005b, pp.137‐136). However,
foreign financial transactions were permitted to continue on the basis of interest,
although later they were forced to shift into using Islamic solutions. Then, in 1985, the
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Islamisation of the country's economy ceased following a change in the government.

Later, in 1990, the process of Islamisation was re‐energized.
Moreover, the Islamisation applied to the financial system and economy as well as the
government sector. The Bank of Sudan, the governmental body who supervises and
regulates the banking and financial system in the country is reliant upon two
techniques to regulate, manage liquidity within the banking system and mobilise
resources for the public sector.
Central Bank Musharakah Certificate (CMC):
CMC was introduced in 1998 to be used against the central bank's ownership in
commercial banks in Sudan. In addition, the idea behind it was an equity‐based
instrument; where "the central bank becomes a partner with the investors in profits of
the underlying assets. The distribution of profit between the central bank and the
investors is negotiable and the certificate can be sold on the secondary market to
another bank or the central bank." Iqbal and Molyneux (2005b, p.137).
Government Musharakah Certificate (GMC):
GMC was introduced in 1999 to be used also against the central bank's ownership in
the commercial banks in Sudan. In addition, the idea behind it was based on
Musharakah, "an instrument that enables the government to raise funds through
issuance of securities that promise the investor a negotiable return linked to
developments in government revenue in return for their investment in the provision of
general government services." Iqbal and Molyneux (2005b, p.137).
Furthermore, both certificates allow the government to manage the liquidity within
the economy. If the government wants to reduce the liquidity in the market, they will
sell more certificates to the banks and the financial institutions and vice versa. In
addition, they could be use as lender of last resort (LLR) instruments.
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5.3.4. Pakistan:
In 1956, the government of Pakistan pledged to eliminate interest from the country's
economy in the shortest possible time. Therefore, government bodies were established
to ease this mission, including the Council of Islamic Ideology (CII) and the Federal
Shariah Court (FSC) of Pakistan. Mainly, the Islamisation of the economy and the
financial system took place during the 1970s and 1980s through a series of
developments as follows (Ul‐Hassan, 2007).
1. The two governmental mutual funds started to get rid of interest in 1979 by
avoiding investing their funds in interest bearing securities. The two funds are
the National Investment Trust (NIT) and Investment Corporation of Pakistan
(ICP). Later in 1980, a new scheme for ICP's investors that was based on profit
and loss sharing was replaced.
2. On 1 July 1979, the state‐run House Building Finance Corporation (HBFC) also
eliminated interest from its operations.
3. A legal framework was adjusted to authorise the issuance of a new interest free
instrument of corporate financing called Participation Term Certificates (PTC)
in June 1980.
4. In June 1980, Zakat Ordinance was introduced by the Supreme Court of
Pakistan, which means an annual tax on surplus wealth obligatory in Islamic
law.
5. A new law was introduced in 1980 named Mudarabah, its aim was to initiate
mudarabah as a two‐tier fund structure for business transactions that comply
with Shariah.
6. In 1983, the Usher Ordinance was introduced; meaning "a form of charitable
investment where a percentage of each donator’s income is accumulated to
help needy peoples." Ul‐Hassan (2007, p.94).
7. The Banking and Financial Services law was adjusted in 1984. Seven laws and
the Banking Tribunals Ordinance provided a new system of recovery for non‐
interest based modes of financing in the industry.
8. From 1 January 1981, all of the nationalised commercial banks started to operate
to mobilize deposits on a profit and loss sharing basis.
9. The State Bank of Pakistan (SBP) issued Banking Control Department (BCD)
Circular No. 13 of 1984 calling for the elimination of Riba from the banking
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system and on 1 January 1985 all financing to Federal and Provincial

Governments, public sector corporations and public or private joint stock
companies were directed to do business only through interest‐free modes.
10. From 1 July 1985 all commercial banking in Pak Rupees was declared interest
free and all deposits were operated on a profit and loss sharing (PLS) basis.
11. Specialised financial institutions were allowed a transitional period from July
1979 until July 1985, and commercial banks were given from January 1981 until
July 1985, to eliminate interest from their operations. All nationalised
commercial banks opened a special counter in 7,000 domestic branches for
accepting deposits on the basis of PLS in 1981.
Furthermore, the country officially eradicated interest in July 1982. Later, in 1984 the
SBP issued and approved the following twelve modes of finance to be used by all the
banks in the country according to SBP (1984).
• Loan related modes i.e. financing by lending:

1. Loans Carrying Service Charges: they are loans that do not carry any interest on
which the banks may recover a service charge not exceeding the proportionate
cost of the operation, excluding the cost of funds and provision for bad and
doubtful debts. The State Bank of Pakistan will determine the maximum
service charge permissible to each bank.
2. Qard‐Ul‐Hasan (Beneficiary Loan): they are loans given on compassionate
grounds free of any interest or service charge and repayable if and when the
borrower is able to pay.
• Trade related/type modes of financing:

1. Mark‐Up/Cost Plus Sale: this is the purchase of goods by banks and their
sale to clients at appropriate mark‐up in price on a deferred payment basis.
In case of default, there should be no mark‐up on mark‐up.
2. Mark‐Down: this is the purchase of trade bills.
3. Buy‐Back: this is the purchase of movable or immovable property by the
bank from their clients with Buy‐Back agreement.
4. Leasing.
5. Hire‐Purchase.
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6. Development Charges: these are financings for the development of

property based on a development charge.
The maximum and the minimum rates of return to be derived by the banks from
theses modes of financing will be as determined by the State Bank of Pakistan.
• Investment related/type modes of financing:

1. Musharakah: Profit‐Loss‐Sharing (PLS).
2. Equity Participation: the purchase of shares.
3. Participation Term Certificate (PTCs): the purchase of PTC and Mudarabah
Certificates.
4. Rent Sharing.
The maximum and the minimum rates of profits to be derived by the banks from such
transactions will be as may be prescribed by the State Bank of Pakistan from time to
time. However, should any losses occur, they will have to be proportionately shared
among all the financers.
Besides, the State Bank of Pakistan set the possible modes of financing for various
transactions that could happen in the economy and the other industries as the
following.
Table 5.1: SBP's Modes of Financing for Various Transactions
Nature of Business Basis of Financing
1. Trade and Commerce:

• Commodity operations of Federal and Mark‐up in price.
Provincial Governments and their agencies.
• Export Bills Purchase/ negotiated under Letters i. Exchange Rate differential in the case of foreign
of Credit (other than those under reserve). currency bills.
ii. Commission or mark‐down in the case of Rupee (local
currency) bills.
• Documentary Inland Bills drawn against Letters Mark‐down in price.
of Credit purchased/discounted.
• Import Bills drawn under Letters of Credit. Mark‐up in price.
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• Financing of export under the State Bank's Service Charge/Concessional Service Charge.
Export Finance Scheme the Scheme for
Financing Manufactured Machinery.
• Other items of trade and commerce. i. Fixed investment: equity participation (PTC),
Mudarabah Certificates, Leasing or hire purchase.
ii. Working Capital: Profit and loss sharing or Mark‐up.
2. Industry. i. Fixed investment: equity participation (PTC), Leasing
or hire purchase.
ii. Working Capital: Profit and loss sharing or Mark‐up.
3. Agriculture and Fisheries:

• Short Term Finance. Mark‐up.
• Medium and Long Term Finance:
a. Tube wells and other wells. Leasing or Hire Purchase.
b. Farm and Fishing Machinery (include Leasing or Hire Purchase.
solar energy plants, etc).
c. Plough‐cattle, Milch Cattle and other Mark‐up.
live stock.
d. Farm constructions. Leasing or Rent Sharing.
e. Land Development. Development Charge.
f. Orchards. Mark‐up, Development Charge or PLS.
g. Forestry. Mark‐up, Development Charge or PLS.
h. Water Course improvement. Development Charge.
4. Housing. Rent Sharing, buy‐back or mark‐up.
5. Personal Advances (other than those for
business purpose and housing):
a. Consumers durables. Hire Purchase.
b. For Consumption purpose. Against tangible security with buy‐back arrangement.
Source: SBP, 1984.
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5.3.5. Iran:
In August 1983, the government of the Islamic Republic of Iran decided to shift the
country's financial system into the Islamic principle, by replacing the interest based
financial system with the interest free financial system. Therefore, they set up a new
banking law namely, the Law for Usury‐Free Banking Operations, which obligated
financial institutions to convert their transactions to make them act in accordance
with the Islamic law. The law required banks to replace their conventional deposits
with Islamic deposits within one year, and types of financial transactions within three
years. It also set the framework of the central banks under the Shariah.
Moreover, on the liabilities side, "the law allows the banks to accept three types of
deposits, viz., Qard Al‐Hasanah Deposits, general term investment deposits and
project‐specific investment deposits." Iqbal and Molyneux (2005a, p.61). Whereby, the
first type which is Qard Al‐Hasanah Deposits, include current and savings accounts;
the client who owns the current or savings account has a guarantee over the principal
without any returns over it. Nonetheless, banks could present their clients. The second
type which is the owners of general term investment deposits, are allowed to receive
returns over their amounts dependent on banks' investment performance. In addition,
the minimum and maximum rates of returns are fixed by the central bank of Iran.
Finally, with the third type, which is project‐specific investment deposits, bank
mobilise their clients' savings into specific investment projects; where the rate of
returns in those types of accounts is based on how much the bank distributes to its
clients from the difference between the rates for its savers and investors.
On the assets side, "the law provides thirteen different modes of contract, through
which finance can be provided. These are: 1) Qard ‐ Al Hasanah, 2) Mudarabah, 3) Civil
Partnership (Musharakat Madani), 4) Legal Partnership (Musharakat Haqooqi), 5)
Direct Investment, 6) Instalment Sales, 7) Hire‐Purchase, 8) Forward Deals (Salaf), 9)
Juaalah, 10) Muzaraah, 11) Musaqat, 12) Debt Purchase, and 13) Guarantee Notes." Iqbal
and Molyneux (2005a, p.62).
Regarding the monetary policy instruments, the Central Bank of the Islamic Republic
of Iran (CBI) has been using three instruments to supervise and control the financial
system and the economy of the country, vis., direct instruments (with no reliance on
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market conditions), indirect instruments (market‐oriented) and Open Deposit

Account (CBI, n.d.).
• Direct Instruments:
a. Banking Profit Rate: includes the minimum and maximum profit rates
or expected rates of return for investment projects, partnership and for
other facilities extended by banks.
b. Credit Ceiling: CBI can intervene in and supervise monetary and
banking affairs through limiting banks, specifying the mechanisms for
the use of funds and determining the ceiling of loans and credits in
each sector.
• Indirect Instruments:
a. Reserve Requirement Ratio (RRR): banks are required to deposit a
proportion of their liabilities with the central bank. The RRR lies within
10 to 30 percent depending on the nature of banks' liabilities.
b. CBI Participation Papers: the central bank controls and monetises the
open financial market operation through this tool which provides the
needed flexibility in liquidity management and intervention in the
money market.
• Open Deposit Account (ODA):
"The main objective of this plan was the adoption of appropriate monetary policies to
control liquidity through absorption of banks’ excess resources. The CBI pays profit to
these deposits on the basis of specific rules." CBI (n.d.).
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5.4. Islamic Organisations:
Further efforts have been made to develop and help the establishment of the Islamic
economy, through setting up Islamic organisations and authorities to elaborate and
increase collaboration between Muslim countries and even non‐Muslim countries to
support Islamic banking and finance, and introduce international harmonisation to
Islamic banking and finance. The following pages outline in some detail those
organisations' objectives.
Firstly, they seek to facilitate and create infrastructures for liquidity management, an
agreement to set up the International Islamic financial Market IIFM was signed in late
2001 by the Governors of the Central banks /Monetary Agencies of Malaysia, Bahrain,
Indonesia, Sudan, and the President of the Islamic Development Bank Jeddah – Saudi
Arabia. The main purposes underlying this were as follows (Abdulmajid, 2003):
1. To spur the establishment and development of an international financial

market based on Shariah rules and principles,
2. Address the issue of liquidity management in Islamic banks,
3. Develop an active, secondary market,
4. Creating the environment that will encourage both Islamic and non‐Islamic
financial institutions to actively participate in a secondary market and the
information of new traceable instructions,
5. To harmonise the Shariah interpretations in the global financial markets and
close the gap between the different shariah interpretations,
6. To enhance the cooperative framework among Islamic financial institutions
globally,
7. To help in cross listing in different stock exchanges of member countries such
as those of Labuan (Malaysia) and Bahrain,
8. To solve the problem of the lack of awareness of attractive investment
opportunities in other markets and facilitate the raising of funds and
investment beyond national borrowing.
Secondly, the Islamic Financial Services Board (IFSB) was established in November
2002 and started to operate on March 2003. It serves as an international standard
setting body of regulatory and supervisory agencies. The objective behind it is to
ensure the soundness and stability of the Islamic financial services industry. Today, the
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total number of board members is 185, including 43 regulatory and supervisory

authorities as well as the International Monetary Fund, World Bank, Bank for
International Settlements, Islamic Development Bank, Asian Development Bank and
the Islamic Corporation for the Development of the Private Sector, Saudi Arabia, and
136 market players and professional firms operating in 35 jurisdictions (IFSB, n.d.).
Third, in 1973 the Islamic Development Bank (IDB) was set up as an international
financial institution. Its purpose is to foster the economic development and social
progress of member countries and Muslim communities individually as well as jointly
in accordance with the principles of the Islamic Law. Today, the number of members
in the bank is 56 countries (IDB, n.d.).
Fourth, the Accounting and Auditing Organisation for Islamic Financial Institutions
(AAOIFI) that was founded in 1990 as an Islamic international autonomous not‐for‐
profit corporate body that prepares accounting, auditing, governance, ethics and
Shariah standards for Islamic financial institutions and the industry. So far there are
200 institutions from 45 countries as members of the AAOIFI (AAOIFI, n.d.).
Finally, other organisations such as, the Islamic International Rating Agency (IIRA),
General Council for Islamic Banks and Financial Institutions (GCIBFI) and Liquidity
Management Centre (LMC).
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5.5. Conclusion:
To conclude, this chapter has identified a series of critical issues and challenges that
are specifically facing Islamic banking and finance in general and Islamic economics.
Start with the ideas, viz., the Islamic money market, regulating and supervising, the
Shariah supervisory board and the Islamic liquidity instrument. Thus, all these issues
and challenges are being shared between all of the Muslim countries that have Islamic
banks or aim to convert their financial system.
Furthermore, the other Muslim countries experiences have been discussed, including
Islamisation or the solutions that they arrived at. The chapter first showed the
Malaysian experience, their history and evolution with Islamic banking and finance;
their Islamic interbank money market and the instruments that they are using in their
financial system. Secondly, Bahrain's financial history and Islamic banking and finance
system was detailed. Thirdly, the history and evolution of the Islamisation of the
Sudanese, Pakistani and Iranian financial systems and economies was summarised. In
addition, the steps that they have taken to convert their system and the rules they had
applied are referred to. The objectives of this chapter are to give Saudi Arabia wider
range of solutions and choices to replace the conventional tools that are currently used
by the central bank SAMA.
Finally, the chapter has included a brief idea about the Islamic organisations in the
world today. Those organisations are important to increase collaboration between the
Muslim countries to establish and ease the creation of Islamic economies and financial
markets. The following chapter addresses the general conclusions and
recommendations of this research.
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6. Chapter Six – Conclusions and Recommendations
6.1. Introduction:
This chapter presents conclusions of the research. It gives the conclusion and the
recommendations. In addition, it includes the limitations of this research and the
other points that need to be covered in future research
6.2. Conclusions and Recommendations:
As previously mentioned there is a paucity of studies that have focused on the subject
of Islamisation. However, the debate regarding whether or not to embrace the Islamic
financial structure is of great relevance in the wake of the global financial crisis
because it is an issue concerning the relationship between financial development,
economic stability and growth. This study tries to link the idea of the relationship
between financial development and economic stability and growth with the idea of the
Islamic economic system as the best solution for the present economic climate. It is
found that the Islamic financial and economic system is more stable and superior to
the conventional system in both the short and long term. In addition, it offers a
solution for the economic collapse and slowdown that has been experienced since
2007. Furthermore, it arguably offers the solution for social wider but related problems
such as unemployment and poverty.
This research has presented a review of the Islamic economic system implementation
through a comprehensive scrutiny of the relevant literatures, and other Muslim
countries' experiences. It has provided a detailed discussion of some of the issues and
challenges facing the Islamic economic systems and other instruments and solutions
that are provided by some of these Muslim countries.
It is hoped that the theory and research findings presented in this research can aid the
development of the Islamic economic system as well as the Islamisation of the Saudi
Arabian Monetary Agency and the financial system in the Kingdom.
The first chapter of this research has introduced the research topic, the aims, the
research question, the purposes, the research methods and the research structure.
Then, the second chapter has presented an overview of the subject through an
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intensive analysis of the relevant empirical and theoretical literature, which involved a
review of the Islamic economic system implementation through a comprehensive
scrutiny of the relevant literatures. Next, the third chapter has linked the literatures
which regarding relationship between financial development, and economic stability
and growth. There is no doubt that financial development is the main cause for
economic stability and growth. In addition, the third chapter has discussed the Islamic
economy, the definition, objectives and the differences with the current conventional
economic system, the forbidden activities in the Islamic system with the reasons
behind those prohibitions.
Last but not least, the fourth chapter has presented the economic and financial history
of Saudi Arabia, the oil discovery evolution and its affect on the country's micro‐
economy and macro‐economy, the Kingdom's plans in diversifies its sources of income
to develop its economy and the macroeconomic indicators the Kingdom's financial
market structure. Also, the fourth chapter has detailed SAMA's and CMA's policies,
roles, histories and the tools that the central bank currently use in controlling the
financial system. The banking sector and the Islamic banking futures, volumes and
performances were provided to present a full picture regarding the financial system in
the Kingdom.
Finally, the fifth chapter has identified a series of critical issues and challenges that are
specifically facing Islamic banking and finance in general and Islamic economics.
Moreover, the other Muslim countries' experiences were provided with the other
instruments and solutions that are provided by those countries.
Regarding the recommendations, this research does not discuss the religious
motivations for the Islamisation of the Kingdom of Saudi Arabia's financial system.
Rather, an economic argument is presented based on the need to make the country's
financial system more stable, secure and able to continue its growth. The Saudi
financial system has not as yet made any such switch but the theoretical argument is
advanced, taking the global financial collapse as a lesson that opens our eyes to the
possibility that there is something wrong with the current conventional economic
system. However, Islamisation remains a totally political decision.
Saudi Arabia's economy is threatened with a serious problem. It may suffer from an
economic slowdown because credit has dried up and the banks are unwilling to lend
| P a g e 73

because of the perceived high risk, especially with small businesses. In addition,
interbank can no longer be relied upon, presenting a liquidity problem for the Saudi
banks.
As a solution, it is recommended that an Islamic interbank money market be created

much like that which already exists in the Malaysian market. The government can use
many types of instruments such as those that are used in the Malaysian, Sudanese or
Pakistan Islamic financial systems. It will be the first step to Islamise the financial
system; it will serve in several ways; first, it will increase lending between the central
bank and the Islamic banks that are not using the current interbank market. Second, it
will increase collaboration between the Islamic banks and the conventional banks. It
will boost liquidity and credit within the financial cycle. Third, the creation of an
Islamic interbank money market could be as an Islamic money market that allows
non‐banks and investors to participate in a safe channel for investment. At the same
time, the government could also participate to fund projects and control the markets.
The economy would receive a boost and the growth cycle could be maintained. In
addition, the Islamic system which is based on real tangible underlying goods would
give more confidence to investors and banks alike.
Moreover, the establishment of an Islamic regulatory body within SAMA is

recommended in order to supervise and regulate Islamic banking and finance within
the country as a first step, before Islamising the central bank (SAMA). Islamic banking
and finance is a growing business in Saudi Arabia, and the county will soon adopt the
mortgage law which will introduce the Islamic mortgage. Also, Islamic banks have a
huge market share and even conventional banks have been growing their ranges of
Islamic products. All of these require regulation and supervision by an Islamic
governmental body to ensure that the long‐term development and soundness of the
financial system is assured.
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6.3. Limitations and Further Research:
As with any research, this study is not without its limitations. Because of the nature of
this subject, which is large, it was not possible to address all areas that were relevant.
In addition, the word limit for a Master degree dissertation, and the time limitation to
write the dissertation did not help the writer to discuss many other important aspects
that were relevant to the Islamic economics system. However, this research made a
solid contribution and acts as a sound base for further future research.
Regarding the further research, as has been mentioned above further research could be
done to cover the technical side of the Islamic economic system, especially the types of
instruments that this research mentioned for use in Islamic monetary policy and
Islamic central banking.
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The Islam

Bangorr Businesss School

Bangor,, United Kingdom

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My special thanks and appreciation are extended to my parents, my wife, my brothers

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Chapter One .............................................................................................................................10

Chapter Two ............................................................................................................................. 13

Chapter Three ......................................................................................................................... 22

Chapter Four ........................................................................................................................... 34

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4.4. The Financial Markets ............................................................................................. 44

Chapter Five ............................................................................................................................ 50

Chapter Six .............................................................................................................................. 72

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List of Charts, Diagrams and Tables:

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AAOIFI Accounting and Auditing organization for Islamic Financial Institution

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IPDS Islamic Private Debt Securities

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1. Chapter One – Introduction

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1.2. The Research Question:

1.3. The Objectives and Purposes of the Research:

1.4. Research Methods:

The research is based mainly on extensive theoretical research, drawing on the

1.5. Research Structure:

The structure of this research is as follows: Chapter 2 provides a review of the

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considering the experiences of other Muslim countries with Shariah‐based finance.

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2. Chapter Two – Overview of the Islamic Economic System and Relevant

2.2. Financial Development and Economic Stability:

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International, Stanley Fischer, suggested at a presentation. He said, "a weak financial

2.3. Islamic Economic System:

2.3.1. Interest (Riba, Usury) and Other Prohibitions:

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2.3.2.The Stability and Superiority of the Islamic Financial System:

An Islamic financial or economic system is defined as a system not based on interest

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commercial banks in eighteen banking systems with a substantial presence of Islamic

According to Zaman who commented on Dr. M. Iqbal’s contributions, the major

2.4. Issues, Challenges and Other Muslim Countries' Experiences:

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3. Chapter Three – Financial Development and Economic Stability

"Economics is about people not curves." Laibman (2001).

3.2. The Relationship between Financial Development and Economic

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An alternative view is that financial development is regarded as a relatively

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"Saudi Arabia’s economy ranks third in the world in terms of macroeconomic

3.3. The Impact of Financial Development on the Reduction and the

Poverty reduction is one of the fundamental anxieties in all countries worldwide

• By assurance of credit availability which "can also be an important factor in the

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3.4. Islamic Economic System:

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Saudi Credit Bank,