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CHAPTER I

INTRODUCTION AND
FUNDAMENTALS TO
ISLAMIC BANKING
AND FINANCE

OUTLINE
Introduction
Evolution of Islamic banks and finance
Factors leading to the emergence of
Islamic banks
The underlying principles of Islamic
banking business
The concept of usury in Quran,
Sunnah and Fiqh
Categories of usury

Introduction

The financial system is a vital component of


any modern economy.

It mobilizes and drives financial resources in


global capital markets through financial
institutions and markets.

Financial institutions are intermediaries through


which resources are channeled towards
efficient allocation of funds in the economy.

Financial markets are the arenas or mechanism


by which financial instruments are traded.

Malaysian Financial System


CENTRAL
BANK OF
MALAYSIA

BANKING
Convention
al
Commercial
Banks (25)

Islamic
Banks
(16)

Internation
al Islamic
Banks (5)

NON BANKING

Investment
Banks (15)

Development
Financial
Institutions (6)

Takaful
Operator
s (12)

Insurance
Companies
(36)

Savings
Institutions
(EPF)
Building
societies,
Trusts
properties,
Leasing
companies,
Investment
agencies

Why Do We Need
Financial System?

Provide mechanism for


saving and borrowing
Mechanism of pooling
of funds and financing
larger scale of
individual projects
Mechanism of
transferring economic
resources: time, agent,
geography
Price risk and enable risk to
be transferred between
different portfolio according
to their abilities & willingness
to absorb them
Deal with asymmetric
information

Managing the payment


system

Bridge different portfolio


preferences of supplies
and demanders of funds
Allocation of funds to the
most efficient use
Managing uncertainty
Offers facilities & markets
enabling wealth holders to
change the structure of
their portfolio of assets &
liabilities
Offers specialist services
Eg. insurance

Financial Intermediation
Savings &
Investment

Financing

Surplus Units
Individuals
Businesses
Government

Return on investment
& savings

Banks Liabilities

Deficit Units
Financial
Intermediary
(e.g. bank)

Individuals
Businesses
Government

Return on
financing

Banks Assets

Functions of an
Efficient Financial
System

Facilitate Efficient
Financial Intermediation
i.e. Reduce information
and allocation costs
Ensure stable payment
system
Stimulate economic
growth and development

Well-developed market for


risk trading, where economic
agents can buy and sell
protection against event risks
as well as financial risks.
Offers efficient and liquid
money and capital
markets

What is Islamic Banking?

Islamic Banking is a banking activity


that is based on shari'ah principles.

It does not allow (prohibited) the


paying and receiving of interest and
promotes profit sharing in the conduct
of banking business

Shari'ah Principles in Islamic


Banking

Islamic Banking has the same purpose as


conventional banking except that it operates in
accordance with the rules of shari'ah, known as
Fiqh
al-Muamalat
(Islamic
Rules
on
Transactions).

The basic principle of Islamic banking is the


sharing of profit and loss and the prohibition of
riba (interest).

Amongst the common Islamic concepts used in


Islamic
Banking
are
profit
sharing
(Mudharabah), safekeeping (Wadiah), joint

Evolution of Islamic Banking & Finance in


Malaysia
1) Phase 1: Establishment of Islamic Banking &
Financial Institutions (1967-1992)
2) Phase 2:
Conventional banks were allowed
to offer Islamic financial products and
services under Islamic Banking
Scheme (1993-2002)
3) Phase 3: Conventional banks were allowed to
set up Islamic subsidiaries (starting in
2003)
4) Phase 4: International integration of the
domestic Islamic banking system
(starting in 2003)

MALAYSIAN HISTORY OF ISLAMIC BANKING


Year

Activities

1960s

Pilgrim Fund Board (Tabung Haji) was established in 1969.

19701980s

Bank Pembangunan Malaysia Berhad was incorporated in 1973 as a government conduit to


strategically develop and promote active participation of Bumiputera entrepreneurs and the first
Islamic financing scheme was introduced under the concept of Bai Muajjal (credit sale)

1983

Bank Islam Malaysia Berhad was set up in 1983, under Islamic Banking Act, 1983.

1984

Syarikat Takaful Malaysia Berhad (Takaful Malaysia) was incorporated on the 29th of November
1984. (1st Islamic Insurance Company)

1993

Introduction of Interest Free Banking & Islamic Banking Window

1994

1997

Formation of shari'ah Advisory Council (SAC) for Islamic Banking & Takaful

1999

Establishment of Bank Muamalat 2nd full fledged Islamic Bank(wing of BBMB).

2001

Formation of the Financial Sector Masterplan which outlined a detailed long term strategy to
promote the Islamic banking industry as a niche area

2002

Introduction of Islamic Inter-bank Money Market


Dual banking system for 3 anchor banks i.e Maybank, Bank Bumiputera Malaysia Bhd
(BBMB) & Public Bank

Islamic Financial Services Board (IFSB) was established


International Islamic Financial Market (IIFM) was launched to speed up the integration of
Islamic finance

MALAYSIAN HISTORY OF ISLAMIC BANKING


Year
2003

Activities

2004

2005

Establishment of Islamic Banking Subsidiary for conventional bank


BNM issued a guideline on the Specimen reports and Financial Statements Licensed
Islamic Banks (GP8-i)
The Central bank of Malaysia Act 1985 was amended as to enhance the role and
functions of SAC
Entrance of Kuwait Finance House, Al Rajhi & Asian Finance (a consortium of Qatar
Islamic Bank, RUSD Investment Bank Inc. & Global Investment House)
A guideline on the issuance of credit card based on shari'ah principles (Credit Card-i)
Market Risk Capital Adequacy Framework for Islamic banks was issued
BNM issued the guidelines on the governance of shari'ah Committee for the Islamic
Financial Institutions to rationalize and streamline the functions and duties of shari'ah
bodies of the financial institutions

BNM approved the Islamic subsidiaries structure to replace of Islamic window


institutions structure
Foreign participation in Islamic subsidiaries and allowed to have up to 49% equity
Announcement the tax neutrality policy for Islamic banking and finance
Government Investment Act 1983 was amended and renamed as Government Funding
Act 1983
Introduction of shari'ah governance framework by BNM

MALAYSIAN HISTORY OF ISLAMIC BANKING


Year

2006

Activities

2010

Launched of the Malaysia International Islamic Financial Centre


A new category of licenses, International Islamic Banks (IIB) under the Islamic Banking
Act 1983 were issued to qualify foreign and Malaysian financial institutions that
conducted businesses in international currencies
Labuan offshore Islamic banks and the Islamic divisions of the offshore banks are
granted approval to establish operational offices anywhere in Malaysia
Approval for the setting up International Currency Business Units (ICBU) within the
Islamic financial institutions

Targeting Islamic banking and finance sector constitutes 20% of overall market

Factors leading to the


emergence of Islamic banks

Why Do
We Need
Islamic Financial System?

SHARIAH PRINCIPLES
Prohibition of riba, and
Sharing of profit & loss
Islamic financial products

as
defined by AQAD methodology,
should contain more benefits
(masalih) and less or no harm
(madarah).

in gambling (maisir) and


liqour (qimar), there are
some sins and some profits.
But the sins are greater than
the profits (Al-Baqarah:
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MAQASID/OBJECTIVES OF Shari'ah
The objectives of shari'ah are as follows:
1. To protect religion/ad-deen: which Islam regulates the
relationship between human and his creator and
human versus human
2. To protect `aqal which permit the right of promoting
& attaining knowledge (therefore forbids consumption
alcohol)
3. To protect the life or living of human being as such
punish those who transgress against it
4. To protect individual descendant of generation to
ensure integrity & unlawful relationship
5. To protect asset / wealth of individual and public to
encourage people to work hard & living lawfully,
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prohibits exploitation & injustice

MAQASID/OBJECTIVES OF Shari'ah
To protect the interest of the public /society by the following;
MAQASID
shari'ah

Removing the
Haram (IBQA)

Securing of
Benefits (TAHSIL)

Maisir gambling

Benefit (Manfaat)

Riba interest on loan

Wealth creation

Gharar uncertainty of
contract/goods

Values

Prohibited products/ good

Welfare

Satisfaction
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Foundations of Underlying Islamic Faith


ISLAMIC FAITH
AQIDAH
(Faith &
Belief)

SHARIAH
(Practices &
Activities)

Ibadah
(Man to God)

AKHLAQ
(Moralities &
Ethics)

Muamalat Ammah
(Human to human activities)

Munakahat
(Family
relationship)

Political

Muamalat
(Transaction/
interaction activities)

Economic

Jinayat
(Legislation)

Social

Salient Features of
Islamic Financial System

Shari'ah
Compliance

Meaning of
Shari'ah
Compliance

Valid
&
Permissible

Validity and Permissibility

Valid is the contract that meets its requirements and conditions.

Permissible (Halal) is the contract that is used to obtain Halal


(Permissible) ends.

A valid contract is not necessarily Halal (permissible).

Initiating a marriage contract with a woman whereby all conditions


are fulfilled but with the intention to divorce her the other day (just to
obtain the sexual pleasure) is a valid contract, but it is not Halal.

Selling guns to criminals is valid, but it is not Halal.

Validity is based on the form of the contract while permissibility is


based on the substance of the contract and the intention of the
contractors.

Free from Riba


Free from Gharar
Fahish

Free from Qimar or


Maysir (Gambling)
Free from element of
exploitation of needs
(bay al-mudtarr)
Free from jahl mufdi
ila al-niza` (lack of
information leading
to dispute)

Free from Ikrah


(coercion/force)

Characteristic
s of Islamic
Financial
System

A system grounded on
moral and ethical
framework of shari'ah
Community oriented and
entrepreneur-friendly emphasising
on productivity and physical
expansion of economic production
and services

Free from Ihtikar


(hoarding/hiding
goods)
Free from Najsh
(Raising prices by
making false bids)
Constructed upon the
principle of
brotherhood and
cooperation

The underlying principles of


Islamic banking business
Al-Riba

Any excess, increase, expansion, growth

Al-Maysir

Any acts of gambling/speculation that relate


to the financial instrument
Eg: Casino

The

Forbidden

Any forbidden items


Eg: Short-guns,

Cont..
Al-Gharar

Literally: Deceit, fraud, uncertainty, danger,


peril, or hazard that might lead to destruction
or loss

Technically: uncertainty and/or ignorance of


one/both parties in a contract over the
substance or attributes of the object of sale, or
doubt over its existence and availability at the
time of contract

Cont..Prohibition of Gharar
All jurists agree that gharar should be avoided in commercial
exchange contracts
Prohibition of gharar are:o Indirect references made in the Quran
o Conclusively prohibited by the Sunnah of the Prophet s.a.w.
Types of gharar:o Gharar yasir (minor or slight)
Tolerated and will not invalidate a contract. Examples: Purchase fruit without peeling/cutting skin to see inside
Charging fixed rate of room although difference time
check-in
o Gharar fahish (major or excessive)
Not tolerated and may result in contract voidability.
Examples of gharar fahish: Sale of fish still in the sea
Sale of birds in the sky

Cont..Categorized into 4 categories


Uncertainty & risk pertaining
to the existence of the
subject matter
2. Over its availability
3. Uncertainty over the
quantities involved
4. Uncertainty over the timing of
completion and delivery
1.

Cont..Rationale for Gharar Prohibition


To ensure full consent and satisfaction of
the parties in a contract
Without full consent, a contract may not be
valid
Full consent can only be achieved through
certainty, full knowledge, full disclosure and
transparency
Gharar in commercial contracts may lead to
injustice, exploitation and/or enmity among
contracting parties

The concept of usury in Quran,


Sunnah and Fiqh
What is Riba?

Riba Prohibited
Al Quran (Surah Al-Baqarah),
verse 2:275, which Allah says:



`Allah has permitted trade and
has forbidden usury (riba)

Juridical Meaning of Riba

Literally means excess, increase, expansion, growth.

In shari'ah: (Refer to Wahba Al-Zuhaily, Fiqh Al-Islami Wa


Adillatuh)
Hanafis School: A surplus of commodity or an excess in return
without
counter value
Riba is a predetermined excess or surplus over and above the
loan received by the creditor conditionally in relation to a specified
time period

Riba was made forbidden in the 8th or 9th year after the
Hijrah (flight from Makkah)

12 Quranic verses dealing with Riba

The word riba occurs 8 times, 3 times in 2:275 and one


time each in 2:276, 2:278, 3:130, 4:161 and 30:39

Quranic Prohibitions

Those who devour riba will not stand except


as stands one whom Syaitan by his touch has
driven to madness (Al-Baqarah: 275)

But Allah has permitted Trade and forbidden


riba (Al-Baqarah:275)

O you who believe! Fear Allah and give up


what remains of your demand for riba, if you
indeed believers. If you do it not, take notice of
a war from Allah and His Messenger; but if you
turn back, you shall have your capital sums;
deal not unjustly and you shall not be dealt
with unjustly (Al-Baqarah:278-279)

Hadith Justification

Avoid the seven grievous sins They asked: What


are they. O Messenger of Allah? He (p.b.u.h.)replied,
Associating anything with Allah, magic, killing a soul
which Allah has declared inviolate without a just
cause, devouring the property of an orphan, dealing
with riba, fleeing on the day of fighting, and
culminating the chaste, innocent, believing woman.
(Muslim)

Riba is of seventy three kinds, the lightest in


seriousness of which is as bad as ones marrying his
own mother; for the Muslim who practices riba goes
mad. (Al-Hakim)

The Messenger of Allah (p.b.u.h.) cursed the


devourer of riba, his constituent, the one who acts as
a witness to it, and one who acts as a notary to it.

Categories of Riba
1.

1.

2.

Riba al-Duyun

Is debt usury that occurs in lending and


borrowing.
Riba al-Qard
Is imposed from the beginning and
will be proportionate to the time
taken by borrower to repay the loan.
Eg: N borrowed RM1000 from Z on
10% interest for one year. Upon
maturity, N will pay Rm1100 to Z.
Riba Jahiliah
There is no riba at the beginning and
riba is imposed upon default.
Eg: N owes Z RM1000 on 1/1. on 1/1 Z is
unable to pay N so N agrees not to
collect his debt until 2/1 in exchange for
Z agreeing to pay him RM1200 instead
of RM1000.

2.

1.

2.

Riba al-Buyu

Applies to sale transactions in


certain commodities
It has two types:
Riba al Nasiah (delay in paying or
delivery of one or the two sold
items);.
Riba al Fadhl (exchanging one
ribawi commodity for the same
commodity but unequal in amount
or excess)
eg: Exchanging of 1 kg of dates for
2 kg of dates on 10 Oct 2011 at the
same time. The excess of 1 kg
dates is riba fadhl.

Riba al bay

The basis for the prohibition of riba in the


exchange of commodities is the famous hadith
of the Prophet on six commodities
Gold for gold, silver for silver, wheat for wheat, barley
for barley, dates for dates, salt for salt like for like,
equal for equal, and hand-to-hand (spot); if the
commodities differ, then you may sell as you wish,
provided that the exchange is hand-to-hand or a spot
transaction.

Bank Interest is
NOT RIBA
because NOT
EXCESSIVE

INTEREST Should be
Allowed because of
Inflation

MISCONCEPTIONS ABOUT
RIBA

RIBA is not
relevant to
commercial loans

RIBA should be
allowed under
Dharurah

Interest-based
commercial transactions
is NOT RIBA because
its newly invented

Comparison between
conventional and Islamic banking

Islamic and conventional banking could be


differentiated on the basis of;
Principles,
Source of earnings,
Objectives,
Risk sharing,
Profit maximization, and
Nature of earnings

Main
difference
Principles

Islamic bank

Conventional bank

Islamic banks follow the Principles of


shari'ah given by Allah Almighty to
perform operations and activities.

Required the shariah council/advisory


to monitor the activities

Conventional banks follow manmade principles


to perform operations and activities.
Does not required the shariah advisory

Source of
earnings

Profit, service charges and consultancy


fee is the main source of earnings of
Islamic banks. Profit is variable which may
be negative in case of loss.

Risk sharing

Risk is shared among borrower, lender Risk is fully transferred to others.


and bank.
It aims at maximizing the profit but subject It aims at maximizing the profit without any
to principles of shari'ah.
restriction even at the cost of other stakeholders.

Profit
maximization

Interest is the main source of income for


conventional banks that is charged on different
types of loans/products. (Difference between
interests charged from borrowers and paid to
depositors). It assures a predetermined rate of
interest.

Objectives

Islamic bank works as a trading concern to It generates income as financial intermediary. Its
generate its income.
prime goal is the maximization of shareholders
value at any cost.

Nature of
earnings

Income of Islamic banks varies depending


upon
business
borrowers
and
environment. It may be negative in case of
loss.

Income of conventional bank is constant even if


business borrowers suffer from loss because it
charges fixed rate of interest irrespective of profit
volume.