Islamic Finance & Economics Intro

Introduction to Islamic Finance and Economics

• Islamic finance core concepts are as old as Islam itself.
• Islamic law, called Shariah, specifies dos and don'ts related to all aspects of life, including commercial and financial transactions.
• Specific financial instruments designed as per the Shariah principles were used from the time of Prophet Muhammad.

Modern Islamic Finance and Banking

• The birth of modern Islamic finance and banking occurred in the second half of the twentieth century as an extension of Islamic economics, through joint efforts of Shariah scholars and bankers.
• Global expansion accelerated due to: discovering oil, rising petrodollars, budget surpluses of Gulf Cooperation Council [GCC] countries, and increased the demand among global Muslims to follow banking to their religious beliefs.
• Mit Ghamr, Egypt had an experimental Islamic bank in 1963.
• Dubai had the world's first commercial Islamic bank in 1975.
• There is a significant lack of awareness and knowledge about Islamic banking.

Awareness and Knowledge

• Awareness and knowledge are important for growth and acceptance in the global finance industry.
• Major driving force that led to the revival of Islamic finance and banking in current times was increasing awareness amongst the global Muslim population about the prohibition of interest.
• There is increasing awareness amongst the global Muslim population about the prohibition of interest in commercial transactions and their growing need to conduct their financial transactions as per their faith.
• Demand was predominant in Muslim majority countries but has been growing amongst the Muslim population in non-Muslim countries.
• Aside from following Shariah law, Islamic banks operate similarly to conventional banks.
• From the beginning of Mit Ghamr in 1963, Islamic banking continues to survive and grow at an unprecedented rate over the last five decades.
• It has attracted many investors and attracted new new customers and continues to grow and earn market share.

Conventional Finance

• Before money was created, economic exchanges occurred via barter which had inconveniences.
• Barter system inconveniences resulted with money emergence, which separated buying and selling by two new activities.
• Historically, livestock like cows, camels, horses, grains like wheat, barley, precious metals like gold, silver, and finally coins and paper money have been used as mediums of exchange.
• Financial institutions whose main purpose was to bring together those with surplus money and those with a shortage were the result of money creation.
• Financial institutions gather money from customers, provide custodial service, and lending or investing funds, which is called financial intermediation.
• This is the core business of banks.

Western Commercial Banking

• Established around the 14th century in Florence and became more established in the 18th century with the advent of the Industrial Revolution by three groups of people: rich merchants, money lenders and goldsmiths.
• Banks finances foreign trade, issues bills of exchange and provides capital to new business ventures.

Definition of Islamic Finance and Banking

• It is a faith-based financial system which foundation is laid down in Shariah law and the principles of Islamic economics.
• Original knowledge of the system is derived from the holy book of the Muslim faith, the Quran, which supersedes scientific methods or human decisions.
• Guiding principles emphasize fairness, justice, empathy, cooperation, entrepreneurship, ethics and the general good of environment and society, but do not prioritize profit maximization.

Distinctive Features of Islamic Finance

• It is based on the rules and regulations derived from the Islamic faith and law.
• Conventional finance has no religious restrictions, Islamic finance must be acceptable by Shariah law.
• At the core is the prohibition of Riba, which is interest or usury, an addition to the loan amount with the passage of time.
• Earning money from money is not allowed, the time value of money is disallowed.
• Money is only a medium of exchange and must not have intrinsic value.
• In contrast, interest payment and interest charging are at the core of conventional finance.
• To avoid money earning money, all Islamic financial transactions are linked to real assets and there is an exchange of goods and services, making them less risky.
• Conventional banks borrow funds from depositors and lend the funds to borrowers/entrepreneurs, while Islamic banks act as a partner to both the depositors and the borrowers.
• Islamic banks also operates as a seller in certain financial transactions.
• Conventional banks pay interest to the despositors and receive interest from the debtors to whom they lend funds.
• Operations are on a profit and loss-sharing basis, an Islamic bank shares in the profit of the client and the bank is required to share in any loss incurred by the business.
• On the deposit side, the Islamic bank shares its profit and loss with the depositors, pro rata to their deposit amounts.

Prudent Selection

• Islamic banks share in both the profit and loss of the borrower's enterprise and encourages the banking to be more prudent by selecting their clients that they finance.
• Conventional banks charge fixed interest from their borrowers regardless of result, hence they are more concerned about the creditworthiness of the client and their ability to provide collateral rather than their business success.
• Productive investment encourages Muslims to invest in productive enterprises, in that idle money cannot earn any interest income, therefore Muslim despositors are encouraged to finance as partners, enjoying profit and bearing loss.

Economics and Islam

• Today we understand economics as the discipline that deals with the production, distribution and consumption of goods or services and wealth in general.
• Economic systems in societies from ancient times have been faith-based or based on capitalism.
• Survival of the fittest, competition and profit maximization dictate capitalistic economic systems.
• During ancient times, economic activities like business and trade were mainly controlled by the rulers or by the religious leaders, and some rich and powerful merchants.
• 13th Century, the below interlinked economic concepts appeared and were the topic of discussions and debate: justice in economic exchange.

Philosophers and Theologians

• Aristotle considered the price of any good to be its intrinsic value.
• Romans say the price of goods was decided by the factors of demand and supply with contracting parties finalizing the price.
• Christian theologians say the intrinsic value meant the usefulness of the good which would decide the price.
• Private property views held that all Abrahamic religions of Judaism, Christianity and Islam considered property to be ultimately owned by God with people acting only as stewards to benefit society.
• Money, usury and prohibition of interest views held that money was only a medium of exchange, without any intrinsic value. Complete bans were common to all three religions.

Modern Economics

• Renowned economist Adam Smith said money or capital was factor of production, like land or labour during Industrial revolution.
• Money had a cost based on risk & opportunity cost associated with it.
• Smith believed in the free market concept, competitive forces and prices determined by supply & demand mechanism.
• Significant economic theory defined by Smith was economic scarcity.
• Islam differs fundamentally from Adam Smith's concept of economic scarcity.
• Globally there are different economic models operating, and these differences are derived from the role of markets and government and morality and justice.

Models

• Market Economy: These economies are self-regulating, without government intervention with demand and supply determining prices. Creates polarization and can be detrimental to society.
• Mixed Market Economy: Under the demand and supply mechanism markets operate, but markets ensure that market rules benefit the country. Defense, infrastructure, public services under governmental control.
• Mixed Socialist Economy: In some market economies, to deal with income inequality, poverty and other social issues, vital sectors are under governmental control.
• Command Or Planned Economy: The opposite of the market economy, the government decides about production, distribution and consumption.

Islamic Economics

• First coined by Abul Ala Al Mawdudi.
• Islam is a way of life, providing guidance for followers in the material and non-material aspects of their lives.
• Islamic economics includes studying rules provided in the Islamic holy book, Quran, and the Sunnah (teachings of Prophet Muhammad), comparing/contrasting these with contemporary economics, finding gaps and bridging gaps.
• Social and economic justice are at the basis, giving equal opportunity in the utilization of natural resources for everyone and encourages cooperation/collaboration.
• Islam assists in allocating and distributing scarce resources, without curbing freedom, causing macroeconomic and ecological imbalances, or weakening family/social solidarity.
• Islam aims to balance social benefits related to private/public property ownership.
• Encourages productive activities/creation of wealth, considering it worship with Shariah rulings.
• Disagrees that material gain is the main reason for existence and discourages the hoarding of wealth.

Islamic Thought

• Mohammad Nejatullah Siddiqui divided the development of Islamic economics into three periods.
• The first period began from Hijra to AH450 (1058 A.D.) when Prophet Muhammad migrated from Makkah to Medina, which is the first year in the Muslim calendar, to AH450, corresponding to.
• Prophet, companions and other Islamic scholars concentrated on Shariah rulings relating to economic issues.
• The second period AH450-AH850 (1058 a.d.-1446 A.D.), focused on basic needs, preservation, justice, accounting and fair pricing.
• Third period (AH850-AH1350) was intellectual/individual stagnation. The economic concepts that had been discussed/developed during the first period included; money as an exchange, usury, taxation, market regulations, permissible economic behavior, labor, wages, prices and ethical commercial behavior.

Principles of Islamic Economics

• Religion and economics are interrelated in Islam.
• Economic and social fairness and justice are not forced, there is encouragement to implement it .
• Property and wealth is ultimately owned by the Creator, though man has control over it as trustee.
• People are moderate in expenses, avoiding wastage and luxury.
• Productive activities are encouraged, adhering to Shariah without harming society or the environment.
• There is encouragement of Halal trade and business but Haram trade and is unlawful and prohibited.
• All human beings have the right to equal opportunity and those who own wealth are responsible for sharing it with the community
• Compulsory charity = religious tax designed to reduce the gap between the rich and the poor, and encourages additional non-compulsory charity.

Islam's Solution to the Classic Economic Problem

• Conventional economics states the classic economic problem is scarcity from both wants ( can be limited), resources (can be limited).
• Islam has a two-pronged solution by focusing on basic needs and and avoids luxury/wastage.
• Individuals should increase resources provided by productive activity to serve the Creator.
• Every capable individual should work for a living-wealth earned not only benefits them but also benefits the community.

Islam and the Welfare Economy

• Human beings are only trustees- the real owner is Allah.
• All Muslims are brothers/sisters, responsible for each other.
• This establishes a welfare economy in Islam, with two important concepts:Al-Adl (just/fair dealings), Al-Ihsan (Muslims show kindness beyond the minimum obligation).
• Other concepts are related to property ownership and the charitable endeavors.

Property Ownership in Islamic Economics

• Ownership is allowed but God is the ultimate owner and people are trustees.
• Property should be available for benefit of the public/environment, in the capitalistic/social systems.
• Demand/supply, competition and rights of contracting parties to determine price/earn profit are all accepted concepts if they maintain fairness/justice.

Principles

• Principles include recognizing Allah as the ultimate owner, all have access to natural resources, property transferred through gifts/exchanges/inheritance, Islam limits wealth accumulation.
• Islam limits wealth accumulation by socially harmful hoarding, which is prohibited) and dictates that all Muslims have a duty to share their income/wealth with the less fortunate, via Zakat or Sadaqah.
• Each Muslim should take care of property and discourage waste/destruction.

Zakat and Sadaqah

• Every Muslim has specific economic obligations to society. Zakat is compulsory, Sadaqah is voluntary.
• Zakat = Muslims impose a compulsory levy on those who own above certain wealth. It transfers from wealthy members to those who are needy. It can be defined as a tax at 2.5% for a certain kind of wealth. It allows Muslims to partake to attain rewards in the Quran/Sunnah like prosperity, purification, and merit.
• It serves as the backbone of Islam's economic system, encouraging the rich to support the poor, as quantized taxation from civilization and act as social insurance. It can be a source of income for the government or for income for public services expenses and act against hoarding.

Important Categories of People to Receive Zakat

• The poor who cannot clothe/feed, the needy who have income that is not sufficient, and those needing financial help.
• Others are: the indebted, the disabled, the unemployed, orphans, travellers, to spend in the way of the lord, and for those saving others from salvation.
• Wealth include: include silver/gold, agricultural produce, mineral assets, trading assets, and livestock (camels, sheep) in traditional Islamic society to determine subject to Zakat.
• In society, Wealth Subject to Zakat is determined by scholars as cash sayings, gold, silver, other non-productive assets and the income of productive assets employee in a business.

Ban on Interest versus Cost of Capital in Islam

• Islam recognizes capital as one of the production factors which there is a cost.
• It considers money as a medium of exchange without any intrinsic value.
• Income is against the time value of money or an unequal good exchanges, Riba. Islam does not accept interest as the measure of investment efficiency, yields only sharing the profit, loss, or prices for lease.

Summary of Quran

• The holy book of Islam.
• As guidance for those who deal in the Quran.

Sadaqah

• Term meaning charity.

Shariah Law

• As a guidance for Islamic economics.

Zakat

• Term meaning tithing.
• As guidance for social welfare in islamic economics.

Comparison: Conventional Economics and Islamic Economics

• Differences between conventional and Islamic economics related to ownership, wealth, wants, markets, rewards and social welfare.
• Private ownership of capital and property is granted in conventional, where God is the sole absolute owner in Islamic.
• An insatiable need for consumption is at the heart of conventional, where controlled desires are at the heart of Islamic.
• Accumulation of wealth is accepted in conventional but is based on shariah compliance in Islam.
• The market economy can be regulated with the state to ensure ethical activity in Islam.
• Economic and social welfare can be created by productivity in Islam.

Evolution of Islamic Finance

• Islamic finance began with Islam in the early 7th Century. The first Islamic financial institution was the Bait al Maal (public treasury) which was setup by the Prophet Muhammad.
• As more issues and questions came to light the answers were discussed among the companions and the judgements came through the process called Ijtihad.
• Islamic economics was maintained to have consistency with the Quran and the Sunnah.
• Zakat was the tool to maintain social well-being in society.

Umar Ibn

• Umar established management of Bait al Maal.
• Later he identified Bait al Maal's main revenue sources included Zakat, Sadaqah, and a land tax called Kharaj.

Early Islamic Tools

• This tool included: Musharaka ( joint venture) and Mudarbba (trust financing, Wakala (agency), Qard Hasan (benevolent loan), Salam or forward contract (Ijarah (leasing).

Achievements

• The Prophet acted as an agent for his wife's trading business and collected a commission as revenue.
• Islamic financial systems encouraged trade and business contracts to be written and witnesses for conflict reduction possibilities.
• Islam Traders conduct business and finance according to the Shariah rulings.

Decline

• 12th-20th century, disappeared because of fall of the ottoman empire.
• Western countries and conventional financial institutions dominated.
• Colonization spread around Muslim world with Shariah institutions subsequently losing capability under the foreign powers.

The concept of modern Islamic finance

• Emerged mid-20th century in Asian/Arab Muslim-majority countries gaining their independence from Western colonial powers, being inspired by distinctive Islamic economics from Western, Capitalist & Eastern Socalist models. Islamic finance and banking evolved from the concepts of Islamic economics, based on the profit and loss-sharing (PLS). It was considered to be equitable and stable; although has only been around for decades.

Current Status

• There 1.8 billion with a quarter of the earth global population.
• It is the fastest growing religion and with Shariah in some countries, and has seen growth and expansion.
• It also includes growth Middle East and South Eastern-Asia.

Important Regulatory Bodies

• Bahrain and Malaysia.

AAOIFI

• Accounting and and Accounting organization.

IFSB

• International finance board.
• As well as, a increase to the sector and internationalization of the sector.