Postgraduate Diploma

in Islamic Finance Practices

Trainer:
Dr. Md. Habibur Rahman, CIFP
Shari’ah And Islamic Finance
Faculty Of Business And Management
University Sultan Zainal Abidin (Unisza)
Terengganu, Malaysia
[email protected]
Unit #3_ FUNDAMENTALS OF ISLAMIC FINANCIAL SYSTEMS
Class #1

Discussion Agenda:

- Overview of the Financial Institutions and Markets

- Islamic Finance and Development of Islamic Financial Institutions
- Islamic finance in different countries (Islamic finance industry outlook 2021)
Overview of the Financial
Institutions and Markets
Introduction
• Financial institutions and markets play a big role in the economy.
• The deeper, broader and better functioning financial institutions and
markets can stimulate the economic growth.
• As such, economic systems rely heavily on financial resources and
transactions, and economic efficiency resets in part on efficient financial
institutions and markets.
Cont’d
• Collectively, financial institutions form the financial market.
• The financial market is really a network where the exchange of capital and credit
occurs.
• The market comprises mainly of money markets and capital markets.
• Its objective is to facilitate organized trading in financial instruments.
• Thus, a financial market is a virtual place where individuals and organizations wanting
to borrow funds are brought together with those wanting to lend.
Cont’d
• Hence, the economic function of financial markets is to provide channels for
transferring the excess funds of surplus units to deficit units.
• In other words, financial markets constitute the mechanism that link surplus and
deficit units, providing the means for surplus units to finance deficit units either
directly or indirectly through financial intermediaries.
Financial System
• Financial system covers financial transactions and the exchange of money
between investors, lender and borrowers.

• Financial systems are made of complex models that portray financial services,
institutions and markets that link depositors with investors.

• Financial system comprises of financial markets, financial institutions financial

instruments, regulatory agencies and the central bank.
Cont’d
Cont’d
• Financial market is a marketplace where the financial securities including
equities, bonds, currencies and derivatives are traded at low transaction costs
and at prices that reflect supply and demand. It brings lenders and borrowers
together.
• Financial institutions are any company that conducts financial transactions
such as investments, loans and deposits. For example, banks, insurance
companies, mutual funds and finance companies.
• Financial instruments used to transfer wealth from savers to borrowers and
to transfer risk to those best equipped to bear it. For example stocks, bonds
and insurance.
• Central bank is an institution that responsible to monitors the financial
institutions and stabilizes the economy.
• Regulatory authorities are responsible for making sure that the elements of
the financial system –instruments, markets and institutions- operate in a safe
and reliable manner.
History and Development
of a Financial System

• This can be explained systematically in four stages:

First: the Basic stage: (commodity money)

In the early stage as the economy developed from the barter trading, the
basic ‘transmission’ unit in the monetary system was ‘commodity money’,
comprising tokens often made of precious metals, which served as standard
units of accounts and measures of value to facilitate trade.

Since the accumulation of such tokens denoted wealth, they comprised

savings for individuals and enterprises in addition to other forms of real
worth, such as land, animals and buildings.
Cont’d
• The second stage: (practice of borrowing)
The next stage of development arrived with the practice of borrowing, that is,
when funds accumulated by a wealthy person were loaned to other
individuals or enterprises who could utilize these excess funds.
So, the borrowing parties are conventionally called ‘deficit’ units and the
lending parties are called ‘surplus’ units.
The loans granted by surplus units to deficit units represent a financial claim
on the latter.
The holding of primary debt, that is the direct loans from surplus to deficit
units, have the following limitations:
- The amount and maturity of loans offered by surplus units might not meet the
exact requirement of the deficit unit.
- There is the possibility of non payment (default risk)
- The holder of primary debt may not be able to dispose of his claim to another
person without significant capital loss, since the other surplus unit might not
be willing to purchase the financial asset without knowledge of the
creditworthiness of the borrower. Hence, this financial asset lacked liquidity.
Cont’d
• The third stage: development of financial intermediaries
The defects of primary debt in the borrowing-lending process were,
however, overcame by the development of financial intermediaries- the
third stage of evolution.
They are a body of specialised financial institutions, which were able to
issue relatively risk free liabilities, was developed to meet the various
needs of the surplus units.
These institutions were able to utilize the fund mobilised from their
customers’ savings to acquire primary debt of deficit units, in amount and
maturity based on the deficit units’ requirements.
The liabilities of these financial intermediaries have come to be known as
secondary or indirect debt.
Thus, they fill a gap in the borrowing-lending process by pooling funds
from the lenders and supplying these funds to the borrowers.
Cont’d
• The fourth and current stage
A variety of financial instruments

The final stage of evolution sets in as financial institutions embarked

on a drive for maturity. Here the market has emerged into a whole
complex web of financial intermediaries, offering a variety of financial
instruments for the surplus units as well as a varied range of credit
and investment facilities to meet the financing requirements of deficit
units.

• The economy may be primarily divided into four major sectors:

Households
Enterprises
Government
Rest of the World
Each sector has different sources and uses of funds and behaves
relatively homogenously as a group.
Cont’d
• These specialized financial institutions not only mobilize funds from the
surplus units in an economy, they also borrow funds from the rest of the
world and channel them to effective users.

• Discount houses and merchant banks, for example, reinforce the operations
of the financial system by providing secondary financial intermediary services.
This includes deriving funds mainly from other financial institutions and
recycling it to ensure liquidity and to reduce the probability of risk through
the intermediation process.
Money creation
• One of the more important functions of financial institutions is
money creation. Money is defined anything that is generally
accepted in payment of goods or services for repayment of debts.

• The major functions of money are to:

• Facilitate medium of exchange: it is used to pay for goods and services
• Provide a unit of account: it is used to measure value in the economy
• Function as a store of value: it is used as a repository of purchasing power
over time.

• Each and every time a bank makes a loan, a new bank credit is
created. As this loan is deposited into borrowers’ account, a new
deposit is created, that is in effect brand new money. When a bank
makes a loan, nothing is lent, for the simple reason that there is
nothing of substance to lend. The bank makes what it terms a loan
against the amount of money deposited with it at that time.
Cont’d
• In other words, when cash is deposited into a bank, the bank loans out
most of that money, and most of money loaned gets re-deposited into the
banking system, and gets mostly loaned out again, and re-deposited, and so
on.

• The total amount of money created in the process described above is the
inverse of the amount of a deposit a bank holds in reserve. Thus, the
Deposit Expansion Multiplier (DEM) is 1/RR, using ten percent as the RR
(reserve requirement) ratio, the DEM is simply 1/0.10=10.

• So, if the deposit is 1,000 and the RR is 10% the amount of money created
will be:
1,000 X 1/RR
1000 x 1/0.10
1000 x 10
= 10,000
Money Transferring
• The payments system is essentially a network of competing and
complementing services that facilitates transactions involving the exchange
of a means of payment in return for goods, services, real assets and
financial assets.

• The financial institutions play a key role in transferring money with a

variety of means of payment.

• The means of payment can take on many forms, from traditional

instruments such as currency and cheques in banking institutions, through
debt and credit cards, to modern electronic vehicles such as stored-value
cards like smart cards, touch and go card, etc. as well as network tokens in
an electronic purse.
Accumulating and
Lending Savings

• It has been discussed that in any financial system, two major parties are employed,
that is the ultimate savers or surplus units, and the ultimate borrowers or deficit
units.

• The ultimate lenders can be further described as non financial economic units that
generate investible funds. They can be split into various categories: households,
corporate, government and foreign sectors. The exact same non financial economic
units also appear on the other side of financial system as ultimate borrowers.

• Financial intermediaries performing so-called indirect financing assist in resolving

the conflict between lenders and borrowers by creating markets in two types of
financial instruments, one type for borrowers and another for lenders.
Marketing and transferring
financial assets

• The transferring of financial assets is done through a process known as

monetization or financialisation. It refers to the conversion of savings from tangible
assets to financial assets. In most cases the economic units hold their surplus in the
form of items such as land, precious metals, jewellery, inventory and livestock. Such
manner of savings is not only less profitable for the saver, but also less productive
for the economy.

• Financial institution play the role to convert the tangible assets into the financial
assets as tangible assets tend to be less productive than financial assets. The saver
can deposit his funds at financial institutions and the investor can in turn borrow
the funds. Since the thrifty saver may not necessarily be an enterprising investor, the
division of labour between saver and investor brought about by financial institutions,
allows for more productive investment.
Financial planning

• Financial institutions also act as financial planners, portfolio managers and

advisers over most of the primary securities owned by investors. The most
reasons for obtaining institutional management are:
• Convenience
• Protection against fraud
• Quality of investment selection and
• Low transaction cost.
Financial Markets Overview
• Financial intermediaries operate in two markets:
First: savings market
Second: credit market.

• In the savings market, they operate as borrowers, offering to meet the demand for
financial assets by the surplus units in the form of their own financial instruments,
like deposits, share capital and other savings media.

• In the credit market, they supply financial resources required by the deficit units in
exchange for their primary debt.
Cont’d
• The financial market can also be broadly identified as money and foreign
exchange markets, and the capital market. The money and foreign exchange
markets transact mainly in short term liquid financial assets which normally
mature within one year. While the capital market deals in long term financial
assets of maturity exceeding one year.
Types of financial markets
Debt Market
• Firm or government agencies can raise funds in a financial market by issuing debt
securities (bond) or equity securities (stocks).
• Debt instrument is very common method of raising funds.
• It represents a contractual agreement whereby the borrower is obliged to pay the
holder of the instrument a certain fixed amount of money.
• The return to investors is in the form of interest income (coupon payments).
• Upon maturity, the principal amount will be paid to the investors.
Equity Market
• Equity securities represent partial ownership in the issuing entity.
• Equity securities also tend to be more riskier than most long-term debt
instruments, hence offer higher expected rate of return.
• As the corporation grows and its value increases, holders of its stocks can
earn return from periodic dividends and capital gain if the sell stocks.
Money and Capital Market
• Short-term debt securities, with a maturity of less than a year are traded in Money
Markets.
• Debt securities with a maturity of greater than a year are traded in Capital
Markets. Similarly, equity securities which are considered long-term securities with
no particular maturity, are also traded in capital market.
• Money market securities are more widely traded and their prices have similar
fluctuations than capital market securities.
• This implies that money market securities tend to be more liquid and represent
relatively less risky investments.
Primary and Secondary market
• It is important to differentiate between the initial trade of securities and
their subsequent resale in markets.
• Corporations and government agencies use a primary market to raise
funds from initial buyers of securities.
• A secondary market is a financial market where existing securities are
bought and sold.
• Secondary markets play important roles in the overall financial system;
1. It provides liquidity, which represents a degree to which securities can be easily liquidated (sold)
to raise cash.
2. It provides necessary information to both savers and borrowers by determining the price of
securities.
Organised exchange market
• Organised exchanges are central locations where buyers and sellers of
securities trade.
• These trades are mainly carried out through brokers and dealers who play
crucial roles for the well-functioning of the secondary markets.
• Examples of exchanges are the New York Stock Exchange, Bursa Malaysia,
NASDAQ.
Over the counter market
• Dealers at different locations use OTC or off-exchange markets to trade
securities.
• OTC markets are highly competitive due to the fact that the buying and
selling of securities are done through a computerised trading system.
• Usually, equities and bonds of large and well-known corporation are traded
on exchanges, while equities and bonds of lesser-known companies are
traded in OTC markets.
Summary
• Financial markets consist of financial institutions, lenders and borrowers.
Financial institutions are agents to lenders and borrowers.
• The key role of financial intermediaries is to facilitate convenience of
transactions between surplus and deficit units, securitize transactions, market
and transfer financial assets, create money, diversify risk, and undertake
financial planning.
Islamic Finance and
Development of Islamic Financial Institutions
Introduction
• This section will discuss the history and development of Islamic financial
institutions followed by the discussion on the origin of Islamic banking and
finance.
What is Islamic finance?
• Finance : Deals with allocation, management and, acquisition of resources, and
investment.
• Inevitably, it deals with fundamental issues in finance which is risk
transformation and investment.
• Means, Islamic finance functions similarly or at least produce the same
economic effect as its conventional counterpart.
Cont’d
• However, ‘Islamic’ term implies some fundamental differences.
• Islamic finance is built upon a number of distinctive and unique characteristics –
principles underlined by Shariah;
❖ Prohibition of interest (riba).
❖ Prevention of ambiguity (gharar).
❖ Prohibition of gambling (maysir).
❖ Prohibition of conducting unethical and socially irresponsible economic or investment
activities (pornography, alcohol, prostitutions)
❖ Prohibition of monopoly
❖ Introduction of alms-giving (zakat)
❖ Cooperation for the benefit of society
❖ Etc.
Hence,
Islamic financial system is…..

• A financial system that is based on Islamic principles and values, which eliminates riba
and ensures a profit sharing mechanism in the financial system.

• It may be characterized by the absence of interest based financial institution and

transactions, doubtful transactions or gharar, stocks of companies dealing in unlawful
activities, unethical or immoral transactions such as market manipulation, insider
trading, short-selling etc.
Principles of Islamic finance
1. Wealth must be generated from legitimate trade and asset-based investment.
(The use of money for the purposes of making money is expressly forbidden)
2. Profit driven; not interest driven
3. Major prohibitions: Interest (riba); Uncertainty (gharar) and Gambling (Maysir)
4. Money against commodity; not money against money
5. Investment should also have a social and an ethical benefit to wider society
beyond pure return.
6. Risk should be shared.
7. All harmful activities (haram) should be avoided.
8. Profit shall be accompanied with liability.
9. Products and services shall be structured based on any permissible contract.
10. Both form and substance of the contract shall be legal and shari’ah compliant.
The difference in relationships
between Islamic and conventional banks
Islamic banking
contracts and products
Categories Contracts Products
Murabahah/BBA/Bay’ Mu’ajjal (Deferred Asset financing/ Trade financing/ Home financing/ Car financing/
sale with a mark-up) Working capital/ Overdraft/ commodity murabahah/ LC
Sale Based

Salam (Forward sale) Agro-financing/

Istisna’ (manufacturing contract) Asset financing/ project financing/ BOT/

Inah/Tawarruq Personal financing/ Commodity murabahah/ Credit Card/
Interbank Liquidity Management/
Lease Based Ijarah (lease) Car financing/ AITAB/
Ijarah muntahiyah bit tamlik (finance Hire purchase/ lease and sale/
lease)
Ijarah wal Iqtina
Partnership Based Mudarabah (silent partnership) Home financing/ deposit product/ investment products/ current
Musharakah (active partnership) account/saving and investment accounts/ working capital/
Diminishing musharakah (Musharakah Interbank money market/project financing/ LC
mutanaqisah)
Service based Wadi’ah/ Kafalah/ Wakalah/ Hiwalah/Ujrah Custodian service/deposit/ guarantee service/ agency service/
remittance/ LC/ Credit Card/ATM
Function of
Islamic financial system
• Similar to conventional financial markets, Islamic financial markets bring
together the surplus fund units (SFUs) to the deficit fund units (DFUs).

• This economic function of channelling funds from households, firms

and governments with surplus fund to those with shortage funds need
to be done through Shari’ah-compliant manner.
• The key functions of Islamic financial system and Islamic banks are:
- Providing Islamic financial contracts
- Effective resource allocation
- Investing in development project
- Profitable placement of surplus liquid funds
- Shari’ah compliant products and services
Financial/ Islamic
financial system in Financial system
bird’s eye view
Indirect funds Direct funds / financial
/financial markets/financial
intermediaries instrument s

Money market
Capital market
Central bank Takaul
Commercial banks
Pension funds
Investment banks
Unit trusts Money market instruments:
Cooperative banks Primary/
Mutual funds Treasury Bills Secondary/
Issuance trading
Government Bonds
Banker’s Acceptance
Negotiable certificates of
deposits
Issuance of: Trading of:
Mudarabah short term
certificates Bonds Bonds
Etc. Sukuk Sukuk
Equities
/Shares Equities /Shares
Derivatives (future, forward,
option, swaps)
Islamic
financial Islamic Deposit and Investment

services Banking
Financing
Equity

Islamic securities/ Sukuk

Funds and Unit Trust

Islamic Financial
Islamic Capital Market REITs
Services

Islamic venture capital/private

equity

Islamic Derivatives

Takaful
Takaful
Re-Takaful
Origin of Islamic financial Institutions-
Baytul Mal
• Translated from Arabic terms as “House of Wealth/Money”.
• Central bank of Muslim states.
• Islamic treasury for benefit of the Masaken (needy) not for leaders or wealthy.
• Extended loans to certain individuals but not accept deposits.
• Mosques was used as treasury by the Prophet while Umar re-organised the
establishment of Baitul Mal and operate as separate entity.
Revenue
• Revenue for Baitul Mal come from:

• Primary sources (zakat, ghanimah, kharaj, jizyah, custom duties, tolls and sadaqah).
• Secondary sources (property with no ownership, property of apostates, estate of
deceased person without legitimate heirs).
Functions
• The main purpose of Baitul Mal is to improve country’s economic
development, providing basic needs and alleviate poverty.
• Current system in general;

• Welfare Budget
• All revenue from zakat and sadaqah are transferred to Baitul Mal for expenditure on welfare
of poor and needy

• General Budget
• Other revenues from taxed and non-taxes resources are allocated for expenditure on civil
administration, defence, economic development projects, payment of state debt (if any).

• Under General Budget, funds collected were channelled into two

broad category of expenditure;
• Claims in regard to state responsibilities (expense for army, salary for state officials)
• Activities for public benefits (constructions of roads and water supplies).
Evolution of
Islamic financial institutions
Cont’d
Cont’d
Discussion

The end result of Islamic Banking and Conventional Banking is

the same. Why do they appear similar? Are they really similar?
Islamic banking and finance
in different countries

Islamic finance industry outlook

2021
DISCUSSION

What are the similarities and difference in Islamic finance

practices in different countries across the globe?

Issues and way forward:

- Different context and different maslahah
- Product development and innovation
- Harmonization and standardization
Thank You.