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Introduction to Islamic Financial System

The current financial crisis debunks the myths of Capitalism, opening the way for alternative economic systems to emerge, among which is the Islamic finance and economy.

Musbri MohamedDIL; ADIL ( ITM )Pursuing MBL ( UKM )

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The basic framework for an Islamic financial system is a set of rules and laws, collectively referred to as Shariah, governing economic, social, political, and cultural aspects of Islamic societies.

Scholars of Islamic economics ought to explain the concepts and principles of the Islamic financial and economic system and present its reference and applications to wider audience.

Shariah allows for a system of funding and investment based on participation in both profit and loss and interaction between capital and labor. Shariah calls on the parties involved in transactions to behave in a truthful, honest, clear and transparent way by prohibiting gharar, jahalah, cheating, gambling, lying, rumors, exploitation and taking people's money unjustly.         In a word, the only way out of this crisis can be found in the principles and regulations of the Islamic economics.

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Shariah originates from the rules dictated by the sources

of Islamic law. The sources refer are in sequence as follows:

(1)the Qur'an, (2)the hadith texts (the words, actions, recorded

statements and practices of Prophet Muhammad (pbuh) and this include hadith Qudsi),

(3)Ijma (consensus of the ulama) and qiyas (drawing analogies deduction and reasoning from the Qur'an and hadith texts), and

(4)Ijtihad (the scholar's own reasoning). Note that a scholar's ijtihad only comes after the analysis of the other sources, and remains within the parameters established by them.

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The basic principles of an Islamic financial system can be summarized as follows:

Prohibition of riba (usury) . Riba (usury), a term literally meaning "an excess" and interpreted as "any unjustifiable increase of capital whether in loans or sales". More precisely, any positive, fixed, predetermined rate tied to the maturity and the amount of principal (i.e., guaranteed regardless of the performance of the investment) is considered riba and is prohibited. The general consensus among Islamic scholars is that riba covers not only usury but also the charging of "interest" as widely practiced. Allah mentioned in many places in the Quran on the prohibition of Riba.

One of the ayah is stated below:

4:161. “ And their taking of Ribâ (usury) though they were forbidden from taking it and their devouring of men's substance wrongfully (bribery, etc.). And We have prepared for the disbelievers among them a painful torment.”

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Islam encourages the earning of profits but forbids the charging of interest because profits, symbolize successful business and creation of additional wealth whereas interest, determined gambling, is a cost that is accrued irrespective of the outcome of business operations and may not create wealth if there are business losses.

Social justice demands that borrowers and lenders share rewards as well as losses in an equitable fashion and that the process of wealth accumulation and distribution in the economy be fair and representative of true productivity.

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In the Islamic financial system, risk sharing, promotes entrepreneurship, discourages speculative behavior, and emphasizes the sanctity of contracts are being encouraged, and it closes the door to the concept of interest and precludes the use of debt-based instruments.

Economic experts assert that the system of financial derivatives can not bring about real development. Financial derivatives create only money, with no real value, causing inflation and price rise ,as well as moral decadence. For example, financial derivatives caused quick collapse of East Asian financial institutions.

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The financial products offer in the financial system by the Islamic banking institution includes financing facilities for asset acquisition, trade financing and corporate financing.

These different contacts i.e. Mark-up Sale (Murabahah), Sale with Deferred Payment (Bai Bithaman Ajil), Leasing (Ijarah), and Benevolent Loan (Qardhul Hasan) are some of the products offer under the financing for assets acquisition. Meanwhile letter of credit, letter of guarantee, accepted bills, and working capital financing are offered for financing purposes (trade and corporate). Different instruments are offered by the market to satisfy providers and users of funds in a variety of ways. These instruments serve as the basic building blocks for developing a wide array of more complex financial instruments, suggesting that there is great potential for financial innovation and expansion in Islamic financial markets.

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Financial products offered by the Islamic banks, just like the conventional banks, aims to gain profit. However in the Islamic financial system, the intermediaries are not allowed to deal with interest or to engage in any business or trade prohibited by Islam.

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The most important difference between Islamic and conventional practices is in the Islamic financial activity the trading principle of buying and selling must be on the fair basis and the profit is legitimate and the monopoly and hoarding is prohibit in all means. Usually in the Islamic financial system, it based on equity whereas the conventional banking system is loan based. Islam is not against the earning of money. In fact, Islam prohibits earning that can cause harmful to society or each other.

Shariah prohibits all forms of investment-based contracts of funding that involve interest loans forbidding financial transactions that involve gharar (risk-taking) and gahalah (unawareness).

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Al-Rahn (Rahnu) Ar-Rahn means to hold a maal as a mortgage to a loan in such a way that the loan can be settled from the value of the mortgaged maal in case of default or inability to pay. Islamic banks are like other conventional bank, which prefer to secure a loan either through personal surety (guarantor) or a pledge.

Syariah Ruling

The Quran also supports the idea of furnishing a pledge against a debt. It is laid down in Surah al- Baqarah 2:283;“…And if you are on a journey and cannot find a scribe, pledges (may be taken) in hand, but if trust one another, then let them who is fulfill his trust, and let him be conscious of god, his sustainer…”

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Al-Ijarah

It literally means to give something on rent. Technically, ijarah means employing the services of a person on wages given to him as a consideration for his hired services or transferring the usufruct of a particular property to another person on a rent claimed from him. There are two types of Ijarah, ijarah al-Ain and ijarah al’amal.

Syariah Ruling Surah Al-Qasas verse 26 “Trully the best men for you to employ is the man who is strong and trusty.”(28:26) Hadith: Prophet Muhammad said that, “Give the employee his due wage before his sweat dries.”

Al-Ijma’: All scholars from sahabah time agree that ijarah is permissible since people need benefits.

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Syariah Rulling

Syariah disallows a bank to prescribe profit at the time of contract. Hadith provides that, “Every loan which is draws benefit is Riba”. Therefore, contract of loan in Islamic finance is called benevolent loan (Qard al-hasan). But it is recommended for the borrower to give something in return for the benevolent act of the bank.

The hadith of the prophet are self-explanatory: Hadith reported by Abu Rafi that the prophet was lent a young female camel. He could not find a similar type of camel and returned a pregnant camel instead. “Indeed a good person among you is he who settles the loan with something better”. Hadith narrated by Jabir, “ I had the right (of loan) on the prophet-settled it made additional payment”.

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Falling stock and home prices have wiped out four years of gains in Americans' net worth since the start of 2008, according to new data from the Federal Reserve. Nearly half of those losses occurred over the last three months of the year, the biggest quarterly decline since recordkeeping began in 1952.

The new data underlined just how quickly wealth created during the biggest credit bubble in history has vanished, leaving Americans without the college funds, nest eggs and other reserves they had set aside.

Who’s to blame ?

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President Obama, speaking at a gathering of chief executives in Washington yesterday i.e 12 March 2009, acknowledged that the nation had been lured by the "illusion of prosperity," and he blamed "reckless speculation and spending beyond our means on bad credit and inflated home prices."

"Such activity . . . hurts us all in the end," he said.

While Obama outlined the steps his administration is taking to pull the country out of recession, the task has become more daunting in recent weeks. Americans continue to turn to the government for help -- the number of people filing continuous claims for jobless benefits jumped last week to another all-time high -- and, according to a new survey, foreclosure filings increased last month, despite foreclosure moratoriums imposed by several states and major lenders.

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Islamic economic and financial system is based on a set of values, ideals, and morals, such as honesty, credibility, transparency, clear evidence, facilitation, co-operation, complementarily ,and solidarity.Islamic economy promotes participation in profit, loss, and actual exchanges of money and assets. In fact, there should be real interaction between the wealthy, employers, the employees, and financial experts. There is no party who is a constant winner or a constant loser; yet profit and loss is mutually shared.

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