Islamic Financial System

IPIEF Week 2nd

The Concept of Money

Money is essential for the activity of IFIs.

Definitions of money:

Based on fiqh, money is synonym of nuqud or tsaman, which is defined as a medium of exchange  or transaction as well as a measurement of the value of goods or services.

Legally, it’s defined as thing that’s formulated by law as a money.

Based on its function, it’s defined as everything that performs the functions of money included as a medium of exchange, a mode of payment, a value store and as a unit of measurement.

The Forms of Money

Full bodied money/commodity money

Fiat money

Commodity Money

Has intrinsic value and long lasting

Gold and silver

Applied in the Islamic State period

In the next development, modified as a gold reserve standard

paper money supported by gold and silver

printed only if gold/silver is provided

gold standard

Fiat Money

Paper money

Not supported by commodity

Only supported by government policy

Managed money standard

Government responsible  for the maintaining of the paper value

The paper its self has no value actually

Forms of Fiat Money


Non cash

Financial System

Subsystem of economic system;

Allows the transfer of money between savers and borrowers;

Comprises a set of complex and closely interconnected financial institutions, markets, instruments, services, practices, and transactions.

The Importance of Financial System

Crucial to the allocation of resources in a modern economy;

Channels household savings to the corporate sector and allocate investment funds among firms;

Allows inter temporal smoothing of consumption by households and expenditures by firms;

Enables households and firms to share risks

Has impact on saving, investment, technology innovation, and economic development;

Controlling and monitoring managers of firms.

Islamic Financial System

A set of rules and laws, collectively referred to as shariah, governing economic, social, political, and cultural aspects of Islamic societies (Iqbal, 1997);

Comprises of:

Islamic Financial Instruments

Islamic Financial Institutions

Islamic Financial Rules and Regulations

Islamic Financial Control and Supervision

Basic Principles of Islamic Financial System

Syar’i principles

Based on Al Qur’an and As Sunnah

Tabi’i principles

Based on the ijtihad and ijma’

Related to contemporary issues such as risk management, cash flow management, technical analysis, capital management and so forth.

Syar’i principles

Prohibition of interest (riba)

Prohibition of speculative behavior (maisir)

Prohibition of uncertainty (gharar)

Risk sharing between suppliers of fund (investor) and enterpreneur

Money as “potential” capital

Money becomes actual capital only when it joins hands with other resources to undertake a productive activity

time value of money, only when it acts as capital, not when it is “potential” capital.

Sanctity of contracts

Disclosure of information and upholding the obligation contract is sacred duty

To reduce information asymmetric and moral hazard

Shariah-approved activities


Excess, increase or addition

Any excess compensation


Riba qardh (any excess for precondition to the borrower)

Riba jahiliyah (debt payment above the actual amount of the debt because the debtor fails to pay on time)

Riba Fadhl (the exchange of ribawi commodities at the different quality and or quantity)

Riba Nasi’ah (differences/excess/additional to the exchanged commodity because of the different time of delivery/payment)

Characteristics of Islamic Financial System

Chapra (2000)

To achieve the economic welfare through utilizing resources efficiently;

Without producing unlawful product

Without great gap between the poor and the rich (Equitable distribution)

Without harming current/next generation as well as environment

Stability of currency value

Mobilization of saving investment to encourage productive activity

To provide effective financial services.

Activities in the IFS

Funding Activities

Collect fund from fund surplus parties (saver, investor)

Financing Activities

Distributing fund to the fund minus parties (entrepreneur, lender)

Consists of two:

Equity Financing

Debt Financing

Exchange goods for money

Exchange money for goods

Exchange money for money

Service Activities

Islamic financial instruments

Depository (wadiah)

Profit-sharing agreement (mudharabah)

Equity participation (musyarakah)

Trade with mark up or cost-plus sale (murabahah and BBA)

Leasing (ijarah)

Sales contracts (salam, istishna)

Money lending (sharf)

Al qardh

Qardhul Hasan

Al Wadiah


IFI is deemed as a keeper and trustee of funds or other asset.

A person deposits funds or other assets in the IFI

The IFI guarantees refund of the entire amount of the deposit when the depositor demands it

The IFI only keeps the asset and has no permission to utilize the asset à idle capacity of the asset

IFI is benefited from cash incurred from safety keeping services

Customers are benefited because their assets are safe

Consists of:

Al Wadiah

Al Wadiah yad Dhomanah

Al Wadiah yad Dhomanah

Modified depository, to avoid idle capacity

IFIs can utilize the asset as Islam encourages productive activities by transfer the assets especially funds to the fund minus parties through financing activities

The depositor, at the IFI’s discretion, may be rewarded with Hibah (bonus/gift) as a form of appreciation for the use of funds by the bank

Al Murabahah

The sale of goods at a price, which includes a profit margin agreed to by both parties

Commonly used for short-term financing is based on the traditional notion of purchase finance

The investor undertakes to supply specific goods or commodities

Incorporating a mutually agreed contract for resale to the client and a mutually negotiated margin

Around 75 percent of Islamic financial transactions are cost-plus sales

Bay’ Bitsaman Ajil (BBA)

A deferred-payment sale

Sale of goods on a deferred payment basis at a price, which includes a profit margin agreed to by both parties

Similar to Murabahah, except that the debtor makes the payment on installments basis.

Al Ijarah

Lease, rent or wage

Selling the benefit of use or service for a fixed price or wage

The IFI makes available to the customer the use of service of assets/equipments such as hous, plant, office automation, motor vehicle for a fixed period and price

10 percent of Islamic financial transactions

Consists of two types:

Ijarah (operating lease)

Ijarah Muntahiya Bittamlik (financial lease)

The Advantages of Ijarah for the Lessee

Conserve the Lessee‘s capital since it allows up to 100% financing

Gives the Lessee the right to access the equipment on payment of the first installment

Ijarah arrangements aid corporate planning and budgeting by allowing the negotiation of flexible terms

Not considered Debt Financing so it does not appear on the Lessee’ Balance Sheet as a Liability

Not included in the Debt Ratios used by bankers to determine financing limits so lessee

All payments towards Ijarah contracts are treated as operating expenses,  thus it’s fully tax-deductible

Al Ijarah Muntahiya Bittamlik

Leases where a portion of the installment payment goes toward the final purchase

Ended by transfer of ownership of the assets to the lessee.

Transfer of ownership methods:

As a gift (hibah),

Sale before the contract period due

Sale after the contract period

Gradually sale (gradually transfer of ownership)

Al Mudharabah

One party acts as shohibul maal (investor, the fund owner) and another party acts as mudharib (entrepreneur/manager, lack of fund)

Identical to an investment fund in which managers handle a pool of funds

The agent-manager has relatively limited liability while having sufficient incentives to perform.

The capital is invested in broadly defined activities, and the terms of profit and risk sharing are customized for each investment

The maturity structure ranges from short to medium term and is more suitable for trade activities

Profit earned from the activities is shared to both parties with the predetermined nisbah (proportion)

Al Musyarakah

Analogous to a classical joint venture

Both entrepreneur and investor contribute to the capital of the operation in varying degrees and agree to share the returns (as well as the risks) in proportions agreed to in advance.

Capital may include assets, technical and managerial expertise, working capital, etc)

Traditionally, it has been used for financing fixed assets and working capital of medium- and long-term duration.

Bay’ mu’ajjal

A deferred-payment sale

Delivery of the product is taken on the spot but delivery of the payment is delayed for an agreed period.

Payment can be made in a lump sum or in installments, provided there is no extra charge for the delay


An advance payment or in front payment

A deferred-delivery sale

Similar to a forward contract

Delivery of the product is in the future in exchange for payment on the spot market

The quality of the commodity intended to be purchased is fully specified leaving no ambiguity leading to dispute

The objects of this sale are goods and cannot be gold, silver, or currencies based on these metals cause the exchange of good, silver, currencies and other ribawi commodity must be done simultaneously.

Bay’ al istishna’

Purchase by order or manufacture

The Differences between Salam & Istishna’