Principles of Islamic Financial System

Summary of the Previous Lecture1. Allah is the Sustainer2. God is Real Owner of Everything and Man is Merely a

Trustee3. Everything Created for Service and Use of Man4. Concept of Halal and Haram5. System of Sadaqat and Zakat6. Prohibition of Interest7. Ban on Hoarding of Wealth8. Policy of Moderation9. Condemnation of Monasticism and Materialism10. Equity and not Equality

Learning Outcomes

After this lecture you will be able to understand the principles of Islamic Financial System (Financial institutions and financial markets)Based on the basic characteristics of the Islamic Economic System

Principles of Islamic Financial System

Basic idea of Islamic Financial System is prohibition of receipt and payment of interest. Literature based on the divine guidance about Islamic financial system suggest the following principles.1. Money as potential capital2. Prohibition of Interest3. Risk Sharing4. Sanctity of Contracts

5. Sharia Approved Activities6. Individual Liberty7. Right to Own Property8. Economic Inequality and Charity9. Social Equality10. Circulation of Wealth

Principles of Islamic Financial System

1. Money as Potential Capital

1. Money is not an asset but a piece of document or a claim.

2. It becomes capital only when it joins hands with other resources to undertake a productive activity.

3. Money cannot be bought and sold as a commodity.

4. Money not backed by assets cannot increase in value over time.

Islamic Currency is Dinar and Dirham made of gold and silver. 1. The Islamic Dinar can be used for saving because they are

wealth in themselves.

2. They are used to pay Zakat as they carry value in itself. Instead of paying Zakat in paper currency gold and silver is used to pay Zakat as part of wealth.

3. They are used to buy and sell since they are a legitimate medium of exchange.

1. Money as Potential Capital

1. Gold cannot be inflated by printing more of it.

2. It cannot be devalued by government decree.

3. Unlike paper currency it is an asset which does not depend upon anybody's promise to pay.

4. Portability and anonymity of gold are both important, but the most significant fact is that gold is an asset not the liability.

1. Money as Potential Capital

2. Prohibition of InterestIslam categorically Prohibits the payment or receipt of any predetermined, guaranteed rate of return (Riba). And this act of involvement of interest or Riba, is declared as an act of war against the Almighty Allah and his Prophet.

2. Prohibition of Interest

What is interest or RIBA?Literal meaning are expansion, increase, addition and growth

Technical meaning are a predetermined increase as a condition for the loan, irrespective of whether the increment is small or big.

When any one of you grants a loan and the borrower offers him a dish [of food], he should not accepted it; and if he offers him a ride on an animal, he should not ride, unless the two of them are accustomed to exchanging such favours mutually (reported by Al-bayhaqi in his Sunan from Anas ibn Malik)

2. Prohibition of Interest

Contemporary definition of interest is a fee paid by a borrower of assets to the owner as a form of compensation for the use of the assets. It is most commonly the price paid for the use of borrowed money, or money earned by deposited funds.

•Islamic sharia considers the Riba and interest as same thing.

Quran and Hadith categorically prohibited riba.Four revelations have prohibited riba:

1. Surah al-rum (30:39)2. Surah al-nisa’ (4:161)3. Surah al-‘imran (3:130-2)4. Surah al-baqarah (2:1275-281)

2. Prohibition of Interest

Allah (SWT) says in Quran1. Those who benefit from interest shall be raised on the day

of judgment like those who have been driven to madness by the touch of the devil; this is because they say: “trade is like interest”, while Allah has permitted trade and forbidden interest: (2:275).

2. O believers! Fear Allah, and give up the interest that remains outstanding, if you are believers (2:278).

3. If you do not do so, then be aware of being at war with Allah and his Messenger. But if you repent, you can have your principal. Neither should you commit injustice, nor should you be subjected to it. (2:279)

2. Prohibition of Interest

There are several Ahadith condemning Interest1. The Prophet, peace and blessings of Allah be on him,

cursed the receiver and the payer of interest, the one who records the transaction, and the two witnesses, and said: “they are all alike [in guilt].

(Tirmizi and Musnad Ahmad).

2. The Prophet, peace and blessings of god be on him, said: “a dirham of riba which a person receives knowingly is worse than committing adultery thirty-six times.

(Ahmad)3. The Prophet, peace and blessings of god be on him, said:

“there will come a time for mankind when everyone will take riba, and if he does not do so, its dust will reach him. (Abu Dawud , ibn Majah)

2. Prohibition of Interest

2. Prohibition of InterestInterest is prohibited in almost all religions• Hinduism• Judaism• Christianity• A number of philosophers and scholars

Types of interest1. Riba al-nasiah“There is no riba except in nasiah” (Al-bukhari)

“The benefit derived form any loan is one of the different aspects of riba” (reported by al-buyhaqi from Fadalah ibn ‘Uhayd). This hadith is mawquf, implying that it is not necessarily from the Prophet; it could be an explanation provided by Fadalah, a companion of the Prophet, peace and blessings of Allah be on him.

2. Prohibition of Interest

2. Riba al-fadlFrom Abū Umamah: the Prophet, peace be on him, said: “whoever makes a recommendation for his brother and accepts a gift offered by him has entered ribā through one of its large gates.” (Ahmad and Abu Dawud)

From Anas ibn Mālik: the Prophet, peace be on him, said: “deceiving a mustarsal [an unknowing entrant into the market] is ribā. (Suyūti, al-jāmi‘ al-saghīr, under the word ghabn; kanz al-‘ummāl, kitāb al-buyū‘, al-bāb al-thānī, al-fasl al-thānī, on the authority of sunan al- bayhaqī)

2. Prohibition of Interest

From ‘Ubādah ibn al-Sāmit: the Prophet, peace be on him, said: “gold for gold, silver for silver, wheat for wheat, barley for barley, dates for dates, and salt for salt - like for like, equal for equal, and hand-to-hand; if the commodities differ, then you may sell as you wish, provided that the exchange is hand-to-hand.”

(Muslim, Tirmizi)

2. Prohibition of Interest

NIGERIAN PRESIDENT ABOUT INTEREST

•All that we had borrowed up to 1985 was around $5 billion, and we have paid about $16 billion; yet we are still being told that we owe about $28 billion. That $28 billion came about because of the injustice in the foreign creditors’ interest rates. If you ask me, what is the worst thing in the world? I will say it is compound interest. ……. Former President Olusegun Obasanjo speaking after the G8 Summit in Okinawa, Japan in the year 2000.

3. Risk Sharing

Because interest is prohibited, the suppliers of capital become investors instead of creditors. The provider of financial capital and the entrepreneur share business risk in return for shares of the profits.

4. Sanctity of Contracts

Islam upholds contractual obligations and the disclosure of information as a sacred duty. This feature is intended to reduce the risk of false information and moral hazard.Quran clearly emphasize the importance of the contract and say; 1.“O you who believe! Fulfill your obligations.” (5:1)

2.“… and fulfill your promise, surely you will be questioned about your promises.” (17: 34)

4. Sanctity of Contract

Abu Hurairah (RA) reported: Rasulullah (SAW) said “Three are the signs of a hypocrite: •When he speaks, he lies; •when he makes a promise, he breaks it; and •when he is trusted, he betrays his trust.” (Al-Bukhari) Another narration adds the words: “Even if he observes Saum (fasts), performs Salaat (prayer) and claims to be a Muslim.”

5. Sharia Approved Activities

• Allah says in Quran “O you who believe! Intoxicants and games of chance and (sacrificing to) stones set up and (dividing by) arrows are only an uncleanness, the Satan's work; shun it therefore that you may be successful” (5:90) .

• Islamic economy rules out the speculative behavior, anti social and harmful practices in the society.

6. Individual Liberty

The liberty that Islam grants is based on commitment and responsibility without which there can be no true freedom. In an Islamic state the individual has a •complete liberty in his/her thoughts and activities •but are not allowed to pose threats or creates problems for the society

7. Right to Own PropertyThere are several verses in Quran explaining the relationship of individual and the property, which explain the rights and wrongs for the individuals to claim and earn property. For example;•Do not devour one another’s property by foul means; (instead of it) do business. (4:29)•Allah has made trade lawful and interest unlawful. (2: 275)

8. Economic Inequality and Charity

Quran describes the economic inequality among people in these words,“We portion out among them their livelihood in the life of this world, and We exalt some of them above others in rank, that some of them may take others in service. (43:32)

9. Social Equality

• So long as the differences in wealth and rank do not create classes in the society, it is permissible.

• Tagging a part of the community as rulers, masters or superiors and the others as ruled, servants and inferiors is strictly forbidden.

• Individual and the community are dependent upon one another. The prosperity of one means the prosperity of the other.

10. Circulation of WealthIslam condemns hoarding in a very strong language; Allah says,

“And there are those who bury gold and silver and spend it not in the way of Allah: announce unto them a most grievous penalty On the Day when heat will be produced out of that (wealth) in the fire of Hell, and with it will be branded their foreheads, their flanks, and their backs. "This is the (treasure) which you buried for yourselves: taste you, then, the (treasures) you buried! (9:34-35)”

Summary of the lecture

After this lecture you will be able to understand the principles of Islamic Financial System (Financial institutions and financial markets);1.Money as potential capital2.Prohibition of Interest3.Risk Sharing4.Sanctity of Contracts5.Sharia Approved Activities

Summary of the Lecture

After this lecture you will be able to understand the principles of Islamic Financial System (Financial institutions and financial markets); 6.Individual Liberty7.Right to Own Property8.Economic Inequality and Charity9.Social Equality10. Circulation of Wealth