M. Kabir Hassan, Rasem N. Kayed, and Umar A. Oseni: Introduction To Islamic Banking and Finance: Principles and Practice

Introduction to Islamic Banking and Finance:
Principles and Practice
M. Kabir Hassan, Rasem N. Kayed, and Umar A. Oseni
Chapter 1
Introduction to Islamic
Banking and Finance
Subject Aims:
The key aim of this subject is to assist students in
understanding the theory and practice of Islamic banking,
based on the contemporary situations. At the end of the
course, students will be able to:
1. Understand the theory of Islamic banking,

2. Understand the operation of Islamic banking,
3. Identify the products offered by Islamic banks,
4. Evaluate the performance of Islamic banks, and
5. Analyse current issues and problems faced by Islamic banks.
Introduction
• Islam is a way of life. A verse from the Quran states, “This

day I have perfected your religion for you, completed My
favour upon you, and have chosen Islam as your way of
life” (Qur’an 5:3). The lexical meaning of the word Islam is
‘submission’
• Actions in Islam can be categorized into two broad
categories, namely ‘Ibadaat and Mu’amalaat.
Introduction (cont)
• ‘Ibadaat – Acts of Worship
Ibadaat are based on the individual’s direct relationship with
God. This entails that specific acts of worship must be directed
solely for Allah (God) alone with sincerity. This includes one’s
Prayers, Fasting, Pilgrimage etc.
• Mu’amalaat – Interactions with People
This refers to the conduct one has with fellow human beings.
This can refer to law, work, marriage, inheritance, business
transactions, partnerships, buying, selling etc. Islamic finance
and banking falls under this category. One must ensure their
conduct is in conformity with Shari’ah principles.
• Objective of human life is to please GOD – Almighty Allah via
Ibadaat and Muàmalaat.
Introduction (cont)
• Shari’ah –Islamic Law

Shari’ah is the set of rules which includes and clarifies
obligations, prohibitions, recommended duties, detested (yet
not blameworthy) actions, what is lawful and unlawful etc.
Therefore it includes ethics, manners, laws, public life, social
life, economic life, politics etc.
• Sources of the Shari’ah

The two Primary sources of the Shari’ah are the Qur’an and
the Sunnah. Other sources include Ijma’ (consensus) and
Ijtihad (juristic decision)
Basis of Islamic Banking and Finance
Figure 1.1: Shari’ah as the Basis of Islamic Banking and

Finance
The Qur’an
• The Qur’an is believed by Muslims to be the word of God

revealed to the Prophet Muhammad – peace be upon him
(PBUH). It is the final revealed scripture and remains intact in
the Arabic language. The Prophet Muhammad was instructed
with the Message of Islam when he was at the age of forty in
the year 610 CE. From then onwards, his Prophethood lasted
twenty-three years until the Message was complete and the
Prophet passed away.
• The Qur’an was therefore revealed over a period of twenty-
three years in stages and intervals. The Qur’an can be studied
closer by looking into the Sunnah, the teachings of the
Companions (who learned directly from the Prophet and were
preserved when verses were revealed concerning specific
circumstances), studies from scholars and experts in the
Arabic language.
Learning Objective 1.1
Describe the conceptual
Basis of Islamic Banking and Finance basis of the modern
practice of Islamic banking
and finance.
The Qur’an
• The first source of the Shari’ah
• General and specific rules on religious, commercial, political,
economic, legal and social norms
• Emphasis on mutual consent and consensus among
consenting parties
• Prohibits exploitative measures:
– Excessive risk or uncertaintly (gharar)
– Usary or interest (riba)
• Prohibits cheating and corrupt practices in the management

of funds
• Does not allow dealings in prohibited products
The Sunnah
• The Sunnah refers to the authentic statements, actions and

approvals of the Prophet Muhammad. Sunnah literally means
way and therefore refers to the way of the Prophet. Another
word sometimes interchangeably used with Sunnah is Hadith
(speech, statement or saying). Therefore, books of Hadith are
referred to as the Sunnah as they are collections of the
statements, actions and approvals of the Prophet Muhammad
- PBUH.
• The Sunnah is collected in many volumes of Hadith books.
Hadith can be used to help explain and elaborate on the
Qur’an. Likewise, the Sunnah contains rulings and guidance
on all kinds of issues and circumstances. There are over forty
verses in the Qur’an which command adherence to the way of
the Prophet (his Sunnah).
Other sources for Shari’ah are Ijma’ (consensus)
and Ijtihad (juristic decision).
• Ijma’ (Consensus) – This refers to teachings in Islam that have
been agreed upon by the early generations of Muslims or
Muslim scholars. These are matters that are established and
leave no room for disagreement in the Shari’ah.
• Ijtihad (Juristic decision) – Ijtihad is applied by the Mujtahid
(Muslim Jurist/Scholar) who does not find the answer clear cut
from the Qur’an or Sunnah. Therefore, they explore into the
Primary sources to find the answer based on their skills of
judgment -maintaining the aims of the Shari’ah- and trying
their best to interpret the intent of the Law Maker.
• Sometimes the word Qiyas (analogy) is used to refer to ijtihad.
Qiyas is used to figure out rulings based on similar existing
rulings by way of analogy.
Explain the historical
Origins and Historical Overview of development and
conceptual arguments of
Islamic Banking and Finance Islamic banking and
finance
• Islamic finance is both a new and old phenomenon. The

history of Islamic finance is divided into two general
aspects:
• The early days transactions (The guiding principles of Islamic

Finance originate from the early days of Islam).
• The modern-day experiments (Experiments in Islamic finance in

Egypt, Malaysia, and Pakistan: the basis of modern Islamic banking and
finance) .
finance
The early days transactions
• The Era of the Prophet
• The Period of Orthodox Caliphate (632 – 661 C.E.)
• Period of the Noble Companions and the Succeeding

Generations
• The Umayyad and Abbasid Eras

finance
The Era of the Prophet

The prevailing modes of transactions during this era include:
• Shirkah (partnership) based on profit-and-loss sharing (PLS)
• Al qard Al hasan (benevolent loan)
• Salam (Forward) contract
• Sarf (exchange of money), i.e. gold for gold and silver for
silver at the same sitting
• Ijarah (leasing)
• Trans-regional trade involved trade caravans from Mecca to
Syria and vice versa
Origins and Historical Overview of Explain the historical

development and
Islamic Banking and Finance conceptual arguments of
Islamic banking and
finance
Timeline of Modern-day Experiments of
Islamic Banking and Finance from 1962 to 1975
• Initial Reforms in the Banking Industry in Pakistan in 1962
• Mit Ghamr Local Savings Bank in Egypt of 1963 (“the first modern-day trial
of Islamic baking”)
• The Malaysian Pilgrims Savings

Board, Tabung Haji of 1969
(managing savings of prospective
pilgrims by investing in Sharī’ah-
compliant investments)
• The new birth of modern Islamic finance took place in Dubai in 1975
through Dubai Islamic Bank as the first Islamic commercial bank in the
world. At the same time, IDB established and started Islamic Finance.
finance
The functions of the IDB are:

• To participate in equity capital and to grant loans
• To provide financial assistance to member countries
• To establish and operate special funds for specific purposes
• To accept deposits and to mobilize financial resources

through Sharī’ah compatible modes
• To promote foreign trade, especially in capital goods, among

member countries
finance
Dubai Islamic Bank (DIB)

The first fully-fledged Islamic world commercial bank in 1975.
Operates five main business groups:
• Retail banking
• Corporate banking
• Real estate
• Investment banking
• Proprietary trading investments

What is Islamic Banking?
Definition:
“an Islamic bank is a financial institution whose statutes, rules
and procedures expressly state its commitment to the principle
of Shariah and to the banning of the receipt and payment of
interest on any of its operation…” (OIC)
Moreover, the Malaysian Islamic Banking Act 1983, defines an
Islamic bank as
“… a company which carries on Islamic business. Islamic
business means banking business whose aims and operations
do not involve any element which is not approved by the
religion of Islam…”
Thus, Islamic banking is banking that complies with Shari’ah or
Islamic law.
The Banking Business
1. Bank is an authorized deposit-taking institution (ADI)
2. Facilitates intermediation between savers and investors.
3. Transfer funds from surplus units to deficit units.
4. It manages payments and clearing systems (EFTPOS, Cards,
BPAY, Cheques,…)
Islamic and conventional banking (1 to 4 above + …)

• The prohibition of riba (interest, usury), gharar (excessive
uncertainty) and haram (impermissible) activities.
• The implementation of profit and loss sharing (PLS) principle.
• The emphasis on productivity and real economic activity
(rather than credit worthiness).
The Banking Business: Flow of money
The Banking Business: Flow of profits
Key 6 principles of Islamic banking
1. Prohibition of predetermined loan repayments as interest
(riba)
2. Profit and loss sharing, which is at the heart of the Islamic
finance system
3. Making money out of money as being unacceptable, with all
financial transactions needing to be asset-backed
4. Prohibition of speculative behavior
5. Only Shariah approved contracts being acceptable
6. The sanctity of contracts
In the News: The Vatican says Islamic Finance May Help Western Banks in Crisis
“The ethical principles on which Islamic finance is based may

bring banks closer to their clients and to the true spirit which
should mark every financial service,” (the Vatican’s official newspaper
Osservatore Romano)*
• *A Lorenzo Totaro 2009 'Vatican Says Islamic Finance May Help Western Banks in Crisis, Bloomberg.com, viewed on 17 February 2010
http://www.bloomberg.com/apps/news?pid=20601092&sid=aOsOLE8uiNOg&refer=italy
Islamic Banking and Finance around the world
And many mo
Islamic Banking and Finance in
Australia
"The LM Australian Alif Fund has been awarded 'Best New Product
2009' at the world's leading Islamic Banking and Finance awards in
Dubai for its innovative approach to Shariah-compliant investment,
beating a shortlist of prominent international Islamic institutions'‘
http://www.lmaustralia.com
What is Islamic Banking?
Definition:
“an Islamic bank is a financial institution whose statutes, rules
and procedures expressly state its commitment to the principle
of Shariah and to the banning of the receipt and payment of
interest on any of its operation…” (OIC)
Moreover, the Malaysian Islamic Banking Act 1983, defines an
Islamic bank as
“… a company which carries on Islamic business. Islamic
business means banking business whose aims and operations
do not involve any element which is not approved by the
religion of Islam…”
Thus, Islamic banking is banking that complies with Shari’ah or
Islamic law.
The Banking Business
1. Bank is an authorized deposit-taking institution (ADI)
2. Facilitates intermediation between savers and investors.
3. Transfer funds from surplus units to deficit units.
4. It manages payments and clearing systems (EFTPOS, Cards,
BPAY, Cheques,…)
Islamic and conventional banking (1 to 4 above + …)

• The prohibition of riba (interest, usury), gharar (excessive
uncertainty) and haram (impermissible) activities.
• The implementation of profit and loss sharing (PLS) principle.
• The emphasis on productivity and real economic activity
(rather than credit worthiness).
The Banking Business: Flow of money
Fund providers Funds users
Mobiliza Allocati
tion Bank on
Surplus (Financial Deficit
of funds of
Units Intermediary funds Units
(savers) ) (borrower
Deposits mechanism: s)
Mobilizes funds from savers
Real Economic
according to return and activity
liquidity (withdrawal)
(assets,
requirements. Efficiency in projects,
mobilization of funds is service…)
improved with increase in
the range of financial assets
The Banking Business: Flow of profits
Fund providers Funds users

Distrib Bank
Alloca
ution tion
Surplu of (Financial of
Deficit
s profits profits
Intermedia Units
Units ry) (borrow
(savers
Unique ers)
) risk/return needs
and expectations by savers Real Economic
and investors are matched activity
through the creation of a (assets,
range of financial products projects,
service…)
and services.
Why so much interest in “No Interest” banking?
Key 6 principles of Islamic banking
1. Prohibition of predetermined loan repayments as interest
(riba)
2. Profit and loss sharing, which is at the heart of the Islamic
finance system
3. Making money out of money as being unacceptable, with all
financial transactions needing to be asset-backed
4. Prohibition of speculative behavior
5. Only Shariah approved contracts being acceptable
6. The sanctity of contracts
In the News: The Vatican says Islamic Finance May Help Western Banks in Crisis
“The ethical principles on which Islamic finance is based may

bring banks closer to their clients and to the true spirit which
should mark every financial service,” (the Vatican’s official newspaper
Osservatore Romano)*
• *A Lorenzo Totaro 2009 'Vatican Says Islamic Finance May Help Western Banks in Crisis, Bloomberg.com, viewed on 17 February 2010
http://www.bloomberg.com/apps/news?pid=20601092&sid=aOsOLE8uiNOg&refer=italy
Islamic Banking and Finance around the world
And many mo
Australia
"The LM Australian Alif Fund has been awarded 'Best New

Product 2009' at the world's leading Islamic Banking and
Finance awards in Dubai for its innovative approach to
Shariah-compliant investment, beating a shortlist of
prominent international Islamic institutions'‘
Video: Why Islamic Finance?
Play
• Any other questions?

ISLAMIC BANKING - FIN5BNK
Topic 2: Ethics & Prohibitions in Mu’amalat
Ethics in Islamic Finance and Banking - Main prohibitions in

Mu’amalat: Riba - Gharar - Impermissible (Haram) activities
Sanctity of Contracts
FACULTY OF LAW AND MANAGEMENT

SCHOOL OF ECONOMICS AND FINANCE
Ethics in Islamic Finance and Banking
"Assist one another in righteousness and piety. And do not assist

one another in sin and transgression…" (Qur’an 5:2)
• One objective of Islamic finance and banking is to assist in the

spread of economic prosperity. The other objective is to do
this in accordance with Shari’ah principles.
• Among the norms concerning Islamic finance are a free
market, where prices are determined by demand and supply,
freedom from manipulation, prevention of hoarding, profit
and loss sharing in partnerships, information efficiency etc.
Among the norms in Islamic finance that we want to
elaborate on here are the following three topics:
• 1. The Prohibition of Riba (Interest or Usury) – Money is not
to be exchanged for money with profit. As a result of this
prohibition, alternative solutions are given which encourage
trade and equity participation.
• 2. The Prohibition of Gharar (Uncertainty) – This demands
transparency in contracts as well as in buying and selling.
Prices should be specified, there should be clarity of the
delivery details, quality of goods, quantity of goods etc. The
information should be available to all parties involved and the
outcomes of a contract should be free from ambiguity etc.
• 3. Sanctity of Contract – Contracts should be fair and agreed
upon by both parties. Therefore, the contract should be free
from the elements of Gharar and reach Shari’ah approval in
their content.
1. The Prohibition of Riba (Interest or Usury)
• Definition of Riba: ‫الربا‬
• Riba in the Arabic language literally means increase. However,
according to the specific Shari’ah definition, it means unlawful
increase ‫الزيادة المحرمة‬. Under today’s literature and
terminologies, riba commonly refers to interest and usury.
• The Islamic Fiqh Academy which was initiated through the OIC
(Organization of the Islamic Conference), was established to
bring scholars from around the world in order to address
current issues and concerns. During the 2000 meeting, the OIC
reaffirmed the consensus of the historical prohibition of
interest. Riba is one of the core concerns in Islamic finance. In
order to avoid riba, many financial alternatives have been
adopted over the centuries. Although scholars describe
rationales as to why riba may be prohibited, the sole reason
for sincere Muslims to refrain from riba is to conform to what
the Law Maker has legislated.
Interest in Judaism and Christianity
The prohibition of interest is not something exclusive to Islam. Jews

and Christians were likewise given instructions in their scriptures
which forbade them to deal with interest or usury. Although
other faiths may have had aversion to interest or usury, only
Judaism and Christianity are singled out here due to the common
historical link between the three faiths. Below are some passages
from the present day Bible.
Old Testament
• If you lend money to one of my people among you who is needy,
do not be like a money lender; charge him no interest (Exodus
22:25).
• Do not take interest of any kind from him, but fear your God, so
that your countryman may continue to live among you (Leviticus
25:36).
• Do not charge your brother interest, whether on money or food
or anything else that may earn interest (Deuteronomy 23:19).
• Hath given forth upon interest, and hath taken increase: shall he
New Testament
• But love ye your enemies, and do well, and lend, hoping for
nothing again; and your reward shall be great, and ye shall be
the children of the Highest: for he is kind unto the unthankful
and to the evil (Luke, 6:35).
In Judaism and Christianity, lending money in order to receive a
profit was strongly condemned. In the Talmud, Ezekiel
condemned interest as an abomination. He also likened
usurers to people who shed blood. In Judaism, the distinction
was made between Jews and gentiles. They tolerated charging
interest to gentiles, yet, were forbidden to practice it with
their own fellow brethren (Deuteronomy 23:20).
Pope Alexander III (12th Century) excommunicated usurers,
which in that period was seen as an extremely harsh
punishment. In 1317 the Council of Vienna took a strong
stance and issued a law that usurers were to be
excommunicated. However, by the fifteenth century in
Europe, usury practices gradually gained ground and
acceptance.
Riba ‫( الربا‬Interest or Usury)
• Riba is strongly prohibited in Islam. The many verses of the
Qur’an leave no question in this regard: “Allah has permitted
trade and forbidden riba.” (Qur’an: Surah Al-Baqarah 2:275).
The verses prohibiting riba are located in four Surahs of the
Qur’an; Surah Al-Baqarah 2:275-276, 278-280; Surah Aal
Imran 3:130; Surah An-Nisaa 4:161 and; Surah Ar-Room 30:39.
• Riba is further elaborated on in the Prophet’s Sunnah.
Numerous hadiths explain the details surrounding riba. In a
hadith narrated by the Prophet’s companion Jaabir: “Allah’s
Messenger cursed the one who accepts riba, the one who
gives it, the one who records it and the two witnesses to it,
saying, ‘They are all the same.’” (Collected By Muslim).
Types of Riba:
• There are two major categories of riba.
• The first category is known as Riba An-Nasee’ah which relates
to riba in debt. It increases with time (e.g. interest on
borrowed money). This is the most common type of riba today
and it relates to return of money on money at any rate (fixed
or floating, compounded or simple interest).
• The other category is Riba Al-Fadl which refers to riba in

exchange. This type of riba refers to the six commodities (e.g.
Gold) mentioned in the hadith.
It increases with the transaction.
Riba An-Nasee’ah - Riba in Debt
• This form of riba was well known in jahiliyah (pre-Islamic era
of ignorance). When the date of maturity neared for one’s
debt, it would be said to him, “pay up, or pay riba (increase)”.
Due to deferment in repaying the debt, the debt would
increase. It would continue to accumulate as compounded
interest until it doubles and so on.
• Another practice from the jahiliyah period included the
loaning of money with a fixed increase in the return. For
example, one would borrow, 10 gold coins (Dinars) with the
condition of returning 12 gold coins at a future date.
• From the above description, we see how riba an-nasee’ah is
equivalent to interest. For example, it includes the use of
credit cards and “interest free” periods, as the date of
maturity passes, interest is incurred. Likewise it is typical of
bonds, or loans from conventional banks today which lend
money with the condition to be paid back with an increase of a
certain percentage in the future, at a variable or fixed interest
rate.
Riba Al-Fadl - Riba in Exchange
• Although gold and silver were the real currency at the time,
the Prophet described certain commodities that relate to riba.
These commodities are prohibited to exchange, same for
same, unless they are of equal amount, without increase. One
hadith states, “Gold with gold, silver with silver, wheat with
wheat, barley with barley, dates with dates, and salt with
salt; same quantity for same quantity, equal for equal;
transaction being made hand to hand (i.e. on the spot
payment)” (Muslim).
• Some scholars have stated that these commodities are only
limited to the six mentioned. Other scholars, by making Qiyas
(analogy), have stated that it can also include other
commodities that can be weighed, or other food, or specific
food which can be stored similar in nature to the six.
Riba Al-Fadl - Riba in Exchange (cont)
• However, gold and silver are the universal tenders like cash
money today. The remaining four commodities may have been
used in a similar fashion to currency.
• Another hadith mentions, “Do not sell gold for gold unless it is
the same amount for the same amount, and do not make one
amount greater than the other. Do not sell silver for silver
unless it is the same amount and do not make one greater
than the other.” (Bukhari and Muslim).
Riba Al-Fadl - Riba in Exchange (cont)
• The following narration sheds light on this form of riba with the
exchange of these types of commodities. A hadith mentions,
“Once Bilal brought Barni (a kind of dates) to the Prophet and
the Prophet asked him, ‘From where have you brought these?’
Bilal replied, ‘I had some inferior type of dates and exchanged
two Sa’s (approximately 6 kilograms) of it for one Sa’
(approximately 3 kilograms) of Barni dates in order to give it to
the Prophet to eat.’ Thereupon the Prophet said, Beware!
Beware! This is definitely Riba! Don’t do so, but if you want to
buy (a superior kind of dates), sell the inferior dates for money
and then buy the superior kind of dates with the money”
(Bukhari).
• This hadith shows the prohibition of exchanging the same
commodity of a different measurement, yet it also displays the
alternative solution. That is to sell the dates, and buy the other
dates with the money.
Riba rules - summary
• The commentator of Sahih Muslim, Imam Nawavi has
summarized these rules in the following way:
• When the underlying ‘Illah of the two goods being exchanged
is different, shortfall/excess and delay both are permissible,
e.g. the exchange of gold for wheat or dollars for a car.
• When the commodities of exchange are similar, excess and
delay both are prohibited, e.g. gold for gold or wheat for
wheat, dollars for dollars, etc.
• When the commodities of exchange are heterogeneous but the
‘Illah is the same, as in the case of exchanging gold for silver or
US Dollars for Japanese Yen (medium of exchange) or wheat
for rice (the ‘Illah being edibility), then xcess/deficiency is
allowed, but delay in exchange is not allowed. (Ayub 2007,
p.52)
Wisdom behind the prohibition of riba as put
forward by some scholars.
• It goes against mutual cooperation, generosity,
and spirit of partnership.
• Acquisition of property by wrongful means and
harm to the needy.
• Removal of the possibility for injustice and
exploitation.
• Drives the capital-owner away from enterprise
and real economic activities that contribute to the
welfare of society (e.g. commerce, manufacturing,
construction and so on)
• Money is meant to be a medium of exchange and
standard of value for other goods. Riba violates
2. The Prohibition of Gharar (Uncertainty)
• Gharar has a broad scope and is not limited to one simple

definition. For our purposes here, it relates to excessive
uncertainty or ignorance by way of a contract, or the goods
involved in a sale, the price, ownership, possession of goods,
deliverability, dates of exchange etc. A hadith collected by
Muslim narrated by Abu Hurairah states, “The Prophet
forbade selling by way of tossing stones to settle a sale (Al-
Haasah), and the sale of Gharar.”
Minor and major Gharar
Minor Gharar
• Gharar has been categorized into two categories, namely
major and minor. It is expected that minor (or trivial) accounts
of gharar will exist and for that reason it is tolerated and not
given concern. Such is the case of catching a taxi, there is an
element of uncertainty in the price as it rises with the mileage,
yet this is a minor form of uncertainty and is permissible.
Another example is buying fruit without peeling the skin to see
inside.
Major Gharar
• Causes for alarm are the major or substantial forms of gharar
which are clearly condemned from a Shari’ah perspective.
Major Gharar will be simply referred to as gharar in the rest of
the lecture notes.
• Gharar can generally refer to the following:
• Lack of Transparency -The Shari’ah stipulates that
transparency must exist in order for contracts to be legitimate.
For example, the terms of the contract must be clear to both
parties involved in order to be just and fair. Under such
measures, individuals are protected from fraud, deceit and
exploitation.
• Deception - Gharar can also imply deceit.
Once Prophet Mohammad came upon a heap of grain in the
market of Madinah and thrust his hand onto it. His fingers felt
dampness. On being asked, the trader replied that rain had
fallen upon it. The Prophet observed, "Why did you not then
keep (the wet portion of) it above the dry grain, so that
people may see it? He who deceives, has nothing to do with
me” (Muslim). Therefore, relevant information cannot be
withheld.
• Selling what you do not have
Part of Gharar is selling what is not in one’s possession. The

common example of this is the selling of the fish in the ocean
which has not been caught yet, or selling vegetables that the
seller is yet to purchase (i.e. they are not in possession or
ownership). This can lead to settlement risk and is therefore a
form of gharar. One should therefore catch the fish and then
sell it, or buy the vegetables from a wholesaler, and then sell
them to avoid the risk of uncertainty.
An exception to this rule is a salam contract (Bai’ As-Salam)
which relates to farm produce which has not been harvested
yet. Such a contract is paid up-front and an agreed upon
amount of goods (e.g. one ton) must be delivered at a later
date when the produce is harvested.
• Ignorance - The buyer should have relevant information
about the goods they intend to buy or the contract they intend
to sign. This is why it is important to inspect the goods one is
about to buy. With regards to what the buyer is buying, the
buyer should know (for example) the quantity, the attributes,
species etc. Or in the case of a contract, both parties should
have a sufficient understanding of the details and outcome of
the contract in order to remove any doubt.
• Unspecified Price - The price of the sale should be stipulated.
This is important if the goods are purchased on credit, in order
to avoid disagreement at a later date.
• Unspecified dates - As for the delivery of goods, the price can
be delayed or the goods can be delayed in delivery, yet this
should be by mutual consent of the buyer and seller.
• Akin to gambling
Maisir (game of chance) is regarded as gambling because the
outcome is unknown and clearly involves gharar. The practice of
Maisir is declared forbidden in Qur’an (2: 219). Therefore,
according to the Shari’ah, such games of chance are to be
avoided. An example of this is speculation in short selling,
conventional methods of forwards, futures, options and other
derivative transactions where future delivery of underlying assets
is uncertain (and usually settled in cash) as being forms of maisir.
• Although excessive gharar is condemned by the Shari’ah, this
does not rule out levels of risk by way of entrepreneurial risk and
risk associated with calamities (such as natural disasters).
Systematic risk and unsystematic risk will be covered in more
detail in the following weeks.
• Complexity in Contracts
Undue complexity in contracts or interdependent contracts
where two sales are combined in one are not permitted. (e.g. I
will sell you A as such a price, if you sell me B at such a price.)
3. Sanctity of Contract
Sanctity of Contract
• As excessive gharar is impermissible in Islam, the Shari’ah
emphasizes that contracts must include transparency and
honesty. Prices should be specified, there should be clarity of
the delivery details, quality of goods, quantity of goods etc.
The information should be available to all parties involved and
the outcomes of a contract should be free of ambiguity.
• When full disclosure is present, both parties eliminate or
reduce financial speculation and undue complexity in
contracts (due to gharar). This will include discloser of the risk
involved by providing as much information as possible for
buyers or investors.
3. Sanctity of Contract (cont)
• If two or more parties come together for a partnership (e.g.

musharakah), all parties should be aware of their profit-
sharing ratio, underlying assets involved, and other conditions
of the contract.
• The parties involved must mutually agree on the sale or
contract, albeit orally or preferably in written form, without
coercion.
• Contracts must be in accordance with Shari’ah principles.
Therefore, investments considered unethical, unlawful
(haram), unjust etc, would not be considered. Although riba
and gharar may not be involved, one must make sure that
other unlawful practices are not present. For example, it is
prohibited to finance a casino or deal with alcohol etc.
Case study: Riba & Gharar today
Identify role of Riba & Gharar in:

I. Global Financial Crisis (GFC)
II. European debt crisis (EDC)
III. Other examples?
Questions?
Topic 3: Equity Based Financing (PLS mode)
Equity Based Financing:

Musharaka (Sharing, Equity/Business partnership, Joint Venture)
Mudaraba (Trustee/Limited/Investment Partnership)
FACULTY OF LAW AND
MANAGEMENT
SCHOOL OF ECONOMICS
Introduction
• The bank generally acts as a financial intermediary between

lenders and borrowers. By connecting savers to borrowers via
various financial products, banks mobilise funds that impact
on economic activities. However, Islamic financial Institutions
are less straightforward because the Shariah prohibits certain
transactions.
• Islam prohibits making money by money and thus all
transactions must not involve any interest (riba). The Qur'anic
verse "Allah has permitted trade and has forbidden interest
(usury)" [2:275] is the main reason why Islamic banking
derives its profit from real economic activities by means of
trading or investment. Given that the Shari’ah equally
prohibits charging and paying interest, opportunities for the
Australian financial sector lie in establishing Shari’ah compliant
financing instruments.
Equity based financing
• Under Islamic Banking there are two main fields of financing.

One is Equity Based Financing and the second is Debt Based
Financing. These modes of financing primarily differ from
conventional financing due to their voidance of interest.
• Equity Based Financing - profit-and-loss sharing (PLS)

• Musharaka (Sharing, Equity/Business partnership, Joint
Venture)
• Mudaraba (Trustee/Limited/Investment Partnership)
Musharaka (Sharing, Equity/Business
partnership, Joint Venture)
• Two or more parties come together and contribute funds in a
partnership. Partners share in the profit or loss of a joint
venture.
• The profit-ratio is determined according to the agreement of
the partners and not necessarily according to their capital
contribution. This could depend on how much each partner
contributes to the partnership beyond their capital share.
However, the losses must be determined according to the
percentage of one’s share in the investment. Scholars agree
(Ijma’) on the equal division of loss in accordance with the
ratio of each investor.
• The profit returned to each partner should reflect the actual
profits made by the enterprise as opposed to a set income.
Partners may contribute cash or assets towards the
partnership. Their contribution ratio should be determined
according to the value of the assets.
Musharaka (Equity partnership, Joint Venture)
$2.5mil Profit
Investor $10mil (25%) 25%

A
Business Profit
10mil
Investor $30mil (75%) Venture
B
75%
$7.5mil Profit
Musharaka - example
Investor Contribution Outcome Outcome

1 2
Profit 200 Loss 100
A 100 (10%) 20 (10%) -10 (10%)
B 300 (30%) 60 (30%) - 30 (30%)
C 600 (60%) 120 (60%) - 60 (60%)
Profit arrangement ratio is pre-agreed at the start (10/30/60 or

it could be eg. 15/30/55) based on investors involvement in the
business management and other relevant factors (eg. experience,
skills and so on). However, loss must be shared in proportion to
contributed capital (in this case 10/30/60) and can not be
changed.
Home purchase
• Diminishing Musharaka – This method can be used in

purchasing property or assets such as machinery for a factory.
For example, under a diminishing Musharakah contract, the
bank (or financier) and the client become partners.
• The client must provide a significant amount of funds e.g. 20%
to purchase the house with the bank. The bank in this case
owns the other 80% which the client will pay over time in
installments. Since the client will be living in the house, they
will pay (on top of the installments) a certain percentage (e.g.
8%) in rent (ijarah) to the bank for the share the bank owns.
• Over time, the client will own more equity in the house until it
is completely bought, while the rent will decrease as the
bank’s share diminishes.
Diminishing Musharaka (Musharaka Mutanaqisa)
Home Purchase
Ownership %
Bank Customer
Bank Transfer of ownership 80%↓ 20%↑
Customer 70%↓ 30%↑
Payment for piece of 60%↓ 40%↑
property (eg. 10%)
50%↓ 50%↑
40%↓ 60%↑
Rent % Rent % 30%↓ 70%↑
20%↓ 80%↑
10%↓ 90%↑
Price 80% Price 20% 0%↓ 100%↑
Bank’s participation diminishes over

time until customer becomes sole
owner of the property.
Mudaraba (Trustee or Investment
Partnership)
• Such a contract requires one partner with the funds, known as
Rabb-ul-Mal (Owner of Wealth), and one partner is the
Mudarib (Entrepreneur, Fund Manager). There can be more
than one Mudarib to work together as partners with the Rabb-
ul-Mal.
• If the business or project is a success, the profit is shared
according to a pre-agreed ratio. Typically, the Rabb-ul-Mal
bears the risk of losing money, while the Mudarib loses time and
effort if the project does not bear fruit.
• The Rabb-ul-Mal may specify where they want the Mudarib to
invest their money (Al-Mudaraba Al-Muqayyada – specific or
restricted Mudaraba, eg. Specific type of business of place).
Otherwise, the Mudarib is free to invest where they best see fit
(Al-Mudaraba Al-Mutlaqa – unrestricted or general investment
(Mudaraba), unrestricted by time, place, activity and so on).
Mudaraba (Investment Partnership)
Share of profits
capital
Investor
Business
Profit
Mudarib management Venture
(entrepreneur)
Share of profits
Profit can not be a fixed amount (for PLS financing) but must be determined
by a pre-agreed ratio. In case of loss, the investor loses capital and the
mudarib loses time and effort. In the case of proven negligence by the
mudarib, the mudarib may be liable for capital as well.
Topic 4: Debt-Based Financing (non-PLS Modes)
Murabaha (Cost Plus Sale) - Bai’ bithaman ajil (BBA, deferred payment) - Ijarah (Leasing)
- Bai’ As-Salam (Deferred Delivery Sale) - Bai’ Al-Istisna’ (Manufacturing Sale) - Bai’
Al-Istijrar (Suply Sale) - Qard Hasan
Contentious Instruments: Bai’ Al-Einah (Back to back repurchase) - At-Tawarruq
(Tripartate Sale) - Bai’ Al-Dayn (Sale of Debt, Bill discounting)
FACULTY OF LAW AND

MANAGEMENT
SCHOOL OF ECONOMICS
Debt-Based Financing or non-PLS Modes.
• The following instruments are the most commonly used within
IBF. They are the Shari’ah compliant alternatives to interest
based modes of financing.
Murabaha (Cost Plus Sale)
Implies a mark-up in price. The merchandise is purchased, the
buyer marks up the price and sells it to the customer and thus
benefits from the profit.
Bai’ bithaman ajil (BBA)- Murabaha (deferred payment) In the
case of financing, Murabaha is the useful alternative to
conventional loans when it is combined with Bai’ bithaman ajil
(BBA). Bai’ bithaman ajil (BBA) means sale with deferred
payment and can also be known as Bai’ Al-Mu’ajjal, which
carries the same meaning.
• BBA and Murabaha are similar concepts and are often used
interchangeably, where Murabaha is used for short term and
BBA represents long term credit sale.
• When a customer seeks to purchase a product and is unable to
pay up-front, the customer may require the bank (or financier)
to purchase the product. Thereafter, the bank (or financier)
sells the product to the customer who will pay at a later date,
in full or by installments (BBA), with a mark-up in price. The
profit is a fixed amount agreed upon at the commencement of
the contract. Under a Murabaha contract, both parties are
aware of the original price as well as the mark up price. This is
different from a typical everyday sale (Musawama) where
costs and profit are not disclosed (like buying from the shop).
Murabaha
Financing asset purchase
Goods Goods
(immediate (immediate
Goods delivery) delivery)
Supplier Bank
$100,000 $130,000 Customer
(spot payment) (deferred
Bank must own payment,
the asset before including profit
selling it. mark up)
Debt Based Financing:

Why it is called debt
Ijarah (Leasing)
• Leasing entails that ownership remains that of the lessor and is

to be transferred to the lessee by way of usufruct (i.e. the right
to use it). The lessee pays the lessor for the duration of the
contract at an agreed amount.
Upon the close of an ijarah contract:
• The lessee may return the assets to the owner.
• The lessee may sign another contract to continue leasing.
• The lessor may offer to sell the assets to the lessee under
another contract. This is known as Al-Ijarah Thumma Al-Bai’
(AITAB).
• The lessor may give the asset as a gift to the lessee. This is
referred to as Al-Ijarah Muntahia Bittamleek (a contract of
leasing ending with ownership).
Ijarah cannot be applied to money, or perishables (food), or
other things that can be consumed (such as fuel).
Ijarah can also be used in reference to the services given by a
Bai’ As-Salam (Deferred Delivery Sale, pre-paid sale)
• When the Prophet came to Madina, the inhabitants use to pay
in advance for dates to be delivered a year or two later. The
Prophet told the people, “Whoever pays in advance for dates
(to be delivered later) should pay it for a known specified
weight and measure (of the dates).” Another hadith mentions,
“…for a specific period”(Collected by Bukhari). The other items
that were sold in the lifetime of the Prophet under a Salam
sale included wheat, barley and raisons.
• Selling agricultural produce in advance is permissible providing
certain conditions are fulfilled. Some may refer to a Salam
contract as a forward contract, however, a forward contract
involves a deferred payment as well as deferred delivery.
Among the conditions of a Salam contract is the up-front spot
payment. This may help the farmer with the means of
sustenance or for the finance needed to harvest the crops. As
the hadiths above mention, the Salam contract must stipulate
a specified measure for a specific time period.
• Bai’ Al-Istisna’ (Manufacturing Sale) – This sale requires the
manufacture, assembly, construction etc of a specified item or
items. This could be used for the production of electrical
goods, machinery, a construction of a house, plane etc. Unlike
a Salam sale, an Istisna’ sale may consist of a deferred
payment, lump sum or installments, depending on the
agreement.
• Bai’ Al-Istijrar (Suply Sale) – This involves the delivery of
certain goods periodically over time. Likewise the price can be
paid periodically according to the agreement of both parties.
• Qard Hasan (Benevolent Loan) – This is a loan that involves no
interest. The principle is paid at a later date without any
increase. If one borrows $1000, they will repay $1000 at a
later date.
Contentious Instruments.
• The following products are used in some countries, yet, have
received the most criticism from various scholars.
Bai’ Al-Einah (Back to back repurchase)
• One contract that comes under scrutiny is Bai’ Al-Einah. When

someone requires money, they sell a product to the bank in
receipt of cash. The seller then agrees to buy back the product
from the bank at a higher price to be paid in the future,
commonly through installments (BBA). Therefore, it includes a
spot sale and a credit sale. Most scholars criticize this sale as a
form of ‘riba through the back door’. The sale is artificial in
order to receive cash. Likewise the bank buys the goods
momentarily for which it has no use. Likewise, Al-Einah
involves two sales in one contract. The Prophet forbade “two
sales in one” (Ahmad, An-Nasaa’i, Al-Tirmithi).
Bai-al-Einah (Repurchase)
In Bai-al-Einah, identity
of the customer &
supplier is the same.
Goods Customer ends up with
$100 Bank $100 (cash) and
Customer (spot deferred debt of $110
payment) is created.
Repurchase Profit in this case is not

of goods result of a genuine sale
$110 and is therefore
(deferred
indistinguishable from
payment) riba.
This mechanism is used
in some countries for
At-Tawarruq (Tripartate Sale)
• Tawarruq has been criticized as being related to Al-Eenah in
the sense that it is seen as a means to by-pass Riba. Others
may see it as a legitimate sale, some scholars do not. Those
who tolerate this sale may do so based on the individual’s
need for instant cash, providing certain conditions are met.
Unlike Al-Eenah which involves only two parties, three parties
are involved in Tawarruq. For example, the customer seeking
cash approaches the bank. The bank buys a product from a
vendor, then sells it to the customer BBA-Murabaha (Mark-up
sale with deferred payments). The customer agrees and then
requires the bank (now as an agent) to sell it to a vendor on
their behalf in order to receive cash. The customer gains
liquidity, yet now they have a higher debt to pay at a later
date.
Tawarruq (Tripartate Sale)
Goods Goods
(immediate (immediate
Goods delivery) delivery)
Supplier Bank Customer
$100,000 $130,000
A
(spot payment) (deferred
payment)
Spot sale for

$100,000
In Bai-al-Einah identity of the customer A &
supplier is the same, while in Tawarruq it is not.
Customer A ends up with cash that is result of a
genuine sale to customer B.
This mechanism is used in some countries for Customer
credit card arrangements. However, organised B
tawarruk where goods supplier and customer B
have same identity may resemble Bai-al-Einah
Bai’ Al-Dayn (Sale of Debt, Bill discounting)
• The Shariah promotes investment in tangible assets

as opposed to investment in debts. The only
exception put forward (by the Shafi’ee School) for the
sale of debt is when the debt is sold off (or passed
on) at par value without any discount. This condition
is necessary in order to prevent any form of riba
(interest).
• In the following weeks we will look at how some of
these mechanisms have been applied in the Islamic
banking industry.
Bai’ Ad-Dayn (Sale of Debt, Bill discounting)
Sale Transfer of debt

A B $115 C
Bill of exchange $110
*Representing Note:
deferred
payment of Selling more money (later) for
money. less money (now).
Eg $115.
Transfer of debt only allowed at
par value in order to prevent
creation of riba (interest).
Questions?
Topic 5: Deposit products
Main Deposit accounts: Current (Wadiah/Qard) account -

Savings (Wadiah/Mudaraba) account - Investment (Mudaraba)
account - Debit and Charge cards
FACULTY OF LAW AND

MANAGEMENT
SCHOOL OF ECONOMICS
Deposit products
• In order to facilitate intermediation between savers and

investor, the bank mobilizes funds via a range of deposit
products with different risk/return characteristics.
• Main Deposit accounts:
1. Current (Wadiah/Qard) account
2. Savings (Wadiah/Mudaraba) account
3. Investment (Mudaraba) account
Deposit Financi
accounts: Deposits
Bank ng Equity-
Produc Based
1.
Current (Financial ts Debt-
(PLS)
account Based
Intermedia (Non-PLS)
Deposit products (cont)
• Deposit accounts play a key role, not just for banks, but for the
economy in general. Much of the wealth kept within the trust
of a bank is utilized in investments, financing businesses etc.
This in turn helps the workforce and stimulates productivity
via a number of PLS and debt-based modes of financing.
Islamic banks therefore, with deposits from customers, utilize
these modes of financing to provide a sustainable service to
the community.
• While mobilizing in a Shari’ah compliant manner, other issues
such as risk, return, liquidity, maturity, safety, and stability are
considered before offering the right deposit account that
would satisfy customers’ needs.
Current accounts
• It is attractive for customers to leave their deposits in banks

for safe-keeping and to have easy access to liquidity. These
accounts allow money to be withdrawn by card access to
automated teller machines (ATM). The deposits are held with
the bank as an Amanah (Trust).
• Current account deposit may be structured on various

mechanisms. Two of the most common are:
1. Wadiah-wad-Dhamanah (Guaranteed deposits)
2. Qard (benevolent loan)
Current accounts (cont)
• Wadi’ah (Safekeeping) – Customers deposit money in Islamic

banks under the principle of Wadi’ah wad Damanah. ‫وديعة‬
Wadi’ah means Deposit or Trust. ‫ ضمانة‬Damanah means
Guarantee. Wadi’ah is like an Amanah (trust), yet under a
trust there is no total guarantee (due to theft, catastrophe
etc). Therefore the word Damanah is added. Under such an
account the customer is able to safely deposit their money on
the basis of trust, knowing that they can withdraw all or part
of their funds when they desire.
• Since there are no conditions for deposits and withdrawals,
funds kept by the bank as a trust may be utilized at the banks
own risk. Depositors do not share any risk, so, any profit or
loss is passed only to the bank.
Current accounts (cont)
• Qard Hasan (Benevolent Loan) – Another way current

accounts may be described is with the use of Qard Hasan. The
deposit by the customer is seen as an interest free loan given
to the bank. The account bears no profit for the customer.
• As was the case with a Wadiah account, the bank may utilize
the funds at its own risk. Any benefit to the lender under this
mechanism is seen as riba and against the spirit of the qard
account.
• The main motive for a customer to have a current account is
to keep excess liquidity available in demand. The objective to
earn profit is not the priority. These accounts are operated for
the safe custody of deposits, and for the convenience of
customers.
Example:* Islamic Bank of Britain:
Features and Benefits
Interest-free bank account: receive no interest, pay no interest

Deposits may be made by cash, cheque or direct account
transfer
Withdraw funds at our branches through an ATM, or by direct
account transfer to another bank account
Funds deposited will be administered in accordance with Sharia
Principles.
Standing order and Direct Debit facilities
International payments
Access to our foreign currency and travellers cheque services
Automatic access to your account via our automated telephone
banking service 24/7 or online
*http://www.islamic-bank.com
Saving accounts
• Deposit products that are modeled on Wadiah/Mudaraba

mechanisms, are known as savings deposits. Their function is
to safeguard deposits whilst providing a modest return on the
capital. In that sense it is similar to the savings account with a
conventional bank.
• This form of deposits is very popular in South East Asian
countries, as customers have a degree of convenience in using
and accessing their funds. Banks must request the permission
of depositors before utilizing the funds for investment. The
bank however claims ownership over the profits and at times
rewards the customers. Withdrawal facilities are provided by
the banks to the customer, such as passbook, ATM cards and
so on.
Saving accounts (cont)
• The bank has no obligation to give beyond what is deposited,
however, the bank may give a gift (for wadiah) or profit (for
mudaraba based deposits) to the customers who meet the
minimum required deposit under this account. For Mudaraba
it is mainly related to a minimum balance maintained for
investment during the time period. For Wadi’ah accounts,
Hibah (gift) varies and is not a condition of the contract.
• Jaabir ibn Abdullah said, “The Prophet owed me something
and he paid me back and gave me something extra” (Abu
Dawud). Regarding this hadith, one commentator (Al-
‘Azimabadi) on the hadith collection of Abu Dawud stated, “If,
while paying off his debt, a person gives something extra of his
own accord, it is not riba but just an act of generosity on his
part”. Although the Prophet gave extra in this case, it
definitely was not a condition prior to taking the loan.
Investment Accounts
• Investment accounts follow the principle of

Mudaraba (investment partnership). The investor
is the Rabb-ul-Mal who deposits money in the
bank under an investment account. The bank in
this case acts as the Mudarib who will manage the
funds. The bank will find Shari’ah compliant
investments such as projects, sukuk (certificates),
financing transactions, property etc. The profit will
be according to a pre-determined ratio agreed
upon by both parties. As it is based on the
success of investments, the rate of return cannot
be fixed.
Investment Accounts (cont)
• The investor will receive weightages which are profit ratios

according to each investment. Inevitably, the depositor (Rabb-
ul-Mal) risks the loss of funds if the investments fail. Although
bearing loss is not common, this is how a Mudaraba contract
works. However, some banks may guarantee the principle of
the deposit if investments fail.
Types of Investment accounts
• Mudaraba Muthalaqa (General Investment Account) – Under

this account, the depositor does not stipulate where they want
their funds invested. They leave the bank with the flexibility to
manage the funds how it deems fit.
The funds may be placed in a pool of funds from other
investors for a fixed period. Likewise, the funds may be used
for a combination of investments with different maturities.
• Mudaraba Mudayyaqa (Special Investment Account) - This
account allows the depositor to specify what type of
investments they prefer. This may require a certain level of
funds to qualify for this account. The bank therefore only
utilizes the funds to invest in a company, project, venture etc,
where both parties mutually agree.
Example:* Al Rajhi Fixed Term
Investment Account
• The Al Rajhi Fixed Term Investment Account-i is a
flexible, easy and ethical way to get your money
to work harder for you. And the peace of mind
that comes with knowing that all Al Rajhi Bank's
products protect you under the principles
enshrined in the Shariah.
• Enjoy a minimum investment from as low as
RM500
• High profit-sharing ratio up to 80%
• Flexible tenure up to 60 months
• The investment period and the profit-sharing ratio
are agreed upfront. The performance of your
investment funds are calculated on a monthly
Debit and Credit Facilities
Debit Cards
• As offered by conventional banks, the debit card
is a useful alternative to credit cards. The card is
merely a prepaid card and therefore does not
assist users by falling into debt and most
importantly, paying interest. Debit cards fulfill the
same purposes of credit cards like online
purchases (such as airline tickets). The major
difference is that customers must upload their
own money to use the debit card. Likewise, debit
cards also allow cash withdrawals from ATMs
worldwide. Some banks charge a monthly or
annual access fee, while some banks charge no
fees.
In 2010 a ‘Halal-approved MasterCard’ was officially launched in
Canada. It is known as the iFreedom Plus MasterCard.
Although it is only a prepaid card, it was endorsed by a
number of Muslim scholars and likewise it offers a range of
discounts when used (such as 10% discount
with Etihad Airways).
Other Shari’ah Compliant Cards
• Other cards function for the purpose of providing the
customer with the means to purchase, however they incur a
debt that must be repaid. Islamic Charge cards for example,
function according to Al-Eenah or Tawarruq where the bank
makes a profit through the transactions. It is an attempt to
replace the credit card by means of supplying credit for
customers. Yet it bears the hallmarks of a real credit card and
for that reason it finds much criticism.
• Some banks promote Shari’ah compliant credit cards. These
are advertised as bearing no interest and no hidden costs. The
customer pays an annual fixed fee which can be paid monthly.
This fee is seen as ijarah for the services provided (or Ujrah).
There is a grace period like a conventional credit card contract,
thereafter penalties apply for late payments.
• Late Fees
According to Taqi Usmani, to incur a fee for the late payment
resembles Riba An-Nasee’ah (Riba of Debt) where the lender
would say, “pay up or pay riba (increase)”. However, some
scholars may tolerate a fee for overdue payments providing
the fee does not go to the bank, lessor, lender etc. It should be
stipulated that the fee will be given to a charity. This may act
as a deterrent for the debtor to delay payments.
Topic 6: Financial management
Risk and Liquidity management

Systematic risk (Macroeconomic factors)
Unsystematic risk (Unique to a firm or an industry)
Risk Management
Financial management
• The objective of financial management is to

maximize the value of the firm.
• The value of the firm can be measured through its
profitability and risk level.
• In reality one of the key aspects of financial
management is risk management because every
decision or process will have a risk.
• Risk arises when there is a possibility of more than
one outcome and the ultimate outcome is
unknown.
The Elements of risk and Liquidity in
Islamic banks
• Risk is the variability or volatility of unexpected outcome.
• Risk can be divided into two types: systematic risk and
unsystematic risk.
• Systematic risk is a risk that arises from the

macroeconomic factors such as changes in economy, political
and social issues, business environment, interest rates,
inflation, war and international incidents.
• As such it can be hedged, but cannot be diversified completely
away. Systematic risk includes: interest rates risk, foreign
exchanges risk, commodity prices risk and industry
concentration risk.
• Unsystematic risk is a risk
that is unique to a firm or an
industry.
• It is associated with random causes
that can be eliminated through
diversification and it can be
controlled through good
governance. The examples of
unsystematic risk are regulatory
action, mismanagement of a firm,
labour difficulties, consumer
preferences, loss of key accounts
and labour strikes.
Risk Management
• The nature of financial institution operations exposes them to

different types of risks. Both depositary and non-depositary
financial institutions are a risky business. According to
Saunders and Cornett (2006), there are five common risks
faced by financial institutions: credit or default risk, interest
rates risk, liquidity risk, underwriting risk and operating risk.
Risk Management (cont)
• Largest source of serious banking problems

is credit risk, the risk of counter party
default. Credit Risk is defined as a risk that
the value of portfolio may change due to
the unexpected changes in the credit
quality of issuer or trading partner (McNeil,
Frey, & Embrechts, 2005).
• Note:Islamic finance is also vulnerable if
care is not taken - not in terms of its
product structuring, but in relation to non-
performing financing due to its credit
policies.
• Islamic banking is involved in risk taking by its very nature,

with the risk minimized by way of valid risk management tools,
but never totally avoided or eliminated.
• In Islamic banking there has to be real business conducted as a
result of which profit or loss can be incurred and hence Islamic
Banks take on risk. The additional risk that IFI have to face,
compared to conventional finance, is asset risk, market risk,
Shariah non-compliance risk, greater rate of return risk,
greater fiduciary risk, and greater legal risk.
• Asset risk is involved in all modes, particularly in Murabaha

(onward sale to the client with mark-up price), Salam (after
taking delivery from the seller) and Ijarah as all the ownership-
related risk belongs to the bank as long as the asset is in its
ownership.
• If the asset is damaged without any fault on the part of the
lessee and it is not deliverable, the bank’s right to receive rent
will cease.
• Shirkah-based risk (PLS) is borne as per the share in the
ownership market risk.
• The bank might not be able to market the goods purchased on

the basis of salam, Istisna etc at a profitable price.
• Rate of return risk is involved as the price (once fixed) in
Murabaha /Salam cannot be increased.
• Remaining within Shariah principles, Islamic banks are allowed
to take risk mitigation/management measures, but transfer of
risk to anyone else without transferring related rewards is not
permissible.
• In addition to effective management and

supervision, other factors necessary to
ensure the safety of the banking institution
and the stability of the financial system and
the market include; sound and sustainable
macroeconomics policies; well developed
and consistent legal framework; adequate
financial sector infrastructure; effective
market discipline; and a sufficient banking
sector safety net.
• Credit risk is simply defined as the potential that a borrower or

counterparty will fail to meet their obligation in accordance
with the agreed term. It is the risk of failure of the counter
party to honour their commitment and also refer to default
risk.
• This arises from the inability of the counterparty to service
the debt on the agreed term. It can also arise when the
solvency or the credit rating of the counterparty changes
adversely.
• In Islamic banking there is limited availability of credit rating
defined from external agencies.
• The risk of non-compliance with Shariah rules is referred to

as Shariah risk. This can be included in operational risk as
non-compliance can lead to reputational damages which can
trigger an exodus of findings from the Islamic investor, causing
failure and system risk.
• If Islamic financing found a product that does not fully comply
with Shariah rules, then it would be subject to Shariah scrutiny
and thus be considered to be an adaptation based on current
market needs.
• These products pose special risks in terms of being rejected
under the scrutiny of Shariah rules. As interpretation can
differ, the utmost precaution is needed before entering into
any contract, with approval from the Shariah council .
• There are four elements that should be

well defined and considered in financial
risk analysis for Islamic products, which
are:
1. The construction of the financial contract
2. Identification of the markets
3. Identification of the behavior of
counterparties
4. Interaction of the above two within a time
period mapped into the financial contract.
• The role of information in the risk management of the

Islamic financial institution can be more critically
compared to conventional finance, with the nature of
contracts in Islamic banking more integrated with the
activities of the entrepreneur.
• The PLS contract is heavily biased towards the
availability of information for managing risks. In the case
of musharakah and mudarabah contracts, there is a
heavy bias towards the availability of information for
risk management.
• There is special emphasis on transparency in the conduct of

activities, calculation of profit and loss, as well as the nature of
activities. This includes a focus on social responsibilities, with
efficient information management requiring special
dimensions in Islamic finance institutions which are more than
merely statutory .
• Profit has to be earned by sharing risk and reward of
ownership through the pricing of good services.
• Investment both by bank depositors and the financial
institution will be considered only if it is part of real activity,
or is itself a real activity. This is because money has the
potential for growth when joined with entrepreneurship, as in
itself, it is recognized as capital and therefore it cannot earn a
return.
• The business risk involved in shirkah (PLS) based modes where

loss has to be borne by the capital provider, whilst the
manager or entrepreneur loses the labour in the case of joint
business venture.
• For the depositor in Islamic banking, risk stems from the
failure of business and uncertainty in the level of profit to be
shared.
• Depositor should not be burdened on the account of
negligence.
• Mitigation of that risk would require special expertise and
sound knowledge of Shariah rules, lest it may lead to non-
Shariah compliance.
• Risk of default by clients can be mitigated, in some cases, by

putting a penalty clause in the contract to serve as a deterrent,
the amount of penalty would go to a Charity account.
• This is in all modes except Istisna, when the bank can insert a
clause for decrease in the price if asset in case of delay in
delivery.
• The logic behind the provision in the case of Istisna is that
manufacturing/construction of any asset depends, to a large
extent, on personal effort, commitment and hard work by the
Manufacturer who may start work on the contract with other
people. While in the case of Murabahah and Salam one has to
pay the deferred liability that has been defined and stipulated
in the contract.
Liquidity Management
• Liquidity management
means ensuring that the
bank has sufficient liquid
funds available for a smooth
running of its operation in
order to meet short term
financial obligations as and
when due.
Liquidity Management (cont)
• Liquidity can be managed by dealing in the Islamic interbank

fund market. The most useful instrument for the transaction is
the mudaraba ratio that could be negotiated according to
market conditions.
• Liquidity management in Islamic banks can also be done

through securitization of the pool of income generating assets.
If the bank requires liquidity it may sell sukuk in the secondary
market to another bank to generate cash. If it is in surplus, it
can purchase sukuk from the market.
Liquidity Management (cont)
In the case of Mudahrabah ,the following process can be

adopted:
1. A mudarabah relationship will be created
2. Funds received will be allocated to pools
3. Weightages will be assigned periodically, based on different
tier/categories
4. Profit earned will be allocated accordingly to weightages
assigned at the beginning of the period.
5. The bank will charge a pre-agreed Mudarib fee as a
percentage of the realized profit, the bank can pay additionally
from its share
6. The investor will be at a loss unless it arises from misconduct
or negligence of the Mudarib.
The differences in managing risk: IB & CB
• Risk management is a process that protects assets and profit
of an organization by; reducing the potential for loss before it
occurs; mitigating the impact of the loss if it occurs; and
executing a swift recovery after the loss occurs (Coffin, 2009).
• Financial institutions are a business entity owned by their
shareholders and the objective of the business entity is to
maximize the shareholders’ wealth. One way to achieve this
objective is that the management should efficiently diversify
the unsystematic risk and reduce or transfer the systematic
risk. In the financial sector, risk management is an area of high
interest due to the financial crises of the last two decades
(Galindo & Tamayo, 2000).
Basic Concept of Risk Management Process and
System
1. Establishing Appropriate Risk Management
Environment and Sound Policies and Procedures
2. Maintaining an Appropriate Risk Measurement,
Mitigating and Monitoring Process
3. Adequate Internal Control
The differences in managing risk: IB & CB (cont)
• Islamic financial institutions can be riskier than conventional

financial institutions due to several reasons including the
specific nature of risk and the unlimited number of ways to
finance a project using either profit loss sharing or non-profit
loss sharing contracts.
• Scarcity of hedging instruments, undeveloped inter-bank
money markets and a market for government securities which
are Shariah compliant. Therefore, Islamic financial institutions
may be more vulnerable to unfavourable events than
conventional financial institutions.
• Inability to utilize money markets makes Islamic financial

institutions more susceptible to liquidity risk.
• For Islamic financial institutions, liquidity risk can be
considered as one of the most critical risks due to certain
factor such as:
(1)limited liability of Shariah compatible money market and inter-bank

market,
(2) shallow depth of secondary market for Islamic financial instruments and
(3) the problem of the lender as a last resort from central bank.
• The last group of risks faced by Islamic financial

institutions are governance risks. Governance risk
refers to the risk arising from: a failure in governing
the institutions; negligence in conducting a business
and meeting contractual obligations; and from a
weak internal and external institutional environment,
including legal risk, whereby financial institutions are
unable to enforce their contracts.
Any Questions?
Topic 7: Introduction to Islamic Capital Markets
Conventional capital markets

Islamic Capital Market (ICM)
Portfolio choices: Investment in Shares
Conditions for investing and trading with shares
Commodity Murabaha - Islamic Investment Fund
FACULTY OF LAW AND
Derivatives in Islamic Finance MANAGEMENT
Sukuk (Islamic equivalent of bonds) SCHOOL OF ECONOMICS
Capital Markets
In the conventional sense, a capital market is a place where debt
(e.g. bonds) and equity (shares) securities are traded.
It is generally divided into:

• Primary market (issuing and trading new securities, raising
new capital)
• Secondary market (facilitates trading of previously issued
securities).
Why is it called ‘capital’ market?

Why do we need them?
How would conventional be different from Islamic capital
Islamic Capital Market (ICM)
• In the Islamic capital market, all financial intermediation
activities must be Shariah compliant (i.e. free from unethical,
immoral, speculative or prohibited activities such as usury
(riba), gambling (maisir), excessive uncertainty (gharar) and so
on).
• Two main components of an Islamic capital market (ICM)
include:*
A. Debt securities market (Instruments created through
deferred contracts of exchange)
B. Equity securities market (Instruments created through
profit sharing contracts)
*(Kettell, Islamic Capital Markets, 2009, p. 76)

Islamic capital market (ICM)
Main objectives include:
• Efficiency in allocation of financial resources including
transparency in pricing of securities with regards to
risk/return/time preference.
• Transfer of funds from surplus saving to deficit spending units
and equitable distribution of benefits.
• Companies: Raise funds that are used to finance buying
buildings, aeroplanes, factories and other assets and/or
business activities.
• Investor: Yield profitable returns from investment.
• Enhancing liquidity, risk management and portfolio

diversification.
Portfolio choices: Investment in Shares
Shares represent units of ownership interest or a specific part
of the total capital of a company.
By purchasing shares in a company a person becomes a

shareholder or partner in a business. As such, a shareholder is
entitled to receive proportional profits that result from the
company’s economic activities. (Similar to a musharaka
arrangement)
In general there is nothing wrong with buying or selling shares

as part of an investment strategy, as long as Shariah conditions
relative to the main business of the company are followed.
Conditions for investing and trading with
 Qualitative Screens shares
Industry screening
Business practices
 Quantitative Screens
Debt/Asset Ratio
Interest-related Income
Monetary Assets
 Prohibited Trading Practices

A Qualitative Screens
There are two types of qualitative screens: Industry screening and
business practices.
Industry screening:
The main concern relates to the type of industry the company is
involved in. The general rule is that most business activities are
permitted (halal) unless specifically prohibited by the Shariah. For
that reason, if the main business of the company is halal
(permissible) and Shariah prohibitions are avoided (e.g. Riba),
then shares of such a company are also permissible.
It is not acceptable to buy/sell shares of a company that is
involved with un-Islamic/unlawful (haram) products or services,
such as, gambling, alcohol, pork, tobacco products, interest based
financial institutions like banks and Insurance companies, adult
products and so on.
Business practices
Islamic principles relating to investing and trading stipulate that the
acquisition of shares, from an investor’s point of view, must also be
done in a Shariah compliant way. The following two principles must
be observed while investing:
1. Investible funds must be free from interest based debt:

Financing investment can not be done by borrowing on interest (e.g.
Margin trading (borrowing and leveraging investment) as it is
commonly done by hedge funds).
2. Prohibition of speculation
Entering market as a speculator and thus making short-term
speculative investment decisions is not allowed (This is fundamental
difference between a true investor which is allowed and a
speculator).
Quantitative Screens
There are three types of quantitative screens:
1. Debt/Asset Ratio
Question of debt to asset ratio and how much has the company
borrowed? Usually it should not exceed 33%. What if it is
interest based? What if it is not? Is a ratio of 33% acceptable?
2. Interest-related Income
Does the company generate any interest or interest-related
income? (For instance, where earning interest is not their
business, but their surplus funds are placed in investments that
yield interest income). What if it is less than 5%? What if this 5%
of the dividend earnings is given in charity? Difference of
opinions- Why?
Quantitative Screens (cont)
• 3. Monetary Assets
To invest in Shariah compliant companies, one has to be very
careful that non-liquid assets be over 51% (note that this ratio
is the matter of ijtihad). The reason is that money cannot be
traded except at par value.
Why Quantitative screens?
Why the difference of opinions?

Prohibited Trading Practices
i. Day Trading
Buying and selling on short-term price fluctuations (normally
within one day) is closer to gambling and speculation than
actual investing. Should it be prohibited?
ii. Margin Trading:

Margin trading involves interest based borrowing from the
broker in order to buy stocks. It is prohibited because it
involves riba and involves excessive risk.
Prohibited Trading Practices (cont)
iii. Derivatives – Options, Futures & Swaps

The opinion that Futures trading is not permitted due to the
presence of gharar and maisir.
iv. Short Selling:

Short selling (borrowing a stock from the brokerage firm and
selling it in anticipation that the stock price will further go
down) involves huge risk and maisir (gambling) in addition to
selling what one does not possess (borrowed stock).
What are some examples?

Dow Jones Islamic Market
Screens for Shariáh Compliance (Dow Jones Islamic Market )
To determine their eligibility for the Dow Jones Islamic Market
Indexes℠, stocks are screened to ensure that each meets the
standards set out in the published methodology.
<http://www.djindexes.com/islamicmarket/>
Industry Screens
Alcohol, Pork-related products, Conventional financial services,
Entertainment, Tobacco, Weapons and defence.
Financial Ratio Screens

All of the following must be less than 33%:
 Total debt divided by trailing 24-month average market capitalization
 The sum of a company’s cash and interest-bearing securities divided
by trailing 24-month average market capitalization
 Accounts receivables divided by trailing 24-month average market
Wholesale Markets
Commodity Murabaha
• Commodity Murabaha is equal to Tawarruk but the commodity
typically represent metals (excluding gold and silver), that is listed on,
for instance, the London Metal Exchange. It is used for short term
financing.
• Under a basic Murabaha, the customer (who wants to own the
commodity) buys goods from the bank with deferred payment option.
Commodity Murabaha is a sub category of Murabaha, but the client
does not want to own commodity. Rather, the objective is to sell it to
another broker for cash (e.g. To be used as a working capital for
business). Transaction may or may not contain elements of interest,
hence, like in Tawarruq*, it is subject to the same controversy,
conditions and possible misuse.
*Tawarruq (or reverse Murabaha) is when a party in need of cash purchases a
commodity on deferred basis, then sells it on the spot for cash. (seeking
Commodity Murabaha (cont)
• Current practices and reasons for it?

• The transaction does not represent a genuine sale (as practiced
on London Metal Exchange)
• Why? What happens with the goods?
• Do they ever leave the warehouse or are they only used to
generate debt?
• What if it was a genuine sale/trading transaction? How would
it work?
• Would it be possible to trade gold and silver? Which type of
riba is this?
• How to prevent faulty structuring of murabaha?
Islamic Investment Fund (List 5 investment funds)
• Islamic Investment fund works on a partnership basis, where
investors jointly pool surplus money for investment purposes.
The subscribers of the Fund receive certificates or shares.
Modes of Investing:
• Equity fund (investment in the shares of a joint stock
company)
• Ijarah Fund (investment used to purchase assets for the
purpose of leasing)
• Commodity Fund (used for purchasing of different
commodities for the purpose of the resale)
• Murabaha Fund (sale on a cost plus basis, deferred payment
basis)
• Mixed Fund (Tangible assets must be over 51%. If liquidity and
Modes of Investing:
• Equity fund (investment in the shares of a joint stock

company)
• Ijarah Fund (investment used to purchase assets for the
purpose of leasing)
• Commodity Fund (used for purchasing different commodities
for the purpose of the resale)
• Murabaha Fund (sale on a cost plus basis, deferred payment
basis)
• Mixed Fund (Tangible assets must be over 51%. If liquidity and
debt exceed 50%, it can not be traded [it must be a closed-
end Fund])
Derivatives in Islamic finance
• A derivative - financial instrument (security) - is a contract between
two or more parties, whose value is derived from expected future
price movement of the underlying asset (e.g. shares, currency,
commodities, bonds, interest rates and market indexes). An example
of a typical derivative that involves the purchase of debt and liabilities
between two parties (subject of a future outcome of the underlying
asset) are options, swaps and futures.
Main Use: hedging risk and speculative purposes.
Example of hedging in a forward contract:

Farmer - Exposure to price fluctuation of the grain.
Contract Involves parties facing risk in opposite directions (win/lose situation). By
agreeing on a future (deferred) price and delivery, both parties eliminate price
movement risk (like insurance).
Why are derivatives forbidden (haram)?
“They ask thee (O Prophet) about Khamr (intoxicants) and

games of chance (gambling). Say: In both of them there is
great harm although there is some advantage as well in them
for men, but their harm is much greater than their
advantages.” Qur’an 2:219
• While there are some benefits in financial instruments such as

derivatives, the general Islamic principle is that harm which
results from gambling and speculative nature of conventional
derivatives is much greater.
Sukuk (Islamic equivalent of bonds)
• Sukuk – plural of Sakk (legal instrument, deed, check).

Sukuk are Islamic Investment Certificates (Islamic
equivalent/alternative of bonds)
Sukuk are defined by the Accounting and Auditing Organisation

for Islamic Financial Institutions (AAOIFI) as:
‘certificates of equal value representing undivided shares in
the ownership of tangible assets, usufructs and services or (in
the ownership of) the assets of particular projects or special
investment activity.’
Sukuk Structure:
Typical Sukuk Structure:
Partial ownership in a debt (Sukuk Murabaha)
Asset (Sukuk Ijarah)
Project (Sukuk Istisna)
Business (Sukuk Musharaka)
Other mixed structures
Note: Typical Sukuk structure is a combination of several

financial mechanisms such as Murabaha, Ijara, Istisna and so on.
Differences between Sukuk and
conventional bonds
• Prohibition on charging or paying of interest and other Shariah
constraints.
• Some Sukuk (e.g. debt) are not tradable in the secondary
market.
• Sukuk – securitisation & issuance of sukuk (taskeek) –
Transforming an asset’s future cash flow into present cash
flow.
Eg: Sukuk Ijara
Name of Sukuk is derived from underlying principle that

underpins Sukuk structure – in this case ijarah!
Lease (Ijarah) Pay Issue price

SPV*
ABC Ltd Investor
Rental Payment
Issue Sukuk
& pay profits
*SPV – Special Purpose Vehicle (Issuer)

Sukuk (cont)
• Ijarah vs Murabaha Sukuk, example:

Q: Who owns asset/debt in each structure and why is that
important? Who should maintain property and how? Can
certificate be traded in secondary markets? Other issues?
• Difference between ijarah and, for instance Murabaha based

Sukuk, is the simple issue of ownership and valuation of share
in the asset. While in Murabaha cash flow simply represents
debt (dayn) resulting certificate can not be traded on
secondary market. This is resolved in ijarah Sukuk where price
of certificate reflect proportional price of underlying asset.
Therefore, since trading with debt at a discount or a premium
is prohibited, ijarah Sukuk represents actual asset and not cash
Example:
GE Sukuk
• GE Capital, the finance

arm of General Electric,
has listed a recently
completed US$500
million Sukuk (Islamic
bond) on NASDAQ Dubai,
the Middle East's
international exchange.
Sukuk (cont)
Structuring Sukuk and Shariah risk

• A recent controversy paralysed Sukuk markets when Sheikh
Taqi Usmani, chair of the AAOIFI Shariah board, announced in
2007 that majority of equity-based Sukuk such as Mudaraba
and Musharaka were not structured in an Islamic acceptable
way.
• For instance, when structuring the question of ownership
must be clearly identified. It is not simply enough that Sukuk
are asset ‘based’ but they must be asset ‘backed’ and
therefore represent real ownership which will provide
sureness for investor in case of the default. It is only in this
situation that performance of the assets will be linked with
profitability of investment and not arbitrary interest rate.
Sukuk (cont)
Contemporary Issues*
• 1. Sukuk should be issued for new commercial and industrial

ventures. If they are issued for established businesses, then the
Sukuk must ensure that Sukuk holders have complete
ownership in real assets.
• 2. The returns of enterprises should be returned to Sukuk
holders regardless of what amounts they reach after costs,
including the manager's fees, or the share of the mudarib in
profits. If there is to be an incentive for a manager, then let it be
based on the profits expected from the enterprise and not on
the basis of an interest rate.
*Read full text:
• Mufti Taqi Usmani, 2007, Sukuk and their Contemporary Applications,
Sukuk (cont)
• 3. It is unlawful for a manager to lend money when actual

profits are less than expected.
• 4. It is unlawful for a manager, whether a mudarib or a partner
or an agent, to commit to repurchase of assets at face value.
Instead, their resale must be undertaken on the basis of the
net value of the assets, or at a price that is agreed upon at the
time of purchase.
• 5. Shariah supervisory boards must abide by the Shariah
Standards issued by the Shariah Council.
Topic 8: Legal and regulatory issues in Australia
Introduction: Islam and Muslims in Australia

Islamic banking and finance in Australia - Legal and regulatory issues
Awareness & Future opportunities
FACULTY OF LAW AND

MANAGEMENT
SCHOOL OF ECONOMICS
Islam in Australia
• Muslims came to Australia as early as the 1600s. Fishermen
from Indonesia’s Sulawesi Island began Australia’s first industry.
It involved the gathering of trepang (sea slug) which were
shipped to Indonesian waters to sell to various trade ships.
• With the introduction of camels, the Muslim cameleers brought
new found hope for Australia in the 1860s. Camels were able to
handle the harsh interior of Australia’s outback. This facilitated
inland exploration, the delivery of supplies, food provisions and
other necessities to remote areas. The cameleers mostly came
from what is known today as Pakistan, Afghanistan and India.
Due to their help, many train lines were made as well as the
overland telegraph line. The overland telegraph line stretched
three thousand kilometers across the interior and thus
connected Australia to the outside world through
telecommunication.
• Today’s Muslim population in Australia is estimated at
400,000. Muslims have migrated to Australia from over 120
countries and are ethnically and linguistically diverse.
• Islamic finance is yet to make significant impact on Australian
soil. However there are signs of facilitation for growth from
the Australian government. During the launch of the booklet
by the Australian Trade Commission (Austrade) titled Islamic
Finance, former Trade Minister Simon Crean said that “Islamic
financing is a crucial plank in the Government's strategy to
make Australia a financial hub in the Asia Pacific region”. In
May 2010 Senator Nick Sherry inaugurated the book launch in
Sydney of Demystifying Islamic Finance: Correcting
Misconceptions, Advancing Value Propositions. He mentioned,
“We are taking a keen interest in ensuring there are no
impediments to the development of Islamic finance in this
country, to allow market forces to operate freely.”
• Senator Nick Sherry also said, “On 26 April, I announced that
the Board of Taxation would undertake a comprehensive
review of Australia's tax laws to ensure that, wherever
possible, they do not inhibit the expansion of Islamic finance,
banking and insurance products.”
Further Readings in PDF Format

Islamic Finance (Austrade Publication)
http://www.austrade.gov.au/ArticleDocuments/2792/Islamic-Finance-
Publication.pdf.aspx
Demystifying Islamic Finance: Correcting Misconceptions,

Advancing Value Propositions (Zaid Ibrahim and Co.
Publication)
https://www.zaidibrahim.com/wp-content/uploads/2010/05/Demystifying-
Islamic-Finance-soft-copy.pdf
Why Australia?
Awareness of Islamic banking products
among Muslims: The case of Australia
Query* Yes No N/A*

(%) (%) (%)
Awareness of halal banking products 55.7 44.1 0.3
Ever having held a halal stylised bank account 19.3 80.1 0.7
Willingness to switch to a halal product given some 92.5 7.4 1.5
quality of conventional banking service (ATM,
online access, phone banking)
Willingness to switch without credit facilities 79.0 20.9 0
Willing to switch to a profit-and-loss agreement 60.8 37.9 3.3
where you might incur losses
Willingness to switch dependant on brand 60.1 39.7 0.3
recognition
*Responses are quoted in
percentage terms with N/A
Awareness of Islamic banking products
among Muslims: The case of Australia
• Table indicates that, over 90% of Muslims would prefer a
Shariah compliant (halal) account and would consider
switching to another bank if opportunity was presented. What
is even more interesting is that the overwhelming majority of
Muslim customers would switch to halal banking even without
facilities (ATM, online access, phone banking) and despite
possible losses.
• While this study was concentrated mainly on the profit and
loss arrangements, it shows a demand and willingness of the
Muslims to engage proactively in Shariah compliant banking
products.
Australia
Introduction
• Islamic banking and finance globally represents one of the

fastest growing financial industries. With its strategic position
and well regulated financial system, Australia is attempting to
create conditions that would facilitate and replicate global
success in the Australian context.
• Australia is, and almost always has been, a capital importing
country. On the road to attract capital, every investment
ultimately needs to pass the test of profitability. Since Shariah
compliant investors have increased the number of global
choices, just offering Shariah compliant products is not enough
to attract key industry players.
Review of the present situation in
Australia
• With an estimated size of $1 trillion, Islamic banking is
predicted to grow at 10% per annum (Austrade, 2010). Major
financial institutions such as Citibank, JP Morgan/Chase,
Goldman Sache, USB, HSBC, ABN Amro, BNP Paribas, Societe
Generale, Deutsche Bank, Nomura Securities and many more
are capitalising on this growth opportunity.
• Since Islamic financial products must be linked with tangible
assets and real economic activities, Australia’s resource
related services and infrastructure creates a superb
opportunity. Moreover, its geographic position and close
proximity to the 972.5 million Muslims in Asia Pacific region
are amongst primary drivers behind the move to position
Australia as a financial centre in the Asia Pacific region
(Austrade 2010).
Australia
• The Australian Financial Centre Forum’s report entitled
“Australia as a Financial Centre - Building on our Strengths” or
as commonly referred as - The Johnson Report - identified the
Middle East as the major global source of offshore capital due
to its booming oil exports.
• The capital intensive nature of Australia’s’ resources related
services and infrastructure (Agribusiness, Mineral resources,
property, Oil and Gas) in addition to Islamic finance which
works mainly with assets, services and projects, creates
prospects for future partnership (Austrade 2010, The Johnson
Report 2009).
The Johnson Report Recommendations 3.6 & 4.8
Issue: Lack of Islamic finance products in Australia is limiting our
access to offshore savings pools.
Recommendation 3.6: Islamic finance products

The Forum recommends that the Treasurer refer to the Board of
Taxation the question of whether any amendments to existing
Commonwealth taxation provisions are necessary in order to
ensure that Islamic finance products have parity of treatment
with conventional products, having regard to their economic
substance.
Recommendation 4.8: Removal of regulatory barriers to
Islamic finance
The Forum recommends the removal of any regulatory barriers
to the development of Islamic financial products in Australia,
guided by the principle that there should be a ‘level playing field’
for such products.
Australia
• However, despite this progress, when compared with other
western nations, Australia is far behind and to see how far, we
only have to look at the IBF situation in the UK with 22 banks
in London (including five that are fully Shariah compliant),
twenty Sukuk issues raising US$11 billion listed on London
Stock Exchange, 20 law firms supplying services in Islamic
finance and a number of institutions offering educational and
training products supporting the IBF industry.
• In the environment that is dominated by the few conventional
banks, ensuring a level playing field will require long overdue
action to remove impediments that relate to taxation, legal
and regulatory obstacles as outlined in the Johnson Report.
Legal and regulatory issues in Australia
• Creating Islamic financial products is a vehicle that allows

Australian assets to be sold to a third party. To make financial
products attractive, beside Shariah compliant issues, it must
be profitable. The key components that determine profitability
typically is the tax treatment and the other regulations.
• For GCC investors - who do not pay taxes and do not have
double tax agreements with Australia - this represents a
particularly important issue. The Johnson report recognises
wholesale investment opportunity and recommends changes
that will attract Islamic investors and make IBF products
more competitive.
Nature of the transaction
• Shariah principle stipulates that in order to sell something one must take
possession and assume all relevant risk associated with the ownership of
the goods. In the murabaha transaction (below) it is required that the bank
must own goods before it can sell it to the third party.
• As apparent from figure A, the bank first obtains the goods
with immediate payment and the delivery. Once the bank
acquires ownership, it is then able to engage with the end
customer and sell with deferred payment and immediate
delivery. The bank in the murabaha transaction makes profit
by charging mark-up that is added to the principle, while on
the other side, the customer benefits from the deferred
payment arrangement.
• From the outset, this transaction is classified as buying and
selling and since the goods change hands twice, it attracts
double Goods and Services Tax (GST). Furthermore, in addition
to double GST, if the product arrangement involves housing
loan that may pose additional burden of double stamp duty.
While this problem was resolved in Victoria, it remains an
impediment on the other jurisdictions, due to the fact that,
property transfer occurs once to the bank and after that to the
customer.
• As a result of a higher cost, Islamic financing translates to less
competitive products that are less attractive to both
customers and investors.
• Finally, since commodities and the other Australian assets can
be packaged with the Islamic financial products, treatment of
the bank’s profit from the customer’s perspective must be
addressed. In general, the tax discount that is applied to
interest payments in conventional banking and profit or mark
up treatment in shariah compliant products, should not
disadvantage customers involved in Islamic financing. In
addition to being taxed twice, which adds to the overall price
of the transaction, profit and mark-up is not tax deductible as
it is the case with interest paid on the conventional loan.
• In order to make Islamic finance competitive and a viable
alternative for a wider customer base, it is necessary to
provide tax neutrality that will accommodate shariah
compliant transactions.
Discussion Paper:
The Board of Taxation (Board) review of
the taxation treatment of Islamic
finance products
The purpose of this discussion paper is to:
• Examines the current approach to

finance taxation in Australia;
• Identifies issues associated with
Australia’s current approach to the
taxation of Islamic finance products;
and
• Examines the tax policy response to the
development of Islamic finance
Example: Discussion paper 2010, Case
study 1
Step 1: A Client agrees to purchase a house from a vendor. The Client

approaches a resident Financier to finance the purchase. A purchase
instruction with promise to purchase is completed by the Client
which is a request that the Financier purchase the asset specified and
an undertaking to purchase that asset from the Financier.
Step 2: If the Financier approves the financing, an Asset Purchase

Agreement will be executed where the Financier purchases the asset
(house) from the vendor on a cash basis for a purchase price of
$360,000. The Financier appoints the Client as its agent to purchase
the asset. The asset is transferred to the Financier at this time.
"The Road Less Traveled“ Ha-ha!
(now I know why) Nice and
easy!
No
uncertain
ty…
Oh! No! Wha

Stamp t!
duty – After
AGAI Doub all this
N!!! le NO
GST deducti
??? ons on
profit

Economic future
• Islamic banking and finance is well positioned to play a major
role in the Australian economic future. While most of the
world suffers from a lack of liquidity, the Johnsons report
identified the Middle East as the major exporter of the capital.
• However, despite its natural advantage and favourable
predisposition, Australia is not utilising opportunities to
connect its capital intensive industry with offshore liquidity.
BOT discussion paper 2010 is designed to highlight changes
that which would ensure level playing filed and the
uncertainty of tax treatment.
• Banks and institutions that embrace introductory steps and
develop shariah compliant products at the retail & wholesale
level will anticipate future opportunities with much more state
of attentiveness. They will have a strong customer base,
knowledge and brand recognition locally and internationally.
In conclusion
 Resource-Related services and infrastructure are ideal for

Islamic financing (Agribusiness, Mineral resources, Oil and
Gas, property, education etc.)
 Proximity to Muslim populations of the Asia Pacific (62% or
972.5 million of the world total Muslim Population)
 Islamic banks are expected to account for 40 to 50 percent
of total savings of the world’s Muslim population within 8
to 10 years* (KPMG Report)
 Billions of dollars needed to finance Australian
infrastructure in the next decade.
Topic 9: Islamic Corporate Governance
Islamic Corporate Governance (ICG) - Shari’ah Supervisory Board (SSB)

Shari’ah Advisor - Institution of Hisbah
Qualifications of a Shari’ah board scholar - Shari’ah Standards Bodies
FACULTY OF LAW AND

MANAGEMENT
SCHOOL OF ECONOMICS
Islamic Corporate Governance (ICG)
• Corporate Governance (CG) is applied at varying degrees to all

industries around the world. Principles of CG relate to the
responsibilities of the board members, monitoring of
management, allocation of duties and responsibilities,
practices in accordance with the law, transparency, interests
of the corporation, serving public interest, effective regulatory
responsibilities, rights of shareholders, rights of stakeholders,
co-operation and teamwork, discloser of accounting and
auditing, high ethical standards, reviewing of strategies and
structure, risk policy and so on.
• Corporate Governance based on an Islamic Framework is
known as ICG (Islamic Corporate Governance). The principles
of ICG laid out by the Islamic Financial Services Board (IFSB)
reflect those of international standard-setting bodies such as
the Organisation for Economic Co-operation and Development
(OECD) (2004) and the Basel Committee on Banking
Supervision (BCBS) (1999).
• ICG however, has the underlying principle of conformity to
Shari’ah principles. Therefore the IFSB recommends
alterations and additions where needed in order to
compensate where other CG models fall short. This is done in
order to avoid “re-inventing the wheel”. Likewise CG models
merely serve as guidelines and may not necessarily be applied
unconditionally in each country.
Principles of ICG as proposed by the IFSB cover the following:
i. General governance approach of IIFS (Institutions offering

only Islamic financial services);
ii. Rights of investment account holders (IAH);
iii. Compliance with Islamic Sharīàh rules and principles; and
iv. Transparency of financial reporting in respect of investment
accounts.
(Source: IFSB, GUIDING PRINCIPLES ON CORPORATE GOVERNANCE FOR INSTITUTIONS

OFFERING ONLY ISLAMIC FINANCIAL SERVICES (EXCLUDING ISLAMIC INSURANCE
(TAKAFUL) INSTITUTIONS AND ISLAMIC MUTUAL FUNDS) December 21 2005)
• Points i, ii and iv share a number of principles with the major

CG models. Nevertheless, all points are valued in light of the
Shari’ah and adjustments are made accordingly to cater for
corporate governance of Islamic Industries.
• However, point iii is the truly unique factor of the ICG model.
Such governance requires a Shari’ah Supervisory Board (SSB).
Industries that are Islamic, or provide Islamic windows, rely
heavily on the endorsement, assistance and advice of SSBs.
• Islamic corporate governance (ICG)
seeks to devise ways in which economic
agents, the legal system and corporate
governance can be directed by moral
and social values based on Shariah laws
(M Bhatti & I Bhatti, 2009).
• Model is also analogous to the
proposed OECD principles emphasizing
the mechanisms of business ethics,
decision-making, bookkeeping and final
accounts, and also of adequate
disclosure and transparency (M Bhatti
& I Bhatti, 2009).
principles:*
• 1. Ensuring the basis for an effective corporate governance
framework.
• 2. The corporate governance framework should protect and
facilitate the exercise of shareholders’ rights.
• 3. The corporate governance framework should ensure the
equitable treatment of all shareholders, including minority and
foreign shareholders. All shareholders should have the opportunity
to obtain effective redress for violation of their rights.
• 4. The role of stakeholders in corporate governance is to be
recognized by creating wealth, jobs and sustainability of financially
sound enterprises.
• 5. Disclosure and transparency
• 6. The corporate governance framework should ensure the strategic
guidance of the company, the effective monitoring of management
by the board, and the board’s accountability to the company and
the shareholders. * (M. Bhatti & I. Bhatti, 2009)
• Islamic corporate governance as based on the ‘stakeholder
model’ of corporate governance as shown below.
Flowchart of Stakeholder Model of Corporate Governance (Sou

Shari’ah Supervisory Board (SSB)
• Also known as a Shari’ah Advisory Council (SAC), SSBs are a vital
need for Islamic Banks and Institutions. Banks have their own
Shari’ah councils which oversee contracts, issue fatwas,
supervise and view procedures. The following points may shed
light on the relationship between Islamic Financial Institutions
(IFI) and SSBs.
• A correspondence should exist between the SSB and the internal reviewers of
the institution for internal Shari’ah compliance.
• The institute or bank must accept the decisions made by the SSB.
• SSBs must review and monitor the implementation of procedures,
transactions, products (current and new), investments etc undertaken by the
IFI.
• The trust of stakeholders is needed as they expect that the IFI is following
principles in line with their religious beliefs. Endorsement by the SSB is crucial
in this aspect.
Shari’ah Advisor
• The SSB is made up of Shari’ah advisors. The
Shari’ah advisor must be specialised in Islamic
Knowledge as well as modern forms of finance and
areas related to it. Their role is to decipher whether
certain practices are halal (permissible) or not.
Depending on the country, the Shari’ah advisor must
take into consideration the local laws.
• Shari’ah advisors can work as part of a board and/or
as individuals. It is useful for institutes to have
Shari’ah advisors present within the establishment or
easily available for general matters, especially the
internal review process. This will help enhance the
effectiveness, compliancy, handling of Shari’ah
related enquiries etc.
• Shari’ah advisors should likewise research new
products, initiate alternatives and provide or
Institution of Hisbah (Enjoining right conduct and
forbidding what is wrong)
• “Let there arise out of you a band of people inviting to all that is good,
enjoining right conduct and forbidding what is wrong. Such are they who are
successful” (Qur’an 3:103).
• Endorsement of enjoining the right and forbidding the wrong

has its roots in the Qur’an and the Sunnah. For this reason the
institution of Hisbah was formed under the historic Islamic
state/Caliphate in order to regulate society with justice and
righteousness, in accordance with the principles of Islam. Ibn
Taymiyah taught that Hisbah relates to the areas where
authority of governors, judges, or other specified public
officers cannot reach.
• One hadith mentions, “Whoever of you sees something
wrong, then change it with your hand, if you are not able to do
so, then change it with your tongue, if you are not able to do
so, then (detest it) with your heart.”
Institution of Hisbah
• Due to the importance of Hisbah, the Islamic state use to
appoint qualified people to take on the more serious roles of
Hisbah. Although individuals may apply Hisbah within their
own capacity, there are issues that must be resolved by the
scholars who are qualified to exercise the best resolve in
accordance with the principles of Islam. Such is the case with
Shari’ah advisors. Although Hisbah is a broad topic and covers
all areas of the state, SSBs and Shari’ah advisors fulfil this role
within the realm of Islamic finance and banking.
• Shari’ah advisors are therefore required to be competent in
Shari’ah. Ibn Taymiyah mentioned, “Allah ordered us to
command good and forbid evil. But commanding something
must be preceded by knowing it; one who does not know the
good will be unable to command it. And prohibiting evil must
be preceded by knowing it; one who does not know it will be
unable to prohibit it.” (Majmu’ Al-Fatawa, vol 15).
Institution of Hisbah
• The Muhtasib (one who practices Hisbah) should have the

necessary experience, knowledge, patience and wisdom. The
role is not to be taken by the ignorant. This would include
those who are not grounded in experience, deep knowledge of
Shari’ah, the aims of the Shari’ah and hikmah (wisdom). For
example, Ibn Taymiyah also stated, “Commanding the good
should not result in the loss of a greater good, or in an evil
greater (than before). And forbidding an evil should not result
in a greater evil, or in the loss of a greater good (than before)”
(Al-Hisbah).
• Fill in the blan para
Qualifications of a Shari’ah board scholar?
“Then We established you on a way (shari’ah) regarding affairs.
Therefore follow it, and do not follow the vain desires of those
who lack knowledge” (Qur’an 45:18).
• There is concern of a lack of specialists in the growing sector of
Islamic Finance. Likewise, there is no universal agreement on
what is required to be a Scholar in this field. Then again there
are various levels of scholarship and specialisation.
• One cannot be expected to have a degree and then instantly
fill this role. There are also prominent scholars of the world
who never had university degrees, however, they spent years
studying under other scholars beyond what universities can
offer. Some may have long experience in the banking/finance
sector as well as education and or traditional scholarly learning
etc.
Qualifications of a Shari’ah board scholar?
• Therefore, the specialist must know the Shari’ah in detail as
well as have necessary experience. If they are required to give
ijtihad, they must be qualified to do so. As was mentioned in
week 1, this requires an excellent understanding of the
Qur’an, the Sunnah, established rulings, as well as a sound
understanding of the Arabic language.
• It is important for the Shari’ah advisor to be familiar with

accounting and auditing, economics and finance, as well as
familiarity with the banking industry.
Shari’ah Standards Bodies
Shari’ah standards are issued by a number of organizations.
They may be adopted by banks or financial institutions locally
or around the world. The following are some prominent
bodies.
The Accounting and Auditing Organization for Islamic

Financial Institutions (AAOIFI)
• AAOIFI is an Islamic international autonomous non-for-profit
corporate body that prepares accounting, auditing,
governance, ethics and Shari'a standards for Islamic financial
institutions and the industry. Professional qualification
programs (notably CIPA, the Shari’a Adviser and Auditor
"CSAA", and the corporate compliance program) are
presented now by AAOIFI in its efforts to enhance the
industry’s human resources base and governance structures.
Shari’ah Standards Bodies
Shari’ah standards are issued by a number of organizations.
They may be adopted by banks or financial institutions locally
or around the world. The following are some prominent
bodies.
The Accounting and Auditing Organization for Islamic

Financial Institutions (AAOIFI)
• AAOIFI is an Islamic international autonomous non-for-profit
corporate body that prepares accounting, auditing,
governance, ethics and Shari'a standards for Islamic financial
institutions and the industry. Professional qualification
programs (notably CIPA, the Shari’a Adviser and Auditor
"CSAA", and the corporate compliance program) are
presented now by AAOIFI in its efforts to enhance the
industry’s human resources base and governance structures.
• As an independent international organization, AAOIFI is
supported by institutional members (200 members from 45
countries, so far) including central banks, Islamic financial
institutions, and other participants from the international
Islamic banking and finance industry, worldwide.
• AAOIFI has gained assuring support for the implementation of
its standards, which are now adopted in the Kingdom of
Bahrain, Dubai International Financial Centre, Jordan,
Lebanon, Qatar, Sudan and Syria. The relevant authorities in
Australia, Indonesia, Malaysia, Pakistan, Kingdom of Saudi
Arabia, and South Africa have issued guidelines that are based
on AAOIFI’s standards and pronouncements.
(Adapted from the AAOIFI website http://www.aaoifi.com/)
The Islamic Financial Services Board (IFSB)
• The IFSB started operations on 10th March 2003. It serves as an
international standard-setting body of regulatory and supervisory
agencies that have vested interest in ensuring the soundness and
stability of the Islamic financial services industry, which is defined
broadly to include banking, capital market and insurance.
• As of April 2010, the IFSB consisted of 191 members and 50
regulatory and supervisory authorities as well as the International
Monetary Fund, World Bank, Bank for International Settlements,
Islamic Development Bank, Asian Development Bank and the
Islamic Corporation for the Development of Private Sector, Saudi
Arabia, and 138 market players and professional firms operating
in 39 jurisdictions.
• Malaysia, the host country of the IFSB, has enacted a law known
as the Islamic Financial Services Board Act 2002, which gives the
IFSB the immunities and privileges that are usually granted to
international organisations and diplomatic missions.
Islamic International Rating Agency (IIRA)
IIRA was established to provide a wide range of services. The
main purpose is to play a pro-active role in the development of
financial markets by providing an assessment of the risk profile
of entities and instruments which can be used as a basis for
investment decisions.
IIRA is a unique rating agency in that it provides a Shari’ah
quality rating, credit rating, corporate governance rating and
sovereign rating services. IIRA will also carry out research,
analysis and evaluation of sectors, industries and entities. For
this purpose, IIRA is building a strong database of individual
firms and industries.
IIRA is structured in a way to preserve its independence. It has a
Board of Directors and a completely independent Rating
Committee. Its Shari’a Board is made up of experts in the field.
(Adapted from IIRA website http://www.iirating.com/home.asp)
Rating Agency Malaysia (RAM)
• RAM Holdings is a leading provider of independent credit

research and advisory services. Their forte is in the provision
of unparalleled insights into the Malaysian bond market – to
help guide their clients’ decision-making processes – and also
in other value-added services that complement their
requirements.
• RAM Holdings (formerly known as Rating Agency Malaysia
Berhad) was established in November 1990 as a catalyst for
the domestic debt-capital market and as the nation’s first
credit-rating agency. Shareholders comprise both local and
foreign financial institutions.
(Adapted from the RAM Holdings website http://www.ram.com.my/default.aspx)
The Malaysian Accounting Standards Board (MASB)
The MASB's mission is to develop and promote high quality
accounting and reporting standards that are consistent with
international best practices for the benefit of users, preparers,
auditors and the public in Malaysia. In a wider context, the
MASB seeks to contribute directly to the international
development of financial reporting for the benefit of users,
preparers and auditors of financial reports.
(Adapted from the MASB website http://www.masb.org.my/)
• Others include:
• The International Islamic Financial Market (IIFM)
• The General Council for Islamic Banks and Financial Institutions (GCIBFI)
Topic 10: Zakah, Waqf & Wasiyyah
Introduction to Zakah, Waqf & Wasiyyah

Other Islamic Banking Concepts:
Ar-Rahn (pawn broking)
Al-Kafalah (Guarantee, Sponsorship, Surety)
FACULTY OF LAW AND
MANAGEMENT
Al-Wakalah (Agency, Representation, Authorization)
SCHOOL OF ECONOMICS
Zakah for Islamic Banking ‫الزكاة‬
• Zakah is the third pillar of Islam and is usually described as
alms-giving or a charity-tax. The Prophet Muhammad said,
“Islam is built upon five (pillars): [1] The testimony that none
has the right to be worshipped except Allah and Muhammad is
the Messenger of Allah; [2] establishing Prayer; [3] giving
Zakah; [4] pilgrimage to the Holy Mosque (in Mecca) and; [5]
fasting (the month of) Ramadan” (Bukhari and Muslim).
• Definition of Zakah (or Zakat): the lexical meaning of Zakah has
a dual connotation of increase and purification. Zakah is
sometimes referred to as Sadaqah (Charity) in the Qur’an and
Sunnah. It is referred to as a tax that only applies to those with
sufficient wealth. Zakah is applicable on wealth (gold, silver,
money), livestock (camels, cattle, sheep), and farm produce
(grain, fruit).
• The Muslim with a sufficient amount of savings (gold, silver,
money) must give 2.5% of it in Zakah. This is done once per year
and must be dispersed as a charity among the needy in the
society. The ratio as well as the nisab (threshold) for livestock and
farm produce is different to that of savings, therefore it will not
be covered here.
• Nur Barizah Abu Bakar summarized some of the benefits of Zakah
wherein he said:
“Spiritually, paying zakat purifies and cleanses one from greed,
selfishness, and arrogance. Economically, at least in theory,
paying zakat will enhance economic prosperity by transferring
surplus wealth to the poor. This will increase their purchasing
power and, hopefully, lead to a higher demand for goods. Thus,
zakat acts as a wealth-distribution mechanism to help close the
gap between the rich and the poor. Ideally, it could help establish
a more prosperous society.”
(A Zakat Accounting Standard (ZAS) for Malaysian Companies)
Ruling (Hukm) on Zakah:
• Zakah is fard (compulsory) for the Muslim who has the nisab.
If the individual does not have the nisab, the obligation is lifted
from them. The nisab is regarded as a threshold. Those who
have savings at or above the nisab are obligated to pay Zakah.
Nisab for Zakah on wealth (Zakat-ul-Mal):
• In the time of the Prophet, the nisab was fixed at twenty gold
coins (dinars) or two-hundred silver coins (dirhams). Whoever
possessed twenty gold coins was commanded to give ½ a gold
coin (2.5% or 1/40) in Zakah. Those who had 200 silver coins
were commanded to give 5 silver coins. Twenty gold coins in
the time of the Prophet equated to 85 grams of gold and 200
silver coins equated to 595 grams.
• Therefore, to find the nisab equivalent today for money, one
must look to the current price of gold. There are scholars who say
that the nisab should be based on the value of silver as it is lower
in value and will enable an additional flow of funds to the needy.
In Australia August 2010, the value of 85 grams of gold
approximated AUS $3560. Anyone with this amount in net
savings or more is liable to pay Zakah. If we were to use the value
of silver to measure the nisab of money, the nisab would be
approximately AUS $375. Note that the prices of gold and silver
fluctuate, therefore, calculations must be based on current
values.
• Before one calculates their savings, they must take into
consideration any liabilities that must be paid. For example, each
year when Uthman (the third Caliph) would announce to the
people regarding Zakah, he would command the people to pay
their debts first, then calculate their Zakah on what remains.
Administration of Zakah
• According to Abul-Hasan Al-Mawardi (11th century), there are

two kinds of Zakatable wealth. One refers to the hidden, such as
one’s money, gold or silver. The other is the manifest wealth,
such as farming produce and livestock. He mentions that the
Islamic state employs experts to evaluate the manifest wealth
and collect its share of Zakah. As for the hidden wealth, it can be
handed over to the Zakah collectors, or it can be given by the
individual on their own accord to those they know to be needy
(Al-Ahkam As-Sultaniyyah: The Laws of Islamic Governance).
• Today a number of banks provide the service of deducting
Zakah from the accounts of depositors/investors. Otherwise, it
is the individuals own responsibility to give their Zakah each
year to the needy or to charity organizations that specialize in
the distribution of Zakah.
AAOIFI for example, in their accounting and auditing standards,
have explained a number of recommendations regarding
Zakah. They serve as guidelines for banks and businesses.
Likewise the MASB (Malaysian Accounting Standard Board) has
taken consideration of Zakah into their accounting and
auditing guidelines for businesses. MASB has released what is
known as TR i-1 Accounting for Zakat on Business.
For example, the MASB states, “When an entity pays zakat on
business, the amount of zakat assessed is recognized as an
expense and included as a deduction from net income in the
income statement of the entity. This treatment is appropriate
as it reflects the discharge of a financial obligation of the
entity” (MASB Technical Release i -1 Accounting for Zakat on
Business).
• In Malaysia where income is taxed, the government’s budget
stipulates that Zakah is to be treated as a tax deduction. The
Zakah may be deducted by the bank, then distributed through
specific charity channels. According to the Shari’ah, Zakah is to
be collected and redistributed within the same region.
Generally the federal government does not get involved in the
distribution of Zakah as it is the affair of individual states or
provinces.
• Zakat-ul-Mal is given once per lunar year as it is based on the
Islamic calendar. There is approximately 10 days difference
between the solar and lunar year. As stipulated by AAOIFI, if
businesses/industries want to give their Zakah in conformity
with the solar year (e.g. for accounting purposes), then they
must calculate 2.5775% of net income for Zakah.
Waqf (Endowment)
Waqf (plural Awqaf) refers to the specified assets that are to be used
for nominated purposes. The following points will shed light on
particular aspects regarding Awqaf:
• The specific assets given as waqf can include land, houses, mosques,
farms, education centers, hospitals etc.
• When assets are given as waqf, they must be maintained as such.
Waqfs are to be used by those who require their use. Therefore,
Waqfs can be regarded as ongoing charities (Sadaqah Jaariyah).
• The assets may be nominated to specific persons to manage, yet, they
must fulfill the specific purpose of their endowment.
• When a property is endowed, the property cannot be sold or given
away. The building can be maintained, renovated, extended etc. The
waqf may be relocated if there is a need for doing so.
• The asset simply becomes waqf by stipulation or pronouncement.
Waqfs have served as a beneficial way of providing public
services in Muslim countries over the centuries such as
universities, roads, infrastructure etc. Revenue generated via
the waqf should be put back into the waqf (such as
management, payment of staff/contractors, development etc)
or given in charity.
Waqfs may also be used today under Takaful arrangements. The
contributors to the waqf are covered if any losses occur. This is
seen as a way of mutual help and not a means to make profit.
Since waqfs are not necessarily for profit making, they are not
widely discussed in contemporary Islamic finance literature.
However, since waqfs provide needs and assistance for
particular beneficiaries, this may limit dependence on public
sector finance.
Inheritance (Faraa’id) and Bequests (Wasaya
[plural])
• When a Muslim passes away, their wealth and estate is to be shared
among certain relatives as it is stipulated in the Qur’an and Sunnah.
These heirs are from the immediate family such as the spouse,
children and parents. In the case of no ascendants or descendants,
then the brother and or sister receive a share. Under a state that does
not acknowledge Islamic laws of inheritance, then a will should
stipulate who the recipients of the deceased should be and their
share of inheritance according to the Shari’ah.
• As for the Wasiyyah (Bequest, Will), the recipients must not be from
the regular heirs as they are automatically included to receive their
share. A hadith states, “No bequest (wasiyyah) may be made for a
(standard) heir” (Ahmad, Abu Dawud, Tirmithi).
• Wasiyyah applies to a share for those who are not immediate
relatives. One may stipulate where they want a portion of their
wealth to go, such as to a friend, a charity organization etc.
• There is a maximum limit that can be bequeathed from one’s
wealth. Sa’ad (the Prophet’s Companion) asked if he can bequeath
2/3 of his wealth, the Prophet said “No”. He then asked ½? The
Prophet answered “No”. He then asked, “1/3?” Thereupon the
Prophet said, “Yes, one third; and even one third is too much.
Indeed, O Sa’ad, it is better to leave your inheritors rich after you
than to leave them as a burden, begging people…”(Bukhari, Muslim
and others).
• When the individual passes away, (1) any remaining debts are to be
paid off first, then (2) the bequeathed portion is given to the
specified recipients, then (3) the inheritance (Faraa’id) is distributed
to the inheritors in accordance with the Shari’ah (as mentioned in
the Qur’an 4:12).
Other Islamic Banking Concepts
Ar-Rahn (pawn broking)
• Ar-Rahn (or sometimes pronounced Rahnu) is a form of

collateralized borrowing. It is narrated in Bukhari that the
Prophet Muhammad pawned his armor with a man in Madina
for a supply of food. Islamic banks may offer this as a way of
providing immediate cash-flow needs for the borrower. It is a
form of micro-financing as it is usually used for small amounts
of cash. The money is lent as a Qard Hassan (benevolent loan)
while the collateral is kept by the creditor as an Amanah
(trust) or for Wadi’ah (safekeeping).
Some of the regulations surrounding Ar-Rahn are:
• Banks require a small safekeeping fee for the collateral.
• The collateral must be worth more than the borrowed amount.
• A tenure period must be stipulated (e.g. 6 months).
• The debtor must own the collateral.
• Whenever the term ends, the creditor can demand the money back. If
the debt is repaid, the creditor must return the collateral.
• If the debt cannot be repaid, the creditor can deduct it from the
collateral. If the collateral (e.g. gold jewelry) sells above the borrowed
amount, the creditor can only retrieve the same amount of money that
was lent to the debtor. Any excess must be given to the debtor.
• If the collateral sells below the borrowed amount and the creditor
cannot recover the debt, the rest of the amount remains due from the
debtor.
• The agreement must be written down and stipulate the term (starting
Al-Kafalah (Guarantee, Sponsorship, Surety)
• Al-Kafalah existed in the time of the Prophet. He allowed one
who is deemed to be wealthy to backup another individual if the
individual defaults or dies. This serves as a useful guarantee
today for those involved in shipping (such as in Malaysia). In this
case the bank serves as the guarantor. These banks also charge
a service fee for the guarantee.
Al-Wakalah (Agency, Representation,

Authorization)
• This involves nominating another person to act as an agent
(Wakeel) on one’s behalf usually for a fee. There are a number
of verses in the Qur’an and hadiths that elaborate on Wakalah.
Al-Wakalah can be used as a contract to support or facilitate the
transfer of capital.
• For example, the one who seeks out to buy a machine for their
company may approach the bank for its finance. The intended
buyer requires the bank to purchase the goods, then when the
bank has possession of the goods, will make a contract with
the bank to purchase the goods BBA-Murabahah. The bank
may require a wakeel in this case to purchase the goods. The
wakeel could be the intended buyer as they know best what
goods they will require. Therefore, they purchase the goods as
an agent for the bank who then takes ownership. The bank
then makes a contract to sell the goods with the mark-up in
price and deferred payments.
The Promise (Wa’d)
• There is concern regarding the nature of a unilateral promise,
is it legally binding or not. It is regarded as a moral obligation
however there is discrepancy on whether it can be
enforceable by law. The bank cannot make a contract to sell
the goods before it takes possession of it. Nor can it make two
contracts in one.
• The promise comes about when the intending buyer
approaches the bank for the finance of certain merchandise.
The bank only buys the goods based on a promise that the
customer will buy it from the bank BBA-Murabahah. If the
customer defaults in their promise, the bank will be left with
the merchandise. For this reason, many scholars (such as the
OIC’s Islamic Fiqh Academy) support the promise as legally
binding.
Islamic Insurance – Takaful
• Although conventional insurance dominates the scene, the major

criticisms of conventional forms of insurance relate to the elements:
of Maysir (chance games), Gharar (ambiguity) and Riba (interest).
• Takaful is the modern form of ‘Islamic insurance’. Takaful made its

debut some thirty-odd years ago in Sudan and Saudi Arabia,
thereafter, other countries followed suit and new models evolved.
• An insurance system that was practiced during the time of the

Prophet Muhammad (over fourteen centuries ago) forms the basis for
the modern day Takaful concept. In case of a calamity, individuals of a
particular tribe sought to contribute from their own resources until
adversity was relieved (Ayub 2007).
Islamic Insurance – Takaful (cont)
• A clear example of this can be found in a hadith collected by Imam

Bukhari wherein an infant died in the womb as a result of an
altercation between two women. Therefore, blood money was to be
paid by the paternal relatives of the accused women as compensation
for the dead (unborn) child (Bukhari 1971). This combined effort of
the tribe from the father’s side was known as ‘Aaqila. It is from this
very concept where modern Islamic insurance (Takaful) emerged.
• Takaful comes from the Arabic word kafala which means to
guarantee. Takaful could therefore refer to a shared responsibility,
shared guarantee or mutual undertakings (Kettle 2008). Although a
number of Takaful models exist, companies generally follow the same
concept where participants pay a fee known as tabarru’ (donation) or
musahanah (contribution). Participants thereafter share the risk or
responsibility.
•
Islamic Insurance – Takaful (cont)
• This differs from conventional insurance where a premium is

paid to transfer the risk to a third party while in Takaful risk is
shared based on the basis on mutual help and joint
responsibility. Takaful companies provide cover for cars,
property, medical needs, life etc.
• In general, the money from contributors is placed in a pool that
is utilized for investment, paying the Takaful operator and
most importantly, to cover the losses of contributors if they
make a claim.
Popular Wakalah-Mudarabah Takaful Model
• This model is a combination of Wakalah and Mudarabah.

Wakalah is used for the Takaful operator, while the profits
made via Mudarabah are shared between the
operator/shareholders and the participants/contributors
according to a fixed ratio as cash dividends or distributions.
• The Hybrid model, with the combination of Wakalah and
Mudarabah, gives the agency the incentive to invest in a good
way as the profits are shared between contributors and
shareholders. Other models, like modified Mudarabah one,
distributes surplus and profit (combined) amongst
shareholders and contributors but this criticised as not being
shariah compliant because contributions do not form part of
Mudarib’s investment capital.
Topic 11: Global Islamic Finance Industry
The performance of Islamic Banking Practices

Middle East Case
Pakistan Case
Malaysian Case FACULTY OF LAW AND
MANAGEMENT
Indonesia SCHOOL OF ECONOMICS
The performance of Islamic Banking
practices
• Islamic banking and finance is the fastest growing industry in
the financial world.
• It has been experiencing exponential growth in three regions
of the world namely the Middle East, South Asia and
Southeast Asia.
• Each nation appears to have its own opinion on how to
administer certain Islamic financial products. This is hampering
efforts for a globalized system of Islamic banks.
The performance of Islamic Banking
practices (cont)
• There are several reasons for these differences.
• The main reason is because the application of the theoretical
aspects of the Islamic banking system differs from country to
country, and under different economic conditions and social
environments.
• Another reason for the differences is due to the different
math-habs (Schools of religious Law). There are four main
math-habs, namely Hanafi, Shafi’i, Maliki and Hanbali. These
math-habs play an important role in developing Islamic
Jurisprudence in countries around the world.
Middle East
Case
Middle East Case
• The practice of IBF acquired significant shape and momentum
by the end of 1970s due to increases in the general economic
prosperity of the Middle Eastern countries.
• The Middle Eastern Islamic financial institutions (IFIs) received
increasing socio-political-economic support for their growth
and prosperity.
• Many reputable Islamic banks came into being, including the
Nasser Social Bank Cairo (1971-72), Islamic Development Bank
(1975), Dubai Islamic Bank (1975), Kuwait Finance House
(1977), Faisal Islamic Bank of Sudan (1977) and Dar Al-Maal Al-
Islami (1980)
Middle East Case (cont)
• The Middle Eastern Economies are highly promising, featuring

a stable currency and lower interest rates and inflation over
the years.
• Having gone through radical restructuring in recent times,
Middle Eastern markets are now more regulated, transparent
and integrated at both the regional and international levels.
• The Middle Eastern regions also enjoy greater political
stability, law and order and are therefore emerging as a hot
spot for International business, finance and investment.
• Bahrain is the biggest hub of IBF affairs worldwide.

• The country hosts 33 Islamic banks and 26 Takaful (insurance),
and three re-takaful companies which operate at both the
domestic and international level. Bahrain is also a hot spot for
international trading in Sukuk (certificates), Islamic equity
funds, mutual funds and other investment instruments.
• Most of the Islamic institutions such as AAOIFI, IIFM, IIRA are
located in Bahrain, with the country also planning to establish
its own Sukuk Exchange Centre in the future.
• Iran is embarking upon a nationwide IBF practice after the

Islamic revolution in 1979. In the first two decades, Iranian IBF
practice remains highly centralized and isolated from both the
Islamic and conventional markets.
• The Iranian government is keen on increasing its interactions
with Islamic banks and financial institutions, as well as the
conventional financial market worldwide.
• Jordan’s Islamic bank has been the pioneer of IBF since 1978.
It held 10.1% of the total investment of the Jordanian banking
industry in 2006.
• Kuwait also hosts the largest number of IFI and ranks third in
term of Islamic banking assets, which are worth US$22.7
billion (Khojah2006). The country hosts the oldest and biggest
Islamic bank, with Kuwait finance House (KFH) established in
1977.
• In Lebanon during the year 2006, four new Islamic banks

emerged, namely BLOM Development Bank, Arab Finance
House, Al-Baraka Bank, and Lebanon and Credit Libanie. The
Central bank of Lebanon has a plan to introduce sukuk and
takaful services in its market over the next couple of years.
• Qatar is another hot spot for IBF in the Middle East. There are
four major Islamic banks in Qatar, namely Qatar Islamic bank
(1983), Qatar International Islamic bank (1991), Doha Islamic
Bank (2006) and Al Rayan Bank (2006).
• Other IFIs include; First Finance company, Investment House,
Al-Jazeera Islamic Company and Islamic Financial Securities
which mainly offers Islamic retail products and brokerage
services to Muslim clientele. Qatar Islamic Insurance company
has emerged as one of the leading insurance service providers
in the country.
• IBF activities have achieved a rapid growth in Saudi Arabia

over recent years. There are two major IBF players in Saudi
Arabia, namely Al-Rajhi Banking and investment corporation
and Bank Al—Jazera.
• Conventional banks are also serving the IBF clientele by
establishing their own Islamic window and subsidiaries. Other
IBF includes Al Bilad, Amlak Finance, and Dallalah Al Baraka
SAAB Takaful Company. In July 2006 SABIC signed under a
written agreement for its Sukuk issuance for a total amount of
SAR 3billion.
• The entry of Syria into IBF club is amongthe most recent

developments in the Middle East. By the end 2006 the Syrian
government permitted three Islamic banks namely Al-Sham
bank, Saudi Dalat, Al-Baraka Bank and Syrian International
Islamic bank to launch their operation in the country.
• Moreover the other Takaful companies, namely Aqeelah
Insurance company, Al-Nour Insurance company and Syria-
Qatari company were established as well and are ready to
operate in the Syrian market after receiving their licenses from
the Syrian Insurance supervision Committee.
Pakistan Case
• The government of Pakistan

embarked upon the project of
transforming the banking and
finance sector on Islamic lines in
the early 1980s. It assigned this
task to the Ministry of Finance.
• The Ministry then advised the
State Bank of Pakistan (SBP) to
take necessary steps to evolve the
IBF practice on the basis of the
1980 CII Report.
Pakistan Case (cont)
• The Superior Task Force suggested the overhauling of the
banking laws that contained the provision of interest and
promulgating new laws to cover IBF practice.
• PBC made the following major changes to conventional
banking laws and systems to provide the required legal and
regulatory framework for the IBF system.
• The 1962 Banking Companies Ordinance (BCO) give
discretionary powers to the SBP for regulating the banking and
finance sector of Pakistan. The 1962 BCO was amended to
allow banks to perform manufacturing and trading activities
under the systems of PLS, mark-up in price (bai
muajjal/murabaha), leasing and hire-purchase.
Pakistan Case (cont)
• The SBP took the first step towards Islamization by directing all
banking institutions to open PLS counters in 7,000 domestic
branches across the country from January 1981.
• The SBP allowed banks to invest PLS funds to finance interest-
free trading.
• The foreign banks working in Pakistan also showed keen
interest in adopting the new system. They sent their top
officials to overseas Islamic banks for training and better
understanding of the IBF practice
Malaysian Case
• Malaysia is the second largest hub of IBF.

In 1983, the Malaysian government
established the first Islamic bank - Bank
Islam Malaysia Berhad - and then
introduced IBF in the country under a
duel system by 1993.
• Presently there are 12 fully-dedicated
Islamic banks, 35 commercial banks, 10
merchant banks and 5 development
banks in Malaysia which offer IBF
products and services.
Malaysian Case (cont)
• The Malaysian government has devised a

roadmap targeting a 20 percent share of
the total banking industry for Islamic
banking by 2010.
• The Malaysian government has established
separate legal, tax and regulatory
frameworks for IFIs.
• The country is the pioneer of Islamic capital
market and hosts the first international
Sukuk centre.
Indonesia
• Indonesia, the biggest Muslim populous country of the world,

embarked upon the IBF venture by establishing Bank
Muamalat Indonesia in 1992.
• Presently IBF assets represent 1.8 percent the total Indonesian
banking assets.
• Bank Indonesia has formulated a 10-year roadmap for growth
and development of IBF operations up to 6 percent of the total
Indonesian banking industry by 2011.
Singapore
• Singapore has been actively involved in promoting IBF

operations in Southeast Asia since 2001. The country aims to
become an international trading centre in Islamic property
funds, hedge funds, Sukuks and wealth management.
• The Singapore Stock Exchange has listed Shariah-compliant
indices, namely Lion 30 and FTSE-SGX Asia Shariah 100 Index.
The Monetary Authority of Singapore is committed to
introduce changes to its tax and regulatory systems to
facilitate proper growth and development of IBF in the
country.
Sudan
• The first Islamic bank in the North African region was in Sudan.
• Faisal Islamic Bank Sudan was established in 1977.
• The government of Sudan passed the Islamic Shariah banking
act in 1984, which required the whole banking and finance
sector of Sudan to be transformed onto Islamic lines by July 1
1984.
• Prolonged political and economic turmoil in the country
however has prevented IBF from growing and prospering.
Since January 2005, IBF practices has been revived in Sudan
under a dual banking system. There are four Islamic banks in
northern Sudan.

M. Kabir Hassan, Rasem N. Kayed, and Umar A. Oseni: Introduction To Islamic Banking and Finance: Principles and Practice

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M. Kabir Hassan, Rasem N. Kayed, and Umar A. Oseni: Introduction To Islamic Banking and Finance: Principles and Practice

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Introduction to Islamic Banking and Finance:

Principles and Practice

M. Kabir Hassan, Rasem N. Kayed, and Umar A. Oseni

1. Understand the theory of Islamic banking,

• Islam is a way of life. A verse from the Quran states, “This

• Shari’ah –Islamic Law

• Sources of the Shari’ah

Figure 1.1: Shari’ah as the Basis of Islamic Banking and

• The Qur’an is believed by Muslims to be the word of God

• Prohibits cheating and corrupt practices in the management

• The Sunnah refers to the authentic statements, actions and

• Islamic finance is both a new and old phenomenon. The

• The early days transactions (The guiding principles of Islamic

• The modern-day experiments (Experiments in Islamic finance in

The early days transactions

• The Era of the Prophet

• The Period of Orthodox Caliphate (632 – 661 C.E.)

• Period of the Noble Companions and the Succeeding

• The Umayyad and Abbasid Eras

The Era of the Prophet

Origins and Historical Overview of Explain the historical

• The Malaysian Pilgrims Savings

The functions of the IDB are:

• To provide financial assistance to member countries

• To establish and operate special funds for specific purposes

• To accept deposits and to mobilize financial resources

• To promote foreign trade, especially in capital goods, among

Dubai Islamic Bank (DIB)

• Proprietary trading investments

Islamic and conventional banking (1 to 4 above + …)

“The ethical principles on which Islamic finance is based may

Islamic and conventional banking (1 to 4 above + …)

Fund providers Funds users

“The ethical principles on which Islamic finance is based may

"The LM Australian Alif Fund has been awarded 'Best New

• Any other questions?

Topic 2: Ethics & Prohibitions in Mu’amalat

Ethics in Islamic Finance and Banking - Main prohibitions in

FACULTY OF LAW AND MANAGEMENT

"Assist one another in righteousness and piety. And do not assist

• One objective of Islamic finance and banking is to assist in the

The prohibition of interest is not something exclusive to Islam. Jews

• The other category is Riba Al-Fadl which refers to riba in

• Gharar has a broad scope and is not limited to one simple

Part of Gharar is selling what is not in one’s possession. The

• If two or more parties come together for a partnership (e.g.

Identify role of Riba & Gharar in:

Topic 3: Equity Based Financing (PLS mode)

Equity Based Financing:

• The bank generally acts as a financial intermediary between

• Under Islamic Banking there are two main fields of financing.

• Equity Based Financing - profit-and-loss sharing (PLS)

Investor $10mil (25%) 25%

Investor Contribution Outcome Outcome

B 300 (30%) 60 (30%) - 30 (30%)

C 600 (60%) 120 (60%) - 60 (60%)

Profit arrangement ratio is pre-agreed at the start (10/30/60 or

• Diminishing Musharaka – This method can be used in

Bank’s participation diminishes over

Topic 4: Debt-Based Financing (non-PLS Modes)

FACULTY OF LAW AND

Financing asset purchase

Debt Based Financing: