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Essays in Islamic Economics
An Overview of the Financial System of Islam 
Mr Fahmi Khan, Islamic Development Bank, Jeddah, KSA
Islamic Foundation, Leicester, UK, 1995

A Point-form Summary

Q A Ahmad

1. Principles

1.1 Prohibition of Interest

"Those who indulge in riba shall rise up (before Allah) like men whom Satan has confounded by his touch; for they claim, 'Buying and selling is but a kind of riba - the while Allah has permitted buying and selling and forbidden riba. So, the one who receives an admonition from his Sustainer and thereby desists (from riba), may keep his past gains; his affairs are with Allah. But he that returns to (riba), shall be among the people of the Fire forever.

"Allah deprives the gains of all blessings through riba, whereas He blesses charitable deeds with manifold increase. And Allah bears no love for the ungrateful sinner."

(Quran, 2:275,276)

a) Riba (used in the Quran) is any increase (large or small, nominal or real) received on a loan. The loan includes all such advances in which the principal amount remains guaranteed.

b) Riba (as defined in the Shariah) is an increase in one of two homogeneous equivalents being exchanged without the increase being accompanied by a return.

"Riba stands for every increase not justified by return'.

Mohammad ibn 'Abdullah ibn 'Arabi

1.2. Return on Financing

a) There is no increase or return in a financing in the form of loan. There is no interest in the Islamic economy.

b) There is no prohibition on earning any return on financing other than loans.

c) For every real economic gain, there has to be a real economic cost in return.

d) Profit is tied with risk-bearing, while loan is tied with non-risk guaranteed principal.

e) The fixity/predetermination of the rate of return is prohibited for the finance provider.

1.3. Financial Capital

a) Financial capital can earn income only by bearing and sharing the risk of loss.

b) If financial capital is not willing to bear and share risk, it can then be advanced on Qard Hasan basis, i.e. neither earning any income nor bearing and sharing any risk of loss.

1.4. Zakah

Zakat is the minimum obligatory levy, being 2.5% on fixed assets, goods and capital. Zakah also serves as obligation-free support to the lowest-income group of the population

1.5. Public Borrowing

Public borrowing will either come in the form of risk-bearing capital for economically productive projects or in the form of Qard Hasan for social and religious projects functioning as a service.

1.6. Government Securities

a) Government securities being an uncertain return can be issued only for such borrowings that are directed to the commercially productive activities.

b) There is nothing to prohibit the government from printing money. It has but to take care that the benefits outweigh the costs.

2. Categories

Financing means to finance (gain money) for any endeavour. Islam encourages financing.

2.1. Return-bearing Financing

a) It is used for potentially commercially profitable activity.

b) Both the provider and borrower bear the risk of possible loss.

c) There is no guarantee for the principal and no guarantee for the return.

2.2. Return-free Financing

a) It is for commercially non-profit activity or for the poor or for the needy.

b) The principal is claimable but subject to the pay-ability of the borrower. There is no return on the principal.

2.3. Charity Financing

a) It is for the poor and for the needy.

b) It is legally obligatory

c) The principal is not claimable and there is no return.

3. Techniques

3.1. Qard Hasan

It is a loan without interest or profit or loss in which the principal is claimable subject to pay-ability of the borrower.

3.2 Loan with service charges

a) The provider is allowed to charge the cost that has been incurred by him in making the loan available to the borrower, e.g. rental of premises, workers wages, stationery, etc.

b) It is most suitable for financial for financial institutions extending loans to their clients/members.

3.3 Mudaarabah: Finance for use in some productive activity

a) All the finance for a specific productive activity is provided by the capital-provider.

b) The capital-user invests his human capital (labour/management) and does not claim any wage/salary.

c) The capital-provider is not authorised to interfere in the management of the business.

d) Willingness to bear the risk of loss justifies a share in the profit for the capital-provider. Profit shall be shared by the capital-provider and the capital-user.

e) The ratio of profit-distribution, being influenced by market forces, is fixed and pre-determined and known to both capital-provider and capital-user.

f) Loss, if any, incurred in the normal process of the business is borne by the capital-provider. In the event of loss, the capital-provider loses his/her capital to the extent of the loss and the capital-user loses all his labour/management.

3.4 Mushaarakah: Additional finance for another party's business

a) The finance-provider provides the additional funds to the party (individual or group) on the condition of having shares in the profits from the busines. The finance-provider is allowed to participate in the management of the business.

b) Both parties are allowed to charge a fee or wage for any management or labour related with the project.

c) The ratio of profit-distribution is fixed, predetermined and known in advance to all concerned. This ratio may be different from the ratio of the investment in the total capital of the project. Market forces influence the determination of the profit-sharing ratio.

d) If the two parties invest only financial capital, the profit ratio should be declared in the ratio of the actual financial investment.

3.5. Muzara'ah/Musaqah: Agriculture financing techniques

It is just like Mudaarabah except that it is the agricultural output that is shared and not the profit.

3.6. Ijaarah (Lease)

An individual with surplus fund gives money to the individual with scarcity of funds to purchase productive asset/assets.

a) The financier purchases the asset and rents it to the person needing the asset

b) The asset-receiver pays the rent.

Conditions of leasing:

i) The service or benefit of the asset must be definitely and clearly known to both parties.

ii) The lessor (financier) remains the owner of the asset and is responsible for its maintenance in order to provide adequate service.

iii) The leasing contract is terminated as soon as the asset ceases to give the service for which it was rented.

iv) The asset can not be sold to the lessee at a predetermined price at the expiry of the contract.

3.7 Bay' Al-Salam (It is also applied in agriculture)

a) Producer can get finance against the sale of the produce before the produce is actually available.

b) Price and quantity of the produce is to be determined very specifically and precisely at the time of the contract.

c) Finance-provider makes a guess at the price at which the goods may be disposed of.

d) Actual rate of return is known anly when the products are delivered to the financier and then he disposes of them in the market.

e) For industrial activities when applied, it is called Ju'alah.

3.8. Bay' Muraabaha bi Thaman Aajil

It is a Sale Contract on a deferred payment basis (Hire Purchase)

a) A business in need of money gets the material/equipment for his/her business and pays the price afterwards.

b) The finance provider purchases the required goods and sells them to the business on the basis of a fixed mark-up agreeing to defer the payment of the price even though the goods are delivered immediately.

c) This mark-up is not related to time. It means that if the financed person is unable to pay in time as agreed, the amount of mark-up remains as fixed in the contract.

d) The mark-up includes the reward for the services that the finance-provider makes available.

4. Instituions

4.1. Commercial Banks

The job of the commercial bank is to finance intermediations just like the capitalistic commercial bank, but with different modes of operation.

a) On the liabilities side:

i) Islamic banks will deal Mudaarabah with their clients

ii) Islamic banks will share with their depositors the profit earned with their clients.

b) On the assets side, income will be generated by:

i) working as mere financial institutions dealing with their clients only on the basis of direct modes of financing, i.e. Mushaarakah or Mudaarabah.

ii) working as trading banks or leasing banks as well as to earn mark-up or earn income from the indirect modes of financing in trading-finance or leasing finance activities.

4.2. Public and Private Baitul Mal (Public Treasury)

The job is to raise funds to meet Qard Hasan needs.

4.3 State and Private Voluntary Zakah & Charity Fund

The job is to organise Zakah and Charity Funds as a social service to meet the survival needs of the less-priviledged.

a) Zakah

i) It is an obligatory payment in the cause of Allah. There is no worldly, percuniary or non-percuniary reward or compensation by the payment of zakah.

ii) All financial holdings and working capitals are subject to zakah at the rate of 2.5% payment per annum.

iii) Following are the expenditure heads of zakah:

1. Poor;
2. The needy;
3. Those employed to administer zakah;
4. Those who have recently reconciled to the Truth (i.e. accepted Islam);
5. Those in bond;
6. Those in debt;
7. Travellers;
8. Those working for the cause of Allah.

b) Charity

General welfare expenses other than the specific heads to be spent from the Zakah Fund.

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