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

Learning Objectives
Upon the completion of this chapter, the reader should be able
to:
1. Describe the conceptual basis of the modern practice of
Islamic banking and finance;
2. Explain the historical development and conceptual
arguments of Islamic banking and finance;
3. Understand the components and operating structure of the
Islamic banking and finance industry as well as the process of
development of Islamic finance products;
4. Describe the current size and worldwide spread if Islamic
banking and finance.

Learning Objective 1.1

Basis of Islamic Banking and Finance

Describe the conceptual

basis of the modern
practice of Islamic banking
and finance.

The basis of Islamic finance is Islamic law, which is also

known as the Shariah

The central ruling body is the International Islamic Fiqh

Academy (IIFA)

The underlying principles of the modern Islamic banking and

finance industry include:
The prohibition of interest and excessive risk
The permissibility of lawful sales
Islamic entrepreneurship

Learning Objective 1.1

Basis of Islamic Banking and Finance

Describe the conceptual

basis of the modern
practice of Islamic banking
and finance.

The Shariah

Defines man-to-God and man-to-man relationships

Shariah is the Devine prescriptions in the form of faith and
belief, laws and moral norms broadly classified into two
strands:
ibadah (worship and devotional practices)
muamalat (civil transactions)
The primary sources of the Shariah are the Quran and
Sunnah

Learning Objective 1.1

Basis of Islamic Banking and Finance

Describe the conceptual

basis of the modern
practice of Islamic banking
and finance.

Figure 1.1: Shariah as the Basis of Islamic Banking and

Finance

Learning Objective 1.1

Basis of Islamic Banking and Finance

Describe the conceptual

basis of the modern
practice of Islamic banking
and finance.

The Quran

The first source of the Shariah

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

Learning Objective 1.1

Basis of Islamic Banking and Finance

Describe the conceptual

basis of the modern
practice of Islamic banking
and finance.

The Sunnah

The second primary source of the Shariah

Comprises the sayings, practices and tacit approvals of the

Prophet Muhammad (PBUH)

Meant to further explain the injunctions of the Quran

For example, there are many prophetic traditions that deal

with riba that highlight the affirmative evidence of the
prohibition of riba already mentioned in the Quran

Learning Objective 1.2

Origins and Historical Overview of

Islamic Banking and Finance

Explain the historical

development and
conceptual arguments of
Islamic banking and
finance

The history of Islamic finance is divided into two general

aspects:

The early days transactions

The modern-day experiments

Learning Objective 1.2

Origins and Historical Overview of

Islamic Banking and Finance

Explain the historical

development and
conceptual arguments of
Islamic banking and
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

Learning Objective 1.2

Origins and Historical Overview of

Islamic Banking and Finance

Explain the historical

development and
conceptual arguments of
Islamic banking and
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

Learning Objective 1.2

Origins and Historical Overview of

Islamic Banking and Finance

Explain the historical

development and
conceptual arguments of
Islamic banking and
finance

The Period of Orthodox four rightly-guided Caliphs: (632 661 C.E.)

Abu Bakr Assidique (632 634)

Failure of a segment of the Islamic state to pay the compulsory
alms known as zakat.

Umar ibn Al-Khattab (634 644)

- Dramatic reforms in the economic policy of the state.
- The introduction of a centralized and permanent Bait al-mal (the
Treasury House)

Uthman ibn Affan (644 656)

The introduction of the first Muslim coins

Ali ibn Abi Talib (656 661)

Learning Objective 1.2

Origins and Historical Overview of

Islamic Banking and Finance

Explain the historical

development and
conceptual arguments of
Islamic banking and
finance

Period of the Noble Companions and the Succeeding

Generations marked by:

Building on the reforms introduced by the Prophet (PBUH)

Tremendous increase in commercial interaction between

merchants in the Islamic state and elsewhere

Further development of fiqh (Islamic jurisprudence)

Advanced economic reforms based on self-exerted judgment

(ijtihad)

Learning Objective 1.2

Origins and Historical Overview of

Islamic Banking and Finance
The Umayyad and Abbasid Eras

Explain the historical

development and
conceptual arguments of
Islamic banking and
finance

Issuance of the first Islamic dirham (containing the crescent, the star,
and bismillah)

Shifting of the Treasury House to Damascus, capital

of the Umayyad, where a
bigger building was designated
as Bait al-Mal

The Treasury House still

significant during the Abbasid
period and Mamluk era

The dinar and dirham still

used as mediums of exchange

Learning Objective 1.2

Origins and Historical Overview of

Islamic Banking and Finance

Explain the historical

development and
conceptual arguments of
Islamic banking and
finance

Modern-Day Experiments of Islamic Finance marked by:

The Ottoman Empires fall resulting in fragmentation of

Muslim nation into different countries

Prevalence of interest-based banking and finance system

Lack of awareness among Muslim communities across

nations on whether to return to Islamic roots

Experiments in Islamic finance in Egypt, Malaysia, and

Pakistan: the basis of modern Islamic banking and finance

Learning Objective 1.2

Origins and Historical Overview of

Islamic Banking and Finance
Timeline of Modern-day Experiments of
Islamic Banking and Finance from 1962 to 1975

Explain the historical

development and
conceptual arguments of
Islamic banking and
finance

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 Sharahcompliant investments)

The Founding of the Islamic

Development Bank (IDB) in 1975

Learning Objective 1.2

Origins and Historical Overview of

Islamic Banking and Finance

Explain the historical

development and
conceptual arguments of
Islamic banking and
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 Sharah compatible modes

To promote foreign trade, especially in capital goods, among

member countries

Learning Objective 1.2

Origins and Historical Overview of

Islamic Banking and Finance

Explain the historical

development and
conceptual arguments of
Islamic banking and
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

Learning Objective 1.2

Origins and Historical Overview of

Islamic Banking and Finance

Explain the historical

development and
conceptual arguments of
Islamic banking and
finance

Timeline of Modern-day Experiments of Islamic banking and

finance from 1962 1975
Figure 1.2:
Timeline of
Modern-day
Experiments of
Islamic banking
and finance
from 1962 to
1975

Learning Objective 1.2

Conceptual Arguments for Islamic

Banking and Finance

Explain the historical

development and
conceptual arguments of
Islamic banking and
finance

The fundamentals of Islamic banking and finance business are:

Interest-free

Ethical

Asset-based and asset-backed

Partnership investment based on profit and loss sharing

(PLS) between financer and entrepreneur

Learning Objective 1.2

The Development of Islamic Banking

and Finance Industry

Explain the historical

development and
conceptual arguments of
Islamic banking and
finance

Emergence of the modern Islamic banking and finance

industry in the 1960s

Gradual expansion of the Asian markets between the 1980s

and 90s

Introduction of Islamic insurance (takaful)

Introduction of project financing with the support of the IDB

Introduction of sukuk (Islamic bonds) and equities markets

in the 1990s

Internationalization of Islamic banking and finance from the

early 2000s

Learning Objective 1.2

The Development of Islamic Banking

and Finance Industry

Explain the historical

development and
conceptual arguments of
Islamic banking and
finance

Figure 1.3: Total Global Islamic Banking Assets Growth 2012

Learning Objective 1.3

Components of Islamic Banking and

Finance Industry

Understand the
components and operating
structures of the Islamic
banking and finance
industry as well as the
process of development of
Islamic finance products.

The four major components of the Islamic banking and finance

industry are:

Islamic banking

Takaful

Islamic capital markets

Islamic non-bank financial institutions

These form the Islamic financial architecture and infrastructure

Learning Objective 1.3

Components of Islamic Banking and

Finance Industry

Understand the
components and operating
structures of the Islamic
banking and finance
industry as well as the
process of development of
Islamic finance products.

Islamic Banking
The Islamic banking component:

Deposit-taking and finance of institutions to meet needs of

Muslim customers and investors

May be:
- Fully fledged Islamic banks
- Islamic subsidiaries or
- Windows of conventional banks

Learning Objective 1.3

Components of Islamic Banking and

Finance Industry

Understand the
components and operating
structures of the Islamic
banking and finance
industry as well as the
process of development of
Islamic finance products.

Takaful (Islamic Insurance)

Takaful based on mutual cooperation, common welfare and

general good of society

Development of modern takaful began with debates about

legality of conventional insurance schemes

Controversy resolved by the Islamic Fiqh Academy in

Resolution No. 9 of 1985

Takaful and retakaful significant in managing and mitigating

risks in Islamic banking and finance

Learning Objective 1.3

Components of Islamic Banking and

Finance Industry
The Islamic Capital Markets (ICM)

Understand the
components and operating
structures of the Islamic
banking and finance
industry as well as the
process of development of
Islamic finance products.

ICM is a special market where investment activities do not

contradict the principles of the Sharah

The Islamic Capital Market is free riba, gharar and maysir

The market players include:

- Brokerage houses
- Investment banks
- Fund management institutions
- Islamic asset management institutions

Learning Objective 1.3

The Islamic Capital Markets (ICM)

Understand the
components and operating
structures of the Islamic
banking and finance
industry as well as the
process of development of
Islamic finance products.

Various international bodies established to study, promote,

develop and set standards for Islamic finance products
include:
- International Islamic Financial Market (IIFM)
- Islamic Financial Services Board (IFSB)
- Accounting and Auditing Organization for Islamic Financial
Institutions (AAOIFI).

Learning Objective 1.3

Components of Islamic Banking and

Finance Industry

Understand the
components and operating
structures of the Islamic
banking and finance
industry as well as the
process of development of
Islamic finance products.

Islamic non-bank financial institutions

Islamic financial institutions that play a facilitative role in

Islamic society ensuring economic development through
non-bank financing

They support liquidity needs of major agents in the economy

They include: finance companies, Islamic housing

cooperatives, Islamic microfinance institutions, waqf
management institutions, private equity /venture capital
firms, hajj and zakat management bodies

Components of Islamic Banking and

Finance Industry
Islamic financial architecture and
infrastructure

Learning Objective 1.3

Understand the
components and operating
structures of the Islamic
banking and finance
industry as well as the
process of development of
Islamic finance products.

Crucial support for Islamic financial services:

payment-settlement, legal institutions and framework

safety net

liquidity support providers

corporate governance e.g Sharah governance structure

standard setters for financial supervision and infrastructure

rating and external credit assessment institutions

financial statistics and information providers

knowledge management/HR development institutions

research and development institutions.

Learning Objective 1.3

Operating Structures of Islamic

Banking and Finance Industry

Understand the
components and operating
structures of the Islamic
banking and finance
industry as well as the
process of development of
Islamic finance products.

Key operating mechanisms of Islamic banking and finance

industry include:

Fund mobilization

Fund utilization
- Sharing modes
- Sale modes
- Leasing modes

Learning Objective 1.3

Key Operating Mechanisms of

Islamic Banking and Finance

Understand the
components and operating
structures of the Islamic
banking and finance
industry as well as the
process of development of
Islamic finance products.

Figure 1.4: Key Operating Mechanisms of Islamic

Banking and Finance

Learning Objective 1.3

Key Operating Mechanisms of

Islamic Banking and Finance

Understand the
components and operating
structures of the Islamic
banking and finance
industry as well as the
process of development of
Islamic finance products.

Fund mobilization
The process of raising funds to establish a viable financial
institution through the sale of shares to investors and
receiving funds from depositors. Features include:

An ethical manner

Net equities owned by shareholders

Investment deposits

Demand deposits

Learning Objective 1.3

Key Operating Mechanisms of

Islamic Banking and Finance
Fund utilization

Understand the
components and operating
structures of the Islamic
banking and finance
industry as well as the
process of development of
Islamic finance products.

The process of using the funds realized in Shar'ah-compliant

business:
Sharing modes - Partnership where funds initially mobilized are
invested in Shar'ah-compliant business; parties share profits
or loss
Sale modes The bank purchases an item on behalf the client
and resells it to them on a deferred basis or immediately
Leasing modes - The rent of an asset or hire purchase where a
rental fee is paid for a stipulated period of time mutually
agreed by the parties

Learning Objective 1.3

The Development of Islamic Banking

Products

Understand the
components and operating
structures of the Islamic
banking and finance
industry as well as the
process of development of
Islamic finance products.

Islamic banking products - financial tools through which the

financial institutions carry out business

Designed to suit conventional market needs while retaining

the true nature of Islamic financial transactions

Involve profitable and non-profitable dealings such as:

- zakat (alms)
- waqf (charitable endowment)
- tabaruat (gratuitous contracts)

Learning Objective 1.3

The Development of Islamic

Banking Products

Understand the
components and operating
structures of the Islamic
banking and finance
industry as well as the
process of development of
Islamic finance products.

Islamic banking products initially based on ideas of equity

partnership or partnership modalities

Early jurists employed ijtihad in developing Sharahcompliant products

Emphasis should be on developing Sharah-based

rather than Sharah-compliant financial products

Learning Objective 1.4

The Growth of Islamic Banking

and Finance

Describe the current size

and worldwide spread of
Islamic banking and
finance.

Islamic banking and finance being integrated into the global

economy

The practice of Islamic banking and finance has now been

accepted as an alternative to conventional financial systems

Acceptance attracts new non-Muslim experts, professionals

and financial institutions

Learning Objective 1.4

Islamic Banking Today: The Size of

the Industry

Describe the current size

and worldwide spread of
Islamic banking and
finance.

The industry has more than doubled in size since 2006

Sharah-complaint assets rose by 8.85% from US$ 822

billion in 2009 to US$ 895 billion in 2010

By end of 2011, total estimate of Shar'ah-compliant assets

was US $1.3 trillion

Rapid growth experienced in the Gulf Cooperation Council

(GCC) countries over the last decade

Growth and expansion of Islamic finance industry continued

at the time of global financial crisis

Learning Objective 1.4

Total Assets of Islamic Banks

in the GCC Region

Describe the current size

and worldwide spread of
Islamic banking and
finance.

Figure 1.5: Total Assets of Islamic Banks in the GCC

Region

Learning Objective 1.4

The World-wide Spread of Islamic

Banking

Describe the current size

and worldwide spread of
Islamic banking and
finance.

Islamic commercial banking experiencing a huge expansion

in products and areas of influence across the world.

2010 estimates show Islamic banks and financial institutions

number 430 across over 75 countries.

Islamic banking spans the Middle East, North Africa, SouthEast and central Asia, sub-Saharan Africa, and western
Europe.

More than 191 leading conventional banks in Europe and

America have opened Islamic banking windows or
subsidiaries such as Standard Chartered Bank, Citibank,
HSBC, ABN AMRO, and UBS.

Learning Objective 1.4

Global Coverage of Islamic Finance

Figure 1.6: Global Coverage of Islamic Finance

Describe the current size

and worldwide spread of
Islamic banking and
finance.

Learning Objective 1.4

Multinational Islamic Banks

Describe the current size

and worldwide spread of
Islamic banking and
finance.

The main multinational Islamic banks are:

Jordan Islamic Bank 1978/1979

Faisal Islamic Banks in Egypt and in Sudan 1977/1978

Kuwait Finance House - 1977

Al Rajhi Bank - 1987

Islamic Development Bank (IDB) - 1975

Learning Objective 1.4

Future of Islamic Finance Industry

Describe the current size

and worldwide spread of
Islamic banking and
finance.

Islamic finance set to continue significant growth path

Legal and regulatory challenges still face the emerging

Islamic financial industry

Islamic finance has the potential of being an alternative

mode of finance

Islamic finance assets expected to grow consistently at 15%

per annum and exceed USD 1 trillion by 2016

Global spread of Islamic finance products likely to soon

engulf Latin America and elsewhere

Key Terms
Bay al-salam

Retakaful

Fund mobilization

Riba

Fund utilization

Sale modes

Gharar

Sharing modes

Hajj

Sukuk

Ijtihad

Sunnah

Leasing modes

Tabaruat

Maysir

Takaful

Mudarabah

Waqf

Qard hasan

Zakat