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Islamic Financial Systems


What is Islamic finance? the ethical, moral, social, and religious

Islamic finance is emerging as Islamic finance was practiced predomi- dimensions, to enhance equality and fair-
nantly in the Muslim world throughout the ness for the good of society as a whole. The
a rapidly growing part of the Middle Ages, fostering trade and business system can be fully appreciated only in the
financial sector in the Islamic activities with the development of credit. context of Islam’s teachings on the work
In Spain and the Mediterranean and Baltic ethic, wealth distribution, social and eco-
world. Islamic finance is not nomic justice, and the role of the state.
states, Islamic merchants became indis-
restricted to Islamic countries, pensable middlemen for trading activities. The Islamic financial system is founded
In fact, many concepts, techniques, and on the absolute prohibition of the payment
but is spreading wherever or receipt of any predetermined, guaran-
instruments of Islamic finance were later
there is a sizable Muslim adopted by European financiers and teed rate of return. This closes the door to
businessmen. the concept of interest and precludes the
In contrast, the term “Islamic financial use of debt-based instruments. The system
system” is relatively new, appearing only in encourages risk-sharing, promotes entre-
the mid-1980s. In fact, all the earlier refer- preneurship, discourages speculative be-

CCORDING to some estimates, ences to commercial or mercantile activities havior, and emphasizes the sanctity of
more than 100 financial institu- conforming to Islamic principles were contracts (Box 1).
tions in over 45 countries practice made under the umbrella of either “interest- An Islamic financial system can be
some form of Islamic finance, and free” or “Islamic” banking. However, expected to be stable owing to the elimina-
the industry has been growing at a rate of describing the Islamic financial system tion of debt-financing and enhanced alloca-
more than 15 percent annually for the past simply as “interest-free” does not provide a tion efficiency. A “two-windows” model for
five years. The market’s current annual true picture of the system as a whole. Islamic financial intermediaries has been
turnover is estimated to be $70 billion, com- Undoubtedly, prohibiting the receipt and suggested in which demand deposits are
pared with a mere $5 billion in 1985, and is payment of interest is the nucleus of the backed 100 percent by reserves, and invest-
projected to hit the $100 billion mark by the system, but it is supported by other princi- ment deposits are accepted purely on an
turn of the century. ples of Islamic doctrine advocating risk equity-sharing basis. Analytical models
The growth in Islamic finance initially sharing, individuals’ rights and duties, demonstrate that such a system will be
coincided with the current account sur- property rights, and the sanctity of con- stable since the term and structure of the
pluses of oil-exporting Islamic countries. tracts. Similarly, the Islamic financial sys- liabilities and the assets are symmetrically
But its continued growth in the face of tem is not limited to banking but covers matched through profit-sharing arrange-
eroding oil revenues reflects the influence of capital formation, capital markets, and all ments, no fixed interest cost accrues, and
other factors, such as the desire for sociopo- types of financial intermediation. refinancing through debt is not possible.
litical and economic systems based on Interpreting the system as “interest free” Allocation efficiency occurs because in-
Islamic principles and a stronger Islamic tends to create confusion. The philosophi- vestment alternatives are strictly selected
identity. In addition, the introduction of cal foundation of an Islamic financial sys- based on their productivity and the
broad macroeconomic and structural tem goes beyond the interaction of factors expected rate of return. Finally, en-
reforms—in financial systems, the liberal- of production and economic behavior. trepreneurship is encouraged as entre-
ization of capital movements, privatization, Whereas the conventional financial system preneurs compete to become the agents for
and the global integration of financial mar- focuses primarily on the economic and the suppliers of financial capital who, in
kets—have paved the way for the expan- financial aspects of transactions, the turn, will closely scrutinize projects and
sion of Islamic finance. Islamic system places equal emphasis on management teams.

Zamir Iqbal,
a national of Pakistan, is an Information Officer in the World Bank’s Treasury Information Services Department.

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Box 1
tive of the outcome of business operations and may not create wealth if
Principles of an Islamic financial system there are business losses. Social justice demands that borrowers and
The basic framework for an Islamic financial system is a set of rules lenders share rewards as well as losses in an equitable fashion and that
and laws, collectively referred to as shariah, governing economic, the process of wealth accumulation and distribution in the economy be
social, political, and cultural aspects of Islamic societies. Shariah origi- fair and representative of true productivity.
nates from the rules dictated by the Quran and its practices, and expla- Risk sharing. Because interest is prohibited, suppliers of funds
nations rendered (more commonly known as Sunnah) by the Prophet become investors instead of creditors. The provider of financial capital
Muhammad. Further elaboration of the rules is provided by scholars in and the entrepreneur share business risks in return for shares of the
Islamic jurisprudence within the framework of the Quran and Sunnah. profits.
The basic principles of an Islamic financial system can be summarized Money as “potential” capital. Money is treated as “potential”
as follows: capital—that is, it becomes actual capital only when it joins hands with
Prohibition of interest. Prohibition of riba, a term literally other resources to undertake a productive activity. Islam recognizes the
meaning “an excess” and interpreted as “any unjustifiable increase of time value of money, but only when it acts as capital, not when it is
capital whether in loans or sales” is the central tenet of the system. “potential” capital.
More precisely, any positive, fixed, predetermined rate tied to the matu- Prohibition of speculative behavior. An Islamic financial sys-
rity and the amount of principal (i.e., guaranteed regardless of the per- tem discourages hoarding and prohibits transactions featuring extreme
formance of the investment) is considered riba and is prohibited. The uncertainties, gambling, and risks.
general consensus among Islamic scholars is that riba covers not only Sanctity of contracts. Islam upholds contractual obligations and
usury but also the charging of “interest” as widely practiced. the disclosure of information as a sacred duty. This feature is intended
This prohibition is based on arguments of social justice, equality, to reduce the risk of asymmetric information and moral hazard.
and property rights. Islam encourages the earning of profits but for- Shariah-approved activities. Only those business activities that
bids the charging of interest because profits, determined ex post, sym- do not violate the rules of shariah qualify for investment. For example,
bolize successful entrepreneurship and creation of additional wealth any investment in businesses dealing with alcohol, gambling, and
whereas interest, determined ex ante, is a cost that is accrued irrespec- casinos would be prohibited.

Basic instruments banks headquartered in Islamic countries but with an Islamic touch that requires a
Islamic markets offer different instru- provide Islamic windows. unique “filtration” process to select appro-
ments to satisfy providers and users of Traditionally, specialized Islamic banks priate shares. The filtration process ensures
funds in a variety of ways: sales, trade have been well positioned to attract that the mode, operation, and capital struc-
financing, and investment (Box 2). Basic deposits from Muslims, but these institu- ture of each business the fund invests in are
instruments include cost-plus financing tions have generally lacked the technical compatible with Islamic law, eliminating
(murabaha), profit-sharing (mudaraba), ability to invest efficiently. This gap has companies engaged in prohibited activities
leasing (ijara), partnership (musharaka), been bridged by the services of Western and those whose capital structure relies
and forward sale (bay’ salam). These instru- banks that swiftly and efficiently deploy heavily on debt financing (to avoid dealing
ments serve as the basic building blocks for funds into Islamically acceptable channels. with interest). For this reason, companies
developing a wide array of more complex But this has often meant lower returns for with a negligible level of debt financing (10
financial instruments, suggesting that Islamic investors owing to the second layer percent or less) may be selected, provided
there is great potential for financial innova- of intermediation. This trend is changing. that the debt does not remain a permanent
tion and expansion in Islamic financial Islamic banks are becoming resourceful feature of the capital structure. The future
markets. and are going global, in part owing to their of Islamic equity funds is bright in part
increased integration with international because of a new wave of privatization
Market trends markets. At the same time, aware of the under way in Muslim countries such as
Banking is the most developed part of potential of Islamic markets, Western Egypt and Jordan, and in high-growth
the Islamic financial system. The state banks are reaching out to investors directly Islamic countries such as Indonesia and
constitutions of Iran and Pakistan, for and eliminating the middleman—the Malaysia, where the demand for Islamic
example, require their banking systems to Islamic banks or Islamic windows of banks financial products is growing rapidly. Com-
be fully compatible with Islamic law. In in Muslim countries. For example, Citibank modity and leasing funds are other forms of
Egypt, Indonesia, Malaysia, Sudan, and the opened its first Islamic bank subsidiary in Islamic funds. Commodity funds invest in
Gulf Cooperation Council (GCC) countries, Bahrain in 1996. base metals. Leasing funds pool auto, equip-
Islamic banking exists alongside conven- Historically, Islamic financial markets ment, and aircraft leases and issue tradable
tional banking. Islamic banking is cur- have lacked liquidity-enhancing instru- certificates backed by the leases.
rently practiced through two channels: ments, thus eliminating a large segment of International and regional institutions
“specialized” Islamic banks and “Islamic potential investors. However, more liquid in- are working with Islamic finance and are
windows.” Specialized Islamic banks are struments are emerging through securitiza- contemplating the introduction of deriva-
commercial and investment banks, struc- tion; Islamic funds, with a current market tive products and syndication to enhance
tured wholly on Islamic principles, and size of $1 billion, represent the initial appli- project finance. The International Finance
they deal only with Islamic instruments. cation of securitization (see table). There are Corporation (IFC) has successfully exe-
Islamic windows are special facilities three types of Islamic funds: equity, com- cuted several transactions in the Middle
offered by conventional banks to provide modity, and leasing. Equity funds, the East and Pakistan that conform to Islamic
services to Muslims who wish to engage in largest share of the Islamic funds market, principles. While the introduction of deriva-
Islamic banking. Both Western banks and are the same as conventional mutual funds tive products is being cautiously studied, it

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Box 2
activities, and the terms of profit and risk sharing are customized for
Islamic financial instruments each investment. The maturity structure ranges from short to medium
Some of the more popular instruments in Islamic financial markets are term and is more suitable for trade activities.
Trade with markup or cost-plus sale (murabaha). One of Equity participation (musharaka). This is analogous to a
the most widely used instruments for short-term financing is based on classical joint venture. Both entrepreneur and investor contribute to the
the traditional notion of purchase finance. The investor undertakes to capital (assets, technical and managerial expertise, working capital,
supply specific goods or commodities, incorporating a mutually agreed etc.) of the operation in varying degrees and agree to share the returns
contract for resale to the client and a mutually negotiated margin. (as well as the risks) in proportions agreed to in advance. Traditionally,
Around 75 percent of Islamic financial transactions are cost-plus sales. this form of transaction has been used for financing fixed assets and
Leasing (ijara). Another popular instrument, accounting for working capital of medium- and long-term duration.
about 10 percent of Islamic financial transactions, is leasing. Leasing is Sales contracts. Deferred-payment sale (bay’ mu’ajjal) and
designed for financing vehicles, machinery, equipment, and aircraft. deferred-delivery sale (bay’salam) contracts, in addition to spot sales,
Different forms of leasing are permissible, including leases where a are used for conducting credit sales. In a deferred-payment sale, deliv-
portion of the installment payment goes toward the final purchase ery of the product is taken on the spot but delivery of the payment is
(with the transfer of ownership to the lessee). delayed for an agreed period. Payment can be made in a lump sum or
Profit-sharing agreement (mudaraba). This is identical to in installments, provided there is no extra charge for the delay. A
an investment fund in which managers handle a pool of funds. The deferred-delivery sale is similar to a forward contract where delivery
agent-manager has relatively limited liability while having sufficient of the product is in the future in exchange for payment on the spot
incentives to perform. The capital is invested in broadly defined market.

is suspected that these incorporate interest emerging Islamic countries such as Egypt, Islamic institutions can afford to train their
and may also support speculative activi- Jordan, and Pakistan are active, they are staffs and deploy resources in product
ties. Simple derivatives, such as forward not fully compatible with Islamic princi- development.
contracts, are being examined because their ples. The stock markets in Iran and Sudan • There is lack of uniformity in the reli-
basic elements are similar to those of the may come closest to operating in compli- gious principles applied in Islamic coun-
Islamic instrument of deferred sale. Project ance with Islamic principles. Moreover, the tries. In the absence of a universally
finance, which puts emphasis on equity secondary market for Islamic products is accepted central religious authority, Islamic
participation, is another natural fit for extremely shallow and illiquid, and money banks have formed their own religious
Islamic finance. The successful experimen- markets are almost nonexistent, since vi- boards for guidance. Islamic banks have to
tation with long-term project financing in able instruments are not currently avail- consult their respective religious boards, o r
the construction industry in Malaysia is a able. The development of an interbank shariah advisors, to seek approval for each
positive development in this area. market is another challenge. new instrument. Differences in interpreta-
• The pace of innovation is slow. For tion of Islamic principles by different
Issues and challenges years, the market has offered the same tra- schools of thought may mean that identical
Islamic financial markets are operating ditional instruments geared toward short- financial instruments are rejected by one
far below their potential because Islamic and medium-term maturities, but it has not board but accepted by another. Thus, the
banking by itself cannot take root in yet come up with the necessary instru- same instrument may not be acceptable in
the absence of the other necessary compo- ments to handle maturities at the extremes. all countries. This problem can be ad-
nents of an Islamic financial system. A There is a need for risk-management tools dressed by forming a uniform council rep-
number of limitations will have to be to equip clients with instruments to hedge resenting different schools of thought to
addressed before any long-term strategy against the high volatility in currency and define cohesive rules and to expedite the
can be formulated: commodities markets. In addition, the mar- process of introducing new products.
• A uniform regulatory and legal frame- ket lacks the necessary instruments to pro-
work supportive of an Islamic financial vide viable alternatives for public debt Future directions
system has not yet been developed. financing. The further g rowth and development of
Existing banking regulations in Islamic • An Islamic financial system needs the Islamic financial system will depend
countries are based on the Western banking sound accounting procedures and stan- largely on the nature of innovations intro-
model. Similarly, Islamic financial institu- dards. Western accounting procedures are duced in the market. The immediate need is
tions face difficulties operating in non- not adequate because of the different nature to deploy human and financial resources to
Islamic countries owing to the absence of a and treatment of financial instruments. develop instruments to enhance liquidity;
regulatory body that operates in accor- Well-defined procedures and standards are develop secondary, money, and interbank
dance with Islamic principles. The develop- crucial for information disclosure, building markets; perform asset/liability and risk
ment of a regulatory and supervisory investors’ confidence, and monitoring and management; and introduce public finance
framework that would address the issues surveillance. Proper standards will also instruments. The Islamic financial system
specific to Islamic institutions would fur- help the integration of Islamic financial can also offer alternatives at the microfi-
ther enhance the integration of Islamic mar- markets with international markets. nance level.
kets and international financial markets. Islamic institutions have a shortage of Securitization is a step in the right
• There is no single, sizable, and orga- trained personnel who can analyze and direction but even this requires more
nized financial center that can claim to be manage p ortfolios, and develop innovative sophistication. The scope of securitization
functioning in accordance with Islamic products according to Islamic financial —the process of unbundling and repackag-
principles. Although stock markets in principles. Only a limited number of ing a financial asset to enhance its mar-

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Emerging Islamic funds

Year Size
Fund Type launched Financial institution (million dollars)

IIBU Fund II Plc Leasing 1994 United Bank of Kuwait 51.5

Faysal Saudi Real Estate Fund 1995 Faysal Islamic Bank of Bahrain 27.0
GCC Trading Fund 1996 Faysal Islamic Bank of Bahrain 10.0
Oasis International Equity Fund Equity 1996 Robert Fleming & Co. (United Kingdom) 16.6
Faisal Finance Real Estate Income Fund II Real estate 1996 Faisal Finance (Switzerland) S.A. 100.0
Unit Investment Fund (all tranches) Income/mudaraba 1996 Islamic Development Bank (Saudi Arabia) 500.0
Al Safwa International Equity Fund Equity unit trust 1996 Al-Tawfeed Company for Investment Funds Ltd.. 27.0
Ibn Khaldun International Equity Fund Equity 1996 PFM Group (United Kingdom) 25.0
Adil Islamic Growth Fund Equity 1996 Faisal Finance (Switzerland) S.A. 10.0

Source: Islamic Banker, 1995–96, various issues.

ketability, negotiability, and liquidity—in asset/liability management will become a An Islamic financial system can play a
Islamic financial markets is very promising, reality. Other strong candidates for securiti- vital role in the economic development of
because current market operations are zation include real estate, leasing, and trade Islamic countries by mobilizing dormant
restricted by the dearth of liquidity-enhanc- receivables because of the collateralized savings that are being intentionally kept
ing products; secondary markets lack depth nature of their cash flows. out of interest-based financial channels and
and breadth; and, more important, instru- Microfinance is another candidate for by facilitating the development of capital
ments for asset/liability management are the application of Islamic finance. Islamic markets. At the same time, the development
simply nonexistent. With the expansion of finance promotes entrepreneurship and risk of such systems would enable savers and
securitization, the customer base of Islamic sharing, and its expansion to the poor could borrowers to choose financial instruments
financial systems will grow as institutional be an effective development tool. The social compatible with their business needs,
investors, who have access to broader matu- benefits are obvious, since the poor social values, and religious beliefs. F&D
rity structures, are attracted to the market; currently are often exploited by lenders
the secondary market will develop; and charging usurious rates.


Private Capital Flows

to Developing Countries:
The Road to Financial Integration

he world’s financial markets are rapidly integrating into a single global
marketplace. Developing countries are being drawn into this process start-
ing from different points and moving at various speeds—some are pre-
pared for the change but others are not. This World Bank report looks at the
important challenges both sets of countries face in a new age of global capital.
The book presents new and compelling evidence that private capital flows have
entered a new phase, driven by increased financial integration. The
report analyzes the causes and effects of integration, with a particular emphasis
on how developing countries in the nascent stages of integration can learn from
the experiences of the more rapidly integrating developing countries.
May 1997. 300 pages. Stock no. 61116-F (ISBN 0-19-521116-2). $40.00.
Published for the World Bank by Oxford University Press
Visit our Website: http://www.worldbank.org
World Bank For US customers, contact The World Bank, P.O. Box 7247-8619, Philadelphia, PA 19170-8619.
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Finance & Development / June 1997 45