Chapter 2Objectives, Philosophy and Principles of Islamic

Banking

FAB 1233 – Islamic Banking

Made by:Nor Izzuddin Bin Norrahman, BBA.

Lecturer of Management, Banking & Islamic Finance

Astin College, Puchong

Reference:

• Sudin Haron, W. Nursofiza, (2009). Islamic Finance and Banking System : Philosophies, Principles & Practices. Selangor, Malaysia.

McGraw-Hill (Malaysia) Sdn. Bhd.

Contents…

• Introduction• Objectives of Establishment and Business

Philosophy of Islamic Banks• Factors that influence the formation of the

philosophy of Islamic Banks• Sources of Islamic Banking Philosophy• Operational Principles• Priorities in the use of Syariah Principles

Introduction

• The process of “Islamize” the economic system raised several theoretical and conceptual considerations in order to implement it in the new economic system.

• At the time, only three system existed – socialist, socio-capitalist and capitalist system.

• At that time also, there were no appropriate model encouraged the Muslim country to start the Islamization from the Banking Sector.

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• The Islamization in the economy involved one principal point : the ELIMINATION of INTEREST in all deposits and financing transactions.

• However, some people may questioned, is it appropriate to call it an Islamic bank when the transaction is similar to the conventional bank except for the matter of interest?

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• The objectives of the Islamic Banks establishment is to offer banking needs to Muslims

• And, these Islamic Banks run alongside conventional bank.

• Thus, there are some similarities showed in the transactions.

Conventional Banks Transaction

Conventional Banks

Primary Function

Savings Deposit

Savings Account

Current Account

Fixed Deposit Account

Negotiable savings certificate

LoansIndividuals,

Businesses, Public Sector, Other Group

Secondary Function

FacilitiesLetters of Credit,

Letters of guarantee, others

Service

Money order transactions, money exchange, advisory

services

Islamic Banks Transaction

Islamic Banks

Primary Function

Savings Deposit

Savings Account

Current Account

Fixed Deposit Account

Negotiable savings certificate

LoansIndividuals,

Businesses, Public Sector, Other Group

Secondary Function

FacilitiesLetters of Credit,

Letters of guarantee, others

Service

Money order transactions, money exchange, advisory

services

FREE FROM RIBA / ACCORDING TO SHARIAH

Objectives of establishment & Business Philosophy of Islamic Banks (IB)

• In principle, business institutions aim for PROFIT MAXIMIZATION

• More-over for the Private Companies• Indicators:– Large Profit – Organization is running effectively– Shareholders – Shareholders would want high

return from their shares.• Is Islamic banks the same?

Islamic Banks objectives…• Founded on 2 key factors:– Religion

• The organization must internalize the teachings Islam.• So, Islamic banks would have to CONFORM and COMPLY with

Islamic principles.• It will involve moral elements by virtue of the factor of Iman (faith

and believe) in the business operations.

– Profit• If the moral factors alone is given importance, there is possibility

that the bank would experience losses and forced to ceased operations.

• And this would deny the objectives of Islamic banks that is to fulfill the needs of Muslim.

• So, Islamic banks also given importance to the business dimension.

Continue…• Khan (1983) stated that:• The objectives of Islamic Banks is to DEVELOP, FOSTER and

PROMOTE the use of ISLAMIC PRINCIPLES, LAWS, and traditions in all BANKING TRANSACTIONS, financial, business and other related areas.

• Another objectives is to promote the establishment of investment companies or other business enterprises which according to Shariah laws.

• Different Islamic banks have different goals and objectives, but it is always includes the moral and business dimension.

Factors that influence the formation of the philosophy of Islamic Banks

Internal• Factors from

the organization itself

External• Factors

beyond the control of organization

Islamic Banks

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• The philosophy of the Islamic banks will be influenced by external and internal factors.

• Internal factors play important role in the initial stage of the bank’s establishment.

• Example:– Investor use their money to set up the bank– As the result, the investor would want high returns : resulting

profit maximization.– In reality, the owner and the manager consist of different types

of group.– This will influenced the philosophy of the Islamic bank : the

owner vs. the management.

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• The management would be influenced by three conceptions:– Demand of high returns from the shareholders.– Rewards received by the management.– The depositors demand.

• All the conception would influence the Islamic bank to look within the business dimension only and disregard the moral dimension.

Class of Islamic Banking Institution• 1st Class

– A financial institution merely offers services which is not prohibited in Islam

• 2nd Class– The financial institution that claimed that they are Islamic

Financial institution, but the products and services that they offer is similar to conventional bank.

• 3rd Class– The best in category– Offer Islamic Financial Services and all of the aspect is based

on Islamic business principles.– View the profit is important, but it must be balanced with the

requirement of social justice.

IB vs. CBIB CB

Must comply fully with the requirements of akidah by avoiding

prohibited elements.

Does not comply with akidah and contain prohibited elements as long as

it is profitable.

IB must be caring and more understanding to their customer.

Did not include moral factors in their operations.

Have goals on socio-economic development and poverty eradication,

not only profit.

Only focus on profit.

The operations is according to shariah. The operation is freely done.

Charges on customers in accordance with the actual cost incurred.

Could charge their customer with cost that incurred in the future.

Sources of Islamic Banking Philosophy

Primary Sources• Al-Quran• As-Sunnah

Secondary Sources• Qiyas• Ijam’• Others

Islamic Banking

Operational Principles of Islamic Banks

Operational Principles

Musyarakah

Mudharabah

Murabahah

Ijarah

Qard Hassan

Wadiah

Rahn

Other Principles

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Other Principles

Bai Bithaman Ajil

Bai al-Dayn

Bai al-inah

Bai istijar

Bai salam

Hiwalah

Istisna

Jo’alah

Musawamah

Sarf

Ujr

Urbun

Wakalah

Tawarruq

Musyarakah• Means partnership in English. (Profit and loss sharing)• Two categories:

– Syirkat al-mulk• Involves joint ownership of certain properties and it does not involve any joint

venture to DEVELOP the properties.

– Syirkat al-’aqd• The concept of joint exploitation of capital and the joint participation in profits

and losses (Saleh, 1986).

• There are three methods in establishing Syirkat al-’aqd:– Syirkat mal

• (Involve money in create partnership)

– Syirkat a’mal • (Depends on the expertise, experience and skills from the partnership)

– Syirkat Wujuh • (Partnership based on asset of the credit or investment made in the company)

Musyarakah (Continue…)

• Partnership:– Unlimited (Mufawada)– Equal (Syirkat al-inan)

• In the context of Islamic banking, the musyarakah principle which is relevance is inan syirkat mal or limited financial investment partnership.

• In simple terms, musyarakah means a joint-venture agreement between two parties to engage a specific business activity to make profit.

Mudharabah

• Translation: profit sharing• Concept: Those who have money (investor) would

assign their money to another party (entrepreneur) to carry out a business and the profit will be split according to the ratio agreed by both party.

• Two type:– Mudharabah muqaiyadah• Certain rules have been set to the entrepreneur in order to carry

out the business.

– Mudharabah Mutlaqah• No specific rules have been set to the entrepreneur in order to

carry out the business.

Murabahah

• Known as cost-plus sale.• Refers to the sale of goods at a price of the

cost plus a profit margin agreed upon by both parties concerned.

• Example:– Cost: $1– Profit margin: 50%– Cost + profit margin: $1 + ($1 x 50%) : $ 1.50

Ijarah

• Term: Leasing• Means contract to lease or rent or hire.• The person that lease a property is only paying

for the benefit of the property, not for it’s ownership.

Qard Hassan

• Term: Benevolent loan• A loan which the borrower is obligate to repay

the lender the exact principal sum borrowed.• Example:– Ali borrowed RM500 to Hassan in a qard Hassan

contract.– So, Ali is only obligate to pay not more, not less

then RM500.

Wadiah

• Term: Safekeeping• An agreement between the owner of assets with another

party (the keeper).• The owner of the asset give the asset to the keeper’s

custody.• If the assets are damage / loss (not in the negligence of the

keeper), the loss will not bear by the keeper.

• Al-Wadiah yad dhamanah (Guaranteed Custody)– The keeper give guarantee to safe keep the asst. The keeper

could use the asset and in case of damage to the asset, the keeper obligate to take the responsibility.

Rahn

• Term: pledge / pawn• It is a contract of security.• The creditor secures a loan trough a pledge of personal

property. The ownership of the property is remain with the borrower but the possession is now belong to the lender.

• Certain fees will be charged if the borrower could not pay the debt in time due to the keeper have to safe keep it.

• In case of the borrower could not pay the debt, the property will be sold to cover the debt and the management expenses. The remaining then will be given back to the borrower.

Bai Bithaman Ajil

• Term: Deferred payment sale• The payment is made in future time. By lump sum

or by deferred payment.• Example: – Ali uses murabahah contract to buy a car. The cost is $

1000 and the profit margin is 20%. So, the selling car price is $ 1200. Ali enters another contract which is to pay the car in deferred payment by monthly payment for 4 years. So, Ali will pay:• $ 1200 / (4 year X 12 Month)• $ 1200 / 48 Month• $25 / month

Bay al-dayn

• Term: Debt trading• Financing is made based on sale and purchase

of trade documents.

Bai al-inah

• Term: Sells & buys back contract• Involving 2 separate contract.– 1st Contract:

• Bank sell a property to Ali $ 1000 and Ali pay the bank with a differed payment method.

– 2nd Contract:• Then, Ali sell back the property to the bank with more cheaper

price, $ 500.• The bank will pay in lump sum.

• That is the example of a bai-al inah contract. The contract is used in the personnel financing tools.

• Some mazhab do not approve this contract.

Bai istijar

• The sale and purchase contract whereby an agreement is made between two parties.

• Under this contract, the buyer agrees to buy on a continuous basis, and there will be no more bargaining afterwards.

Bai Salam

• Contact of sales and purchases.• The payment is made in present but the asset

will be delivered at a later date.

Hiwalah

• Transfer of funds / debts.• Charges will be applied by the bank in

performing the transaction.

Istisna

• A sale and purchase contract.• Under this contract, the buyer is agree to buy

non-existent goods which are to be manufactured later by specification.

• The buyer can pay up-front the contract or when the goods is delivered.

Jo’alah

• Refers to service charges.• Practiced in Iran.• The service will be charged for some amount

of money.

Musawamah

• Similar to mudharabah, except that no reference is made to the buyer as to the cost price.

• There is no need to the seller to disclose the cost price.

Sarf

• Contract of sale and purchase of foreign currencies.

• Mazhab do not allow if it involve forward, specified future date or fixed purchase date.

Ujr

• Refers to fees and commissions charged for services rendered.

Urbun

• Means: to pay or to receive in advance.• The buyers buy commodity and pay deposit

for it.• The deposit may be used by the bank to carry

out certain responsibilities on behalf of its customer.

Wakalah

• Means: Representative• A person is appointed to do something.

Tawarruq

• Differ with bai al-inah.• Involves third party.

Priorities in the use of Syariah Principles

• In the consensus among Muslim scholars, various Islamic principles used by the Islamic Bank can be divide into two category:– Principles which are advocates• Strongly Islamic• Principles are those that conform to Islamic objectives

in form and substance.

– Principles which are not advocates• Weakly Islamic• Refer to practices which conform to the Islamic norms

in form but not in substance.

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• Strongly Islamic principles – Those principles which permit risk-return sharing between providers and users of funds which are:– Musyarakah– Mudharabah

• However, most scholars recommend that the remaining principles be used in cases where risk-return sharing cannot be implemented.