Islamic Financial System

Islamic Financial System - Part 2

Hello, Friends!!

1. Introductions

In part 1 of the Islamic Finance, we were introduced to the history of Islamic Finance and Growth of Islamic Finance. Now Let's Move to one step further to take a glance of Financial operation of Islamic System.

2. Key Principles of Islamic Finance:

The Principles governing an Islamic Financial system was derived from the Sharia (Legal Framework). Sharia jurisprudence doesn't differentiate the principles of religious life and another aspect of life.

There are 3 Main principles the govern an Islamic Financial System:

• Principle of Ownership/Authority,
• Principle of Equity &
• The principle of Participation.

Lets discussed in details each one:

2.1 Principle of Ownership:

The principle of Ownership refer as Rule "Do not sell what you do not own"  and "You can not dispossess of the properties except on the basis of right". Hence unlike other financial systems, Islamic Financial system is assets-based financing. Islamic Financial system disallows the short selling of properties.

2.2 Principle of Equity:

The principle of Equity refers as "Do not make any predetermined payment". Meaning thereby is no payment until the performance to contractual obligations.

2.3 Principle of Participation:

Sharia ruling suggests "Rewards should come only with Risk-taking". One can not be reward merely because of contribution in the Equity of the enterprise.
Return on capital in Islamic finance legitimized upon risk-taking and ex-post based on assets performance. hence "Return is the reward of risk-taking and not for Passage of time".

3. Key Financial Instruments of Islamic Finance.

Mainly there are three financial models in Islamic Financial system:

• Profit-and-Loss Sharing (PLs)
• Non-PLs  Contracts&
• Fee-based Products.

3.1 Profit and Loss sharing (PLs) (Partnership Base Modes)

PLs is closest to the sprite of real Islamic finance. This arrangement considers the Principle of equity and Principle of participation.
This system has the more efficient method of resource allocations.

There are 2 types in this system.
a. musharakah &
b. mudarabah.

A. musharakah:
This is the Profit-and-loss sharing partnership and more authentic form of Islamic finance. partners provide the capital, take the risk and participate in the day-to-day business. this arrangement provides the right to share the result of business. This form gives the opportunity/potential to unlimited earn money.

Return to Partner = { +ve/-ve ------> in agreed proportion} 

B. mudarabah:

Just like private Equity, one partner provides the capital (Financier) and other partner runs the business. Profit is shared by mutual agreement but losses if any is borne by the provider of finance.

Return to Partner = { +ve ------> in agreed proportion & -ve ------> 100% by financier} 

3.2 Non - Profit and Loss sharing (Non-PLs) (Trade base modes)

This arrangement mostly used in common practice for financing the consumer and Loan arrangement.

There are mainly 4 types:
a. murabahah
b. ijarah
c. salam &
d. istisna

A. murabahah:
This is the common sale transaction of goods and assets. This arrangement sometimes includes the deferred payment arrangement.

B. ijarah:
This arrangement is referred as a sale of the right to enjoy or use assets and goods. Here reward is received for temporary transfer of the right and not for the economic value of goods.

Net Value after use of goods = Economic Value of goods - Reward receive for temporary use

C. salam:
This is an arrangement for delivery of goods in predetermined future date at agreed price. here bank assumes the credit risk of the third party.

D. istisna:
Here commodity can be transferred before coming into existence.

3.3 Fee-based products (Rental base modes)
Under the above arrangement, fees are charged for the service provided by Islamic banks.

There are three types of fee-based service mainly provided by banks.
a. Wakalah - Agency service,
b. Kafalah - Guarantor service &
c. Ju'ala - Specific service contract.

4.0 Islamic Banking Model: (Brief Discussion)

Islamic Banking model work in the two-tier arrangement:

Tier 1: (Deposit Holder & Bank) Arrangement where Deposit holder provide the fund to Islamic bank and bank acts as a manager of the fund.

Tier 2: (Bank & Client) Arrangement where the bank provides the money to corporate and corporate use that money to run and manage the business.


5.0 Conclusion:

I hope this reading help you in understanding the Islamic Financial Principles and Banking Business models. We will be going learn more aspect of Islamic finance in part 3.

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