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
Describe the conceptual
Basis of Islamic Banking and Finance basis of the modern
practice of Islamic banking
and finance.

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

known as the Shari’ah

• 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
Describe the conceptual
Basis of Islamic Banking and Finance basis of the modern
practice of Islamic banking
and finance.

The Shari’ah
• The primary sources of the Shari’ah are
○ the Qur’an and Sunnah

• Defines man-to-Allah and man-to-man relationships

• Shari’ah 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)
 Learning Objective 1.1
Describe the conceptual
Basis of Islamic Banking and Finance basis of the modern
practice of Islamic banking
and finance.

Figure 1.1: Shari’ah as the Basis of Islamic Banking and

Finance
 Learning Objective 1.1
Describe the conceptual
Basis of Islamic Banking and Finance basis of the modern
practice of Islamic banking
and finance.

The Qur’an
• The first source of the Shari’ah
• 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)
– Usuary or interest (riba)

• Prohibits cheating and corrupt practices in the management

of funds
• Does not allow dealings in prohibited products
 Learning Objective 1.1
Describe the conceptual
Basis of Islamic Banking and Finance basis of the modern
practice of Islamic banking
and finance.

The Sunnah
• The second primary source of the Shari’ah

• Comprises the sayings, practices and tacit approvals of the

Prophet Muhammad (PBUH)

• Meant to further explain the injunctions of the Qur’an

• 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 Qur’an
 Learning Objective 1.2
Explain the historical
Origins and Historical Overview of development and
conceptual arguments of
Islamic Banking and Finance 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
Explain the historical
Origins and Historical Overview of development and
conceptual arguments of
Islamic Banking and Finance 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
Explain the historical
Origins and Historical Overview of development and
conceptual arguments of
Islamic Banking and Finance 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
Explain the historical
Origins and Historical Overview of development and
conceptual arguments of
Islamic Banking and Finance 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)
 Learning Objective 1.2
Explain the historical
Origins and Historical Overview of development and
conceptual arguments of
Islamic Banking and Finance Islamic banking and
finance

• Uthman ibn Affan (644 – 656)

The introduction of the first Muslim coins
• Ali ibn Abi Talib (656 – 661)
• Administration
• Protection of Rights
• “Every person who believes in Allah and His Prophet is
entitled to the same rights and obligations. Money belongs to
Allah which must be divided equally among people. No one
will get a greater share than others, those pious people
would get their reward in the Hereafter”.
• Fiscal and Monetary Policy
• social privileges, financial statuses and authority were
rationalised.
 Learning Objective 1.2
Explain the historical
Origins and Historical Overview of development and
conceptual arguments of
Islamic Banking and Finance 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 Explain the historical

development and
Islamic Banking and Finance conceptual arguments of
Islamic banking and
finance
The Umayyad and Abbasid Eras
• 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
Explain the historical
Origins and Historical Overview of development and
conceptual arguments of
Islamic Banking and Finance Islamic banking and
finance

Modern-Day Experiments of Islamic Finance marked by:

• The Ottoman Empire’s 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 Explain the historical

development and
Islamic Banking and Finance conceptual arguments of
Islamic banking and
finance
Timeline of Modern-day Experiments of
Islamic Banking and Finance from 1962 to 1975
• 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 banking”)

• The Malaysian Pilgrims Savings

Board, Tabung Haji of 1969
(managing savings of prospective
pilgrims by investing in Sharī’ah-
compliant investments)

• The Founding of the Islamic

Development Bank (IDB) in 1975
 Learning Objective 1.2
Explain the historical
Origins and Historical Overview of development and
conceptual arguments of
Islamic Banking and Finance 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 Sharī’ah compatible modes

• To promote foreign trade, especially in capital goods, among

member countries
 Learning Objective 1.2
Explain the historical
Origins and Historical Overview of development and
conceptual arguments of
Islamic Banking and Finance 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
Explain the historical
Origins and Historical Overview of development and
conceptual arguments of
Islamic Banking and Finance 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
Explain the historical
Conceptual Arguments for Islamic development and
conceptual arguments of
Banking and Finance 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
Explain the historical
Conceptual Arguments for Islamic development and
conceptual arguments of
Banking and Finance Islamic banking and
finance

• What Is Asset-Based Finance?

• Asset-based finance is a specialized method of providing
companies with working capital and term loans that
use accounts receivable, inventory, machinery, equipment,
or real estate as collateral.
• It is essentially any loan to a company that is secured by
one of the company's assets.
• Asset-based funding is often used to pay for expenses when
there are gaps in a company's cash flows, but it can also be
used for startup company financing, refinancing existing
loans, financing growth, mergers and acquisitions, and for
management buy-outs (MBOs) and buy-ins (MBIs).
• https://islamicmarkets.com/education/asset-backed-
financing
• https://www.researchandmarkets.com/research/bq7pb4/
global_islamic?w=12
 Learning Objective 1.2
Explain the historical
The Development of Islamic Banking development and
conceptual arguments of
and Finance Industry 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
Explain the historical
The Development of Islamic Banking development and
conceptual arguments of
and Finance Industry Islamic banking and
finance

Figure 1.3: Total Global Islamic Banking Assets Growth 2012

 Learning Objective 1.3
Understand the
Components of Islamic Banking and components and operating
structures of the Islamic
Finance Industry 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
Understand the
Components of Islamic Banking and components and operating
structures of the Islamic
Finance Industry 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
- ‘Islamic Windows’ of conventional banks
 Learning Objective 1.3
Understand the
Components of Islamic Banking and components and operating
structures of the Islamic
Finance Industry 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
Understand the
Components of Islamic Banking and components and operating
structures of the Islamic
Finance Industry banking and finance
industry as well as the
process of development of
The Islamic Capital Markets (ICM) Islamic finance products.

• ICM is a special market where investment activities do not

contradict the principles of the Sharī‘ah

• 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
Understand the
The Islamic Capital Markets (ICM) 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
Understand the
Components of Islamic Banking and components and operating
structures of the Islamic
Finance Industry 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: Leasing companies, finance companies, Islamic

housing cooperatives, Islamic microfinance institutions, waqf
management institutions, private equity /venture capital firms,
hajj and zakat management bodies
 Learning Objective 1.3
Components of Islamic Banking and Understand the
Finance Industry components and operating
structures of the Islamic
banking and finance
Islamic financial architecture and industry as well as the
process of development of
infrastructure Islamic finance products.

Crucial support for Islamic financial services:

• payment-settlement, legal institutions and framework
• safety net
• liquidity support providers
• corporate governance e.g Sharī‘ah 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
Understand the
Operating Structures of Islamic components and operating
structures of the Islamic
Banking and Finance Industry 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
Understand the
Key Operating Mechanisms of components and operating
structures of the Islamic
Islamic Banking and Finance 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 Understand the

components and operating

Islamic Banking and Finance 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, in an ethical manner.
Sources of fund mobilisation:
A. Net equities owned by shareholders
B. Investment deposits
C. Demand deposits
D. Product sales
 Learning Objective 1.3
Understand the
Key Operating Mechanisms of components and operating
structures of the Islamic
Islamic Banking and Finance banking and finance
industry as well as the
process of development of
Islamic finance products.
Fund utilization
The process of using the funds realized in Sharī'ah-compliant
business:
1. Sharing modes - Partnership where funds initially
mobilized are invested in Sharī'ah-compliant business;
parties share profits or loss
2. Sale modes – The bank purchases an item on behalf the
client and resells it to them on a deferred basis or
immediately
3. 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
 
The Development of Islamic Banking
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
• Activities of Islamic banks, involve both profitable and
non-profitable dealings such as:
• - Business on the basis of sale mode, sharing mode and
leasing mode
- zakat (alms)
- waqf (charitable endowment)
- tabaru‘at (gratuitous contracts)
• Sources of Islamic Law/Shariah are:
A. The Holy Quran (Primary)
B. The Sunnah (Primary)
C. Ijtehad (Secondary)
D. Ijma (Secondary)
 Learning Objective 1.3
Understand the
The Development of Islamic components and operating
structures of the Islamic
Banking Products 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 Sharī‘ah-
compliant products
 ijtihad can be defined as a "process of legal reasoning
through which the jurist-mujtahid derives or rationalizes law
on the basis of the Qur'an and the Sunnah".
• Ijtihād, (Arabic: “effort”) in Islamic law, the independent or
original interpretation of problems not precisely covered by
the Qurʾān, Hadith (traditions concerning the Prophet
Muhammad's life and utterances), and ijmāʿ (scholarly
consensus).
 Learning Objective 1.3
Understand the
The Development of Islamic components and operating
structures of the Islamic
Banking Products banking and finance
industry as well as the
process of development of
Islamic finance products.

• Ijma
• Literally means agreement on a matter
• In its technical sense, it means the
consensus of the independent jurists from the Ummah of
the Prophet Muhammad (SAW) after his death
Example:
• Jurists have reached a consensus (Ijma) that the selling of
goods by any party who does not own the goods
and without the approval of owner of the goods, is void.
 Learning Objective 1.3
Understand the
The Development of Islamic components and operating
structures of the Islamic
Banking Products banking and finance
industry as well as the
process of development of
Islamic finance products.

• Emphasis should be on developing

○ Sharī‘ah-based rather than
○ Sharī‘ah-compliant financial products

○ There are differences between Shariah Based

product and Shariah Compliance product, both may
not constitute any prohibited elements in the product
and marketable to the public,
○ But it would be more advantageous for any Islamic
Financial Institutions to use Shariah-Based approach.
 Learning Objective 1.3
Understand the
The Development of Islamic components and operating
structures of the Islamic
Banking Products banking and finance
industry as well as the
process of development of
Islamic finance products.

• Shariah based products and services are said to be originated

during Prophet’s period.
• These products and services have undergone the process of
cleansing where any prohibited elements were removed by
Prophet Muhammad (pbuh) such as al-
bay’ (trade), mudarabah (profit sharing), musharakah (joint
venture, profit and loss sharing), murabahah (cost
plus), and Ijarah (leasing). 
The Development of Islamic
Banking Products

• On the other hand, Shariah compliance products and

services are the products and services that comply or
adhere to the requirements to the Shariah itself. The good
example would be the Sukuk (Islamic bond) that is invented
from the application of rules from the Shariah based
products. Therefore, it is permissible and complies to the
requirements of Shariah. Shariah compliance products and
services are also can be said as the modern day products
and services after Islamisation of it.
The Development of Islamic
Banking Products

• Shariah based also refers to the desired objectives of

the Shariah (known as the maqasid shariah) when
determining a hukm (rules) aimed at the protecting
human maslahah (public interest).
• Thus, Shariah based products and services
like mudarabah are aimed to encourage the
entrepreneurship among public and to maintain risk-reward
relationships in a just manner.
The Development of Islamic
Banking Products

• The mudarabah doctrine also implies to recognise same and

equal ability to undertake responsibility and to have full
authority to act on behalf of the other and are jointly and
severally liable for the liabilities of the partnership business.
• However, the Shariah compliance products and services
focusing on what it is needed to make the products and
services provided in line with the permissibility in Islam.
• Therefore, the products and services must not have any
elements of riba (usury), maisir (gambling), gharar (excessive
uncertainties), excessive speculations, haram (impermissible
elements like pork) and others.+
 Learning Objective 1.4
Describe the current size
The Growth of Islamic Banking and worldwide spread of
Islamic banking and
and Finance 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
Describe the current size
Islamic Banking Today: The Size of and worldwide spread of
Islamic banking and
the Industry finance.

• The industry has more than doubled in size since 2006

• Sharī‘ah-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 Sharī'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
Describe the current size
Total Assets of Islamic Banks and worldwide spread of
Islamic banking and
in the GCC Region finance.

Figure 1.5: Total Assets of Islamic Banks in the GCC

Region
 Learning Objective 1.4
Describe the current size
The World-wide Spread of Islamic and worldwide spread of
Islamic banking and
Banking 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, South-
East 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
Describe the current size
Global Coverage of Islamic Finance and worldwide spread of
Islamic banking and
finance.

Figure 1.6: Global Coverage of Islamic Finance

 Learning Objective 1.4
Describe the current size
Multinational Islamic Banks 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
Describe the current size
Future of Islamic Finance Industry 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 Tabaru‘at
Maysir Takaful
Mudarabah Waqf
Qard hasan Zakat