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Basic Principles of Islamic Banking:An Overview

Prof Abdullah SaeedUniversity of Melbournea.saeed@unimelb.edu.au

The presentation will cover

• Historical overview• Basic framework and key concepts• Permissible and prohibited contracts• Application of key concepts to banking

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Historical Overview• Dealing with money, investment on profit and loss sharing• Attitude to interest: Sharia on the whole did not accept the

legitimacy of interest• Western banks in Muslim countries: interest• Literature on banking without interest: 20th century• Practical steps: village banks in Egypt• Islamic Development Bank in Jeddah• Islamic commercial banks• Today: network of Islamic banks with a range of products

competing with interest-based banks

Basic Framework-1:Wealth and Ownership

• Wealth as trust– Right of the needy; circulation; spending;

hoarding• Ownership

– Trust; individual/community rights;– Ways and means:

• labour; gift; inheritance• all ways and means to acquisition must be halal• Object of ownership: must be halal

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Basic FrameworkConcept of Halal and Haram - 1

• Basic principle:– Generally all ways and means are halal (except

those that are clearly prohibited).– Prohibition is always an exception

Basic Framework:Concept of Halal and Haram - 2

• Some of the haram ways and means of acquiringwealth:– through riba (interpreted as ‘interest’)– cheating and fraud: quality, measure, weight– games of chance (lotteries, betting)– creating artificial scarcities– manipulation of prices– sale and dealing in haram products– engaging in haram professions (eg prostitution)– exploitation of the poor, the needy and disadvantaged

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Basic Framework:Concept of Money

• Money as a form of wealth• Money:

– primary function: medium of exchange– No price should be charged for money– Basic rule in lending: return an equal amount

Basic Framework:Prohibition of Riba

• Riba as interest (differences among Muslims)• Interest in all forms prohibited• All interest-based transactions should be avoided• Interest-based transactions are seen as ‘unjust’:

risk on the borrower

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Contracts in Islamic FinancePermissible and Prohibited Contracts

• Contracts:– in transactions should be permissible (re

Sharia)– should be based on mutual agreement– should not be based on: riba, haram, fraud etc

• Terms that both parties agree to (and are notbased on haram) are acceptable

Banks

• Important institutions but should not be based oninterest

• Banks should be in line with the requirements ofIslamic law

• Alternative ways of operating banks and financialinstitutions should be found

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Interest-based system, risk and profit

• Problems with the system:– risk on the borrower

• Profit related to risk• Risk should be shared: both parties• Profit should be shared on an agreed upon ratio• Loss should be shared strictly according to capital

contribution

Banks: Profit and Loss Sharing (PLS)

• Banking business should be based on PLS:– the deposits & investments– PLS contracts of mudaraba and musharaka will form

the backbone of Islamic banking• PLS contracts of mudaraba and musharaka will

form the backbone of Islamic banking• Both contracts are developed in Islamic law

Important to refer to Islamic legal texts tounderstand the nature of these contracts

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PLS and Deposits

• Bank will mobilise deposits on the basis of PLS• PLS contract of mudaraba is used• Features of mudaraba contract (bank:depositors)• Relationship of the Bank with the Depositors

PLS and Investments

• PLS contracts of mudaraba and musharaka shouldbe used

• Other forms of non-PLS contracts are also used(murabaha)

• Fee-based services can be provided• Relationship of the Bank with its investment

clients (mudaraba, musharaka, murabaha)

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Objectives of Islamic Banks: AnExample

• To help Muslims, execute their financial dealings in strictrespect of the ethical, individual and social values of theShariah, without contravening the prohibition of dealingin riba (interest or usury).

• To Serve all Muslim communities in mobilising andutilising the financial resources needed for their economicdevelopment and prosperity.

• To serve the Islamic communities and other nations bystrengthening the economic and financial cooperation foreconomic development