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ISB424 ISLAMIC FINANCIAL SYSTEM

CHAPTER I: INTRODUCTION TO THE ISLAMIC FINANCIAL SYSTEM

  • Author: Nadia Farleena Mohd Aznan

1.1 WHY STUDY ISLAMIC FINANCE

  • Historical Context: Islamic Finance entered the global business arena in the 1950s, gaining traction in the 1970s post-oil crisis and exploding in the 1990s.

  • Scope and Focus: Covers corporate finance to asset management, with emphasis on derivatives liquidity management influenced by the oil industry.

  • Financial Inclusion: Provides services to diverse populations, enhancing financial inclusion for Muslims and non-Muslims alike.

  • Funding Alternatives: Offers alternative funding sources for infrastructure, facilitating risk diversification for investors.

WHAT IS ISLAMIC FINANCE?

  • Characteristics: Equity-based, asset-backed, ethical, sustainable, and socially responsible financing emphasizing risk sharing.

  • Shariah Compliance: Banking, lending, and saving practices that adhere to Islamic law, prohibiting:

    • Riba (Usury): Prohibition of interest.

    • Gharar: Avoidance of ambiguity in contracts.

    • Maysir: Ban on gambling.

    • Unethical business activities (e.g., alcohol, pornography).

  • Social Justice: Aims for an equitable society through ethical financial practices and community benefit.

WHAT IS FINANCIAL SYSTEM?

  • Definition: A financial system includes markets (places of buying/selling) and institutions (business entities).

  • Roles: Bridges the gap between deficit fund units (DFUs) and surplus fund units (SFUs).

  • Key Players: Individuals, households, corporations, and governments.

FINANCIAL INSTITUTIONS

  • Examples: Banks, insurance companies, mutual funds, capital, and money markets.

  • Economic Role: Facilitates money flow essential for economic growth and employment.

WHAT IS ISLAMIC FINANCIAL SYSTEM?

  • Dual Banking in Malaysia: Operates alongside conventional finance but adheres to Shariah principles.

  • Components: Includes Islamic banking, money market, Takaful (insurance), capital market, and Islamic financial institutions.

  • Objective: Aims for social justice and prohibition of exploitation, supporting beneficial socio-economic activities.

1.2 VALUE PROPOSITION OF THE ISLAMIC FINANCIAL SYSTEM

  • Ethical Focus: Islamic finance promotes ethical values inherently. Key values include:

    • Maqasid: Focused on public interest.

    • Prevention of harm (mafsadah).

    • Emphasis on genuine trade and productive activities.

    • Governance and accountability.

VALUE PROPOSITION IN ISLAMIC BANKING CONTEXT

  • Customer Benefits: Islamic banks offer Shariah-compliant products focused on ethical and quality service.

  • Market Demand: Increased customer sophistication necessitates banks to innovate beyond compliance.

  • Operational Focus: Aligning with customer needs and interests, showcasing tangible benefits from services.

1.3 FUNCTIONS OF THE ISLAMIC FINANCIAL SYSTEM

  • Resource Mobilization: Mobilizes resources for socially responsible business activities while complying with Shariah.

  • Role of Financial Institutions: Islamic banks and financial companies facilitate fund flows between SFUs and DFUs through compliant instruments.

1.4 TYPES OF ISLAMIC FINANCIAL MARKETS

  • Healthcare: Include Islamic Money and Capital markets, Debt and Equity markets.

  • Raising Funds: Issuance of debt securities (Sukuk) and equity securities (Shariah-compliant stocks).

MONEY & CAPITAL MARKETS

  • Market Definition: Money markets for short-term debt, capital markets for long-term securities.

  • Characteristics: Money markets are more liquid and less volatile, while capital markets encompass broader securities.

ISLAMIC MONEY MARKETS

  • Purpose: Bridging gaps in liquidity, providing short-term capital to deficit units, while adhering to Shariah.

ISLAMIC CAPITAL MARKETS (ICM)

  • Economic Role: Generate economic growth, complement conventional capital markets.

  • Components: Divided into Islamic Debt Market (Sukuk) and Islamic Equity Market (compliant stocks).

B) ISLAMIC DEBT MARKET

  • Sukuk Structure: Structured based on Shariah-compliant contracts, differing from conventional bonds.

  • Investment Returns: Derived from profits rather than interest payments.

B) ISLAMIC EQUITY MARKET

  • Compliance: Equity instruments must follow Shariah guidelines, avoiding unethical business practices.

C) PRIMARY MARKETS

  • Functionality: Create new securities, allowing direct sales to the public.

  • Characterization: Distinction from secondary markets where trading occurs between investors.

C) SECONDARY MARKETS

  • Purpose: Allow buying and selling of existing securities among investors.

  • Liquidity Role: Provides liquidity in the market.

D) ORGANISED EXCHANGE MARKETS

  • Trading Mechanisms: Marketplace ensuring fair trading and transparency via brokers and dealers.

D) OVER-THE-COUNTER (OTC)

  • Market Dynamics: Decentralized trading with less transparency and higher counter-party risks.

1.5 ISLAMIC FINANCIAL INTERMEDIARIES

  • Definition: Entities that facilitate transactions between borrowers and lenders, channeling funds effectively.

  • Shariah Governance: Ensures compliance in resource mobilization and intermediation processes.

1.6 REQUISITES OF THE ISLAMIC FINANCIAL SYSTEM

  • Environmental Needs: Requires conducive environments for effective functioning.

  • Key Requirements:

    • Strong risk management practices.

    • Effective regulations and sound governance.

    • Supportive legal frameworks.

    • Robust accounting and taxation regimes.

STRONG RISK MANAGEMENT PRACTICE

  • Importance: Understanding and managing risks to maintain service quality.

EFFECTIVE REGULATION

  • Necessity: Protects financial system soundness and welfare of stakeholders.

  • Shift in Focus: From conventional debt-based model to equity-based and risk-sharing models.

SOUND CORPORATE AND SHARIAH GOVERNANCE

  • Role: Essential for protecting stakeholders and maintaining Shariah compliance.

SUPPORTIVE LEGAL FRAMEWORK

  • Importance: Ensures the growth and sustainability of Islamic financial services and upholds public interest.

ROBUST ACCOUNTING DISCLOSURE AND TAXATION REGIME

  • Regulatory Framework: Ensures proper accounting, auditing, and fair taxation for Islamic financial institutions.