Islamic Finance and Banking

Prepared By:
Dr. H. M. Mosarof Hossain
Professor
Department of Finance
University of Dhaka
mosarof@du.ac.bd

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 Development of Islamic Financial System
Historical overview of Islamic finance:
In the late 19th Century, the Ottomans introduced western-style
banking to the Islamic world to finance their expenditures. While
some Islamic jurists approved of modern banking practices, the
majority found those practices to be violations of Islamic
prohibitions against usury i.e. riba.This resentment continued
through the European colonial period, which lasted into the mid-
20th Century. Islamic revival played a central role in the intellectual
and social foundations of independence movements of the mid-
20th Century. To many intellectual founders of the movement,
political independence was to be supplemented with economic
independence, through the definition of an Islamic economic
system.

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Early writings on what came to be known as Islamic Economics
focused on macroeconomic developmental issues. By the 1970s,
theoretical discussions of Islamic economics had given rise to
practical discussions of Islamic finance, which turned juristic in
nature: how can Muslims replace (conventional) financial practices
(deemed to be usury/riba-based) with Islamic alternatives. Mid-
Century literature suggested a profit-and-loss sharing silent
partnership alternative to interest-based lending. The Arabic name of
this contract is mudaraba, which is akin to the medieval European
Commenda contract, and the Jewish Heter Isqa, designed similarly
to avoid usurious lending in Jewish and early Catholic Law. This
partnership-based focus survives in some Islamic financial practices .
However, with the help of Islamic jurists and lawyers, Islamic
financial practitioners were soon able to provide close analogues to
almost all financial products, including various debt-instruments and
fixed-income investment vehicles.
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 Modern Day Islamic Finance
The growth of modern islamic banking can be attributed to
three factors such as: the rise of oil prices after 1974 has seen
a number of Arab and Muslim countries experiencing a rise in
national income, economic activity and greater investment;
Muslims would not want to put their money into interest-based
financial system and colonialism free countries faced rapid
industrialization and urbanisation.
(i) Islamic banks coexisting with interest-based banks in
Kazakistan, Egypt, Qatar, Bahrain, Bangladesh
(ii) Conventional banks introduced Islamic Windows in
Malaysia, Qatar, Egypt and Bangladesh
(iii) Entire banking system based on shariah in Sudan, Iran,
Malaysia, Pakistan, Egypt, Dubai, Jordan, Bahrain.
Along with islamic banks there are islamic insurance
companies and islamic investment companies are operating
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in different countries based on shariah.
 Emerging Interest in Islamic Finance in Other
Jurisdictions Today

Islamic finance has been registered in Muslim countries, East

Asian countries, Western Europe, Hong Kong and UK. France
and Japan have made changes to their laws and regulatory
frameworks to facilitate the introduction of islamic financial
products into their markets. The Commonwealth of
Independent State (CIS) countries such as Kazakhastan,
Kyrgystan and Tajikistan are emerging and proactive in
developing islamic finance in their markets. Kenya, Tanzania
and Uganda have reoprted growing interest in islamic finance
while Australia, Mauritius and Sri Lanka have expressed an
interest in developing their countries islamic financial markets.

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 International infrastructure institutions
1. Accounting and Auditing Organization for Islamic financial
institution (AAOIFI): The AAOIFI is a non-profit organization
that focuses mainly on the area of accounting and auditing for
Islamic financial institutions. While recognizing the need for
standards, AAOIFI was established on February 1990 in Algeria
and was registered on March 1991 in the kingdom of Bahrain.
The organization is supported by 200 institution members from
45 countries across the global. The AAOIFI is one of prominent
Islamic agency that attempts to install accounting and auditing
standard for Islamic financial industry. The main object is to
develop and disseminate accounting and auditing thought
relevant to Islamic financial institutions and their applications. Its
tasks include holding seminars, publishing periodicals,
newsletters, commissioning research and prepare, promulgate,
interpret and review, the accounting and auditing standards for
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Islamic financial institutions.
 International infrastructure institutions
Its notable efforts are to inform and encourage banking
supervisors around the world to adopt its standard as the
benchmark for Islamic financial institutions in their countries.
These attempts to improve the transparency and comparability of
the financial reporting of Islamic financial institutions are bearing
fruit. The AAOIFIs standard has been applied in various countries
such as Bahrain and Sudan which require Islamic Banks in their
countries to follow AAOIFIs standards. In Qatar and Saudi Arabia
AAOIFIs standards are specified as guidelines. To achieve
international recognition for its standard, AAOIFI has also been
working with conventional international bodies which involve in the
development of standards and regulation of banks such as the
International Monetary Fund, International Accounting Standards
Board, and the Basel Committee. The organization plays a crucial
role in harmonizing the Islamic financial institution practices with
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the international accepted practices.
 International infrastructure institutions
2. The International Islamic Financial Market (IIFM) : Recent
development for Islamic financial markets was made in 2001
when the Bahrain Monetary Agency (BMA) signed a
Memorandum of Understanding with the Islamic Development
Bank, the Labuan Offshore Financial Services Authority (LOFSA),
Bank of Sudan, and Brunei Ministry of Finance to sponsor the
establishment of a multilateral international financial market. As
the result, the International Islamic Financial Market (IIFM) was
established and headquartered in Bahrain. It main aim has been
to provide global standard and cooperative framework for the
Islamic financial market and to ensure the continued growth of the
market in line with Shariah rules and principles, by promoting the
harmonization and convergence of Shariah interpretation in
developing Islamic banking products and practices which are
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 International infrastructure institutions
universally acceptable. It has also persuaded Islamic financial
institutions in the market to introduce a wide range of Shariah
compliant products and the creation of an active secondary
market which creates liquidity for instruments traded in the
market. It is active in the establishment, and development of
settlement related system infrastructure and increasing trading
value of Islamic financial market. It also involves itself with several
challenging issues for Islamic financial market including Islamic
hedging, secondary market documentation and the creation of
innovative products, an Islamic repo market, treasury, murabahah
contract mechanisms and similar elements vital to a well-
developed and functional Islamic financial system.

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 International infrastructure institutions
3. General Council for Islamic Banks and Financial
Institutions (CIBAFI): It was established in 2001 in Bahrain as an
international nonprofit organization which supports and promotes
the islamic financial services industry through information, media,
research and development, consultancy and human resources
development. Since its establishment, it has supported the
industry with the establishment of the International Islamic Centre
for Conciliation and Commercial Arbitration in Dubai in 2004 that
aims to settle financial and commercial disputes between
concerned parties that have chosen to comply with the shariah to
settle disputes. It laso contributed in establishing a department for
islamic banking in the US Treasury Department in 2002, building a
database containing historical administrative, financial and
statistical information about IFIs and launching the Quality
Certificate Project for islamic products.
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 International infrastructure institutions
4. Islamic Financial Services Board (IFSB): The Islamic
Financial Services Board is an international body based in Kuala
Lumpur, Malaysia, and it began its operations in March 2003. The
institution is working as international standard setting body of
regulatory and supervisory agencies that have their main interest
in ensuring the effective performance and stability of the Islamic
financial services industry covering the area of banking, capital
market, and insurance. The members of IFSB include 49
regulatory and Supervisory authorities in addition to Islamic
Development Bank, Asian Development Bank, Islamic Corporation
for the Development of Private Sectors, the International Monetary
Fund, World Bank, and Bank for International Settlements, and
138 market players and professional firms operating in 39
countries across the world. The primary target of IFSB is to
develop uniform regulatory and transparency
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 International infrastructure institutions

standards to address characteristics specific to Islamic financial

institutions, keeping in mind the national financial environment,
international standards, core principles, and good practices.
The IFSB has also been enhancing awareness of issues that
are pertinent to or have an impact on the regulation and
supervision of the Islamic financial services industry. In short,
the performance of IFSB is divided into three main areas:

a) Regulatory perspective

b) Coordination and harmonization perspective

c) Training and research perspective

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 International infrastructure institutions

standards to address characteristics specific to Islamic financial

institutions, keeping in mind the national financial environment,
international standards, core principles, and good practices.
The IFSB has also been enhancing awareness of issues that
are pertinent to or have an impact on the regulation and
supervision of the Islamic financial services industry. In short,
the performance of IFSB is divided into three main areas:

a) Regulatory perspective

b) Coordination and harmonization perspective

c) Training and research perspective

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 International infrastructure institutions

5. International Islamic Rating Agency (IIRA): In responds to

the sound expansion of Islamic financial services industry, The
Islamic Development Bank (IDB) established the International Islamic
Rating Agency in October 2002 in Bahrain. The IIRA was expected to
be an international body to provide infrastructure assistance to
Islamic capital markets by providing an assessment of the risk profile
of entities and instruments that can be used for investment decisions.
IIRA does rating, evaluating and providing independent assessments
and opinions on the likelihood of future of any Islamic financial
institutions as well as their products and services. It also publishes
and discloses to the public the data and information relating to rated
entities and financial instruments. IIRA will also assess the Shariah
compliant aspects of Islamic financial institutions and Islamic
financial products.The IIRA is sole rating agency established to
provide a rating spectrum that surrounds and deals with the full rank
of capital instruments and specialised Islamic financial products.
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 International infrastructure institutions

6. International Islamic Liquidity Management

Corporation(IILM): Its an international entity established to issue
short-term shariah-compliant financial instruments to facilitate more
efficient liquidity management for institutions offering islamic financial
services and to support the increasing cross-boarder transactions
between these institutions. Its membership is open to central banks,
monetary authorities, financial regulatory authorities, government
ministries that have regularly oversight on finance or trade and
commerce, and multi-lateral organizations which will hold shares of
IILM.

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 International infrastructure institutions

7. Liquidity Management Center (LMC): To enable Islamic

financial institutions to manage their liquidity through short and
medium term liquid investments that are structured in
conforming to the Shariah laws. The LMC was established for
the purpose of facilitating the investment of the surplus funds of
Islamic banks and financial institutions into quality short and
medium term instrument as well as supports the interbank
markets. Liquidity Management Centre (LMC) was established
on July 29th, 2002 in the Kingdom of Bahrain as a Bahraini
joint stock company with an Islamic Investment Banking
license. Its co-founder include Bahrain Islamic Bank (Bahrain),
Dubai Islamic Bank (United Arab Emirates), Islamic
Development Bank (Saudi Arabia), Liquidity Management
House (Kuwait).
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 International infrastructure institutions

8. Islamic Research and Training Institute (IRTI): The

Islamic Research and Training Institute was established by the
Islamic Development Bank at Jeddah in 1981. Its main
functions are to organize and coordinate basic and applied
research with a view to developing models and methods for the
application of Shariah in the field of economics finance and
banking and to provide training in Islamic economics for
personnel in development activities in the member states.
IRTI's objectives are: to undertake research and provide
training and information services in member countries and
Muslim communities in non-member countries to help bring
their economic, financial and banking activities into conformity
with Shariah and to further accelerate economic development
and enhance cooperation amongst them.
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 Models of Islamic Finance

Regulators have allowed dual systems whereby they issue

some additional policies and regulations for IFIs in addition to
the prudential regulatory framework for conventional banks.
Within this category there are variations with regard to the role
of regulators in shariah compliance. Some countries have
decalred the entire financial system to be islamic while in
others, no distinction is made between islamic or conventional
financial systems. Countries like UK and Singapore have
introduced specific regulations to facilitate islamic finance
transactions. Some regulators issue a standard form of banking
licenses (Saudi Arabia) for both islamic and conventional
institutions, while others (Malaysia) issue separate islamic
banking licenses. This may be (i) Market-Driven versus
government initiatives and (ii) Full-Fledged versus dual banking
system. 18
 Infrastructure for Development

The rapid expansions of the islamic financial system are

actively promoted through deregulation and legal reforms that
may give an incentive to foster the development of financial
intermediaries and markets. This development process
includes the followings:
1. Appropriate regulatory and supervisory framework: An
effective regulatory and supervisory framework for supporting
the stability of the financial system is required for a well-
developed financial infrastructure. For example, islamic bank
activities and banking-commerce links, domestic and foreign
islamic bank entries, capital adequacy, deposit insurance,
regulations on easing private sector monitoring of islamic
banks and government ownership of islamic banks.

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 Infrastructure for Development

2. Existence of strong corporate governance: Effective

corporate governance practices are essential to achieve and
maintain public trust and confidence in the banking system.
From a banking industry perspective, corporate governance
involves the manner in which the business and affairs of a bank
are governed by its board and senior management. Islam
strongly advocates all forms of positive governance and these
values have already been built in and are inherent in the
community. Islamic corporate governance serves through its
underlying principles of the economic well-being of the ummah,
universal brotherhood, justice, accountability and equitable
distribution of income.

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 Infrastructure for Development

3. Greater transparency and disclosure of information:

Transparency could be defined as public disclosure of reliable
and timely information that enables users of that information to
make an accurate assessment of a banks financial condition
and performance, business activities, risk profile and risk
management practices. To achieve transparency, a bank must
provide timely, accurate, relevant and sufficient disclosures of
qualitative and quantitative information the enables users to
make proper assessment of the institutions activities and risk
profile. In promoting transparency, supervisors and regulators
need to design effective disclosure standards.

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 Infrastructure for Development

4. Risk management framework: The identification and

assessment of risks and the determination of risk mitigation
and management strategies from an essential part of the risk
management framework of a financial institution. The FASB
has issued the guiding principles of risk management for
offering islamic financial services. The Basel Committee on
banking supervision standards has set out sound practices and
principles pertaining to credit, market, liquidity and operational
risks of financial institutions.

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 Infrastructure for Development
5. Effective and dynamic shariah framework: The shariah
framework includes governance structures, processes and
arrangements to ensure that all islamic financial instituions
operations and business activities are in accordance with the
shariah. The structure and processes include:
i. Rules governing the composition and qualifications of
shariah committee members of the IFI.
ii. Issuance of relevant shariah resolutuions that govern whole
of its operations.
iii. An internal shariah compliance review/audit for verifying
thyat shariah compliance has been satisfied, during which any
incident of noncompliance will be recorded and reported.
Dissemination of information on such shariah
pronouncements/resolutions to the operative personnel of the
IFIs.
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 Development of Vibrant Islamic Financial Markets
The development of an islamic financial system should include
key components comprising the islamic money market and the
islamic equity and debt capital market. The equity and bond
markets will contribute towards a more efficient distribution of
risk within the system, thus creating stability in the system.
Complementing these financial markets is the development of
non-bank islamic financial institutions such as insurance
companies, savings institutions, housing credit institutions need
to be developed to meet increasingly diversified customer
demand. It includes the followings:
1. Large number of players-
2. Wide range of financial products and instruments-
3. Tax neutrality
4. Blue print for islamic finance i.e. long-term master plan
5. Accounting and auditing standards for islamic financial
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institutions (AAOIFI)
 Challenges
Islamic finance faces a number of challenges that need to be
addressed to sustain its development in the global financial
system such as:
1. Adoption of a robust domestic islamic financial system
2. Efficient and active international islamic financial markets
3 Availability of a wide range of instruments (shariah compliant
products)
4. Human resource requirements

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