Question

The Islamic financial system has evolved into a viable and vibrant component of the overall
financial system, complementing the conventional financial system. The system encompasses
the Islamic banking system, Islamic money market, Islamic insurance or takaful, Islamic capital
market and the specialized financial institutions which provide alternative sources of financing.
Evaluate the requisite for a successful Islamic financial system.

Answer 1

Islamic finance may be viewed as a form of ethical investing, or ethical lending, except that no loans are possible unless they are interest-free. The objectives (maqsid) of Islamic finance transactions may be summarised as below:

• To be true to the Shari’ah principles of equity and justice;
• Should be free from unjust enrichment;
• Must be based on true consent of all parties;
• Must be an integral part of a real trade or economic activity such as a sale, lease, manufacture or partnership.

Fundamental principles of Islamic finance

Prohibition of interest

The prohibition of interest is founded on the prohibition of riba, a term literally meaning “an excess” and interpreted as “any unjustifiable increase of capital whether in loans or sales”; this is the central tenet in mutual dealings.

Risk sharing     

Because interest is prohibited, suppliers of funds become investors instead of creditors. The provider of financial capital and the entrepreneur share business risks in return for shares of the profits.

Prohibition of speculative behaviour

Islamic finance prohibits transactions featuring speculation including extreme uncertainties, gambling, and risks. Therefore, transactions in Islamic finance should be backed by real assets.

Sanctity of contracts

Islam teachings upholds contractual obligation's and the disclosure of information as a sacred duty. This feature is intended to reduce the risk of symmetric information and moral hazard.

Shari’ah-approved activities

Only those business activities that do not violate the rules of Shari’ah qualify for investment. For example, any investment in businesses dealing with alcohol, gambling, and casinos would be prohibited. Project finance, which puts emphasis on equity participation in transactions involving real assets, is natural fit for Islamic finance.

Microfinance

Microfinance is another candidate for the application of Islamic finance. Islamic finance promotes entrepreneurship and risk sharing, and its expansion to the poor could be an effective development tool, particularly for economic development of marginalised communities as well as poverty alleviation. The social benefits are obvious, since the poor currently are often exploited by lenders charging usurious rates.