Introduction to Islamic

Economics and the Islamic

Financial System
NAIRA AMBOLA
Introduction

Islamic finance refers to how businesses and individuals raise capital in

accordance with Sharia, or Islamic law. It also refers to the types of
investments that are permissible under this form of law. Islamic finance
can be seen as a unique form of socially responsible investment. Some
of its prominent elements include the following:
The prohibitions of interest or usury (riba), uncertainty (gharar,
gambling (maysir), unethical practices such as manipulation, hoarding
and monopoly, and impermissible business activities such as
pornography, selling alcohol and prostitution.
The consideration of Shari’ah injunctions relating to the principles of
justice, equality, risk and reward, risk sharing, cooperation for the
benefit of society, and others.
Islamic Worldview

Generically, Islam means submission to the one God, that is Allah

(SWT). This has been the essence of all divine revelations since the
creation of Adam, father of humanity. After that, Allah (SWT) sent
prophets with the same basic message to every human community,
culminating with Prophet Muhammad (SAW). Allah (SWT) proclaims:

In matters of faith, He has laid down for you [people] the same
commandment that He gave Noah, which We have revealed to you
[Muhammad] and which We enjoined on Abraham and Moses and
Jesus: ‘Uphold the faith and do not divide into factions within it’
(Qur’an, 42:13).
Islamic Economics

The core principles of Islamic economics originated in the

works of early Shariah scholars who laid down the
foundations of maqasid al-Shari‘ah and utility theory, the
modern industrial environment has brought with it
unprecedented socio-economic issues affecting human well-
being well beyond the traditional Shari‘ah scholarship.
Therefore, Islamic economics is a newly emerging discipline
that takes the lead in resolving newly arising economic
issues from the Islamic worldview.
Islamic system is based on the following
philosophical foundations:
1. Tawhid: God’s unity and sovereignty
2. Rububiyyah: Divine arrangements for nourishment and directing things
towards their perfection
3. Risdalah: Prophethood and guidance
4. Akhirah: Belief in accountability on the Day of Judgement and its
implications for the life of this world and the hereafter
5. Istikhlaf: Man’s role as Allah's (SWT) vicegerent on earth
6. Tazkiyah: Purification plus growth
7. Kafalah: Social solidarity
8. Adalah: Justice
9. Falah: Well-being or success in this world and the hereafter
Objectives of an Islamic Economy

The objectives of an Islamic economy are part of maqadsid al-

Shari‘ah. In brief, the economic maqasid are the answer to the
question: ‘How does Shari‘ah address the overall objective of
well-being?” The economic maqasid take the term ‘well-being’
to stand for the state of satisfaction of human wants from the
socio-economics perspective. The domain of maqasid relates
to how the Shari‘ah addresses vital areas of human socio-
economic life in the face of constantly changing models of
livelihood. This is particularly important in coping with the
modern industrial world where social values and institutional
ceaselessly undergo complex processes of change.
The five elements of pressing
necessities in the overall strategy of
well-being
• Religion: The Vision of Well-being
Religion is the strategic vision of well-being. Shari‘ah provides the Muslim with a
vision of well-being that differs in certain ways from the socio-economic visions
derived from other religions, belief systems or philosophical outlooks of various
human societies.
• Life: The Central Goal
This refers to human life. The goal of Shari‘ah is to promote well-being, as implied
by the verse: ‘It was He who created all that is on the earth for you ... (Qur'an,
2:29). Human life takes the second position after religion because vision must
precede the goal. In particular, all provisions for life must comply with the Shariah
vision that human life has to be regarded with honour and dignity. Allah (SWT) says:
We have honoured the children of Adam and carried them by land and sea; We have
provided good sustenance for them and favoured them specially above many of
those We have created (Qur’an, 17:70).
• Mind or Intellect: The Human Resource
The mind is the human resource that thinks, evaluates, plans,
manages and produces the goods of well-being, thereby
taking the third position after religion and life.
• Progeny: Intergenerational Continuity
Progeny comes next in order to account for intergenerational
continuity of socio-economic well-being subject to the
Shari‘ah. This brings forth the importance of family as the core
educational circuit in human society to transfer a sense of
direction and moral purpose to new generations.
• Wealth: The Material Economic Resource
Lastly, material economic resources must run abundantly in
the economy to activate human resources in the pursuit of
well-being and intergenerational continuity. Wealth stands for
all material economic resources (land, natural resources,
energy, semi-finished goods, equipment, machinery and
money) that support human resources in theproduction
process.
Central Economic Problems

Distribution
Production Management
decision (For
decision (What decision (How
whom to
to produce?) to produce?)
produce?)
Economics of Riba

Riba implies
Riba demeans
improper
Riba corrupts and
appropriation
society diminishes
of other’s
personality
property

Riba is unjust
Trade, Money and Riba

Trade is highly commendable, not only due to the wealth it

generates, but also due to the scope of economic
interdependence it engenders among nations.

Money is the most powerful lubricant in trade. It is the

medium of exchange that facilities the flow of trade all over
the world. Being the medium of exchange is the primary
function of money from an Islamic perspective.
Distributional Consequences of
Eliminating Riba

1. ‘Allah has permitted trade and prohibited riba (Qur’an,

2:275).

2. ‘Allah will deprive riba of all blessing but will give increase
for deeds of charity’ (Qur’an, 2:276).
Economics of the Financial System

The financial system is an offshoot of economics. It consists of

markets and institutions actively engaged in meeting the
investment and financing needs of surplus funds and deficit fund
units.

Islamic Financial System – a clear manifestation of the Islamic

worldview, which is represented by the Shari’ah. The structure of
the Islamic financial system is similar to the structure of the
conventional financial system. The main factors that govern the
structure of financial systems, Islamic or otherwise, are
transaction cost and economic information.
Islamic Financial Markets

It functions as a parallel market to the conventional capital market.

In the Islamic financial market, market transactions are carried out
in ways that do not conflict with the conscience of Muslims and the
religion of Islam.

Most common types of financial markets are:

• debt and equity market
• money and capital markets
• primary and secondary markets
• organized exchanges and over-the-counter markets
Islamic Financial Intermediaries

The essence of financial intermediation is the interposition of a

third party between the ultimate fund seeker and ultimate fund
provider in the saving-investment process. There are two types of
Islamic financial intermediaries; depository institutions and non-
depository institutions.

One of the most important roles played by financial institutions is

to provide a link between SFUs and DFUs. Without it in place, it
would be difficult to match directly in the market, or at least this
matching wouldn’t be as efficient as it is through the
intermediation of financial institutions.
Islamic Financial Instruments

Economics activities within a financial system are performed

by different economic agents who, more often than not,
come into contractual relationship with other agents in
pursuing their economic activities. This contractual
relationship is usually defined through a financial instrument.
Requisites of the Islamic Financial
System

The Islamic financial system, being an integral part of an

overall Islamic economic system, requires a conductive
environment that not only conforms to the rules and
principles of Shari’ah but at the same time enables it to
work effectively and efficiently. The essential requirements
for an Islamic financial system are; strong risk management
practice, effective regulation, sound corporate and shari’ah
governance supportive legal framework and lastly, robust
accounting, auditing and taxation regime.