Sunday, November 29, 2009

Introduction to Islamic Finance (Concordia JMSB Alternative Investment Association) Nov 2009

Preamble Notes
  1. Thanks for the Alternative Investment Association for the event organization
  2. Thanks for the audience
  3. Difference between experts in Finance and Economics and Jurists who in Fiqh el Mou3amalat.
  4. The aim is to present the foundations of Islamic finance, the current practice in Canada (North America), the problems, challenges and potential solutions.
  5. I would quote fatwas and points of views. However, I am not giving any fatwa
  6. This work is a human and susceptible to mistakes.
  7. This series of presentation will not cover everything on the market.
  8. I might use companies as examples but I will not be endorsing any company regardless of their current practice and claimed sharia compliance.
  9. We know that there are people who exploit the lack of knowledge within Muslim communities in North America and there are others who strive to promote the real Islamic financial services.
  10. Muslims have sensitivities in front of Islamic Finance. They like to have a halal service. However, most Muslims can not differentiate between conventional and Islamic transactions.
    1. For them, profits and interest can be the same like “Water is water regardless you have steal it or buy it”
    2. This is a natural confusion and started in the Quran
  1. Finally, the Islamic contract and the legal contract can be the same. However, the essence of the transaction makes it halal or haram.

Basic Structure of this series (4 sessions)

  1. Brief Introduction to Finance and Economics
  2. Economical Foundations of Islamic Finance
  3. General Conditions of Islamic Finance
  4. Permissible financing in Islamic Finance
  5. Permissible investment in Islamic Finance
  6. Insurance in Islamic Finance
  7. Need for Innovation

What is Finance?

Finance is the science of managing funds and resources. It has several sub-areas: personal finance, corporate finance, public finance, international finance, micro-finance. This whole definition boils down to two main issues: how to get resources and where to allocate (spend) resources.
Suppose we have a simplified world with two hypothetical people only. One person has an income that exceeds his expenditure can:
Invest the excess income.

On the other hand, the other person has an income that is less than her expenditure can get more resources by
decreasing its expenses
Or increasing its income. 

Finance has four main foundations:
  1. Economics
  1. Accounting
  1. Values
  1. Regulations

Economics and its constitutes

Economics is a social science dealing mainly with the production, distribution, and consumption of goods and services. A better definition comes from Lionel Robbins in a 1932 essay: "the science which studies human behavior as a relationship between ends and scarce means which have alternative uses."


Production is the conversion of inputs into outputs. It is an economic process that uses resources to create a commodity that is suitable for exchange. This can include manufacturing, warehousing, shipping, and packaging. The inputs or resources used in the production process are called factors of production. Possible inputs are typically grouped into six categories. These factors are raw materials, machinery, labor services, capital goods, land, and enterprise. [it is usually 4 in textbook economics].


Macroeconomics examines the economy as a whole to explain broad aggregates and their interactions "top down," that is, using a simplified form of general-equilibrium theory. Such aggregates include national income and output, the unemployment rate, and price inflation and sub aggregates like total consumption and investment spending and their components. It also studies effects of monetary policy and fiscal policy.

Economy Elements

  • Markets
  • Firms
  • Governments
  • Households
  • Specialization (to a lesser extent)

Supply and Demand

The law of demand states that, in general, price and quantity demanded in a given market are inversely related. In other words, the higher the price of a product, the less of it people would be able and willing to buy it. Supply is the relation between the price of a good and the quantity available for sale from suppliers (such as producers) at that price. Supply is often represented using a table or graph relating price and quantity supplied.

Market Failures

    • Natural monopolies
    • Incomplete markets
    • Information asymmetries
    • Public Goods
    • Externalities (pollution, education, tax…)
    • Macro instability
    • Policies

Basic conventional economy pillars

  • Invisible Hand
  • Free market
  • Individual initiatives
  • Profit maximization (Utility maximization)
  • Time value of money and accumulation of interest
  • Capital and entrepreneurship are different input to the economy. Capital gains interest. The entrepreneur is entitled to profit.
  • Money itself is a good
  • Common monopolies
  • Common speculation
  • Legislative moves against social justice
  • Arbitrage is not favored yet allowed
  • Interest is the only concern and not the usage of the money
  • Loans can be advanced for any purpose (gambling, drugs, porn…)

Examples of economies

Church System: Weak economic foundation, A lot of values, good accounting system, no regulations.
Capitalist System: strong economic foundations, no efficient value system, advanced flexible and interpretable regulations, and generally accepted accounting system.
Communist System: Strong economic foundations, strict accounting measures, a lot of regulations, unrealized value system.
Socially conscious System:  A mixed capitalist-socialist economic foundations, an elaborate set of social values.
Islamic System: unique economical foundations, unique value paradigm, flexible but firm regulations, and generally accepted accounting principles (with few exceptions). 

Basic Islamic economy pillars

  1. The Islamic system IS NOT another conventional system. IT is a total substitute with its own philosophy, principals and conditions
  2. The first principle is to believe Allah’s guidance. All human activities must follow the general guidelines prescribed by Allah who has created the human race and know its needs and capabilities.
  3. Social justice and welfare is an effective pillar of Islamic economy
  4. Money does not have an intrinsic value. It is an exchange facilitator.
  5. Capital and entrepreneurship cannot be separated. Both assume elements of risk. The higher the profit to the business, the higher is the derived profit.
  6. Arbitrage is prohibited
  7. Prohibition of any activity that does not generate an added value. A win-lose transaction is haram.
  8. The Islamic system does not deny the market forces and the dynamics of the economy. Ex.  Ibn Khaldoun and Qadi Abduj-Jabbar.
  9. An interest free economy does not mean that all financial transactions are for charity purposes.
  10. The Islamic system is a substantive system where the concern is on the usage of the money
  11. Financing a business associate means usually sharing loss and profits
  12. Return can be predictable to a high extent (Almost Fixed income)
  13. Return cannot be halal, unless the financier assumes some risk (murabaha and acquisition of the item)
  14. Ideal modes of financing in Islam are: Musharaka, Mudarabah, Salam and Istisna’
  15. Any transaction should create a real asset.
  16. The flow of profits should be distributed in an equitable manner.
  17. The welfare of the society is actually the utmost goal.
  18. Demand is limited by endogenous factors

Major Aspects of conventional Economics
Factors of production are in general the productive inputs or the resources employed to produce any goods and services in an economy.
In the 19th century, the factors were:
  • Labor: ability to produce
  • Capital: any human contributions, skills, tools, machines…
  • Land: All natural resources that are gifted by nature.
  • Entrepreneurship: This item was added during the previous century. Also the human capital was separated from the financial capital.
The important factor varies from one school to another. For example, for a Marxist, the most important factor is the labor (including entrepreneurship and human capital sometimes). For neoclassical (Free market preachers), they think the time of the entrepreneur is the most important factor because this is what decides on the amount of production.
However, almost all schools of economics agree that the scarcity of an input makes it more important than other abundant factors.

Major Aims of Conventional Economics

Economics aims to maximize the society income and provide economic growth to raise the utility and standard of living of participants in the economy (Welfare).
  1. Sustainability.
  2. Full employment.
  3. Price stability (Internal balance, inflation).
  4. External balance.
  5. Equitable distribution of income and wealth (might be equal in some cases).
  6. Increasing productivity (Hourly efficiency of production input).

Major problems with conventional Economics

  • The wealth Gap: (Rich got richer and poor got poorer) or (Money is begetting money like cows beget cows).
    • Several solutions were suggested: usury laws, taxes, redistribution of wealth, training, social welfare programs, price controls…
    • These are temporal solutions: get rid of one abusing group to get another new group.
    • Radical solutions lead to corruption and dictatorship
      • French revolution: No bread. Throw the king, kill the landowners. Make bread cheaper. Nobody wants to produce. Kill farmers. Not enough farmers to produce. Hunger continues
      • US Model: favor groups of farmers. Subsidize them. Make it easier to farm. Prices fell down. In recession, buy and destroy the product. Hunger continues.

Major aspects of Islamic Economies

Ibn Khaldoun was one of the pioneering Muslim economists and he was the first scholar (internationally) to establish the concept of cyclic social forces. He noted that
  • The stronger social cohesion is (asabiyya), the stronger is the distribution of wealth and the greater is the economic growth.
  • Growth and social development enhance demand and supply (at the same time).
  • Demand and supply determines the prices of goods.
  • Production depends on macro-social forces, population growth, human capital development, and technological advancements.
  • Population growth is a factor of wealth (!!!).
Some early Muslim scholars who tackled economical issues are:
  • Imam Abu Hanifah and his student Abu yusuf (Kharaj)
  • Al-farabi
  • Ibn sina (Avicenna)
  • Al-Ghazali
  • Al-Mawardi
  • Ibn Taymiyah
  • Al-Maqrizi
In few words, the major differences in Islamic economics:
  • Trade is allowed by Interest bearing transactions are prohibited “allah has permitted trading and forbidden interest”.
  • Substantive economy
  • No speculation and no abuse (Gharar, gambling…)
  • Circulation of wealth is a religious obligation (Zakah) or favoured (Sadaka)
  • Scarcity is not absolute.
  • Producers need an incentive.
  • Wealth cannot be created without exchange assets (value added transactions).
  • The value of goods should be intrinsic. The value of services should be fair.
  • Intentions are not enough. Some actions would lead to unintentional consequences.
  • Costs can be good or bad but might be minimized without abuse.
  • The only way to increase a nation's real income is to increase its real output.
  • Competition is welcome as long as it does not violate the value of inputs or lead to abuse.

Ultimate Objectives of Shariah (Makassed el Shariah)

  1. Al-shatibi: shariah aims to promote the welfare for the people in this life and the hereafter by protecting:
    1. Vital necessities (darourat)
    2. Needs (Hajat)
    3. Embellishments (Kamaliyat)
  1. Al-Ghazali: sharia aims to promote human welfare which encompasses safeguarding of faith, life, intellect, family/society, and welath.
  2. Ibn-3Ashour: Sharia aims to bring benefits, eliminate harms, establish equity, safeguard the social harmony, sustain the power of the ummah, and reinforce the respect of the religion.
  3. Sheikh al-Qaradawi: added another dimension for the aims of the sharia by concentrating on the current social structure (not the individual or the state). So he thinks that Sharia aims to promote: freedom, shura, justice, equality, and sustainability of societies in addition to the old five elements.

Other Islamic Financial views

Islam is to surrender to Allah and obey all his orders and only through complete submission, Muslims attain welfare and stability. Hence, Islamic finance and Islamic economics are part of this style of life and all social transactions (including the financial ones) have to follow the orders of Allah the Creator.
Michael Bonner labeled the Islamic system as an “Economy of Poverty” during the first six centuries because of Zakat, prohibition of bad circulation of wealth, prohibition of market monopolies.
Islam has special views on:
  • Properties (private, public, and state)
  • Markets (freedom of exchange, fair competition, private initiative, security of contracts). Sharia mandates that consumers are allowed to obtain desired goods, producers to sell their goods, at a mutually acceptable price and a fair competition in the market at anytime as long as there is no speculation, abuse, nor monopoly.
  • Natural capital should be preserved although Allah rizk is abundant. “And in the heaven is your provision and that which you are promised”.
  • All transactions should involve asset movement by a trade move or an equity acquisition.
  • Any business activity should create value for both parties.
Next: Discussion of Riba and Islamic Financial Products