Therefore, a system that prohibits an ex ante fixed interest rate andallows the rate of return on capital to be determined ex post, based onreturns to the economic activity in which the funds are employed, istheoretically viable.
International Conference onIslamic Microfinance in Mauritius Organized By : CENTER OF ISLAMIC BANKING & ECNOMICS
The fundamentals of Islamic Finance;what are its rationale? 5 April 2011 GMBC LTD 2 International Conference on Islamic Finance & Banking in Mauritius
3 GMBC LTD The theory of Riba could be summarised as follows: ‘The stipulation of an excess for the lender in loan is prohibited, and it amounts to Riba, whether the excess is in terms of quality or quantity or whether the excess in a tangible thing or a benefit, and whether the excess is stipulated at the time of contract or while determining the period of delay for satisfaction or during the period of delay and, further, whether the stipulation is writing or is part of customary practice.’ Qur’an 2:275. AAOIFI Shari’ah Standard, No. (19), Qard (loan), 4.4/1
What could a system of finance that originated in the desert over a thousand years ago have to offer to such a world? And how could it possibly compete?
Prohibition of interest (riba’). Prohibition of riba – a term literally “an excess” and interpreted as “any unjustifiable increase of capital whether in loans or sales”.
Money as “potential” capital. Money is not a commodity, but a medium of exchange, a store value and a unit of measurement. Money represents purchasing power and cannot be utilised to increase the purchasing power without any productive activity. Islamic finance advocates the creation of wealth through trade and commerce.
Risk sharing. Because interest is prohibited, suppliers of funds become investors, rather than creditors.
Prohibition of speculative behaviour. Islamic finance discourages hoarding and prohibits transactions featuring extreme uncertainties (gharar), and gambling (maysir).
5 An Introduction to Islamic Finance – 19 January 2011 – FSC Ebene GMBC LTD
Sanctity of contracts. Islamic finance upholds contractual obligations and the disclosure of information as a sacred duty. This feature is intended to reduce the risk of asymmetric information and moral hazard.
Sharia approved activities. Only those business activities that do not violate the rules of the Sharia qualify for investment. For example, any investment in a business dealing with alcohol or gambling is prohibited.
Social justice. Any transaction leading to injustice and exploitation is prohibited.
The asset-backing principle. Each financial transaction must refer to a tangible, identifiable underlying asset.
6 An Introduction to Islamic Finance – 19 January 2011 – FSC Ebene GMBC LTD
A modern financial system can be designed without the need for an ex ante positive nominal fixed interest rate. In fact, as Western researchers showed, no satisfactory theory could explain the need for an ex ante positive nominal interest rate.
The failure to assume an ex ante positive nominal fixed interest rate—that is, no debt contract—does not necessarily mean that there has to be zero return on capital.
The return on capital is determined ex post, and the magnitude of the return on capital is determined on the basis of the return to the economic activity in which the funds are employed.
The expected return is what determines investment.
The expected rate of return—and income—is what determines savings. Therefore, there is no justification for assuming that there will be no savings or investment.
Monetary policy would function as in the conventional system, its efficacy depending on the availability of instruments designed to manage liquidity.
In an open-economy macroeconomic model without an ex ante fixed interest rate, but with returns to investment determined ex post, the assumption of a one-way capital flight is not justified.
Conditions of Islamic Financial Transactions
The asset which is being sold or leased must be real,
and not imaginaryor notional;
The seller or lessor must own and possess the goods
being sold or leased;
The transaction must be a genuine trade transaction
with full intention of giving and taking delivery; and
The debt cannot be sold and thus the risk associated
with it must be borne by the lender himself.
In the process of demonstrating the analytical viability of Islamic financial system, research also clearly differentiated it from the conventional system. In the conventional system, which is based on debt contracts, risks and rewards are shared asymmetrically, with the debtor carrying the greatest part of the risk and with governments enforcing the contract. Such a system has a built-in incentive structure that promotes moral hazard and asymmetric information. It also requires close monitoring, which can be delegated to an institution acting on behalf of the collectivity of depositors and investors; hence the need for banking institutions.
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