Concepts and Theoretical Fundamentals of Islamic

Finance

Salman Syed Ali

Islamic Research and Training Institute

Overview

1. Conceptual Fundamentals of Islamic Finance

2. Strengths of the Conventional Financial System

3. Weaknesses of the Conventional Financial System

4. The Needed Reforms

5. Need for Stability

Conceptual Fundamentals of Islamic Finance

• The financial system is part of the overall economic system

• Characteristics of Market System– Freedom of participants to interact with each

other– Discipline– Efficiency– Equity (Justice)

Strengths (Characteristics) of the Conventional Financial System

• It mobilizes resources from savers

• It makes these resources available to the users

• It is thus an intermediary between the savers and users

• This makes possible the use of idle resources

• It, thus, increases efficiency

Weaknesses of the Conventional Financial System

• Whoever has the collateral and ability to pay interest gets the resources – the end use is not a major concern

• It promotes excessive lending >>

• It promotes excessive lending– Causes booms and busts

– The lender gives no respite – sale of collateral

– Price of collateral falls steeply

– Causes recession

– Since it is only the rich who can provide collateral, they get the resources. This increases inequalities of income and wealth

– It also diverts resources to speculation

– It promotes inefficiency

– It promotes injustice

The Needed Reform

• Introduce greater discipline– P&L sharing

• Introduce greater justice– Make an alternative arrangement for collateral

so that even the poor may have access to finance

• Social pressures– Group solidarity system (e.g. of Grameen)

• Introduce greater efficiency in the use of resources– Ensure that resources are used productively

not for gambling and speculation– PLS will help in this– Also regulation and supervision

Keynes (1926) “The End of Laissez-faire”

“The world is not so governed from above that private and social interests always coincide. It is not so managed here below that in practice they coincide. It is not a correct deduction from the principles of economics that enlightened self-interest always operates in the public interest. Nor is it true that self-interest generally is enlightened; more often individuals acting separately to promote their own ends are too ignorant or too weak to attain even these.”

Keynes (1926). “The End of Laissez-faire”, Sidney Ball Lecture given by Keynes at Oxford in November 1924 and a lecture given by him at the University of Berlin in June 1926. Available on the internet at http://www.panarchy.org/keynes/laissezfaire.1926.html

Need for Stability

• Avoid excessive lending– P & L Sharing– Break on the sale of debt– Reduce leverage– Increase quality of debt

• Excessive lending leads to speculative booms which are usually followed by busts

Economic Cycles

Unregulated credit expansion

Regulated credit expansion

Forbearance enacted

No forbearance

Credit for this slide: Sami Al-Suwailem (2008)

Europe is ablaze with knowledge and skillsTruly its fountain of life is in pitch darkness.

In splendour, in seduction and in grace,The buildings of banks outsoar the churches!

What they call commerce is a game of dice;For one, interest, for millions swooping demise.

• Muhammad Iqbal, (Poet of the East) in Bal-i Jibril

Thank You