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Introduction to Islamic Finance

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  1. Introduction to Islamic Finance Sami Al-Suwailem IRTI, IDB 1429H - 2008

  2. Objectives of Islamic Finance • Wealth creation • Justice • Benevolence Introduction to IF

  3. Principles of Islamic Finance • Economic transactions are generally acceptable unless otherwise stated • Origins of prohibited dealings: • Injustice: Riba • Ignorance: Gharar  وحملها الإنسان إنه كان ظلوماً جهولاً  Introduction to IF

  4. Economic Transactions Acceptable Prohibited Introduction to IF

  5. Riba • All religions prohibit riba • Most legal systems put restrictions on interest: • Interest ceiling • Ban on compound interest • Why? Introduction to IF

  6. What’s wrong with Riba? • Interest grows faster than wealth • Why? • Debt burden destroys the economy • Impossibility of repayment Introduction to IF

  7. 1000 1,546,318,920,731,950,000,000 60,806,303,788,323,700,000,000,000,000,000 1500 2,391,102,204,613,620,000,000,000,000,000,000,000,000,000 2000 $1 Borrowed at 5% in 1 AD Introduction to IF

  8. Borrow 1 pence at 4% in 1 AD In 1750 debt equals weight of the globe of gold In 1990 it equals 8190 globes! Introduction to IF

  9. Money & Debt in the U.S. Introduction to IF

  10. Debt Repayment • Debt exceeds available money • Repayment only with new debt • Economy is servicing debt • Interest exceeds 70% of exports • African countries pay for debt services twice as health-care Introduction to IF

  11. Debt Inverted Pyramid Debt wealth Introduction to IF

  12. Restrictions on Debt • E.U. requirements: • Deficit < 3% of GDP • Debt < 60% of GDP • Intertemporal Budget Constraint: • The present value of debt go to zero • Prevents Ponzi financing • Why this won’t work? Introduction to IF

  13. Islamic Solution • Finance is tied to real transactions • Finance always serves real economy • Return on financing is paired with wealth creation • Address debt creation from the start Introduction to IF

  14. Debt in Islamic Economy Debt Wealth Introduction to IF

  15. Finance in Islam • Finance is embedded in real transactions • Islamic contracts: • Deferred sale, leasing, Salam, Musharakah… • Time value is in line with real value • Lending is strictly a non-profit activity • Lending vs. financing? Introduction to IF

  16. Riba vs. Deferred Sale Introduction to IF

  17. Types of Riba • Debt riba: riba nasee’ah • Incremental riba: riba al-fadhl Introduction to IF

  18. Riba al-Fadhl • Debt Riba consists of: unequal amount + delay • Unequal amount = riba al-fadhl • Delay = riba al-nassa’ • Each component is prohibited to prevent any possibility of debt riba Introduction to IF

  19. Riba al-Fadhl… • Specific types of commodities: • Gold and silver (money) • Wheat, barley, date, and salt (staple food) Introduction to IF

  20. Introduction to IF

  21. Range of Riba al-Fadhl • Applies to any fungible and necessary commodity • Contemporary example? • What about water? Introduction to IF

  22. Reasons for Riba al-Fadhl • Prevents the possibility of debt riba • How? • Protects necessary commodities and goods Introduction to IF

  23. The Principle of Similarity • Similarity negates gain from trade • Variety allows mutual benefit • Diversity is essential for prosperity • Stronger similarity imposes stronger restrictions of exchange • Riba: imbalanced exchange of similars Introduction to IF

  24. Similarity Low High Locate sale and riba Introduction to IF

  25. Conclusion • Roots of prohibited transactions: • Riba • Gharar • Islamic principles promote better growth and more balanced wealth Introduction to IF