Concept of Islamic Economics; Public Finance,

Islamic Banking and Islamic Investments.

Submitted By:
Khaki Audil Rashid
MFC 4th Semester (2009)
Department of Business and Financial Studies
(Erstwhile Department of Commerce)
University of Kashmir.

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 Introduction

History of Islamic Economics begins with the advent of Islam.

Throughout the fourteen centuries of Islamic History we find
continuity of work in which economic issues were discussed in the
light of Shari'ah.

The early Islamic Jurists have explored the different issues and
aspects relevant to Public Finance such as economic responsibilities
of the ruler, mechanism of revenue collection, its disbursement,
equity and justice in its administration, public expenditure, its role
in economic development, work of public utilities, utilization of idle
resources for the development of economy. However, this study
focuses on Public Finance, Islamic Banking and a brief idea about
Islamic Investments.

This study is divided into three parts. The first part contains
explanation of the basic terms associated with Public Finance and
the mechanism thereof. The second part is an attempt to throw light
on the mechanism and issues relating to Islamic Banking. However,
in the final section a brief explanation of the issues relating to
Islamic Investments is given.

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 Development of Public Finance
Public finance is that branch of economics which deals with the
provision, custody and disbursement of the resources needed for the
conduct of the functions of the government. It is concerned with the
issues of the fiscal nature, and attempts to analyse the effects of
government policies like taxation and expenditure on the overall
economic situations of individuals and institutions, and examines
their impact on the economy as a whole.
The systematic study of fiscal problems or the development of public
finance in modern terminology is believed to be a late fifteenth
century phenomenon. It developed and acquired the new significance
with the emergence of „Nation States‟ in Europe. In his encyclopedic
work, J. A. Schumpeter, a noted historian of economic analysis
points out:
“Public finance especially modern taxation first developed in the
course of fifteenth century in the Italian city republics, Florence in
particular, and in German free-towns (Reichsstadte).”
However, the publication of Adam Smith‟s „Wealth of Nations‟ gave
a new direction to this discipline. In this masterly work, Smith very
intelligently summarized the earlier works on the subject and broke
new grounds by giving his own views and formulating new ideas. His
maxims of taxation, his emphasis on the role of state, his treatment
of public revenue, debt and expenditure are his strong contributions
to the subject. Indeed, the ideas given by Smith remain the main
source and basis for all treatises on the subject.

Public Finance in Islam

With the fall of Roman Empire, the world witnessed the emergence
of Muslims as a source of power, civilization, culture, science and
system of government. Rising from the Arabian Peninsula in the late
seventeenth century, the Islamic State extended its boundaries to
North Africa and Spain in the west and to Central Asia and China in
the east.
As a matter of fact, it is quite obvious that such a large empire
which existed for several centuries and dealt with large population
with a huge budget must have established a consistent and
operational system for fiscal administration. From the historical
records of the early Islamic History, we find that fiscal planners and
policy makers of the period dealt with a host of fiscal issues that we

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classify today under the banner of public finance such as revenue
collection, rate and structure of taxation system, the distribution of
tax burden in accordance with the Islamic values of Equity, Justice,
distribution of revenue for the welfare of the people and development
of economy and so on. The Muslim contribution to the evolution of
public finance remained almost neglected by the historians of the
subject till now. Interestingly these ideas came in an era when
Europe was sinking into what historians commonly called “the Dark
Ages of Europe.”
Public finance as practiced in the early Islamic period had a clear
basis in the overall ethical and social philosophy of Islam. It was not
merely a fiscal operation at the discretion of the ruler; rather it was
based on the guidance from Islamic Shari‟ah and aimed at public
interest. The main sources from which ideas of public finance are
derived in Islam are:
# The Holy Qur‟an. # Sunnah of the Prophet (SAW).
# Consensus of the opinion.
# Analogical reasoning of experts of Islamic Law for the Public
Interest.
In the Islamic system of public finance, the public money is
regarded as a trust in the hands of a ruler and must be directed, in
the first place, to the weaker and needy sections of the society in
order to bring social security, general prosperity and equitable
distribution of income among various sections of the society-the
concept same as Modern Social Cost Benefit Analysis (SCBA). The
Holy Qur‟an recommends:
“What Allah has bestowed upon His Messenger (and taken away)
from the public of township, belongs to Allah, to His Messenger and
(his) kindred, the orphans, the needy, and the wayfarer in order that
it may not (merely) make a circuit between the wealthy among you.”
In the early Islamic literature on public finance, there is much
emphasis on equity and justice in tax collection and its assessment.
On the other hand, the manhandling of tax payers and oppression
are severely condemned. The imposition of taxes is rationalized on
the ground that their income should be spent on the care of the
have-nots of the society. Also the rates of taxes and taxable items
were subjected to change according to the needs of the economy and
the paying ability of taxpayer.

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The economic role of the State

The theory of public finance finds its foundation in the principles,

policies and role of the state in economic life. The State is regarded
as agency acting for the provision of the collective good of the society.
Its role is rationalized on the ground that the market mechanism
alone cannot perform all economic functions and public policy is
needed to guide, correct and supplement the private sector.
In the Islamic System of government, organization is viewed primary
concern. Since Islam focuses on the organization and authority in
public affairs, the state assumed an active role for the realization of
material and spiritual goals. It becomes a moral obligation for
authorities to help realize the well being of all, preserve the interest
of the people and maintain stability and growth of economy.
According to the 13th century Jurist Al-Ghazalli;
“It is incumbent on the ruler to help the people when they are
facing scarcity, starvation and suffering especially during a famine or
when prices are high, and people fail to earn a living in these
circumstances and it becomes difficult for them to make both ends
meet. The ruler should in these circumstances feed the people and
give them financial assistance from their treasury in order to
improve their lot.”

Provision of Social Goods through the State

Social goods (actions) that provide benefit to all citizens of the

society are to be supplied by the state and made available free of
direct charge. This widely discussed theme covers not only that but
fulfillment of basic needs such as, food, clothing, shelter, education,
etc,. has also been regarded as the primary objective of the state.
Besides, the state has to provide infrastructure needed for the
development of the economy and general prosperity. As pointed out
by the famous jurist - Al-Mawardi, there are some „public services‟
that should be provided by the state‟s treasury (bayt al-maal). He
mentions:
“If the living in the city becomes impossible because of the non-
functioning of its drinking facility (spring) or destruction of its wall
then the state is responsible for its remedy (from its own resources
and if it lacks funds, it must find a way to get them).”
Besides, it has been mentioned at places by various jurists that any
action which is by its nature beyond the controls and affordability of
individuals (citizens), and which is economic either in the sense that

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 it adds to the state treasury or in that it is for the overall good of the
society, should be carried out by the state from the State‟s Treasury
(Bayt al-maal) Funds.

Supply of social goods through voluntary sector

Besides the supply of the social goods by the government, there

was a mechanism which added to the economic well being of the
State. This mechanism which worked with the help of voluntary
contributions came to be known as an institution of Waqf. Under
this scheme a particular property was earmarked and dedicated to a
cause so that the income occurring from that would be extended for
expenses in that Cause. The provision known as Waqf (endowment)
is a well known practice in Islamic traditions. The voluntary
institution of Waqf supplemented the state in fulfillment of its
obligations towards the provision of public goods.

Functions of the state

The state played an active role in the economic life represented

basically in its commitment to cater for the minimum standard of
living to all members of the society. These economic functions
include:
 Provision of conducive environment for economic activities.
 Provision for public administration, judiciary and enforcement of
Islamic legal code.
 Collection of revenue from available sources and also to raise
revenue by imposing new taxes if the situation so requires.
 Disbursement of funds on those heads that are obligations on the
treasury.
 Protection of the community from its enemies.
 Maintenance of law and order among the people in order to prevent
mutual hostility and attack upon property. This includes improving
safety of the roads.
 Supervision of such general matters that involve their livelihood and
mutual dealings as food stuffs and weights and measures in order to
prevent cheating.

The Executive
For the implementation of various policies, a state requires an
efficient and honest administration. As described by Prophet (SAW):

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 “An office is a trust, it would be a humiliation on the day of
judgement except for those who rise equal to the task and pay
anyone his due. The worst of the officials are those who are harsh
and unkind.”

Defense
There is also an emphasis on the need of the state for enough
power to attain and maintain military strength in order to preserve
the sovereignty and independence of the state.

Social Security

The Islamic state must be committed to provide social security to

all its citizens especially those who volunteer themselves for the
cause of Islam and the state. This includes the scheme of granting
pensions and aids in order to provide benefits to the „have-nots‟ of
the society and extend support to those who have done something
beneficial to the Islam and the Muslim state.

Economic Activities and the state

The jurists of the Islamic Governance stress on the obligations of

every citizen to earn a living to support himself and his family. Umar
II in this regard suggests:
“Look into the state lands in your province and distribute them on
the condition of share-cropping at half of the yield or even less,
reducing the state share to one tenth. However if the land is so
infertile that nobody likes to cultivate it even at one tenth, give it for
nothing. If even then there is nobody to accept it, spend on its
cultivation from the state treasury (Bayt al-maal) so that no land
under your control is neglected.”

Economic Development

In Islamic State, maintenance of a healthy treasury and

achievement of a high rate of growth have remained major issues of
concern for economic development. The various development steps
have been suggested, for example Abu Yousuf once said:
“The expenses of the upkeep of the walls on the river bank to
prevent flooding and expenses of the dams and of the water locks
must be borne by the state treasury, because it is in the public
interest that they should be kept in order as any malfunction will

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 cause damage to agriculture and decrease the income from
taxation.”
Islamic state always targets full utilization of its resources and high
rate of economic growth. The revival of dead lands has always
remained the top priority of Islamic Development.

Distribution function

The fair distribution of income on the welfare of the people always

remains the top priority in the public finance in Islamic Systems.
Caliph Umar placed much emphasis on the distribution aspect of
budgetary policy. He states:
“Taxes are justified if they are collected in a just, legal way, and
that they are spent justly and legally. I consider myself, with regard
to the taxes collected, as a guardian of an orphan‟s property. The
people have the right to question whether I spend the taxes collected,
in a legal way.”
A distinctive feature of the role of Islamic state is that all economic
activities and fiscal policies are guided and constrained by Islam‟s
own ethical philosophy. Thus, social justice, fulfillment of needs and
distribution of income and wealth is not an economic and social end
but it is religious duty and a social obligation as well. The public
policies are not guided by the whims of the rulers arbitrarily. Rather
they must be within the constraints of the Islamic Shar‟iah.

Sources of Revenue

For the smooth running of an Economy, there must be some

system of revenue collection. In the Islamic System of public finance,
the revenues from various sources are broadly classified into three
main categories:
 Ghanimah Revenue.
 Sadaqah Revenue.
 Fay Revenue.

 Ghanimah(war booty): Ghanimah is the property which Muslims

seize from the enemy. This constituted one of the main sources of
revenue of the early Islamic State. The discussion of ghanimah as a
source of state revenue is justified by the fact that one-fifth of the
total proceeds belonged to the state and the remaining four-fifth was
divided among the fighting army. Thus one fifth (khumus) of the
entire volume of ghanimah was available as state expenses. However

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 the khumus (one-fifth of ghanimah) was not a full-state revenue in
the ordinary sense, as it was/is earmarked for special beneficiaries
clearly mentioned in the Holy Qur‟an. The verse reads:
“And know that out of all the booty that Ye may acquire (in war(, a
fifth share is assigned to Allah and to the Messenger, and his
near relatives, the orphans, the needy and the wayfarer.”
 Sadaqah Revenue: Sadaqah revenue is the most important
component of Islamic revenue system. It comprises the Zakah (alms)
collected from the wealth of Muslims and custom duties collected
from Muslim traders on articles of trade trafficking through octroi
posts.
Zakah is the hub of Islamic public finance since it is the most
important source of revenue for any Islamic state. It provides relief
from poverty and brings other forms of social security. Abu Ubayd
states that Zakah is the share of the poor in the property and wealth
of the rich.
The assets are liable to Zakah only when they exceed a certain
minimum value called „nisab‟ which varies for each item. The
fundamental requirement implies that only those who have
sufficiency to pay and possess wealth beyond their needs for a period
of one year are liable to pay Zakah. The Zakah is therefore, a
determined right of have-nots in the property of the rich and
prosperous.
To sum up, it would be appropriate to say that although the
Zakah has been practiced centuries before the birth of modern
taxation, it embodied various aspects of modern canons of taxation.

 Fay Revenue: Literally meaning of „fay‟ is „return of a thing‟. Legally

speaking it denotes all the property received from enemy without
actual fighting. It legally includes the levy charged from these lands
(kharaj), poll tax (jizyah) and custom duties collected from non-
Muslim traders. However, this revenue did not belong to Zakah or
Ghanimah category. Since the state had a full authority in disposing
off „fay‟ revenue, it can be regarded as full-state revenue, the benefit
of which was generalized for the common good of the entire
population. Al-Ghazali has termed it as amwal al-masalih i.e., the
revenue of the public welfare.
From the view point of taxes all lands under the rule of Islamic
state has been divided into two categories:
# Ushr lands, the levy on which is regarded as Zakah and it
is earmarked for specific charitable heads.

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 # On the other hand, the revenue of fay lands can be utilized
for the general expenses of the state.
Regarding revenues on „fay‟ lands, there is a consensus that the
ruler has the authority to distribute it among the fighters as a war
booty. However, if he thinks it better the ruler may return it to its
owners and levy kharaj tax as a permanent source of income to the
State.
 Regarding the State ownership of lands, the unclaimed and
abandoned land which is not owned by anyone, nor brought to
life by anyone is ultimately at the disposal of the public
authority (iman). Abu Yousuf holds that state is the owner of all
those lands which have fallen into the hands of the state either
by means of war or taken by a peace treaty and where no signs
of cultivation or building of anyone is found, nor are they a
common land or grazing grounds of a village and did not belong
to anyone and not in the possession of anyone.

 Revival of Dead land: As a principle the ownership of a dead

land remains with the state, but he who revives any dead land
acquires the right of ownership to it. And in return of the
ownership, he will have to pay ushr levy if the land is from ushr
category and kharaj levy for kharaj land.
The main objective of giving permission to individual ownership
of the dead land is to encourage the cultivation and development
of dead land. The utilization of unused land, naturally benefits
the treasury in monetary terms by generating more revenue
through land tax.
Another concept of the revival of dead/unclaimed land is
related to the granting of land of this category by the state in
return for the ushr or kharaj. The state being the owner of the
said lands have general authority to grant them to someone in
order to bring them into cultivation and increase the revenue
from taxes. The procedure of granting unclaimed land is referred
to as iqta in legal terminology.
The purpose of revival of dead land and granting iqta is
totally economic as it is intended to bring unutilized lands for
cultivation in order to increase the agricultural production and
augment the revenue of the state.

 Sources of „fay’ revenue: The fundamental component of „fay‟

revenue comprise of kharaj. The other major components of „fay‟

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 revenue are jizyah, custom duties and other miscellaneous
sources, as briefly discussed below:
 Jizyah: The term jizyah is derived from the word „jaza‟
meaning compensation. In Islamic fiscal terminology, the
term is used for the levy taken from the non-Muslim
inhabitants of the state in lieu of the protection provided to
them. Jizyah is a financial obligation on the non-Muslims of
the state in lieu of which they are granted protection of life
and property and freedom to practice their religion. Jizyah is
not only a tribute of military defeat and political subjugation,
rather by its payment the non-Muslims enjoy protection and
other benefits from the Islamic State. Thus the aged and
destitute of non-Muslim community are granted social
security as a Muslim citizen. Abu Ubayd reports that caliph
Umar ordered taking care of aged people and destitute and
exempted them from the payment of jizyah. Jizyah is to be
taken from those who decline to embrace Islam. However,
those who are unable to pay should be exempt, and people
should be encouraged to reform and plough their land, for
tilled land adds to their happiness and reinforces their energy
to fight against enemies. The status of every individual
(among dhimmis) should be checked and to whom you find
too old and feeble to earn a living, to each of them allocate
money as is necessary, to ease their financial plight.

 Custom duties: The taxation of goods at the frontier-posts or

on a crossing a fixed boundary line has been practiced almost
since the beginning of inter-regional and international trade.
In pre-Islamic Arabia, it was customary for the market chiefs
to impose a duty of 10% on the goods brought for trading by
foreign traders in their territory. In Arabian peninsula each
tribe collected these taxes on the goods imported by the
foreign traders passing through their tribe. However, Prophet
Muhammad (SAW) after establishing the political authority
over the peninsula condemned the collection of taxes by the
tribes. The aim was therefore, to subjugate the tribes to the
political authority of Islam. However, later in the time of
caliph Umar, taxations were introduced, which were collected
at octroi posts established at the boundaries of the peninsula
to enhance international trade by avoiding undue taxations
as practiced earlier. However, the level of taxation depended
on the status of the trader and his tax paying capability.

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  Miscellaneous Sources:

# Waqf (endowment): The provision of waqf is a well known

practice in Islamic traditions. The precedents of waqf for the
benefit of the Muslims have been prevalent throughout the
Islamic history and it became a regular source of income for
the Islamic state. As the income from waqf is generally
earmarked for the specific charitable and welfare heads, the
state has no full authority over its dispensation.

# Property of a deceased with no legal heir is being transferred to

the treasury.

 Additional taxation and borrowings: So far we discussed

various sources of revenue namely kharaj, jizyah and custom
duties. Sometimes the revenues from all these heads may not
be sufficient to finance the defense, development and welfare
heads as they are linked and proportional to a certain tax-
base such as agricultural produce, and thus resulting in the
deficits. In such cases however, historically voluntary
contributions were made. Besides voluntary contributions
state treasurers resorted to public borrowing as well and the
amount was paid back as soon as the fund was available.
Public borrowing has been approved in Islam as categorically
stated by Al-Ghazali:
“One cannot deny permissions to the ruler to borrow from
the people when needs of the state so require and if it is
backed by the existing and anticipated economic conditions.
However, if the state does not anticipate future income, in
such a case public borrowing is not at all permitted.
Regarding additional taxes, Ibn Azam and Ibn Taymiyah in
making such an argument state:
“It is the duty of the rich in every society to support the
poor. If the revenue from Zakah and Fay does not suffice for
this purpose the ruler will oblige them to fulfill this
responsibility. Enough funds will be mobilized for these
(needy) people to provide them with food, clothing for summer
and winter and a house that protects them from rain and sun
and gives them privacy.”

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 Concept of kharaj taxation: Literally kharaj means lease, rent or
simple yield. In Islamic fiscal terminology, kharaj is the levy on the
land/land produce which the peasants of conquered territories pay
to the Islamic state. Kharaj is imposed in accordance with the tax
bearing capacity of the land. The factors determining the tax bearing
capacity of the land are:
 Fertility of Land.
 Type of crop.
 System of irrigation.
Thus the assessment of kharaj should vary according to the
above factors with each affecting the amount of kharaj. The fertility
of land is an important factor since by virtue of it, the production is
more or less. Since the prices of various crops vary with their nature
thus the taxes should be adjusted for that factor too. Also for the
crop that has been irrigated by manual labour cannot stand the
same rate of taxation as the land irrigated by natural means.
Furthermore, there is another factor which also needs to be adjusted
which is the distance from the market place.

Assessment of Kharaj: The kharaj is levied only on those lands

which come under the definition of kharaj land, irrespective of
whether the kharaj land is held by a dhimmi or a Muslim. Al-
Mawardi recommends any one of the following ways for the
assessment of kharaj:
 Assessment may be made on the basis of the measurement of land.
The method termed as misahah requires imposition of fixed kharaj
irrespective of whether the land is cultivated or not provided it is
cultivable.
 Assessment may be made on the basis of cultivable lands only,
leaving uncultivated land out of consideration.
 The third method of assessment is the muqasamah (proportional
kharaj) under which the kharaj may be charged as percentage of the
produce. The proportional kharaj is to be collected after the crop is
harvested.

Administration of tax collection: Islamic point of view in this

regard is against tax farming. Islamic Fiscal system recommends that
the tax be collected in a fair and transparent manner and no merging of
different heads of collection is allowed. A person of good character,
pious and trustworthy should be selected and appointed as a tax
administrator. He should be a person, who when authorized with the
collection of taxes to take what is allowed and keep away from what is

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forbidden, and will be left free to decide what to collect and what to
exempt from tax. If such a person is just and reliable, he cannot be
trusted with such discretion concerning the collection of taxes.

Principles of Taxation: Taxation policies of Islamic state are guided

by the basic ethos and principles of Islamic Shar‟iah. The principles
relating to taxation in an Islamic state are briefly explained below:

 Conditions for Imposing Taxes: The fundamental point of taxation

in Islam is that only rich and prosperous who have sufficient
resources to pay and are able to bear the main burden of taxes, are
subject to taxation.

 Defining Tax Base and Tax Rate: A defined and certain tax rate
and a clear tax base is one of the basic features of Islamic taxation
policy. This is also one of the basic canons of taxation attributed to
Adam Smith who states that the amount of taxes should be certain
and known.

 Principle of Equity: The equity criterion implies that each tax payer
should contribute his or her fair share to the cost of government.

 Flexibility in imposing of Taxes: In the Islamic system of taxation,

the rates of taxes and the tax bases are subject to change to suit the
changing circumstances in order to benefit the tax payers and
increase the revenue of the treasury.

 Economy and Convenience to tax payers and economy in tax

collection must be followed in the matter of tax collection.
 Care should be taken to avoid double taxation.

 Tax incentives: Sufficient provision for tax incentives to increase

the volumes of production and trade.

 Theory of public expenditure

Distribution function is the distribution of income and wealth to
ensure conformity to what is known as fair and just state of
distribution. A considerable amount of attention has been given to

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 this aspect of the fiscal policy in Islamic Economies. The analysis, in
a very pragmatic way, as to how the state funds have been allocated
for the achievement of certain goals such as fulfillment of needs,
welfare of the people and development of the economy. In Islam, the
fundamental point regarding principles of public expenditure is that
the public resources are like trusts in the hands of the ruler. He is
the guardian and the trustee of the public funds and is responsible
to spend them in the best interest of the people and the state in
accordance with the principles of Shar‟iah.
 Role of Bayt al-maal: The inflow of revenue from the
conquered territories required to establish a permanent office
of finance during the earlier periods of the flourishing of Islam.
A regular department of finance called diwan (commonly
known as Bayt al-maal) is being established to keep the income
from various sources and disburse it for the general welfare of
the society. Regarding this mechanism , fiscal operations are
being carried out, in general, by local units of Bayt al-maal in
their provincial branches. Revenue from each province is
applied to meet the expenses of that province. If the expenses
are less than the local income, the governor remit the balance
to the central treasury. On the other hand, if the expenses
exceed the revenues, the surplus from other provinces or
central treasury is transferred to balance the deficit.
The liabilities of Bayt al-maal has been classified by Al-
Mawardi into two categories:
 Liabilities resulting from the property kept in the bayt al-
maal as a trust for special categories of beneficiaries. This
category of liabilities of bayt al-maal is related to the
revenue from Sadaqah
 Liabilities arising with respect to the revenues which are
treasury‟s own assets like the income related to fay
revenues.
Besides the mandatory obligations of the state, public interest
(masalah) provides a permanent basis for public expenditure,
which either should be met by the state from its own assets
or otherwise financed indirectly by well-to-do inhabitants of
the state.

 Expenditure pattern: The first and the foremost factor in

determining the public expenditure is the principles of Shar‟iah. The
expenditures under various heads of expenditure is regulated by the

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principles of Shar‟iah regarding that head. The pattern is briefly
discussed below:

 The Sadaqah revenue are only for poor and the needy and
those employed to collect them and those whose hearts have
been reconciled to the truth and for those in bondage and in
debt; in the cause of Allah, and for the wayfarers. Zakah will
be collected from the rich and returned to poor.

 Ghanimah (movable war booty), like zakah, did not

constitute the asset of bayt al-maal as it is not a full state
revenue. In accordance with the general direction laid down
in the Holy Qur‟an, four fifth of ghanimah is to be distributed
among fighters and remaining one-fifth (termed as khumus),
is to be retained by the state for specific purposes.

 The Fay revenue constituted the main component of public

budget in the earlier times. Thus all types of welfare projects
and other general expenses of the state are financed through
this source.

The various heads of expenditure in the theory of public finance in

Islam are:
 Need fulfillment.
 Defence.
 Administrative services.
 Social security.
 Pension and grants.
 Education
 Development heads.

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 Islamic Banking and Islamic Investments

Concept of Banking in Islam

It is generally believed that there can be no banking system in

Islam as Interest. However, the veterans of Islam propose that a
sound system of Banking is possible in Islam which should be based
on the concept of Mudharaba. The concept of Mudharaba is a simple
system of partnership, which will work by the distribution of half
yearly profits to the account holders/customers who in fact are the
shareholders to the Bank. The bank will accept deposits from the
community both for safekeeping and profit sharing purposes. A
certain personal loans while the major portion will be utilized to meet
the credit requirements of the business and the industry.
The interest-free banks will provide credit facilities and perform
all the functions of commercial banks. Being partner in business and
industry, they will supervise the progress of work and under the
vigilance of Bank staff the chances of loss are minimized. The profit
sharing principle will provide incentive to the investors who will
invest their money in the Bank. The partners in such banks shall
have mutual gain and mutual loss whereas in the modern banking
the losses are borne by the borrowers alone and the lender always
stands to gain.
When speaking about the consumer loans, the well-to-do should
grant loans to the needy. Or the credit unions and cooperative
societies be formed as to provide interest free loans to the members.
There is a concept of nationalization of the function of financial
intermediation; however that does not suitably fit within the
principles of Shariah.

Islamic Society in its real sense is an association for the purpose

of harmonious co-existence. The actions of individuals in the Islamic
society should carry on the code of moral values and conduct.
Islamic society is thus, based upon righteousness and mutual help.
“Help ye one another unto righteousness and piety, but help ye not
one another unto sin and transgression” is the call of Qur‟an.
Since things have changed due to astounding development of
science and technology, the Muslims are confronted today with the
new problems due to the great revolution of science and technology
and thus the economic rules have taken a new direction and
demands wholesale measures to combat these hurdles. However, in

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evolving a system of banking we have to take into consideration all
the material facts like the necessity of credit etc., and the fact that
the Muslims have to deal with the non-Muslims within their own
country and outside. The various dimensions of the Fit of Islamic
banking within the present capitalistic world will be discussed in the
following sections.

Mudharaba: The basic concept on which earlier Islamic Banking

functions depended and flourished was Mudharaba. Mudharaba,
according to jurists, is a social contract whereby one gives his
property to another to carry on business therewith and the profit to
be shared between them according to the specked terms such as
one-half, one-third or so. In Mudharaba, the entire loss is always
attributed to and deductible from the capital Mudharib and thus
agent has nothing to loose except his labour. There is yet another
marked difference between Mudharaba and other kinds of
partnership; whereas all other kinds of partnership may consist of
two or more persons, Mudharaba consists of only two – one is the
financier and the other his agent. The financier invests his capital
and the agent his skill. Whereas in other partnerships each partner
is and agent of and for each other, there is no case of Mudharaba.
The capital must be surrendered to the mudharib so that he may
handle it alone (without any interference, whatsoever, from the
lender or principal). Loss, if any should be assigned to the capital,
the agent or Mudharib will not bear it, neither should Mudharib
invest anything of his own nor bear any material loss.
Now the question remains that Whether Mudharaba is
practicable or not. Mudharaba becomes impracticable as the
complexities of business increase. Say for example in case of
accepting/financing a trade bill, the credit will be allowed only if the
issuer of the bill holds 1/3rd of the bill amount in the current
account of the bank. But this is not possible because of the diversity
and complexity of the nature of International transactions.
Mudharaba is also a risky proposition as the partner may lead the
bank to other encumbrances. As explained by Pollock, such person
may bind his firm by any of the following acts:

1. He may sell any goods or personal chattels of the firm.

2. He may purchase on account of the firm any goods of any kind
necessary for or usually employed in the business carried on
by it.
3. He may borrow money on credit of the firm.

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 4. He may, for the purpose, pledge any goods or personal chattels
belonging to the firm.

Due to these and other limitations, Mudharaba is of a limited

scope and risky proposition for banking. But if Mudharaba is not a
universal solution to Islamic Banking then what is? To answer this
question let us have a look at the Islamic Laws relating to Loan
transactions, Pledge, Lien and other things which are explained in
the following section.

Islamic law relating to Loan: Let us briefly analyse what Qur‟an

says about the loan transactions:

“O ye who believe! When ye deal, one with another, in lending for a

fixed term, reduce it to writing. Let a scribe write down faithfully as
between the parties: let not the scribe refuse to write: as Allah has
taught him, so let him write. Let him who incurs the liability dictate,
but let him fear his Lord Allah, and not diminish aught of what he
owes. If the party liable is mentally deficient, or weak, or unable
himself to dictate, let his guardian dictate faithfully, and get two
witnesses, out of your own men, and if there are not two men, then a
men and two women, such as ye choose, for witness should not refuse
when they are called for evidence. Disdain not to reduce to writing for
your future period, whether it be small or big: it is jester in the sight of
Allah, more suitable as evidence, and more convenient to prevent
doubts among yourselves but if it be transaction which ye carry out on
the spot among yourselves, there is no blame on you if ye make a
commercial contract; and let neither scribe nor witness suffer harm. If
ye do (such harm), it would be wickedness in you. So fear Allah; for it
is Allah that teaches you. And Allah is well acquainted with all
things.”

The motive of this text is to explain that lending is allowed both in

spot and in future, for fixed term and on demand. The first part of
the text deals with the transactions involving future payment and
the second part with transactions in which payment and delivery are
made on the spot.
As narrated by Ibn Abbas, while Riba (usury or interest) is
prohibited, salam which is in fact a short term loan is allowed. Such
transactions may be of two types Salaf and Qard.
The word Salaf literally means a loan which draws forth no profit for
the credit. In its wide sense it includes loans for specified periods

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(short, intermediate and long term loans). But if it is immediately to
be paid it is called Qard or loan payable on demand. This is in fact, a
particular type of Salaf. Lending and borrowing, are indeed,
unavoidable in this worldly life, and, therefore, permissible in Islam.
To sum up, it will be appropriate to say that loan under Islamic
law is permissible, and may be classified into Salaf and Qard, the
former being for a fixed time and the latter on demand. And every
loan that draws forth or stipulates profit is unlawful. For this
purpose it is necessary for us to understand the nature of
unlawfulness-which in fact is Riba.

Riba: The word Riba literally means „increase‟ or „excess‟. As an

excess over the principal is Riba, it covers usury and interest both.
Therefore, it cannot be contended that Riba applies to usury or
lending of money at an exorbitant rate which is cruel, while interest
at a low rate is allowed, nor can there be any distinction between the
interest for productive purposes and the interest for non-productive
purposes. There are two kinds of Riba:

 Nasia which means delay granted to the debtor. It is used in

this sense because the creditor, so to say, overlooks the delay
in payment of the debt in consideration for something in excess
over the principal.
 Fadhal signifies the excess charged in the exchange or sale of
things of homogenous nature of the same species.

Considered from the legal point of view, while Nasia relates to the
excess charged in loan transactions, Fadhal relates to the excess
charged in sale transactions. While Nasia is forbidden, Fadhal is
prohibited. The adverse effects of Riba can suitably be explained with
the help of an example. Suppose an amount is advanced as loan for
a fixed time, then the creditor continues adding to it, and for each
delay in payment of debt, a further additions are being made, to the
extent that the whole property of the debtor is consumed by a small
amount of a loan, and often so happened that the debtor payment of
the debt went on extending time on a promise to the creditor, of
something more towards interest which ultimately resulted in his
complete ruin. This is destructive to the society and thus forbidden.

Loans and Securities: Banks borrow and lend again and very
lender must have a lively regard to the chances of repayment since
no lender from the earliest times has been content to rely upon mere

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words to borrower to pay, but has demanded some tangible security
to which he could have a recourse in the event of failure by the
borrower to fulfill his obligations. Islam is not repellant to the idea
and has laid down some broad principles in this regard.
According to Islamic law, pledge is a security for the satisfaction
of debt if the debtor failed to repay it and whatever validity forms the
subject of sale may be given as a security. However, if pledge
consists of an object, which needs maintenance such as animal, the
pledge can benefit by it for what he spends towards its maintenance.
The permission of the pledger is not needed in the case. Otherwise in
cases in which security consists of objects which do not need
maintenance, permission is needed from the pledger to derive
benefits from such security.

Lien: Apart from pledge, the Islamic Bank has the right of lien i.e.,
right to retain the property belonging to another possessor lien,
which may be permissible under Islamic law on the analogy of a
seller who has been invested with the right to retain the property,
sold by him, in his possession, until its price is paid to him.

Mortgage: Mortgage has no place in Islamic Law as interest only in

the property is transferred to the Mortgagee and not possession.

Discounting: Depending upon the nature and amount of discount

on the bill, discounting in certain cases has been suspected as Riba.
The loan that draws forth or stipulates profit is Riba. Thus in case of
Discounting, it has been agreed that if the Bank discounts the bill to
the extent of its service charges only, the discount in that case does
not account to Riba.

Islamic Bank: According to Islamic law, partnerships are of

various kinds but one best to the purpose of banking is a
partnership whereby two or more persons join in business, each of
them being an agent for the other. The capital is not necessarily to
be shared equally and profit to be distributed according to the terms
agreed upon between them. Under the principle of what is not
forbidden is permissible, an Islamic Bank may be a company, an
association or a concern owned by an individual.

Central Bank of the Muslim State: Bayt al-maal is often spoken

as the Central Bank of the Muslim State but it is entirely concerned
with the public finance, its collection and expenditure. Each Muslim

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State, shall have to establish a Central Bank to act as its fiscal agent
and the custodian of treasury funds. It will control the credit by
acting on the system of special deposits as introduced by the Bank of
England, (but these deposits will not earn any interest for the
depositoe banks), and alteration in the reserve requirements. Besides
note issue and control of currency it will act as the depository of the
banks and the lender of the last resort. Regarding the International
transactions, if Banks, on their foreign account or accounts with the
foreign correspondent banks, earn interest on these deposits, they in
such a case must have a reserve to be given to the poor and needy to
save them from starvation. The Central Bank shall keep an account
of this amount and, if necessary, hold it as its own reserve for
charitable purposes.

Muslim World Bank: For the establishment of interest free

banking, there must be a Muslim World Bank on the lines of World
Bank. The Central Banks of Muslim States may on behalf of their
Government have a share in the Equity of the Muslim World Bank.
There can also be an establishment of a Dinar zone, the same
pattern as Euro zone.
As to the method of investment, priority must be given to the
development of natural resources in which a Muslim State is in an
advantageous position over their counterparts. This will pave way for
economic internationalism, which, as opposed to economic
nationalism (a potent cause shall contribute largely to the peace and
prosperity of the World).
The establishment of such institutions will not only develop the
resources of the Islamic State but also unite them together in close
cooperation and mutual help which itself negates the idea of Riba.

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 Islamic Investments
Islamic Investments: Central to Islamic banking and finance is an
understanding of the importance of risk sharing as part of raising
capital and the avoidance of riba (usury) and gharar (risk or
uncertainty).

Islamic law views lending with interest payments as a

relationship that favors the lender, who charges interest at the
expense of the borrower. Because Islamic law views money as a
measuring tool for value and not an "asset" in itself, it requires that
one should not be able to receive income from money (for example,
interest or anything that has the genus of money) alone.

Deemed riba (literally an increase or growth), such practice is

proscribed under Islamic law ( haram, which means prohibited), as it
is considered usurious and exploitative. By contrast, Islamic banking
exists to further the socio-economic goals of Islam.

Accordingly, Shari'ah-compliant finance ( halal, which means

permitted) consists of profit banking in which the financial
institution shares in the profit and loss of the enterprise that it
underwrites. Of equal importance is the concept of gharar. Defined
as risk or uncertainty, in a financial context it refers to the sale of
items whose existence is not certain. Examples of gharar would be
forms of insurance, such as the purchase of premiums to insure
against something that may or may not occur, or derivatives used to
hedge against possible outcomes.

The equity financing of companies is permissible, as long as

those companies are not engaged in restricted types of business--
such as the production of alcohol, pornography or weaponry--and
only certain financial ratios meet specified guidelines.

Below is a brief overview of permissible financing arrangements

often encountered in Islamic finance:

 Profit-and-loss sharing contracts ( mudarabah). The Islamic

bank pools investors' money and assumes a share of the profits
and losses. This is agreed upon with the depositors. What does
the bank invest in? A group of mutual funds screened for

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 Shari'ah compliance has arisen. The filter parses company
balance sheets to determine whether any sources of income to
the corporation are prohibited (for example, if the company is
holding too much debt) or if the company is engaged in
prohibited lines of business.
 In addition to actively managed mutual funds, passive ones
exist as well, based on such indexes as the Dow Jones Islamic
Market Index and the FTSE Global Islamic Index.
 Partnership and joint stock ownership ( musharakah). Some
structures are most common:

Declining-Balance Shared Equity: Commonly used to finance a

home purchase, the declining balance method calls for the bank and
the investor to purchase the home jointly, with the institutional
investor gradually transferring its portion of the equity in the home
to the individual homeowner, whose payments constitute the
homeowner's equity.

Lease-to-Own: This arrangement is similar to the declining balance

described above, except that the financial institution puts up most, if
not all, of the money for the house and agrees on arrangements with
the homeowner to sell the house to him at the end of a fixed term. A
portion of every payment goes toward the lease and the balance
toward the purchase price of the home.

Installment (Cost-Plus) Sale ( murabaha): This is an action where

an intermediary buys the home with free and clear title to it. The
intermediary investor then agrees on a sale price with the
prospective buyer; this price includes some profit. The purchase may
be made outright (lump sum) or through a series of deferred
(installment) payments. This credit sale is an acceptable form of
finance and is not to be confused with an interest-bearing loan.

Leasing ( 'ijarah/'ijar): The sale of the right to use an object (

usufruct) for a specific time period. One condition is that the lessor
must own the leased object for the duration of the lease. A variation
on the lease, 'ijarah wa 'iqtina provides for a lease to be written
whereby the lessor agrees to sell the leased object at the lease's end
at a predetermined residual value. Only the lessor is bound by this
promise. The lessee, by contrast, is not obligated to purchase the
item.

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Islamic Forwards ( salam and 'istisna): These are rare forms of
financing, used for certain types of business. These are an exception
to gharar. The price for the item is prepaid, and the item is delivered
at a definite point in the future. Because there is a host of conditions
to be met to render such contracts valid, the help of an Islamic legal
adviser is usually required.

Basic Investment Vehicles

Here are some permissible types of investment for Islamic

investing:

Equities. Shari'ah law allows investment in company shares

(common stock) as long as those companies do not engage in
lending, gambling or the production of alcohol, tobacco, weaponry or
pornography. Investment in companies may be in shares or by direct
investment (private equity).

Islamic scholars have made some concessions on permissible

companies, as most use debt either to address liquidity shortages
(they borrow) or to invest excess cash (interest-bearing instruments).
One set of filters excludes companies that hold interest-bearing debt,
receive interest or other impure income, or trade debts for more than
their face values.

A further distillation of the aforementioned screens would exclude

companies whose debt/total asset ratio equals or exceeds 33 per
cent; companies with "impure plus nonoperating interest income"
revenue equal to or greater than 5 per cent, or companies whose
accounts receivable/total assets equal or exceed 45 per cent or more.

Fixed-Income Funds

 Retirement Investments. Retirees who want their

investments to comply with the tenets of Islam face a dilemma
in that fixed-income investments include riba, which is
forbidden. Therefore, specific types of investment in real estate,
either directly or in securitized fashion (a diversified real estate
fund), could provide steady retirement income while not
running afoul of Shari'ah law.
 Sukuk. In a typical ijara sukuk (leasing bond-equivalent), the
issuer will sell the financial certificate to an investor group,

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 which will own them before renting them back to the issuer in
exchange for a predetermined rental return. Like the interest
rate on a conventional bond, the rental return may be a fixed
or floating rate pegged to a benchmark, such as LIBOR.

The issuer makes a binding promise to buy back the bonds at

a future date at par value. Special purpose vehicles (SPV) are
often set up to act as intermediaries in the transaction. A
sukuk may be a new borrowing, or it may be the Shari'ah-
compliant replacement of a conventional bond issue.

The issue may even enjoy liquidity through listing on local,

regional or global exchanges, according to an article in CFA
Magazine titled "Islamic Finance: How New Practitioners of
Islamic Finance are Mixing Theology and Modern Investment
Theory" (2005).

Basic Insurance Vehicles

Traditional insurance is not permitted as a means of risk

management in Islamic law. This is because it constitutes the
purchase of something with an uncertain outcome (form of ghirar),
and because insurers use fixed income--a form of riba--as part of
their portfolio management process to satisfy liabilities.

A possible Shari'ah-compliant alternative is cooperative (mutual)

insurance. Subscribers contribute to a pool of funds, which are
invested in a Shari'ah-compliant manner. Funds are withdrawn from
the pool to satisfy claims, and unclaimed profits are distributed
among policy holders. Such a structure exists infrequently, so
Muslims may avail themselves of existing insurance vehicles if
needed or required.

Conclusion

Islamic finance is a centuries-old practice that is gaining

recognition throughout the world and whose ethical nature is even
drawing the interest of non-Muslims. Given the increased wealth in
Muslim nations, expect this field to undergo an even more rapid
evolution as it continues to address the challenges of reconciling the
disparate worlds of theology and modern portfolio theory.

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