Islamic Financial System, Based on the Elements of a Financial System

What does an Islamic financial system look like ? In order to describe the characteristics of an Islamic financial system, we divide the description based on the elements of a financial system.

Islamic Financial System : Banks

Islamic banks operate under the principle of sharia, in which its main characteristics is the total prohibition of interest. Thus, Islamic banks are required to establish their deposit and lending system mainly based on equity-participation basis.

The end product would be almost like mutual-fund system in which the depositors lose when the banks loses, and the banks (as lenders) loses when their borrower loses. For more description of Islamic banks in Islamic financial system, refer to another post here.

Islamic Financial System : Primary Markets

It is unanimously believed that although Islamic financial system differs from western ones, it still needs to have a functioning primary markets for corporate securities.

In other words, a stock market where people trade corporate stocks is an absolute necessity. However, an Islamic stock market is projected to be a market where the investments are made on the basis of the company’s profit prospects. In this case, the profit rates in the stock fully reflect the efficiencies between firms and are not distorted by market imperfections.

No distortion means that there is nobody who exploit the market price differences and invest their money speculatively without considering the future prospects of the company itself. This sounds like a new perfect market utopia, but some of the characteristics are actually present in the western style of “efficient market” concept.

Islamic Financial System : Secondary Markets

One key difference between the conventional secondary market and Islamic secondary market concept is that in Islamic secondary market, it is argued that the central bank has to take the important role of the market dealer (the one who manages and settles transactions).

Or, if not the central bank itself, the central bank must provide the financing needed to the market dealer. This is different from the traditional system which the commercial banks are the ones who support the dealer’s financials.

Islamic Financial System : Money Markets

Key concept of money market in Islamic financial system is that the market arranges so that the surplus funds of one financial institutions are channeled to fund profitable projects of another under profit-sharing mechanism.

Since the investment portfolios of the Islamic banks will much likely contain equity positions, it’s also possible that these equity holdings can be offered in the money market in exchange for liquidity.

But a sharia-compliant mechanism must be established, since there is a profoundly similar transactions in conventional system, i.e. the repo transaction, which also trades equity shares for liquidity.

However, since this is in substance a loan (and the equity only act as collateral), this is not permitted under Sharia rule.

Islamic Financial System : Monetary Policy

The chief role of monetary policy in Islamic system is to promote and regulate the financial institutions to facilitate efficient mobilization of savings and allocate resources.

The central bank will act as the primary upholder of this role, as the prime monetary policy maker.

For more description of central bank in Islamic financial system, refer to another post here.

References

  • Monetary Management in an Islamic Economy. 1994. JKAU: Islamic Econ., Vol. 6 pp. 3-21.

Islamic Financial System, Based on the Elements of a Financial System, articles by rifqilazio

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