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Annex 4.2. Islamic Financial Institutions and Instruments
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4.248. This annex describes how Islamic financial institutions operate under the Islamic
principles (Shari’a) and how they differ from conventional financial institutions. For the
purpose of compiling monetary statistics, various types of Islamic financial instruments are
discussed in comparison to those of conventional financial institutions. This subject warrants
special discussion due to the increasing number of countries that have Islamic financial
institutions and the growing numbers of Islamic financial institutions in some countries.
4.249. Islamic financial system refers to a financial system or financial activity that follows
the principles of Shari’a. Sharî’a, which denotes the Islamic law that governs the entire
framework of activities in Islam, includes law regulating economic and financial activities in
order to ensure fair transactions and economic justice. Even though Shari’a principles have
existed throughout the Islamic history, the application of Shari’a principles in modern Islamic
financial system began only in the last quarter of 20
th
century, with the formation of Islamic
Development Bank (IDB) in 1973.
4.250. The Islamic financial regulatory bodies such as the Accounting and Auditing
Organization for Islamic Financial Institutions (AAOIFI)
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and the Islamic Financial Services
Board (IFSB) have made efforts to develop regulatory framework and accounting standards
for Islamic financial institutions which include capital adequacy and risk management
framework, as well as in accounting, auditing, corporate governance, Shari’a, and ethical
standards. These efforts are aimed at ensuring a safe and sound Islamic financial system
(Shari’a compliance) and to effectively integrate and harmonize the Islamic financial system
and practices within the international financial system.
4.251. Although both Islamic and conventional financial institutions are for-profit entities,
their philosophy and operations are different in that for Islamic financial institutions Shari’a
prohibits financial transactions associated with: (i) pre-determined interest (Riba) for lending
and borrowing; (ii) uncertainty (Al-Gharar)—no contracts or contingents on the occurrence or
non-occurrence of an uncertain future event; (iii) speculation (Al-Maisir)—conversely, trading
or transactions entailing a chance of gain or risk of loss are allowed. Commercial trade and
investment for profit are acceptable and encouraged. Islamic financial institutions use either
trading models or profit and loss sharing models in financing customer’s needs, participate in
investments that meet Shari’a principles, and earn fees for services rendered. For example,
Islamic financial institutions offer investors /depositors participation in risk-bearing, open-
ended, mutual fund-type packages rather than fixed interest on deposits. In addition, Shari’a
also prohibits financial transactions associated with businesses that produce goods and
services considered contrary to its principles, like tobacco, alcohol, gambling, vulgar
entertainment, etc.
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This annex draws on Zubair Iqbal and Abbas Mirakhor, Islamic Banking (Washington: International Monetary
Fund, 1987); and Muhammad Hanif, Islamic Banking, Theory and Practice (2
nd
edition, 2012).
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The AAOIFI is a self-regulatory international autonomous non-profit organization that was established in 1991
in Bahrain. The IFSB, which is based in Kuala Lumpur, was officially inaugurated on November 3, 2002, and
started operations on March 10, 2003.