Islamic Finance Principles

       The Shariah governs all aspects of an individual’s life from matters of state, such as governance and foreign relations, to issues of daily living and financial transactions. It is the set of rules and principles that Muslims believe expresses God’s guidance on the way individuals should lead their lives. The Shariah is derived from two primary sources, the Quran and the Sunnah. The Quran, Muslims believe, is the word of God revealed to the Prophet Muhammad (570-632 AD). The Sunnah is the recorded collection of the sayings and practices of the Prophet Muhammad. Specific rulings are derived from these sources to create a body of law known as Fiqh. A number of accepted schools of interpretation have emerged in Islam that differ in their methodology for deriving Fiqh.

       The Shariah lays down general and specific principles which govern how financial transactions should be conducted. Some of the general principles are discussed below.

Interest (Riba)

       The Shariah prohibits Riba in transactions. Linguistically, the word Riba means “increase”. In a commercial context, the Shariah concept of Riba is similar to the payment of interest in conventional financings. Riba occurs when money is lent and paid back with interest, whether fixed or floating. It also occurs when money or currency is exchanged in unequal amounts (Riba al-fadl) or in equal amounts with one or both payments deferred (Riba al-nasia). In principle, the Shariah requires that returns on capital must be linked to the success of a business venture rather than emanating from the mere act of lending money.

Uncertainty (Gharar)

       Agreements that contain a material degree of uncertainty are not recognised as valid under the Shariah. It would not be acceptable to enter into a sale agreement, for example, where the existence or material characteristics of the assets are unknown. Therefore, care should be taken when drafting documentation to ensure that there is certainty of the relevant subject matter and any relevant payment obligations. If these foundational elements are not determined in advance, the transaction would not usually be approved as Shariah compliant.

Speculation (Maisir)

       Transactions that rely on mere chance are not permitted under the Shariah. Returns from a business venture should result from the efforts of the parties to a transaction. On account of this prohibition, certain types of derivatives such as futures and options that are employed for speculative returns are prohibited. Returns on capital must be linked to the success of a business venture.

Prohibited investments (Haram)

       In addition to giving guidance on how a transaction should be structured, the Shariah stipulates that the nature of the underlying investment must also be acceptable from a Shariah perspective. Capital therefore, cannot be used to promote unlawful investments. Investments in the alcohol trade, armaments and gambling are some examples of prohibited investments.

Risk taking (Mukhatarah)

       As the Shariah prohibits the guarantee of a fixed return on an investment, the parties must assume some risk in a transaction. Notwithstanding this limitation, taking security over assets is not prohibited, as this is viewed as a prudent means to guard against a contractual breach, wilful wrongdoing or negligence by any of the contracting parties.

Source: http://www.simmons-simmons.com/docs/an_introduction_to_islamic_finance.pdf

 

Understanding Islamic Finance

       As a complete way of life, Islam has instituted a comprehensive regulatory framework to guide humanity on the best way to conduct its relationships and behavior within a diverse and developing social setting. These relationships of human behavior are centered around three different levels:

  • Relationship with The Creator, Allah
  • Relationship with One’s Self
  • Relationship with the Outside World (People and Creatures)

       In Sharia’h (Islamic law), there are well-defined and compact set of rules laid down through divine revelation in the Holy Quran and the Sunnah of the Messenger of Allah (peace and blessings of Allah be upon him) which were expounded upon by several renowned Muslim scholars throughout the ages. These rules describe in great detail what is permissible (Halal) from what is not permissible (Haram) for each of the above three behavioral relationships and within the norms of human intentions and actions.

       It is of significance to point out that jurists in Islam have recognized two broad sets by which the issuing of religious rules (Ahkam) are carefully considered. The first deals with all activities related to worship (Ibadaat) which covers the first two relationships. The second deals with human behavior with others (Muamalat) covering the third relationship. It is important to note here that these two sets have totally opposite structures when it comes to the Fiqhi rulings related to the activities performed under them.

       For example, under Ibadaat, all modes of worship are forbidden except what Allah and His Prophet have evidently ordained to be performed as a mode of worship. Conversely, the reverse is true for the set of Muamalat, i.e. all modes of business transactions are naturally permissible except what Allah and His Prophet have evidently forbidden. Since Islamic finance is categorized under Muamalat, it can be seen that there is enormous difference in the derivation of these rules under each set.

       For example, under Muamalat all types of business transactions are permissible except what has been clearly barred by Sharia’h. Consequently, one could easily come to recognize if something is Halal or Haram by first identifying to which set it belongs. If an activity belongs to the set of Muamalat, then it is clear that it will be Halal by nature unless there is an unambiguous Hokum to prohibit it. Conversely, the same rule is true for the set of Ibadaat i.e. any worshipping activity will be haram by nature unless there is an unambiguous Hokum that allows it. This is a very useful and powerful tool and overview of Fiqh that makes the classification of Usool-al-Fiqh much clearer to the learner. The same will of course apply to all the other variants / shades of Halal and Haram (e.g. Mustahab, Makrooh and Mandoob).

       In Figure-1 below, Islamic Fiqh is summed up by the two circles showing the nature and significance of the original bases of which all the Fiqhi Rules (Ahkam) and their relationship under the various jurisdictions – those related to Muamalat and Ibadaat. The smaller circle inside each of the large circles places everything permissible (or not permissible) respectively and puts them into unique perspectives.

 

 

       Islamic finance is only one of many inseparable components within the Sharia’h (e.g. Islamic economics) that aim at regulating the conduct of humanity in relation to its daily business affairs. All the other components under the Sharia’h – once implemented together—make-up the complete socioeconomic system that is envisioned by Islam and which aims at shaping the three primordial relationships with a view to achieving Falah (salvation) in this life (Dunya) and in the next (Akhira).

       Islamic economics has some distinct features when compared to the conventional economic systems (socialist or capitalist). For example, it considers the ownership of private property as constituting a sacred right to be protected and safeguarded at all times provided the responsibility towards the vulnerable and weak members of the society is regularly upheld and the rightful dues accrued to the poor segment within the society are adequately distribuited (Zakat). Also, any financial dealings must shun all types of uncertainties and / or indetermination (Gharar) such as gambling is prohibited in Islam). Equally so, any shade of interest (Riba) is prohibited in business transactions. Cooperation is frequently preferred over competition as the Islamic economic system is anchored on the concept of Amanah: that is all members of humanity will be held accountable for all of its actions to The Creator, Almighty Allah – Who Is The Real Possessor of All Things.

       In establishing the right balance in a given Muslim society, Islam sanctions that social gains take the upper hand over private benefits (La Darar wa La Dirar is one famous Fiqhi ruling). This is a key economic policy imperative with critical consequences on the practice of any economic activity that is not considered as sustainable and hence may adversely affect (Fasad) the environment. Also justice is established in the Sharia’h by rejecting any forms of exploitation but at the same time enabling a conducive business environment that promotes basic needs fulfillment for the needy while simultaneously protecting social cohesion for all (Maslaha).

       The key principle for the development of any Islamic enterprise rests on the basis of profit-and-loss sharing. Islam is disinterested in charging interest on loans whereas keen on the successful outcome of a given concern or enterprise. While in conventional finance, interest-bearing loans are common, it is disinterested in the outcome of the enterprise. i.e. loans must be repaid irrespective of the outcomes of a given venture or enterprise (Profit or Loss).

       Islamic finance is very much concerned with the promotion of the production of useful goods and services and also with the exchange of these goods among members of the society. In doing so, Islamic finance aims at promoting equity and discouraging debt. Money is only permitted to be exchanged for either the production of new goods / services, the procurement of finished goods / services or for acquiring assets and services. Money is not permitted to be exchanged for its own sake without being backed up by an equivalent value of goods (through the flow of the production of goods and services i.e. money is only a medium to command goods). One of the most important characteristics of Islamic finance is that it is an asset-backed type of financing whereas the conventional financing system predominately deals in money and papers (detached from the real flow of goods or assets in the physical economy). This is why money in Islam has no intrinsic utility as it is only to be used as a medium of exchange for the creation, sale or lease (as the case maybe) of Halal goods and services that generate income and employment to the members of the society and help them achieve Falah in this life (Now) and also in the Next. Sharia’h, therefore, gives the right only to those who accept the responsibility of the ownership of an asset to reap the profits or realize any increase in the value accrued to that asset (i.e. a return on financing can only be claimed on the basis of ownership of the asset). In Islam, lending is an act of benevolence which does not entitle the creditor to any return because he/she is not the owner of the lent resources whose payment is guaranteed by the debtor (borrower). All exchange relationships which postpone either the payment of the price or the delivery of the goods and services fulfill the fundamental function of financing (i.e. facilitating the ownership of such resources which was not possible before the financial transaction).

 

A Brief on Some Terms

 

Riba:
       The word Riba in Arabic, means “in excess of” or “a surplus” or “in addition to”, which in Sharia’h implies a compensation without any due justification or reasonable consideration. Riba (agreed by the majority of Muslim scholars represents the taking of conventional interest on loans – be these loans for production or for consumption purposes) and is wholly prohibited in Islam.

       The rationale for the prohibition is that a reward is being claimed when no ownership of the asset exists or when no efforts are made (as against the efforts made in trade exchange or investment ventures) so as to justify a reward. The usurer is in fact ‘selling time’ to the borrower when time cannot be owned by anyone except Allah. In this sense, usury is one of the greatest sins (Haram) not only in Islam but in all the previous Abrahamic faiths as well (i.e. usury was strongly discouraged in Judaism and in Christianity).

       There are different types of Riba possibilities. Two major types of Riba are: (1) Riba Al-Fadl and (2) Riba Al-Naseeah. Riba-Al-Fadl is when there is an exchange of certain commodities whereby one commodity of the same quality and type is exchanged for more (or less) amounts of quantity of the same type and whereby an unjustified surplus is realized without due consideration or delivery at different time periods. This is clearly prohibited in accordance with the well-known hadith of the Messenger of Allah, Narrated by Ibn `Umar: – “The Prophet said, “The selling of wheat for wheat is Riba (usury) except if it is handed from hand to hand and equal in amount. Similarly the selling of barley for barley, is Riba except if it is from hand to hand and equal in amount, and dates for dates is Riba except if it is from hand to hand and equal in amount.” Also narrated `Umar bin Al−Khattab: Allah’s Apostle said, “The bartering of gold for silver is Riba, except if it is from hand to hand and equal in amount, and wheat grain for wheat grain is usury except if it is from hand to hand and equal in amount, and dates for dates is usury except if it is from hand to hand and equal in amount, and barley for barley is usury except if it is from hand to hand and equal in amount.”

       Riba Al-Naseeah is defined as a case where a loan matures but the borrower cannot for some reason fulfill the obligations under the loan i.e. make payment / settlement of the loan to the lender as agreed at the time of the loan. In this case, the lender / creditor extends the period of the loan by compounding the interest payments on the loan against the extra period of time that was granted for repayment. This is the most common practice of Riba and is strongly prohibited in Islam. The Holy Qur’an clearly states:
       – { But Allah Has Permitted Trade and Prohibited Usury }- (2:275)
       – { If the Debtor is in a difficulty, Grant him time till it is easy for him to repay }- (2:280)
       Islam has permitted many forms and modes applicable to financing. For example, Mudarabah, Musharakha, Murabah and Qard Hasan are the major modes practiced by many Islamic banks worldwide including the Islamic Development Bank Group. The following brief description of the different major modes of Islamic financing gives an introductory summary. A comparative analysis of the key differences between Islamic and conventional modes of finance is given in Table-1.

Mudarabah:
       This is a contractual agreement between two parties: an owner of capital (Rabb Al-Mal) and a manager of investment (Mudarib). Profit is distributed between the two parties in accordance to a ratio that both agree upon at the time of the contract signature. In the case of any loss, the whole loss is borne by the owner of capital (Rabb Al-Mal) alone. The investor (the Mudarib) loses his / her time spent on the venture as the opportunity cost of the labor exerted and time spent that failed to generate income.

Musharakah:
       Musharakah contract is similar to Mudarabah except that in this case both parties engage in the provision of capital and also management of the investment portfolio. Profit, if any, is distributed in accordance with the agreed ratios. However, in case of loss, it must be borne in accordance with the capital ratio provided by each in the investment.

Murabaha:
       In this most common mode of financing, the client makes an order to the Bank to purchase a good or commodity at an agreed price to be repaid over time. The difference between the cash price and the deferred payment price is the mark up or profit margin realized by the Islamic Bank. The buyer maintains ownership of the asset. All short and long term trade financing activaties are also under this mode of finance.

Ijarah:
       The usufruct (say for a machine or a plant) is rented out / sold at an agreed price for a period of time to be agreed by the parties involved in the contract. The lesser in this case, unlike in Murabaha, still maintains the ownership of the asset with all the rights and responsibilities that go with ownership.

Istisnaa:
       This is a contract in which one party requires specific goods to be made / produced which may not necessarily exist. The parties agree on the description of the goods, the delivery date, the price and term to be paid. Deferred payment is permissible under this mode as well.

Sal’am:
       This is a special type of finance in which the price is paid in full at the time of the agreement but the delivery of the goods is made at a future date according to certain specific description and quality of the goods. It is mainly practiced in trading agricultural produce.

Qard Hasan:
       A loan free of interest to be paid over a period of time which could vary in the number of years. The loan bears a small service charge to cover any administrative cost towards processing the loan.

 Table-1 Key Differences Between Islamic and Conventional Financing

 

Main Characteristics:

(Structure & Process)

Conventional

Islamic

Functions And Operations Are Guided By…

Secular Law

The Shari’ah

Door Is Open To Muslims And Non-Muslims…

Yes (But Issue Of Riba With Muslims Only)

Yes (But No Issue With Non-Muslims)

Deposit-Taking From Savers…

Yes

Yes

Money Functions As A…

Commodity / Source of Profits

Means For Trade And Production

Time Value Is The Sole Basis For Reward…

Yes

Time Value Is Rewarded Only When Real Value Is Generated

Guarantee Of Capital/Principle Amount…

Yes

No

Financing Modes Are…

Debt-Backed

Backed By Economic Activities

In Case Of Default Or Late Payment /Early Withdrawal…

Penalty 

No Penalty

Reward For Parting With Funds…

Fixed/Pre-Determined (With Main Motive Of Profit-Maximization)

Not Determined (Fixed or Floating)

Profit Generation…

Not Necessarily Real Assets (Paper/Credit Speculation/Derivatives)

Based On Real (Physical) Economic Activities

Scope Of Operations…

Mixture Of Halal, Non-Halal Or All Non-Halal

Halal Activities Only

Profit Distribution…

Fixed/Pre-Determined Even When A Loss Is Realized

On Agreed Profit Ratios And Only When A Profit Is Realized

Longer Term Reward Is Higher Than Shorter Term Reward…

The Rate Of Interest Is Higher The Longer The Period

The Profit Share Is Generally Higher The Longer The Investment Period

Risk Sharing…

Bank Bears Risks And Takes All The Reward

Bank And Depositors Share The Risks And The Rewards

Social Responsibility…

Income / Wealth Tax – Charity Is Not Mandatory

Zakah / Sadaqat Mandatory

Executive Pay/Bonuses…

Excessive Lump Sums Paid (Even If Performance Is Low)

Pay Is Subject To Good Performance

       (Allah Knows Best and Peace and Blessings of Allah on His Last Messenger and his family and Companions, amin.)

       والله أعلم، وصلى الله على سيدنا محمد وعلى آله وصحبه ومن اتبعهم باحسان الى يوم الدين آمين

 

References:

 

•  كتاب مقاصد الشريعة للعلامة الشيخ محمد الطاهر ابن عاشور    

 

•  Principles of Islamic Financing IRTI Research Paper #16 (1992) Monzer Kahf and Tariqullah Khan

 

•  Islamization of Knowledge in Economics: Issues and Agenda (1998) Zubair Hasan

 

•  Methodology of Economics: Secular versus Islamic  (2008) Waleed Addas

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