TOPIC 6 Islamic Banking and Finance

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This topic reviews some basic concepts of Islamic banking and finance. It deals with riba and commercial contracts. This topic helps us to understand/justify the need for IBF. Coverage include:

Riba: Definition, Evidence, Types Issues on Riba: Misconceptions & Rationales Financial contracts in Islam

RIBA: DEFINITION, EVIDENCE & TYPES

Riba - Definition
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Literally excess, increase, expansion, growth Technically every excess in return of which no reward or equivalent counter-value is paid a predetermined excess or surplus over and above the loan received by the creditor conditionally in relation to a specified time period A forced increase in value in the amount being loaned out Premium that must be paid by borrower to lender along with the principal amount as a condition for the loan or for an extension in its maturity

Riba - Definition
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During pre-Islamic days (jahiliyyah):

Lending out money for a specified time and received from him a fixed amount of money every month as interest

Modern jahiliyyah:
Lending out money to another on a condition that after a certain time it would charge a fixed amount in addition to the principal Addition with no additional labor but due to time for which the principal has been borrowed

3 elements of riba:
Excess/surplus over and above the loaned capital Determination of the surplus according to time Bargain to be conditional on the payment of the pre-determined surplus

Prohibition of Riba: Evidence

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Besides Quran, other earlier scriptures had also prohibited usury

Bible: Lend, hoping for nothing again in Luke Aristotle: A piece of money cannot beget another piece Thomas Aquinas: To take usury for money lent is unjust in itself, because this is to sale what does not exist

Al-Quran on prohibiting riba: al-Rum verse 39, al-Nisa: 161, al-Imran: 130, al-Baqarah: 275-281. For example:
(2:275) they say, trade is like riba, but Allah has permitted trade and prohibited riba beware of the war on the part of Allah and His Apostle

Various sunnah on prohibition of riba, severity of its sin and its form. An example:
The Prophet of Allah s.a.w. cursed the receiver and the payer of riba, the one who records it and the two witnesses to the transaction and said: they are alike (in guilt)

Prohibition of Riba: Evidence

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All jurists agree that riba is prohibited (haram) Prohibition of riba comes in stages:
Stage 1: Stress the fact that riba does not increase individual/national health, but on the other hand it decreases wealth (al-Quran, 30:39) Stage 2: Warning if not obeying the injunction (al-Quran, 4:161) Stage 3: Muslims are told not to take compound interest if they want real success in life (al-Quran, 3:130) Stage 4: Distinguish between trade and riba. Believers should refrain from interest or they will suffer both in this world and in the hereafter (al-Quran: 2;275-276) Stage 5: Clear prohibition of interest and declared it as unlawful in muslim society (al-Quran, 2:278-281)

Types of Riba
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1. Riba al-Qard (debt) riba an-nasiah

As being highlighted in Quran, thus also known as riba al-Quran Root word nasaa means postponement meaning to defer, to wait Time that is allowed for the borrower to repay the loan in return for the premium Debt resulting from loan contract or from a deferred payment sale Fixing in advance of a positive return; any amount over & above principal Common in conventional banking products

2. Riba al-Bay (sale) riba al-fadl

Also known as riba al-Sunnah Applies to sale transactions in commodities: exchanging one commodity for the same commodity but unequal in amount

Riba al-Qard
1. Loan with interest or other benefits
-when there is a predetermined excess/surplus over the loan received by the creditor conditionally in relation to a specified time period

Various incidences of riba al-Qard (i.e. riba that arises from loan):

2. Excess amount imposed due to delinquency in debt

repayment or default
-Jahillians increased the amount of debt outstanding if payment is overdue = riba al-jahiliyyiah

Riba al-Bay (sale)

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The Arabs used certain commodities like wheat, barley, dates and salt (termed as ribawi items) as medium of exchange to purchase other things, and as such they were like money The basis for prohibition of riba in exchange of commodities is based on hadith of the Prophet on six commodities (i.e. ribawi items): Gold for gold, silver for silver, wheat for wheat, barley for barley, dates for dates, salt for salt like for like, equal for equal, and hand-to-hand (spot); if the commodities differ, then you may sell as you wish, provided that the exchange is hand-to-hand or a spot transaction. [Muslim]

Riba al-Bay

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Summary of rules under the hadith

Exchange Money1 + Money1 Food1 + Food1 Money1 + Money2 Condition (Amount & Time) Equality Hand-to-hand (spot) Equality Hand-to-hand (spot) Hand-to-hand (without exception)

Food1 + Food2
Money + Food Money + Others

Hand-to-hand (with exception)

No conditions free trading No conditions free trading

Food + Others
Others + Others

No conditions free trading

No conditions free trading

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Riba al-Bay

Interpretation
In trading commodities of same group (gold for gold), both commodities must be exactly equivalent and prompt delivery In trading commodities of same group but different kind (gold for silver), promptness of delivery a condition with some exception in food and food exchange (eg. Rice with wheat).

In trading commodities of different groups and kind (gold for wheat), no condition imposed, free trading can exist.

Islam encourages earning of profits from trade but forbids charging of interest

Riba al-Bay
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Implications
Certain restrictions imposed upon trading of ribawi commodities One presumable rationale for such an injunction is to curb price speculation on essential items Some jurists have relied on this Hadith to render modern-day currency derivatives impermissible

Issue: What commodities do this Hadith apply to?

Strictly these 6 commodities only- [Jurists Qatadah & Tawoos] Any commodity which is sold by weighing or measuring- [Hanafi & Hanbali] Either eatables or used as universal legal tender- [Shafii] Either food items or they can be stored- [Maliki] Staple food such as rice? Non-food commodities such as oil?

ISSUES ON RIBA: MISCONCEPTIONS & RATIONALES

Selected Issues on Riba

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What constitutes riba?

Al-Quran does not specify what riba is and the context that it is used refers to the particular practice at the time Prophet mentioned Beware, riba of jahiliyyah has been abolished Al-Quran al-Baqarah: 275-280 al-bay and riba are different

Several misconceptions about riba and its prohibition, resulting in confusion in its applications
Interest-based commercial transactions were invented by modern day business; thus, not covered by the riba referred to in the Quran Bank interest is not riba because it is not excessive (usurious) Riba should be allowed under dharurah Riba is only relevant to consumption loans, not commercial loans

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Modern day interest is not riba

Argument
Prohibition of riba was revealed in the last days of the Prophets life Did not elaborate on the interpretation and definition of riba Ambiguity in the meaning of riba (area of Mutashabihaat): its prohibition cannot be extended to modern day banking

Addressing Misconception
Fact that Prophet included prohibition of riba in his last sermon does not mean that the prohibition was only introduced at that time Emphasizing importance, given the last sermon was attended by most of his followers, reiterate prohibition of riba Other prohibitions were also not given elaborate definitions E.g. prohibition of pork, liquor, gambling, adultery, etc. These were well known to its immediate audience

Modern day interest is not riba

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Addressing this Misconception

Mutashabihaat refers to verses of the Quran which the correct meaning is not known to anybody for sure . Ignorance of correct meaning does not affect lives of Muslims because no precept of Shariah is revealed through them
E.g. Alif Lam Mim References made to the hand of Allah in the Quran, in An-Nisaa 3:73

However, riba has substantial affects on wellbeing - relates to prevalent economic and social practice It is not imaginable that Allah the All-Merciful would wage war against a practice, which correct nature is not known to anybody

If it is not excessive, it is not riba

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Argument
Al-Imran (3:130) - O those who believe do not eat up riba doubled and redoubled If rate of interest is not excessive (e.g. doubled) then it does not constitute riba and therefore not prohibited

Addressing this Misconception

Other verses on the same subject matter must be studied in relation to each other Al-Baqarah (2:278) O those who believe fear Allah and give up whatever remains of riba, if you are believers Every amount, regardless of magnitude, over and above principal is riba Quran is a book of guidance, not a book of statutes and legal text Embodies many expressions having persuasive value Al-Baqarah (2:41) Do not sell My verses for a little price does not imply that one can sell Verses for a high price Expression doubled meant to emphasize added severity

Riba is allowed under dharurah

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Argument
Doctrine of Necessity under dharurah circumstances, the haram is permissible E.g. It is permissible to consume pork to save ones life from dying of hunger

Addressing this Misconception

Is the necessity real or exaggerated by imaginary apprehensions? Can the necessity be met with by any other permissible means? Have all other permissible alternatives been exhausted? Islam provides means of financial intermediation in the form of profit and loss sharing

Riba allowed for commercial loans

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Argument
-The common practice of riba during the time of its prohibition was the charging of interest on consumption loans taken by poor people to finance their basic needs -This form of exploitation is not present in production loans whereby in many cases, the debtor is economically well-off
Loans taken by rich businessmen are used to generate profit Basic cause of prohibition of riba, zulm (injustice), is absent

Addressing this Misconception

To say that commercial or productive loans were not in existence then is not accurate
There are evidences to substantiate that the practice of interest-based production loans dated back to much earlier times As early as 2000 B.C. in Babylon, 500 B.C. in Greece, in time of Byzantine emperor Justinian (527-565 A.D.) A number of al-hadith reporting on the practice of riba-based commercial loans Nature of Quranic prohibition - includes all forms of riba regardless of whether or not prevalent at time of its revelation

Rationale for Prohibition of Riba

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1. Element of injustice in financing productive activities

Riba-based loan constitutes contract with unequal countervalues certainty of interest obligation vs. uncertainty of business outcome Injustice to debtor obligated to pay interest even if business venture results in no profit or loss Injustice to creditor in event of substantial profits, creditor receives a return disproportionate to amount of generated profits Unlawful appropriation of other peoples property.

2. Element of exploitation in financing consumption

The rich is able to generate more wealth without exerting much effort or contributing to productive activity Riba assumes money as a commodity, one which the rich has in abundance

Rationale for Prohibition of Riba

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3. Negative effects of a credit society

Easy availability of credit cultivates a materialistic society
People work harder to repay bank debt Banks exercise control over economic agents, people become enslaved to banks

Quest for economic development clouds good moral judgment and Islamic value system
Greed leads to unethical business practices eg. greed in pay packages Degradation of natural environment (to reduce cost) Less emphasis on institution of family leads to social ills Essentially, Muslims forget their roles as abd and khilafah Members of society should help each other in times of need Riba entails taking advantage of another people Breeds hatred, jealousy, ill-will towards the rich

Social relations amongst people negatively affected

FINANCIAL CONTRACTS-i

What Is Islamic Banking and Finance?

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Islamic financial products and services that are in accordance with the shariah (shariah-compliant) Emphasizes on ethical, social and dimensions of financial transactions which enhance equity and fairness for general benefit of the society Financial transactions which are free from riba, gharar and maysir Important role of financial contracts

Contract in Islam
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Islam prefers a market system where there is a need for exchange of goods and services. This exchange needs to be taken according to rules and regulations as defined by the shariah Contract in Islam is known as aqd

4 necessary elements in contract formation:

Contracting parties: individual/group/organization/state Medium/channel of communication: verbally/letter/telephone/sign/electronically Subject matter: physical goods/products/services Primary objective: al-bay (exchange and benefits of counter-value) or hibah (gift). Secondary objective (motive) must not conflict with primary objective

Contract in Islamic Financing

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1. Trading-based arrangements


Murabahah Bai-bithaman ajil

2. Leasing-based arrangements
Operating lease Financial lease

3. Equity-based arrangements
Mudharabah Musyarakah

Trading-Based Arrangements
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Most Islamic banking products are of this type Murabahah

Re-sale above the cost price (cost-plus) Shariah condition: Goods be clearly specified; quantity, kind/type, attributes Price to be paid including the profit must be agreed upon Complete/total posession must be given to buyer Transaction must be free from riba, gharar and maysir There must be two separate contract between the bank and supplier, and between the bank and customer

BBA

Deferred payment sale A type of murabahah where the murabahah payment is being deferred to a future date

Trading-Based Arrangements
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Murabahah
i) Used for short-term (less than one year) financing i)

BBA
Used for medium and long term financing

ii) Payment is made in lump sum

ii) Payment is made by installment

iii) Used to finance working capital

iii) It is used to finance acquisition of assets

iv) Refinancing is applicable

the

iv) It is not applicable for refinancing

Trading-Based Arrangements
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Trading: Islamic vs. conventional banks

Islamic
1. Financial flows run parallel to real flows
2. Claims of Bank/obligations of Bank Client are time-invariant

Conventional
1. There is dichotomy between financing and the use of funds
2. Claims of Bank/obligations of bank Client are adjustable

Leasing-Based Arrangements
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Al-Ijarah is a contract for the usufruct of an asset,

while its ownership still remains with original owner (lessor)

Four fundamental conditions for a valid ijarah

contract

Asset remains the property of the lessor Period of contract be specified Rental and its payment schedule be precisely stated Asset remains in working condition during the period of
the contract (lessors responsibility)

Leasing-Based Arrangements
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Leasing: Islamic vs. conventional banks

Islamic 1. Financial flows are tied to real flows 1. Conventional There is a dichotomy between financing and the use of funds

2. Claims of Bank/obligations of Bank client are timeinvariant

2. Claims of Bank/obligations of Bank client are adjustable

Leasing-Based Arrangements
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There are primarily two kinds of leasing: financial or capital leasing and operating leasing Operating leasing

Bank can adopt the course of operating lease with its client The obligation to arrange the asset can also be delegated to the client through wakalah (contract of agency)

Al-Ijarah al-Muntahiyyah Bi al-Tamlik (financing lease-i)

Also called al-Ijara wa al-Iqtina Leasing ends with ownership transfer of asset to lessee Differences of opinions among Muslim scholars regarding validity of this type of leasing, majority goes in favor

Equity-Based Arrangements
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Partnership modes that allow two or more

parties to share both contributions to and fruits of economic activity

Common modes of financing

Mudarabah: where one partner (rabbul mal-owner of

capital) provides capital, while the other (Mudaribentrepreneur) provides his effort or expertise

Musharakah: is when both parties contribute to capital.

The quantum of effort put in by either partner is not critical in this regard

Equity-Based Arrangements
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Some of critical points and conditions about Mudarabah and Musharakah from the shariah perspectives:

1.

All the arrangements represent a situation in which

Ownership of capital is shared, albeit for the duration of the contract Rewards are addressed through a share in the outcome of the activity Material losses are shared in proportion to ownership stakes of the various partners along with labor going totally unrewarded

2.

Nature and scope of partnership must be defined Nature of role of mudarib/entrepreneurs must be explicitly stated Profit-sharing ratio of fruits of economic activity need not be proportion to equity-stakes of the partners (e.g. when capital ratio is 50:50, profit sharing ratio can vary, such as 70:30). Ratios must be precise and set before the contract goes into effect.

3.
4.

Major Issues in IBF

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In relation to the practices of modern Islamic banking

Contentions regarding shariah-compliancy of some trading and

leasing products, especially Murabahah, BBA and financial leasing, service charges on loans, credits Some Muslim scholars believe that these products operate on the basis of time value of money, which is basically tantamount to Riba Issue on well-defined standards for Islamic banking products

Accounting standard Operating standard Risk management standard

Prohibition of gharar
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Literally: Deceit, fraud, uncertainty, danger, peril, or hazard that might lead to destruction or loss Technically: uncertainty caused by lack of clarity regarding the subject matter or price in a contract of exchange All jurists agree that gharar should be avoided in commercial exchange contracts A sale of a thing which is not present at hand or whose consequences is not known

Classical examples of gharar sale

Sale of fish still in the sea Sale of birds in the air Sale of unborn animals

Prohibition of gharar
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Contemporary scholars differentiate between minor and major gharar Types of gharar 1. Gharar yasir (minor or slight)
Tolerated and will not invalidate a contract

2.

Gharar fahish (major or excessive)

Not tolerated and may result in contract voidability

Rationale for prohibition of gharar To ensure full consent and satisfaction of the parties in a contract
Without full consent, a contract may not be valid Can only be achieved through certainty, full knowledge, full disclosure and transparency

Gharar in commercial contracts may lead to injustice, exploitation and/or enmity among contracting parties

Prohibition of maysir
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Definition: easily available wealth; acquisition of wealth by chance A form of gambling Many direct references in the Quran prohibiting gambling, for example: Satan intends to excite enmity and hatred among you with intoxicants and gambling, and hinder you from remembrance of Allah, and from prayer (5:90) They ask thee concerning wine and gambling. Say: In them is great sin and some benefits for people; but the sin is greater than the benefits (4:219)

Concept of iwad
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Definition: equal countervalue

element of iwad in sale promotes a sense of equity and justice in economic transaction, differentiating it from riba Islam prohibits riba but permits sale (bay)

Shariah requires all legitimate exchange to contain iwad

Every increase, which is without iwad or equal countervalue, is riba [ Ibn al-Arabi ]

Components of iwad
1. 2. 3. Risk (ghurm): Market risk price risk, holding costs, obsolescence Work and effort (ikhtiyar): Services or activities that value-add Liability (daman): Product liability borne by seller, in the event of defects

CONCLUSION
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To be safe: Follow mainstream view on riba and interest IBF is not only about interest-free banking Debt-based is never totally impermissible even though equitybased instruments have more economic merits. Ingredients of a successful project is