ISLAMIC BANKING :

Basic Concepts
and Philosophy

By

Muhammad Ayub
National Institute of banking and Finance,
State Bank of Pakistan, Karachi

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Pre-requisite for Isl. Banking

 Convincing clarity of the concepts

 All stakeholders
 Bankers, in particular
 Shariah scholars
 Regulators
 Product developers
 Implementers
 Those sitting at the front office

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 Myths
 Any Return on deposits is Riba;
 Any prefixed return – Riba
 Islamic banking: cost-less money
available – Approach of Businesses
 Repayment of loans not a serious issue
–be waived of
 Trade profit similar to interest on loans /
debts

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 Myths (Cont’d)
 Credit and cash market prices of a
commodity must be same
 Profit margin on credit sale by banks
resembles Riba.
 Sharing vs. Non Sharing instruments:
 Permissibility & Priority two
different aspects
 Money can be rented like other assets

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 Loans in Islamic Finance

Qard (Loan) : to give anything in ownership of

other by way of virtue - same or similar amount of
that thing would be paid back on demand or at the
settled time.
Dayn (Debt) : Incurred by way of rent or trade-
ought to be returned at the settled time without any
profit.

Āriyya: To give any commodity to other for use

without taking any return for its use-Ghazwa
Hunain; Camels and iron chest plates .

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 Welfare Economy Framework
 Socio-economic & Distributive Justice
 Ethics and value system
 Functioning of the Market & Role of the State:
 Right of ownership, freedom of enterprise,
 Competitive price mechanism
Transparency and disclosures
 Over seeing role of the State;
 Creating additional value and sharing gains
 Closer linkage between real economy &
finance
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 Riba Prohibition
 Unanimity on Riba Prohibition;
 Problem then?
 Interpretation
 Consensus (Holy Quran gives principle
defining Riba in Verse II-279).

“O you who believe. Fear Allah, and give up the Riba

that remains outstanding if you are (in truth)
believer”. (11:278).
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 Riba - Unanimity (Contd)

“If you do not do so, then be sure of

being at war with Allah and his
Messenger. But, if you repent, then
you have your principal”. (11:279)

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 And if you repent, then you have your
principal. Wrong not, and you shall not be
wronged ”. {without inflicting or receiving
injustice}

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 Foundation

Those who protested and argued that lending on

interest was like an act of trade, were
admonished through revelation that while ‘trade’
was permitted, ‘Riba’ was forbidden and in loan
transactions they were entitled to their principal
sums only.

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 They used to say that it is all equal whether
we increase the price in the beginning of the
sale, or we increase it at the time of maturity.
It is this objection which has been referred to
in the verse by saying “They say that the
sale is very similar to Riba.” (Ibn-Abi-Hatim)

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 Types of Riba

 Riba Al-Fadl - sale transactions,

 Quality premium in exchange of low quality
with better quality goods of same kind;
prohibited e.g. dates for dates, wheat for
wheat etc.

 Riba Al-Nasia - loan transactions.

 Riba Al-Nasia (Riba Al-Ouran) involved in
credit/delay; modern banking transactions
falls under Riba Al-Nasia,
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 Overall Consensus
 Council of Islamic Ideology (CII): Preliminary Work
 CII Report on Elimination of Interest from the
Economy (June, 1980) – Unanimously Endorsed
 Representation of all Muslim sects in Pakistan
 Justice Dr. Tanzil-ur-Rahman (J Afzal Cheema)
 Mawlana Zafar Ahmad Ansari
 Mufti Sayyahuddin Kakakhel
 Khawaja Qamruddin Siyalvi
 Mawlana Muhammad Taqi Usmani
 Mawlana Muhammad Hanif Nadvi
 Allama Syed Muhammad Razi
 Mr. Khalid M Ishaq
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 Prohibitions
 Earning returns from a loan or debt contract
(Riba/Interest)
 Compensation-based restructuring of debts

 Excessive uncertainty in contracts in respect of

the subject matter or the price. (Gharar)

 Gambling and chance-based games (Qimar)

 Selling debt contracts at discount

 Delayed exchange of foreign exchange 14

 Encouragements

 Benevolence

 Transparency and disclosures

 Purification of income

 Comprehensive and universal ethical

approach
 Documentation
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Business Vs. Benevolence

 Banking or Benevolence ?
 Sharing of profit and loss on post facto
basis arising from:
i. (Deferred) Trading– profit margin for
the seller
ii. Rentals on leased assets
iii. PLS
iv. Combination of contracts
 Return free (loans)
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 Businesses Modes

 Trading, Muzara’ah, Musaqat (Gardening

with Shirkah), Services (Ujrah and Ijarah)
– The Main businesses;
 Barter and the Money based transactions;
 Individual Businesses, with self capital or
arranged on Riba;
 Loans, Debts (Credit /Forward contracts –
Salam/Salf
 Partnership
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 Impact of contracts
 Bay: Definite transfer of ownership of goods against
payment of price-spot, delayed and forward;
 Hibah: Permanent transfer of ownership of assets
free of any payment;
 Riba (al Nasia): Temporary transfer of ownership of
goods/assets against payment;
 Qard Hassan / Tabarrue: Temporary transfer of
ownership of goods/assets free of any payment;
 Ariyah: Temporary transfer of usufruct of goods
along with or without assets free of any payments

 Ijarah: Transfer of usufruct of goods against payment

of rent.
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Principles of Islamic Finance
 Lending a virtuous act – Not a business.

 Prohibition of Riba and Gharar; permission of trading.

 All gains to principal not prohibited.

 Deciding Factor: nature of transaction.
 Entitlement of profit: liability of risk of loss with the
capital itself; (Al Kharaj bil Daman)
 Profit to be earned by sharing risk and reward of
ownership through pricing of goods, services or
benefits.
 Time has value that can be discounted only through
price; not in the form of interest, sometimes
negative value as well.

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Profit linked with Liability
 Ownership cannot be separated from the risk of its
loss
 Al Kharaju Bil daman
 The above implies that entitlement to return from
an asset is intrinsically linked to the liability of loss
of that asset
 What that implies for the attitude towards risk?
 What that implies for time value of money?
 in loans
 in deferred sales

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 Principles of Islamic Finance
(Contd)
 Ability to cause ‘value addition’.
 Differentiating: Trading, loaning and leasing
 Ownership Transfer in: Sale of assets, Loans and
Leasing;
 Any thing which cannot be used without
consuming its corpus, or whose corpus changes
its form in the process of its use, cannot be leased
out like money, edibles, fuel, etc.
 Taking rent on leasing of asset permissible while
rent on loan is prohibited.
 Repayment of loan- Must.
 Husan al qada: Repaying a loan in excess of the
principal.
 Debt contracts cannot be sold at discount.
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 Prepayments

 Jews of Bani al Nadhir expelled from Madina, ‘Da’awoo wa

Ta’ajjaloo’
 Another Hadith: Miqdad bin Aswad, 90 for 100 Drahim of
Loan; Holy Prophet termed it as Riba; Holy Prophet asked
Ka’ab bin Malik to waive half of the debt payable by
Abdullah bin Abi Hadrad;
 Jurists : remitted amount in case of Bani al Nadhir related
to amount of Riba accrued to Jews
 Imam Malik: no difference of opinion about illegality of
remitting a part of Dayn;

 Duyoon Haalah and Dyun Mu’ajjalah; Remission in due

loans allowed as delay is not right of the debtor: Shah
Waliullah also of this view. 22
 Exchange Rules
 Different for different contracts and types of wealth:
 Goods, Durable assets, Shares representing pool
of assets - Market based pricing

 Gold silver or any monetary units (Athman) –

Rules of Bai al Sarf

 Usufruct and services (Leasing/ Services)

 Loans/Debts – Repayment or Assignment of the

same amount.
 Well-Known Injunction on exchange of six
commodities: Gold, Silver, Wheat, Barley, Dates and
Salt. 23
 Exchange Rules (Nawawi)
 Illah (Effective Cause of prohibition): Unit of value
and Edibility

 When underlying illah is different, short fall/excess

and delay both are permissible, e.g. sale of gold for
wheat.

 When commodities of exchange are similar, excess

and delay both are prohibited, e.g. gold for gold or
wheat for wheat, Rupee for Rupee, etc.

 When commodities of exchange are heterogeneous

but the illah is same, as in the case of gold for silver
(medium of exchange) or wheat for rice (edibility),
then excess/deficiency is allowed, but delay in
exchange is not allowed. 24
 Exchange of Currencies Contd)

 Special rules for exchange of monetary

values.

 Forward Currency Contracts : Some scholars

forbid them while others distinguish between
the two cases:

 First, where one currency is delivered on spot and

the other is delayed - forbidden.
 Second, permitted, involves the future exchange of
both currencies at the previously agreed rate. 25
Alternative Financing Principles
 Participation and sharing principle

 Deferred trading principle

 Interest free loans

 Combination of contracts

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 Main Financial Contracts
A. Debt creating Modes (Low Risk Category)
1. Qard Al-Hasan (interest-free loan)
2. Bai Muajjal (Price deferred sale)
3. Murabaha and Musawama
4. Salam (Commodity sale)
5. Istisna´a ((Order to Manufacture)
B. Semi-debt Modes
1. Ijara
C. Sharing or Non-debt Modes (Full Risk
Category)
1. Musharaka (Close to Venture Capital)
2. Specific Purpose Mudaraba
3. General Purpose Mudaraba 27
 Shirkah Rules
 Commingling by two or more persons, their
money or work or obligations to earn a
profit or a yield or appreciation in value and
to share the loss if any according to their
proportionate ownership.
 In Shirkah, pre-stipulated ratio of profit distribution
may differ from ratio of investment but the loss
must be shared exactly in accordance with the
ratio of capital (as also in Mudaraba).
 Not allowed to fix a lump sum amount for any of
the partners, or any rate of profit tied up with
investment.

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 Shirkah

 The profit ratio must relate to the

actual profit accrued to the business;
e.g. between two parties: fifty: fifty,
sixty: forty or thirty: seventy; or
partners A, B and C, can get 30%, 40,
and 30% of the profit.
 Shariah scholars accept the concept
of ‘Projected profit’ subject to final
settlement.
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 Musharaka
 Where all the partners invest some capital into
a commercial enterprises or they jointly
undertake to render some services to their
customers and share the fee charged by them
according to agreed ratio.
 Or they avail credit from market using their
credibility and sell the commodity to
share the profit so earned at an agreed
ratio.

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 Mudaraba
 Mudaraba/Muqarada; one party provides capital
and the other provides entrepreneurship.

 The basis for relationship between banks,

depositors and entrepreneurs.

 The amount of investment: be precisely

determined.

 Entrepreneur can be a natural person, a group of

persons, or a legal entity and a corporate body.
 Profit to be divided in strict proportion agreed at
the time of contract.
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 Principles of Credit Sale
 Installments Sale permissible, even if the deferred
price exceeds the spot price.

 Deferred prices can vary so long as price not finalised.

 Sale cannot take place until the parties agree to a

particular price & mode of payment.

 Not permissible to fix the spot price on cash basis,

then to charge interest expressly tied with different
periods.

 Commercial papers are lawful types of authentication

of a debt by putting it down in writing; - Treated by
Shariah near to mandatory.
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 Two main prohibited Sales

 Bai al inah
 Creditor purchasing assets from debtor on
cash and selling back to him on credit
• Bai al Dayn
• Trading of debt securities
• On face value- Hawalah - Permissible
• On premium or discount – Not permissible

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 Murabaha
 Basic concept: Sale on mutually agreed profit margin on
the known cost of goods; payment of sale price is
deferred.

 Real, tangible goods to be traded and not papers of debt

or credit documents.

 Murabaha cannot be used as mode in case no commodity

is purchased by the client.

 Buy-back arrangement: not allowed.

 MUAJJAL; Credit price may include margin of mark-up,

taking into consideration the deferred payment. As a debt,
no return can be charged on the amount of Note/Bill.
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 MURABAHA Contd
 Seller having a good title
 physical / constructive possession.
 Defaulter: different punishments, penalty for
charity.
 Solatium through court (out of penalty).
 Client as Agent to the Bank;
 Better to have a third party as agent;
 Roll-over.
 Asset price Risk or commodity risk ( client
might not take delivery);
 Market risk,
 Credit risk,
 Reputational Risk
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 Rules in Musawamah

 A general kind of sale: Price bargained without any

reference to the price paid or cost incurred.

 Seller not obliged to reveal his cost.

 Different from Murabaha in pricing formula only.

 Musawamah can be used for big single deals.

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 Salam
(Forward Sale)
 Prepayment of price in full for goods to be delivered in
future.

 Allowed by Holy Prophet (SAW) himself to meet

farmers’ money need.

 Banks will receive contracted commodities, not money.

 Parallel Salam: a bank can sell a commodity purchased

through Salam for even the same date of delivery or the
quantity;
 As long as the two contracts are not made
conditional on each other.
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 Salam Conditions
 not where delivery has to be
simultaneous, e.g. Gold, silver or
currencies.

 Date and place of delivery must be

specified in the contract.

In case of a number of commodities, the

amount and delivery period should be
separately fixed.
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Istisna’a (Order to Manufacture)

 Istisna’a, an agreement for order to manufacture,

culminating into a sale at an agreed price;

 The things to be manufactured must be known and

specified to the extent of removing any ignorance
or lack of knowledge of its kind, type, quality, and
quantity.

 Price be known in advance that can be readjusted

only by mutual consent of the parties.

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 Istisna’a (Contd)

 Prepayment not necessary in Istisna’a

 Not necessary for seller to
manufacture the commodity himself

 Parallel Istisna’a contract; without any

condition attached to the original
Istisna’a contract.

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 Reference Rates
 Reference rates needed for executing and pricing the
contracts.

 Different scales for different kinds of financial

contracts.

 For Conventional finance: Only one reference rate

(interest rate),

 Islamic finance: Two : debt/semi-debt contracts and

non-debt (equity) contracts,

 Therefore, two reference scales are needed:

• Price mark up/rent reference scale
• Share ratio reference scale, through the Central
Bank Mudaraba ratio or Interbank Mudaraba ratio. 41
 Myths Removed
 Fixed return by way of pricing of goods and
their usufruct is permissible.

 Islamic banking is also a business, It does not

mean availability of cost free money.

 Repayment of loans and debt is must.

 Time value of money is accepted to the extent

of pricing of goods but not in the form of
conventional opportunity cost concept.
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 Myths Removed (Cont’d)
 Profit margin that banks charge in their
trade operations is permissible if trading
principles given by Islam are properly
taken care of.
 PLS modes have preference but Debt
creating modes also permissible; Banks
can use any modes keeping in view the
Risk Profile of the investors

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Key Areas in Future Direction

 Justifiable profit distribution mechanism

 Focusing on asset management
 Potential scope of Shari’ah complaint
financial engineering
 Financial stability
 Shari’ah complaint risk management
tools
 Corporate governance, transparency and
disclosures requirements 44
Thanks

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