INCEIF

The Global University in Islamic finance

Kuala Lumpur, Malaysia

CIFP part 1
SH1002 Shariah rules in financial transactions

Title
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Standardization versus diversity of Shariah rules in Islamic Finance

Semester September 2000

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 Abstract
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Key terms of the research

1………………. 2……………. 3……………….4…………….5……………….

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Objectives of the research:

• To discuss the issue of standardization and harmonization of Shariah

rules in Islamic finance in order to achieve a uniformity in the practices of
the Islamic Institutions
• To discuss issues of diversity in Islamic law and its implication, and
• The proper methodology to address it within the framework of
standardization

Table of content

Introduction

• The difference between Islamic finance and conventional finance

• An overview of Islamic financial institution
• Introduction to Shariah law
• Issues of standardization and harmonization of Shariah rules in Islamic
finance
• Shariah expertise
• Shariah compliant securities
• How do we solve this?

Conclusion and finding

References

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Introduction

Globally, Islamic finance has exhibited its potential through the ever-increasing number
of Islamic financial institutions (IFIs). Unofficial estimates figure Islamic financial assets
of the IFIs at nearly a trillion dollars. The Islamic financial industry is still growing and
is finding its niche in many Muslim as well as non-Muslim countries. The growth is
swift, but it is accompanied by standardization and harmonization issues and challenges
which will need to be addressed in order to facilitate and coordinate the innovation and
.diversity that it brings

The difference between Islamic finance and conventional finance

In order to understand Islamic finance it must be known that the underlying theme of
Islamic finance is the niyah or “good intention”—the element that drives the Islamic
socio-economic system for ensuring the enhancement of the welfare of society. The
niyah may represent the Islamic philosophy of conducting life and business, but it is not
restricted to Muslims. The tenet pertains to justice and fairness which can be practiced by
all, Muslim and non-Muslim alike. The Islamic financial system, therefore, hinges on the
.niyah as an essential ingredient for every contractual transaction that is executed

For the layman, the fundamental difference between Islamic finance and conventional
finance is the feature in the latter to put a cost on money in financial transactions, i.e.
interest, or riba as it is known in the Islamic financial world. Basically, whatever is
.borrowed has to be returned but with an increment

In Islamic finance one of the questions most often visited is: “Money has time value;
how can it not have a cost?” The simplest answer is that in Islamic finance there is no
concept of money as a commodity: There is always an underlying contract in the form of
a partnership or venture that is entered into between the lender and the borrower, with the
profits or losses and the risks all being shared. Therefore, a fixed return per se cannot be
assured. This perspective of Islamic finance confers a “soul” to business activity. The
motives are the welfare of the people; an egalitarian society; the opportunity for all to

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benefit without being exploited. Islamic finance covers the social aspect of being in
enterprise. Above all, it is trust-based

An overview of Islamic financial institution

A financial institution is an institution that provides financial services for its client or
members. Probably the most important financial service provided by financial institution
is acting as financial intermediaries. Most financial institutions are highly regulated by
:government. Broadly speaking, there are three types of financial institution

1. Deposit taking institutions that accept and manage deposits and make loans,
including banks, building societies, credit union, trust companies and mortgage loans
companies.
2. Insurance companies and pension funds; and
3. Broker, underwriters and investment funds

But to make our discussion easier to understand, I shall use Islamic banks, as my main
example to explain an overview of how Islamic financial institution works. Islamic
banking is a type of universal banking. However, Islamic banks have their own special
characteristics. The majority of Islamic banks perform two basic functions, namely
investment management and commercial banking. Unlike conventional commercial
banks, Islamic banks do not pay or charge interest on lending or borrowing of money.
This is because the Shariah strictly prohibits, among other things, the receipt and
payment of riba (interest). Hence, Islamic banks cannot hold or issue interest-bearing
securities such as treasury bills or bonds. The banking services provided by Islamic
banks to business customers are mainly confined to letters of guarantee, letters of credit,
.and current or demand accounts

Investment management is the main service provided by almost all Islamic banks. As an
alternative to borrowing funds and paying interest on them, Islamic banks use a version
of the profit sharing mudaraba contract to mobilize funds in investment accounts in order
to invest them on behalf of holders of these accounts. This service is performed also, but
to a lesser extent, on the basis of the agency contract. As an alternative to lending funds

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and charging interest on them, Islamic banks use various contracts (e.g. murabaha,
musharaka, ijarah, salam, etc.) including the mudaraba contract to invest funds under
.management as well as their shareholders’ funds

Although Islamic banks tend to perform a hybrid of services of both commercial and
investment banking, the structure and processes of Islamic banks do not readily fit in
with those of conventional universal banking, which combines banking and investment
businesses. For example, unlike conventional banks, Islamic banks do not erect firewalls
to separate, legally, financially, and managerially their investment and commercial
banking services. Rather, the majority of Islamic banks combine investment accounts’
funds with their shareholders’ funds, invest both funds under the bank’s management in
the same investment portfolio, and report these investments and their results in the bank’s
balance sheet and income statement. Hence, investment accounts’ funds are not ‘ring
.fenced’ from the bank’s funds

Furthermore, investment companies (e.g., mutual funds) ‘‘sell their capital to the public,
while Islamic banks accept deposits from the public. This implies that shareholders of an
investment company own a proportionate part of the company’s equity capital and are
entitled to a number of rights, including receiving a regular flow of information on
developments of the company’s business and exerting voting rights corresponding to
their shares on important matters, such as changes in investment policy. Hence, they are
in a position to influence strategic decisions. By contrast, depositors in an Islamic bank
are entitled to share the bank’s net profit (or loss). Moreover, depositors have no voting
rights because they do not own any portion of the bank’s equity capital. Hence, they
.’’cannot influence the bank’s investment policy

And unlike those of investment companies, Islamic banks’ financed assets are neither
marketable securities nor are they measured on the basis of ‘‘mark to market’’ or fair
value. Rather, as mentioned above, the assets of Islamic banks are governed by various
forms and are stated at cost and/or the lower of cost and market. However, given that
Islamic banks cannot hold treasury bills or bonds or other interest yielding securities, it is
claimed that bank supervisors would have difficulty in putting a value on the assets of
these banks. Steele (1984) argues that this is because ‘‘the traditional banking system has

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much of its assets in fixed interest instruments and it is comparatively easy to value that.
But it is very difficult indeed to value an Islamic asset such as a share in a joint venture
and the, bank supervisors, would have to send a team of experienced accountants into
”.every Islamic bank, to try to put a proper and cautious value on its assets

Furthermore, the characteristics of Islamic banks tend to raise a set of issues concerning
corporate governance and agency problems that have no parallels in either commercial
.banks or investment banks

The mudaraba contract has detailed juristic rules that are derived from the Shariah and
which regulate the relationship between investment account holders (IAH) as providers
of funds and the bank in its capacity as mudarib (entrepreneur). The mudaraba contract
is a profit sharing financial instrument that is neither a financial liability nor an equity
instrument in the normal sense. Unlike equity instruments, investment accounts are
redeemable at maturity or at the initiative of their holders, but (usually) not without the
prior consent of the bank. Islamic banks can refuse to pay IAH until the results of the
investments financed by IAHs’ funds are determined. In addition, IAHs do not have the
benefit of a board of directors to monitor management on their behalf. On the other hand,
unlike debt instruments, investment accounts are not a liability of the bank because they
earn their returns by sharing in the profits generated from their funds, and also bear their
share in any losses incurred. Furthermore, Islamic banks do not guarantee the value of
these investment accounts. Thus, holders of these accounts have a claim on the bank’s
earnings or assets, which ranks pari passu with that of the shareholders. The fact that the
mudaraba contract is neither a debt nor an equity instrument means that it is not a hybrid
instrument comprising debt and equity (for example, it is not debt with an embedded
.(equity derivative

In the unrestricted type of mudaraba, IAHs authorize the bank to invest their funds at its
discretion including commingling the IAHs’ funds with those of shareholders. In the
restricted mudaraba, IAH specify to the bank, among other conditions, the type of
investment in which their funds should be invested, e.g., real estate, currencies, leasing,
etc. However, in both types of mudaraba IAH do not have the right to interfere in the
management of the fund, and violation of this condition can nullify the contract. Hence,

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although holders of both types of investment accounts are exposed to different degrees of
risk, their relationship with the management of the bank is subject to the same
.monitoring arrangements

The aggregate investment portfolio of an Islamic bank is usually financed by IAHs’

funds, plus some of shareholders’ equity and other sources of funds (e.g., current
accounts) the latter being mobilized on bases other than the mudaraba contract. If the
aggregate investment portfolio yields a positive return, then the shares of profit are
allocated between the parties to the contract, IAH and the bank, according to their
proportionate shares of their respective investments in the portfolio. The bank’s share of
profit relates to both its shareholders’ funds and to other funds invested in the investment
portfolio that do not participate in profit-sharing (e.g. current accounts which are capital
protected but nonparticipating). It is to be noted that shareholders’ funds invested in the
investment portfolio (and elsewhere) and the other nonparticipating funds are not
covered by the mudaraba contract, and are not governed by its rules. Hence, the bank’s
shareholders receive the entire profit from these sources, and IAH cannot claim any
profit share from them. The bank also receives what is called the mudarib share of profit,
based in principle on a predetermined percentage of the profit attributable to the IAH,
which is specified in the contract. This is a reward for the managerial effort of the bank
in managing the funds of IAH. The mudarib share of profit allocated to the bank
.constitutes a return to the bank’s shareholders

If the bank’s aggregate investment portfolio yields a negative return, then, according to
the mudaraba contract, this loss should be borne by the IAH and shareholders pro rata to
their respective investments in this portfolio, bearing in mind what was said in the
previous paragraph. Like that of shareholders, the liability of IAH is limited to the
amount of their investment and no more. In the case of a negative return, in addition to
the shareholders’ proportion of the loss which is determined pro-rata as indicated above,
the bank in its capacity as mudarib receives no profit on behalf of its shareholders (the
mudarib share having a lower bound of zero). However, according to the mudaraba
contract, if the loss is due to misconduct or negligence of the mudarib, then the Islamic
.bank has to make good the loss

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Introduction to Syariah law

Islamic law is known as Shariah law, and Shariah means the path to follow Allah's law.
Shariah law is holistic or eclectic in its approach to guide the individual in most daily
matters. Shariah law controls, rules and regulates all public and private behavior. It has
regulations for personal conduct such as prescribing specific rules for prayers, fasting,
.giving to the poor, and many other religious matters

Shariah law can also be used in larger situations than just guiding an individual's
behavior. It can be used as guidance for how an individual acts in society and how one
group interacts with another. The Shariah law can be used to settle business disputes or
conflicts between or within an organization. This law does not exclude any knowledge
from other sources and is viewed by the Muslim world as a vehicle to solve all problems
.civil, criminal and international

Shariah law has several sources from which to draw its guiding principles. It does not
rely upon one source for its broad knowledge base. The first and primary element of
Shariah law is the Quran. It is the final arbitrator and there is no other appeal. The
second element of Shariah law is known as the Sunnah, the teachings of the Prophet
Mohammad (s.a.w) not explicitly found in the Quran. The Sunnah is a composite of the
teachings of the Prophet (s.a.w) and his works. The Sunnah contains stories and
anecdotes, called Hadith, to illustrate a concept. The Quran may not have all the
information about behavior and human interaction in detail but the Sunnah gives more
.detailed information than the Quran

The third element of Shariah law is known as the Ijma. The Muslim religion uses the
term Ulama as a label for its religious scholars. These Ulama's are consulted on many
matters both personal and political. When the Ulama's reach a consensus on an issue, it is
interpreted as Ijma. The concepts and ideas found in the Ijma are not found explicitly in
the Quran or the teachings of the Prophet (s.a.w). Islamic judges are able to examine the
Ijma for many possible solutions which can be applied in a modern technical society.
They are free to create new and innovative methods to solve crime and social problems
based upon the concepts found in the Ijma. These judges have great discretion in
.applying the concepts to a specific problem

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The Qiyas are a fourth element of Shariah Law. The Qiyas are not explicitly found in the
Quran, Sunnah, or given in the Ijma. The Qiyas are new cases or case law which may
have already been decided by a higher judge. The Shariah judge can use the legal
precedent to decide new case law and its application to a specific problem. The judge can
use a broad legal construct to resolve a very specific issue. For example, a computer
crime or theft of computer time is not found in the Quran or Sunnah. The act of theft as a
generic term is prohibited so the judge must rely on logic and reason to create new case
.law or Qiyas

The fifth element of Shariah law is very broad and "all encompassing." This secondary
body of knowledge may be ideas contained in the other written works. The New
Testament is an example of this area of information, and legal discourses based upon
Civil Law or Common Law may be another example. All information can be examined
for logic and reason to see if it applies to the current case. It also may be a local custom
or norm that judge may find helpful in applying to the issue before him. The judge may
also weigh the impact of his decision upon how it will affect a person's standing in the
community.

Issues of standardization and harmonization of Shariah rules in Islamic finance

The contracts prescribed in Islamic law provide a significant part of the principles and
procedures explicitly laid down in the Fiqh or Islamic jurisprudence which must be
observed for shariah compliance. For instance, the Qur’an is replete with passages that
denounce riba as exploitative and against the norms of fairness. The problem arises
where the principles and procedures for specifics are not so easily found and therefore
have to be derived from the fatwas, or interpretations of the shariah scholars. The fatwas
awarded on financial transactions differ amongst scholars and across jurisdictions, which
produces the problem of pluralism in shariah interpretations. There are mainly five
,schools of thought in Islamic jurisprudence for example
Hanafi, Shafei, Hanbali, Maliki, and Ibadi amongst others. Each school of thought has its
own set of muftis (scholars) on Islamic financial issues which, more often than not,
creates conflict and ambiguity in decisions on the veracity of a transaction in terms of its
compliance with the shariah. In this context the Quran states “As for those who divide

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their religion and break up into sects, thou hast no part in them in the least: their affair is
with Allah: He will in the end tell them the truth of all that they did.” Al-Qur’an, Surah 6
(Al-Anaam) Ayat 159

So, the biggest challenge faced by the regulators of Islamic finance is harmonizing and
standardizing these interpretations into a consistent and efficient regulatory framework
.that will ensure unimpeded Islamic financial intermediation amongst the participants

The process of harmonization and standardization of transactions across and within

borders is undoubtedly a daunting one and has to be comprehensive. In some
jurisdictions certain transactions are considered shariah-compliant while in others they
may not be accepted as so. It is extremely difficult to adjudge as to which is the closest to
shariah. Consensus in the fatwas may be overcome by the centralization of the shariah
rulings in a central Islamic authority such as the Islamic Fiqh Academy of the
Organisation of the Islamic Conference (OIC), which is recognized by a large majority of
.scholars. In the event of disagreement the Academy can give its verdict

The pursuit should be toward uniform regulatory frameworks based on principles and
standards designed by universally accepted organizations such as the Islamic Financial
Services Board (IFSB) and the Accounting and Auditing Organization of Islamic
Financial Institutions (AAOIFI). The adoption of the guidelines drafted by these
.institutions is the panacea for the shariah arbitrage that exists otherwise

Not secondary to this issue is the problem of emulating the conventional financial system
and applying the BASEL II principles. Effective risk management measures applied to
the conventional financial system need to be applied to Islamic finance, but with certain
modifications and adaptations. The Islamic financial industry has to be adept with
techniques and competitive products to improvise and emulate the conventional banking
and finance industry. Only then can IFIs compete with the conventional giants and access
.the international markets while maintaining their Islamic identity

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Shariah Expertise

The lack of shariah expertise is also one of the challenges that face the regulators of the
Islamic financial industry. Due to the infancy of the system, very few institutions have
produced the desired skill set for the Islamic financial and banking industry. While there
are plenty of Islamic jurisprudence experts, there is a dearth of Islamic financial experts
with a knowledge of the dynamics of conventional finance and its transformation to an
Islamic/shariah-compliant system. Due to the regulatory obligation of instating Shariah
oversight, IFIs employ less-experienced shariah scholars, as only a limited number of
professionals are available, and they are usually attached to more than one IFI
.concurrently

The transition to Islamic finance is highly technical and complex. A balance has to be
maintained in order to provide, on the one hand, an adequate return and to remain, on the
other hand, within the boundaries of the Qur’an and Sunnah, which cannot be done
without quality shariah supervision. In order to achieve this, regulators of the capital and
money markets will have to encourage the development of educational institutions that
offer programs and syllabi for Islamic financial technical skills. INCEIF (International
Centre for Education in Islamic Finance) in Malaysia is an example that has designed an
outstanding course—namely, CIFA (Chartered Islamic Financial Analyst), which
.prepares the student for a specialized course in Islamic finance

Shariah-Compliant Securities

The limited number of shariah-compliant securities emanates from the lack of both
harmony and Islamic financial prowess, and poses yet another problem in the
development of the industry. Due to the paucity of available instruments in the market,
investors are constrained to take their funds elsewhere. The limited choices also affect
the liquidity of the securities as there is a limited market for them. The buying and selling
of such securities is not as lively as in the conventional securities market, possibly due to
their nonspeculative nature. Nevertheless, investors are eager to place their funds in
shariah-compliant securities, even for a comparatively lower return, provided that a
reasonable degree of assurance can be given with regard to their nearness to shariah. The

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market for shariah-compliant securities, in terms of buyers and sellers, quite certainly
exists, but it awaits the introduction and innovation of new Islamic instruments. Much
of the apprehension that exists in the market with regard to shariah-compliant securities,
or Islamic banking and finance for that matter, is owed to the slow pace of development
of products and awareness-creating endeavors. In this context, the Liquidity Management
Centre and the International Islamic Financial Market (IIFM) have a huge mandate and
are vigorously involved in bridging the gaps in terms of investment of surplus funds of
.IFIs and creating Islamic financial markets

The combination of services offered by operating IFI and the prevailing practices“
”.compound the difficulties of designing a regulatory framework to govern them

?How do we solve this

The solution to the harmonization problem is to design regulatory frameworks that are
standard. Thus, all criteria relating to the formation of Islamic financial institutions, the
induction of shariah experts, the risk management measures, and the various codes
should conform with a standard document, such as an enabling Islamic financial services
law, which prescribes common Islamic financial accounting standards, corporate
governance practices, and prudential regulations for risk management for the industry,
and which interfaces with the IFSB’s Ten-year Master Plan for Islamic Financial
.Services

To bolster the Islamic securities market, companies listed on the stock exchanges
(financial or
manufacturing) should be encouraged to pursue shariah compliance. To achieve these
.objectives the role of the regulator(s) is emphasized

Conclusion

A purely Islamic financial system would be ideal—one in which the niyah and trust are
predominant so that a self-perpetuating regulatory system prevails. There would be
minimal regulatory interference—only for transparency and disclosure. In such a system,

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issues of compliance diminish directly with the prevalence of a coherent and trustful
financial environment in which profits and risks are authentically disclosed and equitably
.distributed

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References:

A: Book
Wahba Al Zuhaili (2003), Financial transaction in Islamic jurisprudence, Beirut: Dar al-
Fikr al-Mouaser, First Edition, Vol.1: p50.

B: Journal:
Hassan, Ahmed. (2006), “Instruments in Islamic finance" INCEIF, Vol. 1 (5): p200.

C: Data from the net:

Guidelines
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1. Format: Follow the format provided by the lecturer

2. Font: Times New Roman
3. Size: 12 for the Main page.
4. Footnote: Size 10
5. First page: Bold
6. The titles: Bold
7. Space: 1.5
8. Project paper length: 20 – 25 pages

Important notes:
• The topic should have a link to the relevant issues faced by the industry,
either in the contents, issues discussed or by relevant examples.
• You must submit your Project Paper before or on (21/11/2010).
• Submission of the Project paper must be in soft copy to the system (LMS).
• You should use the available references and data base in the libraries at
your convenient; please refer to the hard copy references first before you access
to other materials in form of soft copy in the data base.

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 • This is a professional paper you should use the academic references and
citation, please do not use the open domain in the internet only when necessary.

For any further clarification, assistance, or consultation, you can contact me according to
the following details:

Submission
You must submit your Project Paper before or on (21/1/2010).

Dr. Ahcene Lahsasna

Email: hasan@inceif.org
Contact: 27814000

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