PRINCIPLES OF ISLAMIC BANKING AND FINANCE

By ASSOC PROF DR MUHAMAD RAHIMI OSMAN Director Centre for Islamic Thought & Understanding (CITU) UNIVERSITI TEKNOLOGI MARA

CONTENTS

Introduction Principles of Islamic Finance Classification of Contracts General Rules of Commercial Transactions Conclusion
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INTRODUCTION

Islam is a complete code of life. It encompasses all of human activities from the family life, social, political and economic activities up to international relations. The Holy Quran provides general principles/rules and ethics Emphasises on justice, fairness and mutual consent between the parties Islam comes to improve the system of life as a whole and reconstructs the political, social and economic activities in accordance to Islamic teachings

OVERVIEW OF ISLAMIC SYSTEM

ISLAM
AQIDAH
(Faith & Belief)

SHARIAH
(Practices & Activities

AKHLAQ
(Moralities & Ethics)

IBADAH
(Man-to God Worship

MUAMALAT
(Man-to Man Activities

POLITICAL ACTIVITIES

ECONOMIC ACTIVITIES

SOCIAL ACTIVITIES

BANKING & FINANCIAL ACTIVITIES

GENERAL RULES OF COMMERCIAL CONTRACTS

1)

Rule of permissibility (al-ibahah)

The original status of each transaction is permissible unless there is a prohibition (al-asl fi al-ashyia al-ibahah hatta yarid al-man ) No legal injunction is needed in sanctioning new contract Every new contract is considered lawful and permissible unless there is a clear injunction to the contrary. Contrary to the devotional matters (ibadat)
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Contd
2)

The originality in transaction is analogy and ratiocination (al-asl fi al-muamalat al-qiyas wa altalil).
The rules in the transactions based on causes, rationale and benefit (maslahah) Application of Qiyas using ratio decidendi (illah) and maslahah for new cases eg. aqd al-istisna
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Cont
3)

The Role of Custom (urf)

Recognised as a sources of law Custom is an indicator of the societys needs to change Therefore, ijma (consensus), maslahah (public interest) and fatwa (juristic opinion) often originates in the custom and living experience of the community eg. Bay al-wafa or conditional sale (jual janji)
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PRINCIPLES OF ISLAMIC FINANCE

Transaction Based on a Valid Contract Prohibition of Riba Prohibition of Gharar Asset-backed Financing Risk-bearing and Profit-Sharing Financing
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TRANSACTION BASED ON A VALID CONTRACT (AL-`AQD)

The underlying contract in Islamic banking and finance transactions is very important The concept of `aqd in Islamic law is very fundamental because it is based on certain religious and moral principles Transactions in Islamic banking and finance are based on various contractual agreements between the bank and the customers
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Contd

The Quran orders that contract and obligation must be fulfilled awfu bi al-uqud. The whole idea of having a contract is to satisfy the consent of both parties to a contract and it seems, not only in the Islamic legal system but also in other legal systems, contract is the best available means to reflect the intention and accordingly the consent of the parties. To this effect, the Quran has already prescribed on the believers not to devour your assets among yourselves in vanity, except in trading by your consent (trade by mutual consent)
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CLASSIFICATION OF CONTRACTS

In general, there are various types of contracts in Islamic commercial law Some types of contracts (despite their difference), share some common features, purpose, circumstance as well as legal consequence Thus, they can be classified under the same group Classifications according to the very purpose and raison detre of the deal and agreement
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Contract of Exchange (uqud al-muawadhat)

Contracts of sale and purchase (bay), including all its subdivisions, like: * normal or spot sale * mark-up sale (murabahah) * deferred payment sale (BBA) * sale with advance payment but deferred delivery (bay al-salam)
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Contd

Sale for future delivery of goods with flexible payment of the price or manufacturing contracts (bay alistisna) Sale of currency (al-sarf), etc Some controversial sales: Sell and buy back (bay al-inah) Sale of debt (bay al-dayn)
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Partnership Contract (uqud al-Sharikah)

Islam recognises partnership contracts which are mainly based on profit and loss sharing (PLS), e.g: * mudharabah * musharakah A relatively new invention in this regard is: * Musharakah mutanaqisah
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Leasing Contract

Islam recognises contract of leasing * Ijarah * Operational lease * Financial lease Al-Ijarah Thumma Al-Bay (AITAB) (hybrid contract)

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Contract of Security

Islam recognises other additional contracts to provide security to the parties in a contract, i.e., the contracts of security (uqud altawhiqat), e.g: * guarantee (kafalah) * mortgage (rahn)

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Contd

These security contracts are normally combined with other types of contracts, e.g.: * the contract of BBA may be secured by a contract of security involving collateral (rahn)

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Other Conracts

Other contracts recognised in Islamic law: * contracts of trusts (al amanat), e.g: safe-keeping (wadiah) * contracts to do a specified task, e.g:commision (ju alah); agency (wakalah)

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PROHIBITION OF RIBA

The most essential principle of Islamic banking and financial transactions that differs from western banking and financial system is regarding the element of riba Riba is prohibited explicitly in the Quran and the Sunnah. However, the Quran does not give specific definition for the term riba

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Definitions of Riba

Riba literally means : excess, increase, expansion, growth Definition 1: Riba is every excess in return of which no reward or equivalent counter value is paid Definition 2: Riba is a predetermined excess or surplus over and above the loan received by the creditor conditionally in relation to a specified period
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Contd

Generally speaking, riba can be defined as an increase or addition charged over and above the principal amount of debt, whether the debt is created through a sale transaction or through a loan transaction conditionally in relation to time or period. The common features of riba can be derived as follow: An increase or addition over the principal amount of the debt or capital The determination of this addition in relation to time The stipulation of this surplus in the debt 21 agreement

Prohibition of Riba in the Quran

Riba was prohibited by the Quran in four stages: - 1st in Surah al-Rum:39; - 2nd in Surah al-Nisa:160-161 - 3rd in Surah Ali Imran:130; and - 4th in Surah al-Baqarah: 275-281

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Prohibition of Riba in the Quran

4 STAGES
First Stage (30:39) Second Stage (4:160-161) Attaching the practise of riba with the Jews Consider the practice as an iniquity (zulm) Third Stage (3:130) Prohibiting the practice of charging double and multiple riba Fourth Stage (2:275-281) Conclusively prohibiting all forms of riba Any excess over the capital is disallowed

Compare riba with zakat & charity Praising zakat & charity, not riba

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Contd

In the 4th stage, the final prohibition of riba is made conclusively and decisively in al-Baqarah (2:275): they say: trade is like riba, but Allah has permitted trading and forbidden riba

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Contd

There are also a number of narrations from the Sunnah on the prohibition of riba Some of the narrations give general prohibitions of riba, e.g.: 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).
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Contd

There is complete unanimity among the jurists of all the schools of thought in Islam, contemporary Shari`ah scholars and Muslim economists that the term riba stands for interest in all its types and forms However, there are lengthy discussion among jurists on the scope and types of riba
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TYPES OF RIBA

Riba al-Buyu (exchange transaction)

Riba al-Duyun (loan / debt transaction)

Riba al-Fadl (due to excess)

Riba alNasi`ah (due to delay)

Riba alNasi`ah (due to delay)

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Riba al-Duyun (Loan)

The basis for the prohibition of riba in loan transactions as a result of delay in time is the Quranic verses, e.g. 2:275 In loan transactions, riba will occur if the three conditions below are fulfilled: * There is excess or surplus over and above
the loan capital; * Determination of this surplus in relation to time * Stipulation of this surplus in the loan agreement

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Obsevations

In modern banking, riba may occur as a result of many factors, such as delay in time and excess in quantity; * Example 1: interest charges for bank loans are riba al-nasiah because they were charged in relation to the time given to repay the laons; * Example 2: the delay in the exchange of currencies may amount to riba al-nasiah currency exchange must be cash/spot because currencies are riba-bearing (ribawi) items
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Riba al-Buyu` (Riba in Sales) Contd

It is based on the hadith of Bukhari and Muslim:

From `Ubadah bin al-Samit after the Prophet who said: Gold for gold, silver for silver, wheat for wheat, berley for barley, dates for dates, salt for salt; exatly equivalent for equivalent, hand to hand. You are free to trade objects as long as they differ and are traded hand to hand.
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Rules Governing Riba al-Buyu`

Muslim jurists deduced from this hadith the following rules which govern riba albuyu`: 1) When trading metal for metal (gold fr gold) and food for food (dates for dates), there are two conditions should be fulfilled: i) The equality of both objects quantitattively ii) Promt delivery (hand to hand)
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Contd
2) When trading metal for metal or food for food from two different genres/kinds, such as gold for silver or wheat for barley, there is only one condition, i.e the promptness in delivery 3) When trading metal for food, eg. gold for wheat, both conditions are omitted and free trading can be done.

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Summary of Rules

Money1 + money 1

Food1 + food1

Money1 + money2

2 conditions: * Equality * Hand to-hand 2 conditions: * Equality * Hand-to-hand 1 condition: * Hand-to-hand

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Summary of Rules

Money1 + money 1

Food1 + food1

Money1 + money2 Food1 + food2 Money + food trading Others + others trading -

-2 conditions: * Equality * Hand-to-hand 2 conditions: * Equality * Hand-to-hand -1 condition: * Hand-to-hand 1 condition: * Hand-to-hand No condition free No conditions free
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Type of Riba al-Buyu`

Riba because of delay in time (riba alnasiah) can occur in the exchange of certain riba-bearing (ribawi) items, whereby the exchange is deferred or not spot/cash riba al buyu Riba due to excess (riba al-fadl) occurs in the exchange of exactly similar ribabearing (ribawi) items, whereby the exchanged counter values are not equal in amount/quantity
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PROHIBITION OF GHARAR

All jurists agree that gharar should be avoided in commercial exchanges contracts This is because gharar is one of the elements prohibited in Islamic law

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Meaning of Gharar

Literally: Gharar covers a number of negative elements, e.g deceit/fraud (khidaah), uncertainty, danger/risk, and peril/hazard (khatar) that might lead to destruction and loss Technically:Gharar is often used to refer to uncertainty and ignorance of one/both of the attributes in a contract over the substance or existence and availability at the time of contract Thus, gharar in a contract/transaction exists when its consequences are hidden and unknown to the contracting parties
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Gharar in the Quran

The word gharar and its derivatives appear in the Quran in 27 instances But, in all these instances, the word gharar has been used to refer to theological and religious themes, i.e. the need for the believers to be aware and vary of the deceptive character of the worldly pleasures of this profane life, and not to be deceived by such temptations
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Contd

Thus, the jurists did not use these 27 references to gharar in the Quran to justify the prohibition of gharar in contracts they were meant exclusively for religious themes However, through the observations of the jurists, and guided by the many ahadith on gharar, it has been concluded that gharar is an element that comes under the meaning of other terms that are expressly prohibited in the Quran i.e al-batil
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Contd

The prohibition of al-batil (falsehood/deception), is made, for example, in surah al-Nisa (4:29) [O you who believe! Eat not up your property among yourselves unjustly (bi al-batil i.e., by falsehood and deception) except it be a trade amongst you, by mutual consent ]

The jurists agree that the word al-batil in the above verse includes all categories of illegal and defective elements in commercial contracts, including that of gharar
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Gharar in the Sunnah

The Sunnah uses the word gharar and its derivatives much more extensively than the Quran in the sense that several new meanings are added In relation to commercial transactions, the Prophet SAW in many of his sayings directly prohibited the sale involving gharar (uncertainty) and jahalah (ignorance)
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Contd

Thus, the prohibition of gharar is made conclusive by the sunnah / hadith of the Prophet SAW Examples: the prohibition of gharar sale (i.e., the sale contract affected by gharar), the prohibition of the sale of fish in the sea, bird in the air, unborn animals, lost items, etc.
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Gharar in Fiqh

Gharar is prohibited by the Muslim scholars and jurists by consensus (ijma), right from the time of the companions (sahabah), their followers (tabiin) and other subsequent scholars until now

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Purpose of the Prohibition of Gharar

To ensure full consent and satisfaction of the parties in a contract Without full consent, a contract may not be valid certainty, full knowledge, full disclosure and transparency, and zero deceit/fraud
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Types of Gharar

Gharar yasir (minor/slight) tolerated and will not invalidate a contract Gharar fahish (excessive/major) not tolerated and may result in voidability of a contract

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Gharar in Contracts

Generally, gharar only affects exchange contracts (uqud almuawadhat), in particular, the contract of sale and leasing Gharar does not in principle affect contracts of charity (al tabarruat), such as, gift and bequest

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Contd
Gharar cab be averted if:

both the price and the subject matter are proved to be in existence at the time the transaction is concluded; their qualities are known and their quantities determined; the parties have control over them so as to ensure that the exchange takes place; any term of time involved is precisely determined
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Gharar in Contracts

None/incomplete ownership do not sell what you do not have cannot legally guarantee delivery Non-possession of the object prohibition of the sale of food bought but without taking possession yet cannot guarantee physical delivery & to avoid any manipulation by the 1st buyer and protect the interest of the 2nd buyer Insertion of extraneous stipulations that would render certain elements or the result of the contract uncertain want of knowledge, e.g., conditional sales
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ASSET-BACKED FINANCING

Islamic financing is based on illiquid assets, which creates real assets and inventories. In the conventional financing, banks and financial institutions deal in money and monetary papers only Islam, on the other hand, does not recognise money as a subject-matter of trade
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Contd

Money is not a commodity that demands a price and does not give birth to money Money is a means of transacting business Money has no intrinsic utility; it is only a medium of exchange Therefore, profit earned through dealing in money is interest, hence prohibited

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Contd

Profit is generated when something having intrinsic utility is sold for money Or when different currencies are exchanged one for another Not true the lending money on interest

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RISK BEARING AND PROFITSHARING FINANCING

The principle of no profit sharing without risk sharing (al-ghunm bi al-ghurm) i.e earning profit is legitimised by engaging in an economic venture that contributes to the economy The relationship between Islamic banks and their customers is not that of creditors and debtors, but on the basis of partners and investors, or profit and loss sharing between owners of capital (rabb al-mal) and fund managers or investors (mudarib) through the mudarabah and musharakah contracts.

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Contd

In both mudarabah and musharakah, the capital provider is responsible for bearing all the financial loss of the enterprise or in proportion to his capital in the total amount of investment and remains at stake until the project is completed In the case of ijarah (leasing), the capital owner is responsible for all the risks attached to the life of the asset, until the asset successfully completes its anticipated productive life
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Contd

In bay salam, the risk bearing arises from the uncertainty of the future prices of the commodities involved in the contract In bay murabahah, the risk is only up to the stage when the goods are handed over to the buyer and not until the capital is returned as in the previous techniques. Once the goods are handed over to the buyer, the risk lie with him and the finance provider shares no risk
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CONCLUSION

Islamic law is everlasting and dynamic due to the continuous development through the practice of ijtihad The general rule in Islamic finance and commerce is permissibility, which open the door for innovation of the new contract The variety of contracts expressly and impliedly allowed by Islam are potential instruments to meet current and contemporary financial needs
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Thank You & Wassalamu`alaikum

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