05 MBAgeelani

Islamic Finance: A Synthesis Iftikhar Geelani MBA
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Business School

Islamic Finance: A Synthesis

Iftikhar Geelani

MBA
2005
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Islamic Finance: A Synthesis

by

Iftikhar Geelani

Year of 2005

A dissertation presented in part consideration for the degree of Master
in Business Administration in Financial Studies at the University of
Nottingham.
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ABSTRACT
Islamic finance has the same purpose as conventional finance except
that it operates in accordance with the rules of Shariah (the Islamic
law), known as fiqh al muamalat (Islamic law of contract). Not all
means of conventional financing are Shariah compliant, or at least there
are some restrictions, especially in the debt mode of financing. Shariah
compliant financial instruments are those that do not contravene
Islamic prohibitions and ensure that the financial contracts would not
contain Riba and Gharar (explicated further), which are forbidden in
Islam in business transactions. In Islam, money is not looked at as a
commodity that commands a price. Money does not reproduce and give
birth to money. Economic activity such as production and trading
produces the money. Money is a medium of exchange and a means of
measuring the efficiency of a business through the use of `rate of return
on investment. Moreover, risk taking on permissible activities is praised
in Islam; in fact it is considered a prerequisite for profits and
enrichment. However, being involved in gambling-like activities, which
create pure risk for the sake of risk, is prohibited and renders the
contract to be null and void.
According to the Quran (sacred text of Islam) and Sunnah (Prophet
Muhammads PBUH sayings and actions), maximizing profits and risk
management is encouraged in Islam in legal permissible ways. Several
classical jurisprudential methodologies have been employed to create
financial instruments, which concur with the spirit of Islam and
encounter consumers need. Absence of adequate understanding of fiqh
al muamalat, imitative approach, and the tendency to apply a rigid
`textualist framework on finance is countered by the growing
significance of the global integrated financial market.
This dissertation examines the rationale of Islamic finance, presenting
basic theoretical understanding of the concepts of Riba and Gharar and
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an economic argument for their prohibition. Basic Islamic financial
instruments are explored in view of modern finance, highlighting
different scholars opinions. Finally, the issues and challenges facing
Islamic banking in a hyper-competitive environment are addressed.
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TABLE OF CONTENTS

Abstract III
Table of contents V
Acknowledgements VII
1. Introduction: Why Islamic Finance? 1
1.1. Rationale of Islamic Finance 6
1.1.1. Islamic Identity 5
1.1.2. Problems with Conventional Banking 8
1.1.3. Ethical Prospective 10
1.1.4. Allocation Efficiency 12
2. Riba 14
2.1. Types of Riba 18
2.2. Does Riba Mean Interest? 14
2.3. Why is Riba Prohibited? 21
2.3.1. Ethical Prospective 22
2.3.2. Financial Prospective 25
2.4. Economic Efficiency Achieved from Prohibiting Riba 27
2.5. Economic Inefficiency in Interest-based Contracts 29
3. Gharar 31
3.1. Quran and Hadith Banning Gharar 33
3.2. Why Gharar is Forbidden? 35
3.3. Is Risk-taking Forbidden in Islam? 38

3.4. Excessive and Minor Gharar and When a Contract is
Classified as Gharar
39
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4. Islamic Instruments 43
4.1. Debt-based Contracts 46
4.1.1. Murabahah 47
4.1.2. Ijarah 50
4.2. Equity-based Contracts 53
4.2.1. Mudharabah 54

4.2.2. Musharakah
57

4.2.3. Financial Engineering of Mudharabah and Musharakah
60

4.2.3.1. Financial Objectives
60

4.2.3.2. Risk Profile
61
4.3. Derivatives 62
4.3.1. Salam 62
4.3.2. Futures 64
5. Current Status and Future Prospective for Islamic Finance 69
5.1. Current Market Trend 69
5.2. Issues and Challenges 70
5.2.1. Regulatory Framework 70

5.2.2. Slow Innovation and Solutions
72

5.2.3. Uniform Global Guidelines
73

5.2.4. Islamic Institutions Size
75

5.2.5. Sound Accounting Procedures and Standards
76
6. Conclusion 78
References 82

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ACKNOWLEDGEMENT
I take this opportunity to express my debts of deepest gratitude for the
absolutely essential assistance and prayers of my mother Dr. Khadija
Bagum. This assistance has not been limited to this dissertation, it was
a form of continuous support all through the various stages of my life,
and without her love and support this study would never have been
completed.
My gratitude also goes to my family. Without my wifes Abeer Saati,
support through out the time I spent in UK, this dissertation would not
have been written. Also, my gratefulness goes to my wife for taking
care of my both sons Hattan and Rakan.
A special debt is owned to Professor Muhammed-Shahid Ebrahim, who
helped me to formulate the ideas in my dissertation through our
discussions. Professor Ebrahim also provided me with full support in my
data/material collection. Hopefully, the lessons of this dissertation will
enable readers to enjoy more leisure time in the future.
Finally, my sincere gratitude to Saudi British Bank for providing me
opportunity to perform the MBA Degree in the University of Nottingham.

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1. Introduction: Why Islamic Finance?
Islamic finance has emerged in recent decades as one of the most
important trends in the financial world. There has always been a strong
demand among Muslims for financial products and services that
conform to the Shariah (the Islamic law). With the development of
viable Islamic alternatives to conventional finance, Muslims are
beginning to find Shariah compliant solutions for their financial needs.
Given a total population of more than 1.6 billion Muslims worldwide,
Islamic finance is a collective effort of financier practitioners,
economists and Islamic scholars to develop and expand financially and
geographically over the past several decades.
Many of the international financial institutions are now focusing on
Islamic instruments (halal) to gain a significant market share of the
funds. Al-Khaleej (Times on 3
rd
Aug. 2005) reported that today there
are about 265 Islamic banks and financial institutions worldwide, with
total capitalisation exceeding $13 billion, assets surpassing $260 billion,
and customer deposits amounting to $200 billion, with financial
investments of twice that figure. Additionally, conventional financial
institutions manage $1.1 trillion in Islamic funds
(www.khaleejtimes.com). These figures show explicitly how Islamic
financing is gaining momentum and spreading radically since the
modern Islamic finance began in the early 1970s.
Islamic financial institutions operate in compliance with Shariah law and
government regulations. As far as compliance with Shariah is
concerned, the form of the contract is what matters. Islamic finance is
based on human justice and ethical mode of financing, which derives its
principles from Quran (sacred text of Islam) and the Sunnah (referring
to the way in which the Prophet Muhammad Peace Be Upon Him (PBUH)
lived his life). Islamically, financing contains injunctions which result in
hardship; however, the hardship itself is never the intention of Islam.
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As will be seen in this dissertation, the intention of Shariah by banning
certain elements in financing is to bring a larger benefit or to prevent a
larger loss. The main difference between the conventional financing and
the Islamic system, as we shall observe in Chapter 2, is that the latter
is based on keeping in view certain social objectives for the benefit of
the overall society.
While permitting the individuals the right to seek their economic well-
being, Islam makes a clear distinction between what is halal (lawful)
and what is haram (forbidden) in pursuit of such economic activity.
Central to the Islamic finance system is the prohibition of Riba and
Gharar (further explicated). Both Riba and Gharar result in tremendous
injury to the society, and injustice. In Islamic finance, the money itself
has no intrinsic value; it is simply a medium of exchange. Money does
not reproduce and give birth to money. As a matter of faith, a Muslim
cannot lend money to, or receive money from someone and expect to
benefit. Lending and/or dealing in money in the same way as
commodities is prohibited. Returns on lent funds must be based on
actual profits generated and not on a pre-determined interest rate. In
broad terms, to make money from money is forbidden. Money must be
used in a productive way, and wealth can only be generated through
legitimate trade and investment in assets.
On the other hand, Shariah determined that, in the interest of fair and
transparent dealing in the contracts between the parties, any unjustified
wealth enhancement arises out of delusion or deception transactions;
for example, selling assets that the seller might not be able to deliver,
is prohibited. Such speculative behaviour and trading under pure
uncertainties is called a `Gharar transaction in Islamic contracting law.
Gharar is a sophisticated concept that covers certain types of
uncertainty or contingency in financial contracts. If the object dealt with
is not fully certain and transparent this might invalidate the deal to buy
or sell. Contracting parties should have perfect knowledge of the
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counter values intended to be exchanged as a result of their
transactions.
The Islamic way of enrichment is established by the famous Hadith "Al-
Kharaj Bil-damn (liability justifies utility or return); that is, the
entitlement of any return from asset or project/investment rests on one
bearing risk of it. This maxim establishes the principle of Justice. Rights
and obligations must go along with each other and they have to be
balanced. Devouring other peoples money unlawfully or without
justified effort creates injustice and imbalance between rights and
obligations. Islam not only prohibits dealing in Riba and Gharar but also
in liquor, pork, gambling, pornography and anything else that the
Shariah deems haram (unlawful). Islamic banking is an instrument for
the development of an Islamic economic order. In broad terms, Islam
forbids all forms of economic activity, which is morally or socially
injurious.
The main trust of Islamic financing is based on sharing the risk and
reward principle, substituting equity for debt and transferring the
borrower-lender relationship to joint participation through sharing
profits/losses is a potential solution that promotes entrepreneurship. Yet
Islamic finance worldwide has not come up with the competitive
financial instruments and products which allow them to provide valid
avenues for the universal consumers and deliver solutions to modern
challenges. Conventional practitioners argue that Islamic instruments
lack the quality and security of the products offered by other
conventional financing instruments.
Globally, Islamization of the financial sector varies dramatically across
countries. Iran, Pakistan, and Sudan are at one extreme, where they
attempt an entirely Islamic financial system. Malaysia, Saudi Arabia,
and some other Arab countries have developed a hybrid dual financial
system where Islamic banks coexist with the conventional banking
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system, and the monetary authorities of those countries regulate both
types of financial institutions. On the other hand, Islamic financial
institutions themselves adopt different forms: wholly Islamic
institutions, Islamic specialized subsidiaries of conventional banking
groups, and Islamic banking windows within conventional banks. In the
remainder of this chapter, the rationale of Islamic finance will be briefly
discussed examining the theory behind Islamic banking in contrast to
conventional banking.
Chapter 2 will start by presenting the theoretical understanding of the
concept of `Riba, types of Riba and the intention of Interest in contrast
to Riba. This will be followed by the rationale behind prohibiting Riba,
going through the Ethical prospective, Financial prospective and the
Economic efficiency gained by proscribing interest-like transactions
(Ebrahim and Tan Kai, 2001). Chapter 3 will introduce the notion of
`Gharar in a hypothetical manner, scanning the definition, the types,
banning rationale, and finally comparing the business risk with Gharar.
Islamic financial instruments are conceptualized as non-recourse asset-
backed securities. Islamic financing contracts in this dissertation are
classified as: (i) Debt-based (credit) facilities such as Murabahah and
Ijarah, which resemble the conventional products, are elaborated in
section one of Chapter 4; (ii) Equity-based facilities including
Mudharabah and Musharakah are based on the profit and loss sharing
concept, and these will be addressed in section 4.2; (iii) Derivatives:
these products are basically structured for managing the risk. Futures
and Salam (Islamic Forward) contract features and debates will be
highlighted in section three (4.3.) of the same chapter. Chapter 5 is
divided into two sections: (i) current market trend of Islamic banking
and finance; (ii) issues and challenges facing Islamic institutions from
operating far below the potential such as lack of uniform regulatory and
legal framework, slow innovation and immature accounting procedures
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and standards. Ultimately, the concluding remarks will be presented in
the final part of this dissertation.

1.1. Rationale of Islamic Finance
It has been more than a quarter of a century since the first Islamic
bank was established in Egypt in 1963. Islamic finance is a growing
phenomenon and is emerging rapidly as a part of the financial sector
worldwide. It came into existence to satisfy the financial devout needs
of 1.6 billion Muslims globally who wish to follow the Islamic way of
dealing. Islamic finance is not restricted to Islamic countries, but
spreading wherever Muslim community exists. The Islamic financial
system is a relatively new concept, appearing only in 1970s. In fact, the
earlier references to commercial activities conforming to Islamic
principles were solely considered under the umbrella of an ìnterest-free
banking/financial system. However, describing the Islamic financial
system simply as an ìnterest-free system is imperfect and incomplete.
Undoubtedly, receipt and payment of interest on monetary transactions
is prohibited, and considering the nucleus of the Islamic financial
system, which will be dealt with in detail in this thesis, this principle is
supported by other doctrines such as risk sharing, capital formation, fair
dealing etc. The three decade practice and the theory, both show that
the Islamic financing concept is feasible, and conversion of the entire
system into an Islamic system will not result in financial collapse as
predicted by some Western economists.
Despite the many critics form Muslim scholars levelled against the
conventional Ribawi banking system, this Riba-based financing system
has been around for a very long time and will continue to be so for a
long time to come. As a matter of fact, all countries of the world,
including Islamic countries (except Iran, Pakistan and Sudan) operate
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by conventional financing methods in their financial system. Therefore,
the proponents of conventional financing claim that, if this system was
really bad it would not have been able to survive till now. Beside, the
Islamic banking system is not very prevalent even in Muslim countries.
Moreover, a number of Islamic scholars, such as Abdullah Yusuf Ali the
well-known translator of Quran (p. 111 note 324, translation of
Quran), and Sheikh Mohammed Sayed Tantawi, the famous
jurisprudence in Egypt (2002), have permitted employing
predetermined interest-based transactions. Nevertheless, the
prevalence of interest-based financing could not be taken as correctness
and superiority of such a system. Allah (SWT) said in the Quran, "And if
you obey most of those on the earth, they will mislead you far away
from Allhs Path. They follow nothing but conjectures, and they do
nothing but lie. (S6: 116)
Islamic finance is in many ways very similar to conventional finance in
terms of delivering financial needs. However, it has emerged in recent
decades as one of the most important trends in the financial world.
Islamic financial institutions try to ensure all their instruments adhere to
Shariah requirements. Nevertheless, the notion that Islamic finance is
an instrument for the development of an Islamic economic order is
countered by the question: why do we need Islamic finance? Islamic
finance received great attention as an alternative option in the
international financial scene in the 1970s. The rationale of Islamic
finance can be summarized in the following four points:

1.1.1. Islamic Identity
Islam prescribes this life as a place where Muslims prepare themselves
for the next life and thus they should treat this life as a test and trial.
As a result, Muslims should plan and achieve goodness in this world and
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the hereafter. Islamic identity is the most important living reality for
Muslims. Islamic finance is vital to reflect the fixed, transparent, and
eternal teachings of Islam on financing behaviour. Religious rationale is
far more important than the economic justification. It is not proper for a
Muslim to undertake a comparison between the Halal (permitted)
methods and Haram (prohibited) practice, because a Muslim who
believes in God and the Day of Judgment has no option in choosing
between the two extremes. In Quran, Allah (SWT) ordered, "It is not
for a believer, man or woman, when Allh and His Messenger have
decreed a matter that they should have any option in their decision.
And whoever disobeys Allh and His Messenger, he has indeed strayed
into a plain error (S33: 36). The life goal of Muslims is not only to
satisfy temporary financial needs, but it is to achieve falaah (success)
and prosperity that lead to a good life in this world and the hereafter.
Thus Ìslamic Finance is more comprehensive than that of the
conventional in the sense it includes satisfying financial need, protection
from exploitation, and justice in order to get a good life in this world
and the hereafter.
Muslim nations therefore developed ways to integrate their religious
beliefs with the external economic realities of the nations they live in. It
is endeavouring to undertake the task of development of Ìslamic
Finance on earth on the basis of piety to God to achieve His bounties.
Islamic finance, besides the material and financial aspects, comprises
spiritual, moral and Islamic identity aspects. It, therefore, participates
in the establishment of monetary ideology, which embodies Islamic
principles in the life of individuals in their financial practices.

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1.1.2. Problems with Conventional Banking
Muslim economists have always searched and are still searching for
flaws in an economy that is driven by Riba and Gharar so that they
could justify their theories of the Islamic monetary system. Given the
financial crises over the past 20 years in both developed and developing
countries are clearly not random or isolated events, this indicates the
existence of such flaws in the western financial system. Meanwhile,
each financial crisis has its unique and country-specific features; for
instance, the Korean crisis had little to do with the asset inflation of the
kind seen and was a major cause in the rest of South-East Asia. Having
said that, the financial crisis globally yet shared a lot in common. The
banking crises in Japan, East Asia, Russian, Venezuela, Mexico,
Argentina, and others are the result of a complex set of factors. Mishkin
(1999), Renaud et al. (2000), Llewellyn (2000), Herring et al. (1999),
Kim (2001), and other economists pointed out several crisis factors,
emanating from fundamental weaknesses, surges in capital inflows,
financial liberalization, underestimation of risk and fragile credit policies,
overexposure in a particular sector such as real-estate, poor banking
system, currency failures and exchange rate regimes, asset
depreciation, sudden drop in collateral, faulty ineffective regulation and
government intervention, illiquidity, macroeconomic shocks and
accountancy maladministration.
All financial instability hypothesis links analysis of flaws in conventional
banking mainly to the investment vulnerability, which is based on
interest-bearing lending debts. Tlemsani and Matthews (2002) in their
paper reported that, while Fisher (1945), Simons (1948) and Friedman
(1969) have argued that the current one-sided liability ìnterest-based
financial system can be fundamentally unstable, Khan (1986) on the
other hand noted that the abolition of interest-based transactions is not
a subject alien to Western economic thought. As mentioned earlier,
analyses of financial crisis provided a long list of their causes, yet
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surprisingly little has been said about the one underlying common
denominator to all of them debt contracts, exuberance in lending, and
greediness of high income from high interest charges during the crisis
periods. If we consider the East Asian crises, for example, we witness,
once the asset prices decelerate after the real estate boom, the highly
leveraged firms found themselves drowning in debt interest
commitments consuming a high portion of the cash flow, while the cost
of rolling-over with even higher interest (sometimes due to government
intervention to defend the currency) placed a further burden and
deficits. This created two extreme phenomena: first, moral hazard
incentives for the borrowers in the private sector to take greater risks
because they have less to lose if the loans go sour; second, a
movement towards liquidating the assets to meet the debt service
commitments. Dar and Presley (1999) claimed that the latter intention
resulted in two phenomena: 1) asset prices fall due to the rush in
selling, consequently lowering the collateral values, which makes banks
very cautious of rolling-over the existing loans; 2) banks hoarding cash
leading to money supply contraction, consequently further raising
interest rates and motivating further bankruptcies.
The use of the profit-loss sharing principle to reward depositors has
important implications on the stability of the banks. The payoffs
fluctuate with the economic outputs. If the return of the bank is low due
to overall economic downturn, then this will be reflected on both sides
of the balance sheet. In practice, if the asset side did not chip in a high
return, due to economic slowdown, this low return would be transferred
to the liabilities (deposits in Islamic bank). Linking the return on
liabilities to the return on assets creates stability, whereas this is not
the case in conventional practice where the fixed-interest debts impair
the overall economy. The decline in asset values is cushioned by a
corresponding decrease in liabilities, protecting the net-worth of the
bank (Ahmed, 2002). The surges of outflow funds in 1997 triggered the
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market crash and resulted in the South East Asian crisis. The
conventional interest-based financing method fell short to stop such
panic and the contagion. The economic crisis in the Asian countries was,
though, partially caused by imprudent lending and other mentioned
factors; it is yet not unfair to imply that it was fuelled by the dominated
interest-based financial system. Dar and Presley (1999) stated "The
`financial instability hypothesis marries an analysis of conventional
banking, stressing the procyclical nature of lending policies, with an
examination of the vulnerability of an economy when investment is
financed by issuing liabilities which have a fixed nominal value i.e.
interest-bearing debt.
International debts played a major part in causing the financial crashes.
Interest bearing debts were the integral part of social, financial, and
political problems in Argentina, Mexico, South East Asian countries and
other crisis countries. The Islamic economic principles of sharing risks
and rewards, and joint participation in the wealth creation activity by
borrower and lender, through substituting equity for debt, is a potential
solution that promotes entrepreneurship and creativity in the economic
cycle. A significant outcome of an Islamic-based profit and loss sharing
system may be to introduce greater stability into Western-style financial
transactions.

1.1.3. Ethical Prospective
Islam enthusiastically promotes trading within permitted areas on the
basis that it contributes to the betterment of society in general.
However, its laws of commerce are against charging interest on loans,
uncertain trading and certain forbidden areas of business. Islamic
finance conforms to moral principles as well as the religious aspect.
There is an obvious set of haram business activities that Islamic
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financial institutions should avoid, such as trading in pork, alcohol,
gambling and pornography. While permitting the individual the right to
seek his economic well-being, Islam makes a clear distinction between
what is halal and what is haram in pursuit of such economic activity. In
broad terms, Islam forbids all forms of economic activity, which are
morally or socially injurious.
Another key tenet of Islamic finance is that, under Islams Shariah law,
charging interest on loans or any kind of Riba is considered immoral,
because it involves no real business activity. Additionally, involving
transactions where there is excessive risk and uncertainties is also
dishonest dealing, because it motivates exploiting and taking advantage
of uncertain circumstances. Under Islam, money is considered potential
capital that only becomes actual capital when it joins hands with other
resources to undertake a productive activity. Justice is the sprit of Islam
and has to do with the fairness of social arrangement in the society.
Moreover, justice in Islam in economic activity is considered as a means
to an end, not an end only. In financing, Islam actualizes the concept of
justice by prohibiting Riba and Gharar. "Islam is deeply concerned with
the problem of economic development, but treats this as an important
part of a wider problem, that of total human development. The primary
function of Islam is to guide human development on correct lines and in
the right direction. It deals with all aspects of economic development
but always in the framework of total human development and never in a
form divorced from this perspective (Al-Harran, 1993).
However, the Western conventional financial system focuses merely on
economic and financial aspects, to the extent that "Milton Friedman
(1997) feels no discomfort in stating that `profit should be the business
of business, even if these profits lead to deaths (Zaman and Zaman,
2001). The Islamic system in contrast places equal emphasis on the
ethical, moral, and religious dimensions, and equality fairness of society
as a whole, as well as the economic and financial aspects. The Islam
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prohibition of interest on monetary transactions and speculative
behaviour is basically rationalized as a way of: (i) avoiding the
tremendous injury to the society, particularly when the greedy
financiers could exploit the weak borrowers either by imposing
exorbitant interest rates or by excessive injustice and cheating; (ii) the
issue that reward should be given for lawful productive behaviour, and
prohibiting payment or receipt of predetermined guaranteed rate of
return or receiving profit without putting in a real and serious lawful
effort is to ensure economic efficiency and justice. Ebrahim and Tan Kai
(2001) sum up "Interest creates social divisions between the rich and
the poor and especially causes hardship to borrowers. This is so
because the lender is seen to be exploiting other peoples needs without
actively using to advantage the productive nature of the capital in
question. Any profit-seeking or wealth-increasing endeavours should
be legitimate and in accord with ethical requirements. Charging interest
on loans and deception trading (Gharar) render the financer to be
assured of his capital plus premium on maturity of loan in the case of
Riba, and illicit capital gain in the case of Gharar, regardless of sharing
the risk inherent, executing any costs or examining the real outcome of
the capital employed.

1.1.4. Allocation Efficiency
Islamic financial system for investment opportunities could be expected
to be more stable owing to elimination of debt-financing methods, in
which the lender does not get directly involved in a project and puts his
emphasis only on securing his predetermined guaranteed returns;
meanwhile, replacing the said by an equity-sharing investment basis.
Iqbal (1997) argued that analytical models demonstrate that such a
system will provide more consistency since the term and structure of
the liabilities and assets are symmetrically matched through profit
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sharing arrangements. The allocation efficiency occurs because the
investment appraisals are done more strictly and the alternatives
selected based on their productivity and expected rate of return.
Moreover, the entrepreneurship turns out to be more effective, as the
entrepreneurs compete to become the agents of the funds suppliers
who closely scrutinize the investments. From a theoretical point of view,
there is no reason to believe that the Islamic financial institutions may
not be able to fulfil the intermediary task required by them, if not better
in some cases.
In the following chapter, we shall review the two fundamental Islamic
prohibitions, Riba and Gharar, which render the financial contracts to be
null and forbidden.

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2. Riba
The prohibition of Riba in Islam is perhaps the topic most commonly
discussed in the jurisprudence of financial transactions. The Prophet
(PBUH) warned the Umma during his lifetime form about the spread of
Riba. Abu Huraira (r.a.) reported Gods Messenger (SAW) as saying "A
time is certainly coming to mankind when only the receiver of Riba will
remain and if he does not receive it some of its vapors (or alternatively,
its dust) will reach him (Ahmad, Abu Dawud, Nasai and Ibn Majah).
Therefore, the attempt will be to provide a fresh clear understanding on
the concept.
Riba literally means an ìncrease or addition. Technically in simple
definition it denotes any increases or advantage obtained by the lender
as a condition of the loan. Additionally, any risk-free or `guaranteed
rate of return on a loan or investment is also classified as Riba.
Riba is forbidden in Quran and Sunnah, and avoiding all kinds of Riba
transactions is the basic concept of Islamic finance. All forms of Riba are
prohibited in Islam and have been given explicit treatment, and
mentioned in severe terms in both Quran and Sunnah. Riba is the
destroyer, and Allah (SWT) clearly said that he (SWT) will desecrate
Riba, and described the people who exercise it that, on the day of
resurrection, they will awaken as if Satan had beaten them.
"Those who eat Riba will not stand (on the Day of Resurrection) except
like the standing of a person beaten by Shaiatn (Satan) leading him to
insanity. That is because they say: 'Trading is only like Riba whereas
Allah has permitted trading and forbidden Riba. So whosoever receives
an admonition from his Lord and stops eating Riba shall not be punished
for the past; his case is for Allah (to judge); but whoever returns [to
Riba], such are the dwellers of the Fire - they will abide therein forever
(S2: 275).
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There are many proofs of the prohibition of Riba in Quran and Sunnah
and are regarded as one of the great destructive sins and doers (Riba
eater); if did not desist, there has been a warning to be prepared for a
war against Allah (SWT) and his Apostle (PBUH). Allah (SWT) said in
Quran: "O you who believe! Be afraid of Allah and give up what
remains (due to you) from Riba (from now onward), if you are (really)
believers (S2: 278).
"And if you do not do it, then take a notice of war from Allah and His
Messenger but if you repent, you shall have your capital sums. Deal not
unjustly (by asking more than your capital sums), and you shall not be
dealt with unjustly (by receiving less than your capital sums) (S2:
279).
Practicing Riba is considered one of the Kabayr (major sins) in Islam. In
the Hadith, the Prophet (PBUH) said "Avoid the seven grave sins .
among which He (PBUH) mentioned `devouring Riba. The Prophet
Mohammed (PBUH) further in another Hadith cursed all the parties
involved in the transaction. In Sahih Muslim (Book 10, Number 3881),
Jabir said that Allahs Messenger (may peace be upon him) cursed the
accepter of interest and its payer, and one who records it, and the two
witnesses, and he said: "They are all equal. Not surprisingly, therefore,
Umar (radiallaho unho) used to say in absence of certainty, one must
"leave behind Riba and doubt.
Thus, the penalty is also extremely massive in Sahih Bukhari (Volume
9, Book 87, Number 17), Samura bin Jundub (radiallaho unho)
narrated: Allhs Messenger (salallaho alaihi wasallam) very often used
to ask his companions, "Did any one of you see a dream? So, dreams
would be narrated to him by those whom Allah willed to relate. One
morning the Prophet (PBUH) said, "Last night two persons (angels)
came to me (in a dream) and woke me up and said to me, `Proceed! -
later in context the Profit (PBUH) said, "And behold, in the river there
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23
was a man swimming, and on the bank there was a man who had
collected many stones. Behold, while the other man was swimming, he
went near him. The former opened his mouth and the latter (on the
bank) threw a stone into his mouth whereupon he went swimming
again. Then again he (the former) returned to him (the latter), and
every time the former returned, he opened his mouth, and the latter
threw a stone into his mouth (and so on); the performance was
repeated. I asked my two companions, `Who are these two persons?
They replied, `Proceed! Proceed! . The Profit (PBUH) said to them, Ì
have seen many wonders tonight. What does all that mean which I have
seen? They replied, `we will inform you: . and the man whom you saw
swimming in the river, and was given a stone to swallow, is the eater of
Riba .

2.1. Types of Riba
Islamic scholars have divided Riba into different categorizations. The
most common and the one the majority of jurists consented on is:
Ribaal-fadl (Ribaal-buyu) and Ribaal-nasiah (Ribaal-diyun). There are
numerous Hadiths from which we can observe this classification, and let
us examine three of them.
1) Bukhari narrated in his Sahih (Volume 3, Book 34, Number 385) on
the authority of Abu Said Al-Khudri (radiallaho unho): Allahs Apostle
(PBUH) said, "Do not sell gold for gold unless equivalent in weight, and
do not sell a lesser amount for a greater amount or vice versa; and do
not sell silver for silver unless equivalent in weight, and do not sell a
less amount for a greater amount or vice versa and do not sell gold or
silver that is not present at the moment of exchange for gold or silver
that is present.
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24
A similar Hadith from the same narrator is there in Sahih Muslim (Book
10, Number 3845).
2) In Sahih Muslim (Book 10, Number 3878), Ibn Àbbas (Allah be
pleased with them) reported on the authority of Usama b. Zaid Allahs
Messenger (may peace be upon him) as having said this: "There is no
element of interest when the money or commodity is exchanged hand
to hand.
3) Also in Sahih Muslim (Book 10, Number 3877), Ubaidullah b. Abu
Yazid heard Ibn Àbbas (Allah be pleased with them) as saying: "Usama
b. Zaid reported Allahs Apostle (PBUH) as saying: `There can be an
element of interest in credit (when the payment is not equal).
From the above three Hadiths it is clear that there are two conditions
for exchanging money for money in Islamic terms: First, it should be
hand to hand, and Second it should be equal in quantity. The breach of
any of these will result in one of two forms of forbidden Riba.
1) Ribaal-fadl: where money is exchanged for money hand-to-hand,
but in different quantities.
2) Ribaal-nasi'ah: where money is exchanged for money with
deferment (interest on lent money).
Thus, Ibn Qayyim, a great thinker of Islam, said in such regard, "it is
forbidden to depart before the physical exchange of goods takes place.
This is to prevent it from becoming a source of late payment which is
the main cause of interest.
It is quite interesting to note that the economist St. Thomas, a medieval
scholar (1225-1274), who was considered as "the greatest Catholic
philosopher of all time by Newman, Gayer and Spencer (Ghazanfar,
2000), stated the same two forms in his famous book Summa
Theologica: "It is said that if a man wishes to sell his goods for more
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25
than their just price, expecting the buyer to pay later, it is plainly a case
of usury (which is a sin in Christianity), because such waiting for
payment has character of loan. Hence whatever is exacted for such
waiting, in excess of the just price, is a kind of price of a loan, which
comes under the head of usury. And, likewise, if a buyer wishes to buy
for less than the just price, on the ground that he pays the money
before the thing can be delivered to him, it is a sin of usury, because
that money paid in advance has the character of a loan, the gain of
which is the amount deducted from the just price of the thing bought
(Summa, II.II, Q78, quoted in Ghazanfar 2000 - italic added).
Ibn Qayyim, apart from the above categorization, further divided Riba
into Open Riba 'Jiali and Disguised Riba 'khafi. The former type was
common in the pre-Islamic period (Jahiliyyah), in which they used to
extend credit with an increase and differ payment for the used to say
"extend me time, and I will increase (in payment) (amhilni azidaka).
This is considered the worst form of Riba condemned in the Quran. This
type is the same as the concept of trading in debt, which is an element
of conventional finance in which the debt is sold to the debtor, where
the price is even higher and a longer deferment period is granted.
Meanwhile, the disguised interest or Ribaal-khafi is prohibited to stop it
from becoming an aid to interest proper, as will be explained latter.

2.2. Does Riba Mean Interest?
The starting point is to answer: is the interest paid on debts or received
on deposits Riba? The three Hadiths mentioned so far do not directly
touch upon the existing interest-related debts, which is the basic
principle of the current financial system. The key explicit Hadith used by
Muslim scholars as the basis of interest-rate-related transactions
prohibition is the one reported by Al-Shawkani in `Nayl Al-Awtar that
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26
Prophet (PBUH) said "Every loan (qard) that attracted benefit is Riba.
Muslim scholars classify the interest-rate charges on the loan as benefit.
Mirakhor (2005) illustrated four characteristics of the prohibited interest
rates: 1) determined and fixed ex-ante; 2) tied to time period and the
amount; 3) payment is guaranteed by the borrower regardless of the
project/investment of the outcome; and 4) apparatus sanction and
collection enforcement. In conventional terms, Riba and ìnterest are
used interchangeably and the first axiom is that the interest on loans
and deposits is definitely the forbidden Riba. In the conventional
system, the depositors do not share in the banks profits and losses, nor
do the banks share the profits and losses of their borrowers. Gamal
(2001) and Al-Zuhayli (1997) argued that the conventional financial
practice, which has been built on lending, and the `time value of money
that is reflected by the interest payment on debt and the interest
received on deposits are exactly the latter form of Riba (al-nasiah) that
is forbidden in Islam whether it was simple or compounded.
Having said that, it does not mean that capital is costless in the Islamic
system. Moreover, it is not true to imply that Islam does not deny the
notion `time value of money. There are numerous statements by
classical Islamic jurists, such as Ibn Rushd (1198), who said "lil-zamani
hazzun fi al-thman, which means, "Time has a share in the price. In
addition, the Islamic financial instruments such as Murabahah (cost-plus
sale) and Ijarah (leasing) clearly justify the compensation of the
òpportunity cost of deferred payment; in other words, `time value of
money, whether or not that increase is called interest. Further quotes
of Islamic scholars emphasizing the time factor are stated later on in
the Islamic instrument section. Al-Masri (2004) illustrated that in
Islamic finance selling a commodity on credit for deferred payment is a
higher price than its immediate cash price. This interest involved in
return for the time factor, which is permissible. It is clear that the term
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27
ìnterest used in todays financial and economic language is much
broader and goes beyond the fixed and floating interest rates on loans.
On the other hand, it is worth mentioning that it is NOT always Riba
that is the forbidden interest. The first kind of Riba (al-fadl) does not
involve temporal or interest elements. If we examine Abu Said al-
Khudris (Allah be pleased with him) Hadith in Sahih Muslim (Book 10,
Number 3854), who reported Allahs Messenger (PBUH) as saying:
"Gold is to be paid for by gold, silver by silver, wheat by wheat, barley
by barley, dates by dates, salt by salt, like by like, payment being made
hand to hand. He who made an addition to it, or asked for an addition,
in fact dealt in Riba. The receiver and the giver are equally guilty.
Clearly, we witness from this Hadith that Riba al-fadl does not
necessarily relate to debt or interest.
Moreover, exchange of extra quantity under barter trading, even if one
of the items was of higher quality, is also Muharram (prohibited) Riba in
Islam, and does not involve any Ìnterest element. For instance, it is
pure Riba to lend, say, 100 kg dates for receiving 150 kg of dates either
on the spot or on deferment.
The question follows: is it unlawful to exchange a lesser amount of high
quality of a commodity, gold for example, for a higher amount of lower
quality in Islam? In order to avoid being trapped in Riba al-fadl, the
exchange of commodities should be equal in amount and quantity even
if there was quality difference. Nevertheless, this exchange is permitted
once the trader sells his gold to obtain cash and then buy the other gold
he needed with the cash.
The following Bilal (radiallaho unho) story illustrates further the two
points:
1) Not all Riba means Ìnterest.
2) How to barter in different qualities in the same commodity.
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28
In Sahih Bukhari (Volume 3, Book 38, Number 506), narrated by Abu
Said al-Khudri (radiallaho unho):
Once Bilal brought Barni (a kind of dates) to the Prophet (PBUH) and
the Prophet (PBUH) asked him, "From where have you brought these?
Bilal replied, "I had some inferior type of dates and exchanged two Saa
(volumes) of it (lower quality) for one Saa (volume) of Barni dates
(better quality) in order to give it to the Prophet; to eat. Thereupon the
Prophet said, "Beware! Beware! This is definitely Riba! This is definitely
Riba! Dont do so, but if you want to buy (a superior kind of dates) sell
the inferior dates for money and then buy the superior kind of dates
with that money.
A similar Hadith from the same narrator is in Sahih Muslim (Book 10,
Number 3871).
The platform behind assembling such processes is to evade the routes
of extra charges due to uncertainties involved in assessments of the
difference in qualities. At the first glance it may not seem to be making
much sense of selling one kind of commodity in the market only to use
the proceeds to buy the same commodity but of better quality, but if we
elaborate Ibn Rushds explanation, demonstrated later on, we can
understand the motives behind this method of transaction and economic
elaboration gained therefrom.

2.3. Why is Riba Prohibited?
Before going further, it seems useful to illustrate and to understand the
philosophy of banning Riba in Islam. This query can be dealt with from
an ethical prospective and a financial prospective.

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2.3.1. Ethical Prospective
The basic platform of answering the question "Why is Riba forbidden?
is simply because "God made it so. It should be an undoubted belief
that all business transactions that Allah prohibited will surely benefit all
mankind at large and increase their wealth and piety. In addition,
Muslims must not forget that relying on Riba as a legitimate business
transaction will eradicate Allahs blessings, as affirmed in the Quran
"Allah will destroy Riba and will give increase for Sadaqat (deeds of
charity, alms, etc.) And Allah likes not the disbelievers, sinners (S2:
276). It will also result in becoming Allahs and his Prophets (PBUH)
enemy while receiving Allahs wrath, as confirmed in Quran "And if you
do not do it, then take a notice of war from Allah and His Messenger .
(S2: 279).
Banks and other financial institutions are at the heart of the economic
structure, they act as intermediaries mobilizing the savings of parties
with no investment plans to those who lack funds. The financial
intermediaries charge the borrowers interest fees in excess of what they
pay to the depositors and that is how they make profits. Moreover, they
penalize the delayed repayments by charging even higher interest
rates; in extreme cases, if the debt is not repaid on time, they
overwhelm the whole asset/property for which it was used.
The Islamic economic system is based on honouring certain social
objectives for the benefit of human beings and society, unlike
conventional finance, where the financial institutions have no concern
with the moral implication of the business for which the money is lent,
as far as the repayment is guaranteed. In the Islamic environment the
borrowers activities extend to welfare of the entire society. In order to
promote brotherhood and fraternity, Islam prohibited exploitation of
human beings and charging interests on loans. However, to deny the
reality that there are sacrifices made by the lender is wrong. For
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30
instance, these scarifies include the possibility of missing profitable
opportunities (opportunity cost), anxiety as to whether or not the loan
would be repaid, and others. But, Muslims are asked to make such
sacrifices in order to be rewarded the good deeds. This sacrifice conveys
the lenders gratitude and reward hereafter. But if someone charges
interest or premium for his generosity, there is no question of thanks
and reward. In Islam, the exploitation of troubled people and benefiting
from financial weakness of customers is forbidden. In fact helping
people facing financial difficulties is a great good deed in Islam, and
rewarded generously by God. In Sahih Bukhari (Volume 3, Book 34,
Number 292), Abu Huraira (radiallaho unho) narrated that The Prophet
(PBUH) said, "There was a merchant who used to lend the people, and
whenever his debtor was in straitened circumstances, he would say to
his employees, `Forgive him so that Allah may forgive us. So, Allah
forgave him. Additionally, the Prophet encouraged Muslims to be
lenient with the financially-distressed customers, when He (PBUH) said,
". If a debtor is in difficulty, grant him time till it is easy for him to
repay (narrated by Aisha in Sahih Bukhari, Volume 6, Book 60,
Number 66).
It is worth noting that the scriptures of the Old Testament of other
religions also recommended interest-free loans. Christians and Jews
both opposed Riba dealing and considered it as being among the worst
sins. The Economist magazine (1993 - No. 329), in an article titled
"Usury: The lenders long lament, mentioned that three major
religions, Islam, Christianity and Judaism all have formally forbidden
usury. Although, often, this directive has not been followed strictly, two
points were the main arguments against usury in these religions. First,
the lender is getting something for nothing ùnearned income as
termed by churches in Christianity, in other words getting reward
without sharing any risk. Simply, there should be no gain without pain.
Second, the individuals should help their brothers/neighbours without
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31
hoping for return from them. For example, if a person places 1,000 in
a fixed deposit account at 5% interest for a year, he will earn 50 profit
on his saving. But no risk is taken or work done. On the other hand, a
bank lends 1,000 and charges a 9% interest rate. It bears no risk
because the loan is collateralized and inflation and default premiums are
added. The loan for the bank is risk free because everything is well
placed to prevent any possible losses. In both mentioned scenarios, the
exploitation is evident.
From a different prospective, the financial institutions distinguish
between different customers depending on their worthiness. A customer
with a weak financial background will not be provided with facilities, and
will be charged even higher fees if granted the access to any fund than
the other ones. Islam came with the message of equality and treated all
levels of society in an identical manner, particularly when it comes to
discriminating between rich and poor. Moreover, Islam urged people to
trade and earn profits at all times BUT through lawfully (halal) and
morally justified sources. This engorgement was even evident during
the performing of Haj, the fifth pillar of Islam, when Allah said in
Quran, "It is no sin to seek favour of your Lord by trading when you
start from Arafat in concourse . (S2: 198). But it is unlawful to
increase the property without any real economic activity and also it is
illicit to enhance the value of the debt without any real benefit obtained
by the borrower. Besides, interest as a reward for saving or lending is
not considered to have any moral foundation or justification. Allah
rewards Muslims extending interest-free loans (qard hasan) for such a
deed: had they not forgone the interest rate, they would not be eligible
for such a reward. Ethically, in Islam, the financer cannot reap extra
reward without sharing the risk for which the funds were borrowed.

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2.3.2. Financial Prospective
The classical Islamic legal approach hesitates to draw `qawaid (general
principles) of the motives and rationales behind Gods law, specifically
where a clear text in Quran or Sunnah exists. Nonetheless, it is useful
to understand the economic reasons behind prohibiting Riba. In doing
so, rationales of three famous Islamic scholars, Ibn Rushd, Ibn Qayyim,
and Abu Hamid Al-Gahzzali, will be introduced.
Basically, all scholars consented on the basis that Riba is prohibited
because of its tremendous injury to society and injustice. The
commodities mentioned in Abu Said al-Khudris Hadith can be divided
into two categories: (a) precious metals; and (b) foodstuffs. Since
barter trading in foodstuffs is no longer practised, only the gold and
silver, which pertain to monies, will be taken into consideration in the
discussion.
The two precious metals (gold and silver) mentioned in the Hadith were
meant to serve the purpose of money, the medium of exchange. Ibn
Qayyim is one of the early scholars who defined money based on its
classical function: Means of exchange and Measure of value. He
elucidated and referred to the reason behind prohibiting unequal
exchange of the same kind of precious metal as being that this exercise
will destroy their purpose of moneyness of valuing things in circulation
(al-thamaniyyah) and preventing the currencies from becoming
commodities. Al-Zuhayli (1997) in such context consented on the same
opinion "Permission of Riba would lead to dire economic consequences,
since the resulting commodification of money and trading it in different
quantities, would cause an imbalance by preventing money from
serving the role of a stable numeraire. The Islamic Fiqh Council of the
Organization of Islamic Conference ruled in 1997 "the legal reason for
this ruling (considering gold and silver as paper currency and vice
versa) is the use of such monies as monetary numeraires, in term of
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33
which prices are specified (al-thmaniyyah). Dar and Presley (1999)
distinguished between money and capital: "To transform money to
capital requires the application of enterprise, that is risk taking and
knowledge required to bring factors of production together in order to
create profit (or loss). Having a fixed guaranteed return capitalizes the
money without having capital elements. Gahzzali in such context argued
money is not created to earn, it is only a means to acquire other things
not for itself. Charging interest deflects money from its key function of
measuring usefulness of object of exchange. If a larger sum of money is
received than had been given then illicit modification occurs for the
standard value. On the other hand, if such transactions become the
goal, the money will be hoarded (Ghazanfar, 2000).
Moreover, Ibn Qayyim is of the view that Riba al-fadl (disguised
Ribakhafi) prohibition, particularly in monies, is in the category of
`Blocking access to evil (sad-al-dharaiaa). "This is because if someone
sold a dirham for two dirhams . and one would do this only because of
disparity between the two types, either in quality, mintage, weight or
otherwise . they would move by degree from current profit in them to
delayed profit, which is precisely Riba al-nasiah.
Ibn Rushd, alternatively, pointed to the principle of fair economic
transactions, and how Riba contradicts with such a concept, this notion
being further discussed in the following section. In contrast, Ibn Qayyim
and Gahzzali concurred that the intent of the prohibition is to avoid
commercial exploitation due to the profiteering aspect of Riba, while
Gahzzali, separately, indicated acceptance of the idea of a "fair rate of
return (Ghazanfar, 2000). It is worth noting that the notion of a fair
rate of return is by design considered for both parties; that is, the idea
of profit sharing may exceed the market interest rate and be more
favourable for the creditor. Therefore, profit sharing not only serves the
borrower fairly but also the lender. Moreover, if the money is borrowed
to increase the wealth (i.e. not to fulfil any basic needs such as food or
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34
any basic living aspect), then it is fairer to the lender to share the
additional incremental wealth, not a fixed return irrespective of the
additional wealth (Dar and Presley, 1999). Money is a measuring tool:
success or failures of projects are determined by the return on
investment. This return can be estimated only, not determined in
advance.
The mere fact that the interest-based loans existence and the wide
utilization of it is not evidential enough is the optimal way of financing
and banking. Since interest is prohibited in Islam, Christianity, and
Judaism, it means there were long periods of history without an
interest-based financing era. Several authors claimed that past
economies were simple and not as complex as the current period and
thus could be avoided. Zaman and Zaman (2001) responded to this
illusion by stating, "A serious study of history dispels this nave idea.
Historical studies show that sophisticated and complex business
transactions were conducted in many periods of history.

2.4. Economic Efficiency Achieved from Prohibiting Riba
Ibn Rushd asserted that the Shariah law prohibited Riba on the grounds
of the excessive injustice `ghubn fahish involved, and the justice is
achieved by approaching fairness. In exchanging homogenous products
which have similar utilities/benefits, justice can only be achieved by
requiring equality in measure, volume, or weight. Since achievement of
extreme fairness in items of the same commodity with different quality
is difficult, therefore, there should be a perfect mechanism to do so.
This mechanism in todays terms is known as `marking to market,
which is the most precise criterion for equalizing between two
commodities of the same genus, by determining their values in
monetary terms (cash). Ibn Rushd argues further, that the parties
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35
involved in such a transaction would like to make sure that the ratio at
which they trade is close to market prices.
Extracting from the very basic notion of trading and Pareto efficiency,
where it is not possible to make someone better off without making
someone else worse off, Gamal (2001) claimed that the trade will be
conducive to economic efficiency only if the trading ratios were equal to
marginal utilities over the entire economy, and this is ensured by
equating market prices to the marginal benefit/utility of the product.
Conversely, if barter trading were conducted with commodities of
different essences, i.e. objects cannot be measured by weight or
volume, the fairness can only be achieved by means of proportionality.
In other words, it is the equating the ratios of the values of each traded
item to its genus or valuing of one genus to another. Ibn Rushd, to
clarify this notion, presented an example of bartering a horse with
clothes. If the value of the horse was 50, then the number of clothing
items bartered should equal 50 as well.
We shall now address the Bilal (radiallaho unho) story further, where
the Prophet (PBUH) ordered that the barter trade in dates (or any other
commodities) should be in the same quantities. Otherwise, if the quality
differed, then the trader should `mark to market; the trader would sell
the dates to the market and get a fair price from this trade. At this
point, the trader is not obliged to buy from any particular seller; instead
he can buy from any seller in the market and get a fair market price for
the second trade as well. In both dealings, given a set of alternative
allocations and a set of traders, a movement from the first option
(barter the dates) to the Islamic dealing `marking to market can make
the buyer better off, without making any other individual (sellers) worse
off, and Pareto improvement is achieved.
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36
Therefore, the net out come from prohibiting Riba al-fadl can be
summarized in two points. First, the recommitment, as termed by
Gamal (2001), where the prohibition of Ribaal-fadl forces the traders to
`mark to market; this mechanism avoids inefficiency in the market,
which could occur due to lack of information about the fair prices of the
exchanged goods. Second, fair dealing in the sense of the accurate
compensation gained by both counterparties for their goods as
determined by the marketplace, which is known as Pareto efficiency in
economic terms.
2.5. Economic Inefficiency in Interest-based Contracts
The ultimate investor cannot foresee 100% precise outcomes of the
enterprise he is considering to undertake due to the uncertain world.
His only guide in such is the future market and economic expectations.
Nevertheless, if he borrows from a financial institution, he is committed
for repayment of a fixed percentage of return over and above the
principal. If the future expected profits are lower than the borrowing
interest rates or, more realistically, not sufficient to leave him with
profit after deducting the interest obligation, he will drop the project.
Siddiqi (1983) claims that the public sector, therefore, is obliged to take
care of such a project (if it were essential) in a poor inefficient manner,
or finance the project through publicly-raised funds through higher
taxation. In either case, the project outcome would not be as pleasant
as if the investor would have done it. The interest charges, therefore,
are inimical to growth of a free society. Siddiqi further argues that the
interest cost places additional burden on the expenses curve,
influencing the investor to raise the products prices, lower labour
wages and limit the scale of production. On the other hand, the profit-
sharing entrepreneur does not face all this strictness. Finally, it could be
argued that, in interest-based financing where the notion is based on
money-for-money, the economy does not expand in real terms because
the money will breed only money, not the real economy. Meanwhile, in
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37
Islamic finance, the notion of financing is based on commodity/asset for
money, which leads to real economy growth.

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3. Gharar
Gharar literally means danger; thus human life on earth has been
referred in Quran as utilities of danger and menace "mata u al-ghurur.
Al-Zuhayli (1997) said Gharar lexically refers to deception, while Qadi
Iyad (mentioned in Al-Zuhayli, 1997) said it is something that has a
pleasant appearance and hated essence; in other words, as Kamali
(2000) said, "In contract of sales the word Gharar often refers to
uncertainty. Gharar is, however, a broad concept and may carry many
different shades of hazard meanings in different transactions.
In jurisprudence, it refers to purposive cheating and deception as well
as ignorance of the object of contract or the contract itself. There is no
unified definition of Gharar on which different sources of Islamic
contract law agree. However, Islamic scholars had sought many
attempts to define Gharar under a general understanding by Jurists of
the term as undertaking speculative transactions. Ibn Taymiya, for
instance, conveyed that Gharar occurs in a contract when one party
takes what is due to him but the other does not receive his entitlement.
Al-Zuhayli (1997) argued that it is where necessary conditions for
accountability may or may not exist and defined Gharar as "any
contract which incorporates a risk which affects one or more of the
parties, and may result in loss of property.
Al-Zuhayli (1997) quoted a number of definitions from Muslim scholars:
Al-Sarakhsi: "Gharar is that whose consequences are hidden.
Al-Isnawi: "Gharar is that which admits two possibilities, with the less
desirable one being more likely.
Ibn Taymiya: "Gharar is that whose consequences are unknown.
Ibn Al-Qayyim: "It is that which is undeliverable, whether it exists or
not.
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39
Ibn Hazm: "Gharar is where the buyer does not know what he
bought, or the seller does not know what he sold.
Al-Zarqa: "Gharar is the sale of probable items whose existence or
characteristics are not certain, due to the risky nature which makes the
trade similar to gambling.
Al-Dhareer (1997) reported that, based on different scholars in
jurisprudential terms, Gharars definition could be summarized under
three headings: First, Doubtfulness or Uncertainties: Gharar applies
exclusively to cases of not knowing the circumstances whether or not
something will take place. Ibn Abidin said "Gharar is uncertainty over
the existence of the subject matter of sale/contract. Second, a purely
Unknown prospect adopted by Ibn Hazm, "Gharar in sales/contracts
occurs when the purchaser does not know what he has bought and the
seller does not know what he has sold. Third, a combination of the
above two categories, both Unknown and Doubtful, as proposed by Al-
Sarakhsy, "Gharar obtains where consequences are concealed. This
view is favoured by most jurisprudents.
Recent renowned studies tackled the topic of Gharar more economically
and financially. Gamal (2001) argued that some scholars definitions fall
significantly short of explaining the economic content of the term.
Consequently, he follows the conception of the risk characteristic
involved in the dealing suggested by Al-Zuhayli as a "sale that
incorporates a risk that affects one or more parties . and may result in
loss of property, and by Al-Zarqa: "It is the sale of probable items
whose existence are not certain due to their risky nature. Thus, Gamal
claims that `bay al-Gharar is best translated and described as the best
identifier of the term Gharar as `trading in risk.
Al-Suwailem (2000), on the other hand, put noticeable effort into
developing a unique framework of analysing Gharar derived from the
economic aspects of so-called `zero-sum game theory. Al-Suwailem
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40
defines Gharar based on the uncertain payoffs as in the zero-sum
theory, in which the amount of winnable goods is fixed: whatever one
party gains is the loss of the other one in other terms of a strictly
competitive game. We could derive here the example of gambling in
order to clearly understand the authors interpretation. Gambling
involves exploitation: whatever a gambler gains the other parties loses;
in general, one partys payoffs cannot increase without reducing the
other partys payoffs. In this contest model, win-win and lose-lose
results do not come about; as expressed by Friedman (1990), there is
no room for cooperation between parties and no outcome which both
parties prefer. The author (Al-Suwailem, 2000) in such regards said,
"uncertainty or risk is what tempts a rational agent to engage in an
exchange in which they know in advance that only one will gain from it
while another must lose. This temptation is best described by the term
Gharar, which means deception and delusion. It follows that a Gharar
contract is characterized as a zero-sum game with uncertain payoffs.
Furthermore, in Gharar dealing, individuals rely on blind luck, ignoring
the natural means. Therefore, Gharar is "deception that distracts the
decision maker from real causes to reliance on pure chance to achieve
desired objectives.
It is to be noted that, based on the concept built regarding Gharar
definitions so far, in this thesis the terms `risk and ùncertainty will be
used interchangeably.

3.1. Qur'an and Hadith Banning Gharar
Gambling and all kinds of pure uncertainties transactions are forbidden
in Quran. In Surah al-Baqarah God mentions "They ask you (O
Muhammad) concerning alcoholic drink and gambling. Say: 'In them is
a great sin, and (some) benefit for men, but the sin of them is greater
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41
than their benefit. And they ask you what they ought to spend. Say:
'That which is beyond your needs. Thus Allah makes clear to you His
Laws in order that you may give thought. Then in another verse God
mentions O you who believe! Intoxicants (all kinds of alcoholic drinks),
and gambling, and Al-Ansab, and Al-Azlam (arrows for seeking luck or
decision) are an abomination of Shaitans (Satan) handiwork. So avoid
(strictly all) that (abomination) in order that you may be successful
(S5: 90). From the above verses, it is understood that, firstly, God
mentions that there might be some profit in gambling (pure Gharar),
but the sin is greater. Secondly, gambling has been accompanied with
the involvement of drinking intoxicants, and both are considered to be
great sins as they are Satans handiwork. Finally, gambling drowns
Muslims in exploitation people and hinders them from the remembrance
of God.
While Quranic texts are (usually) general in meaning, the Sunnah
extends the prohibition to all speculative forms of commerce, and
Gharar was forbidden in commutative contracts in the number of
Hadiths. In Muslim (Book 10, Number 3614), Abu Huraira (Allah be
pleased with him) reported that Allahs Messenger (PBUH) forbade a
transaction determined by throwing stones, and Gharar (the type which
involves uncertainties). There are a number of Hadiths in which Gharar
contracts are forbidden either by name or by specifying one of its
instances such as fish in the water, bird in the sky, unborn calf in its
mothers womb and others.
Al-Dhareer (1997) extracted three juristic consequences from the above
Hadith: First, the Hadith proscribes Gharar in a word which indicates
prohibition of Gharar contracts, and this form of prohibition expresses a
total ban. Second, any contract encompassing Gharar is null and void.
Third, all forms of Gharar contracts are prohibited. If a Companion
stated that the Prophet (PBUH) has forbidden something, this indicates
generality.
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42
Avoiding uncertainties is human nature by which they more often than
not seek to adjust risky situations to avoid the consequences of the
ambiguities. Knight (1921) is among the early economists who
discussed how people react, "With uncertainty present, doing things,
the actual execution of activity, becomes in a real sense a secondary
part of life, the primary problem or function is dealing what to do and
how to do it. After conducting an extensive study on more than 500
senior business managers, MacCrimmon and Wehrung (1986) arrived at
the fact that decision makers try to escape from uncertainties. In their
model, the participants were presented with problems, for which the
consequences were uncertain, and asked to take a decision. The major
finding was that only 4% did not modify the situation, the rest of the
majority attempted to control or adjust the risks they faced.

3.2. Why Gharar is Forbidden?
Authors have presented different views in comparable manners along
with the definitions acknowledged. Ibn Taymiya, for example, sees the
Gharar as whether or not a transaction involves gambling and unlawful
devouring of the property of others àkl mal al-ghayr bil batil. Al-
Sarakhsi and Ibn Taymiya thus contended that Gharar contracts mostly
lead to potential dispute (al-muaddah lil-niza), which is `Haram by
itself. Ibn Taymiya went further and stressed that the corrupting factor
in Gharar is the fact leading to dispute (kawnuhu matiyyat) and
devouring others wealth wrongfully is the rationale for the prohibition.
Additionally, it could be argued that the major Islamic jurisprudence
rule is the one so-called `sadd al-dharaiaa, meaning closing the
avenues for circumvention of the law triggers the prohibition.
Al-Kharashi (n.d., vol. 5, under `forbidden sales) summarized most
medieval Islamic scholars view in his statement, "... and know that
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43
there have been differences among legal scholars with regards to the
legal reason (illah) for the prohibition of Gharar. Thus, some said that
the prohibition is due to the unjustified devouring of peoples property,
others said that it is due to the potential for disputation, and a third
group said that it is based on the inability to deliver the promised
goods.
A broader interpretation of banning Gharar on the grounds of social
harm was submitted by Vogel and Hayes (1998), "Another reading of
Hadiths is possible, one which starts from Quranic prohibition of Maysir,
which mentions as its reasons only enmity and distraction from religion.
These reasons resemble the ground on which many societies prohibit
gambling contracts, that gambling leads to individual immorality (the
compulsion) and social harms.
Al-Suwailem (2000), alternatively, in conjunction with his analysis,
refers the prohibition to the uncertain payoffs in the zero-sumness
game and the investor/contractor shell not relying on pure chance to
achieve the desired outcomes. Presenting as an example the of selling
of a lost camel, where the seller loses a potential gain that he was
entitled to had he not sold it; because finding the runaway camel is
pure chance, the seller will sell his camel cheaper than he would
otherwise. What the buyer benefits here are what the seller gives up as
a forgone profit, which he would enjoy if he could find the camel. A
similar illustration is also true for the buyer: in sum, one party wins
only at the expense of the other.
Gamal (2001), however, justifiably criticized the zero-sum approach.
Indeed, there are many examples of zero-sum games which are not
forbidden based on Gharar, such as exchanging different merchandise
by two parties in order to sell the goods in another market based on
their respective perceptions of the market. On the other hand, there are
other contracts which are not banned based on the zero-sum concept
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44
but are forbidden on the grounds of Gharar, such as pebble-sale,
unborn calf in womb, milk in an udder, etc.
The author suggested a different method of justifying the prohibition of
Gharar: "Thus, the `trading in risk which is forbidden in the Hadith may
refer to riskiness implicit in the contract language, uncertainty
regarding the parties of the contract, or riskiness associated with the
object of the sale and price. The author proposed applying cost-benefit
analysis for distinguishing between the permission and prohibition.
Further, in his writing the author declared two valid points. Firstly, he
argued that `trading in risk is more often inefficient, especially if
compared with `risk sharing. Secondly, the injunction against Gharar
can be explained more clearly by consideration of the economic
inefficiency arising from the risk of mis-pricing. Furthermore, Saleh
(1992) and Naughton and Naughton (2000) consented on the same
basic principle. The latter asserted that the prohibition of
speculation/Gharar in Islam is due to its association with gambling and
excessive risk taking and the former concurred that the rationale behind
banning is uncertainty, risk and speculation.
Even in the last argument and with rationalization presented, it can be
realized that riskness by itself is not sufficient to justify the prohibition,
because it is very unlikely to find commutative financial contracts which
are totally risk free, and we shall see later how Islam differentiated
between controllable and uncontrollable risk and permits the former
while prohibiting the latter. Moreover, a certain degree of uncertainty is
found in a number of Islamic contracts such as Musharakah and
Mudarabah that are based on the idea of shared profits and losses of
which both are uncertain. Thus, the fact that accepting the excessive
risk, which leads to potential losses and dispute between parties, could
be considered as the basis of the prohibition. If we examine all classical
examples of Gharar mentioned in Hadiths or jurists literatures such as
selling a bird in the sky, runaway animal, fish in the water, unripened
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45
fruit on a tree, fish in the water, etc., we observe clearly that accepting
the excessive risk and pure uncertainties is the dominant character in
all examples.
In the modern financial transactions, many scholars particularly Gulf-
based Fiqh academic totally forbade variety of financial derivatives such
as Options, Futures, and Forwards on Gharar grounds, and rendered
them as invalid contracts. In many cases the asset/object of sale does
not exist: the buyer accepts excessive risk and those trading do not
fulfil the requirements of Islamically-trading contracts. Obviously, this
body of opinion falls short of profound understanding of the fiqh al
muamalt (transaction law) and lacks the understanding of the
normative guidance of the Quran and Sunnah. Detailed discussion of
Future contacts is illustrated later in the Islamic Instruments section.

3.3. Is Risk-taking Forbidden in Islam?
It should be emphasized that involvement in risk is NOT prohibited in
Islam. Ibn Taymiya in "Al-Fatawa Al-Masriya (see ref.) stated, "It is
well known that Allah and his Messenger did not prohibit every kind of
risk. Nor are all kinds of transactions that involve the possibility of gain
or loss or neutrality prohibited. Al-Suwailem (2000) added, "Risk
taking is praised for promoting growth and economic development, it is
responsive risk, not chance. Therefore, Islamic transactions, such as
Musharakah and Mudarabah, though involving risk taking, are
encouraged, as they are value-adding activities which improve
economic and financial efficiencies and promote the managers to modify
and utilize skills and work on the dangers they face.
Gambling, for example, involves creation of risk for the sake of risk,
which would not be present otherwise. Gamblers just trust their luck;
they do nothing about the events on which the outcome of their
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46
gambling depends. On the other hand, in the Islamic lawful
transactions, the investor is aware that the fundamental of the
investment can identify the expected return, the risk involved, and
performs the homework i.e. assesses the risk, manages it, utilizes
hedging strategies, etc., whereas it is not possible in Gharar
transactions.
Risk in is the financial meaning relates to circumstances surrounding
the contract operation whereby the objective of the contract may not be
achieved. Gharar, on the contrary, relates to defects in the contract
itself. Risk by itself does not lead to violation of a contract; for example,
selling an asset for a deferred price. This contract may carry a high risk
if the payment was not secured by collateral or the buyer had low
creditworthiness. However, the rights and obligations arising from the
contract are clearly specified for both parties. El-Gari (2003) simplify it
by saying "Gharar, pertains to contractual relationship and depends on
the form of the contract. Risk, on the other hand, relates to outcomes
arising from the contract.

3.4. Excessive and Minor Gharar and When a Contract is
Classified as Gharar
There is general agreement among the Islamic authors about the fact
that the substantially excessive Gharar is one prohibited by the Quran
and Sunnah; equally, a minor Gharar is tolerable and makes the
transaction lawful. It is necessary to differentiate between the
Uncontrollable Risk in which the decision maker has no control
whatsoever over the risk, and Controllable Risk where the risk can be
managed entirely or partially. The prohibited Gharar is merely accepting
the excessive risk which comes under the former type. Shapira (1995)
in his book presented the outcome of a survey conducted on more than
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47
700 business managers on risk transactions. One of the important
findings was that managers made a sharp distinction between risk
taking and gambling. The former involved judgments, analysis, skills,
etc. while the latter purely accepted the risk.
Al-Baji Al-Andalusi and Taqiyyudin Al-Subki and others, agreed on the
argument that a contract is rendered valid if the Gharar was trivial
(haqir) `Controllable Risk such as sales of nuts, beans, rice, etc., in
their shells (on the condition of giving the buyer the option of
inspection). Otherwise, if the uncertainty/risk was significant and a
major component (ghalaba alayhi) of the contract, the contract then
becomes defective and is described as bayu al-Gharar, Ùncontrollable
Risk, which is prohibited and invalid. Examples of this include: a
contract in which delivery is not attainable (such as sale of runaway
animal), contracts in which price or object are unknown, and future
contracts in which the deferment period is unspecified. Al-Zuhayli
(1997) concurs with the idea that all minor Gharar is `halal (lawful). In
such regards, Ibn Juzay stated that Gharar is forbidden and must be
avoided unless it is very minor.
Considering Kamalis (2000) and Dr. Mustafa Al-Zarqas interpretation
of Gharar as being uncertain, a contract if truly involved in ambiguity
and significant uncertainty becomes invalid. Since most of the
commercial transactions involve some element of uncertainty, Al-
Dhareer (1997) believed that there should be boundaries for excessive
Gharar alone and anything else is considered ineffective. Nevertheless,
the writer of this thesis is of the view that the economic and financial
transactions differ in different times and societies, and characteristics of
Gharar contracts also differ accordingly; therefore, identifying whether
Gharar is major or minor is relativistic and should be determined on a
case-by-case basis. As mentioned earlier, there is general agreement
on the two extremes (major and minor): the moderate Gharar àl-
Gharar almutawassit is the most debatable and susceptible to be
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48
rendered wrongly whether they go along with the major category or
with the minor one.
Ibn Rushd in such regards elaborated that, if one of the following
conditions existed, the contract is described as excessive Gharar:
-Ignorance or lack of information about the nature of the underlying
asset or object.
-Doubts about availability, existence, and quantity of the asset.
-Lack of information of payment terms, i.e. currency, price, others.
-High concerns regarding the prospect of delivery according to the
contract.
-Other forbidden conditions expressed clearly in different Hadiths such
as throwing pebbles, two bargains in one, etc.
Moreover, the massive Gharar could be either in the essence of a
contract or in the object of a contract, as classified by Al-Dhareer
(1997). The former means the contract itself has been concluded in
words that imply ambiguity. For instance, a financial institution
contracts to sell an asset if a third party sold them another asset, and
the buyer accepts the offer. In this hazy contract the asset (object)
itself is identified, but both buyer and seller do not know whether the
contract will conclude.
Moving forward, Al-Dhareer later in his book affirmed that, for massive
Gharar to have legal consequences, it must fulfil four conditions: (i) it
should be excessive, not trivial; (ii) it must occur in the context of a
cumulative financial contract; (iii) it must affect the subject matter of
the contract directly (e.g. price, object, language of contract etc.);
(iv) the parties involved in the contract should not be in need of the
contract, should there be a public need for it - even significant risk will
be acceptable and the contract will be valid such as the Salam and
Istisnaa contacts. This permission, I believe, is based on the grounds of
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49
`General Public Need and Òbjective of Islamic Law (al-maslaha al-
aama and maqasid al-shariaa), the major Islamic jurisprudence law.
Kamali (2000), consequently, declared that Gharar is prevented when
contracting parties have adequate knowledge of the contract object,
which is obtainability, quantities and qualities are identified, and it can
be delivered on the spot or at a future clearly-specified date. This is also
his basis of judging that Future contacts are halal, as we shall see later
on.
From the above different scholars opinions, it can be summarized that
four conditions are required for Gharar to be considered massive and
consequently illegal.
First, if there was ambiguity in the contract language leading to
uncertainty about actual existence of the object/asset at the time of
contracting, such as selling hidden unknown assets.
Second, the object/asset might exist, but there is uncertainty
surrounding its availability at the time of the delivery; in other words,
selling assets for which the delivery is doubtful at maturity.
Third, if there was uncertainty over the quantity or the price of the
asset/object, i.e. unspecified or uncertain terms of payments, although
some jurists believe that the parties can refer to `market price to
overcome pricing problems.
Fourth, if there was uncertainty about the time of completion/maturity
and delivery of the object.

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50
4. Islamic Instruments
All buying and selling transactions are permitted in Islam, where
prohibition is the exception. Ibn Taymiyah (r.a.) explicated this as
follows: "In muamalat (business transactions) all activities are
permissible unless forbidden by revelation (Quran) or the practice of
Prophet Muhammad (PBUH) (Sunnah). Prohibition of interest, as has
been seen, is evident in Islam and, therefore, there is no reason to
discuss whether the interest amount is exorbitant or mild, why interest
is paid and how its rates are determined. According to Joseph Schacht
(1994), "... they (Muslims) were always conscious that a direct breach
of the prohibition of Riba (interest) was a deadly sin. Although
analysing deeply all Islamic tools replacing the conventional Riba
contracts is not attainable in this dissertation, nevertheless, highlights
of a few Islamic alternatives in light of modern finance will be presented
briefly. There are two important characteristics differentiating Islamic
finance from the conventional concept of monetary paper financing.
First, Islamic financing is asset-backed financing (El-Gamal, 2000;
Ebrahim and Tan Kai, 2001; Al-Jarhi, Mabid, Iqbal and Munawer, 2001;
Charlton and Garcia-Bennett, 2004). Money has no intrinsic utility, it is
only a medium of exchange, and profit earned through dealing in the
same currency is prohibited. The profit is generated when something
having intrinsic utility is sold or its usufruct is granted. In the
conventional financial market, no tangible goods or services are
exchanged. Financial claims are in the form of promissory notes or title
over future cash flows. In contrast, not all Islamic financial instruments
are purely financial claims. Some of them hold ownership of the
underlying assets together with the claim of cash flows (Hairetdinov,
2004).
Second, unlike the Western conventional financial system where loans
are backed up by collateral, the lender is not involved in the business
project and its social implications; potentially very good investments
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51
would be passed away if the investors were not able to provide enough
collateral to guarantee their repayments. Moreover, the conventional
financial institutions will have no real incentive to chase the project
information (its guaranteed fixed return anyway). In the Islamic
economic model for investment projects finance would shift towards
being more profitable because the borrower/lender relationship is
transformed into a partnership through the `risk sharing concept and in
particular the sharing of profits (and losses). In other words, in Islamic
financing dealing, there has to be an element of risk. The investor or
the lender cannot claim guaranteed profit.
As we know so far, financial systems represented by banks and other
intermediaries play a critical role in the economy because they channel
funds from one group of those who have saved surplus funds to another
group that needs funds for investment opportunities. But, one might
ask, how would banks have the capital that is necessary to lend, when
banks do not pay interest for savings accounts or capital providers? Al-
Anjari (2002) attempted to answer the question by describing banks
role in Islam: according to Islamic economics there would be a triangle
or three-way system, where all participants are mutually beneficial or
not beneficial from engaging themselves in projects. Those are 1) the
Bank, 2) the Saver and 3) the Entrepreneur. Now, it is obvious that not
only banks and entrepreneurs are exposed to risk but also the supplier
of the funds. After discussing the above, one might conclude what is the
role of banks and ask: why do we not simply cut out the middle man
(banks) and maximize profits by having only a lender and a borrower?
The reason for this is that, in a world of imperfect information, it is very
difficult to perfectly evaluate all aspects of the lending and borrowing,
given the time constraints. People would rather trust the banks due to
their specialization. Greenbaum and Thakor (1995) argued that the
banks and other financial intermediaries perform two main functions:
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52
1) The Brokerage function
By providing secrecy about the information and analysing with
specialized skills, the brokerage offers timeliness and costs savings
function. These services include: transaction services (securities
trading), financial advice, screening (rating), financing, etc.
2) Qualitative Asset Transformation (QAT)
Banks and other intermediaries facilitate in providing greater efficiencies
by better allocation of financial resources. Reducing the gap between
asset and liabilities, managing duration mismatch, liquidity, default and
credit risk assessments, guaranteeing services, monitoring the adverse
selection and moral hazard are examples of QAT.
Islamic intermediaries are above all financial institutions which basically
perform the same above two functions. Islamic financing is restricted to
complying with two sets of laws: Shariah and the state law. The Islamic
financial contracts available therefore fall under three categories. First,
the asset-backed facilities those accompany the sale contract. These
instruments, that are purely monetary, claim to be an expected income
stream from a commercial transaction named Debt-based contracting
modes of financing instruments. Second, participating instruments,
classified as Equity-based contracting modes. Hairetdinov (2004)
claimed that the former type could be traded in the secondary market
at its face value declared at the end of the contracting period but
cannot be discounted while the latter instruments are tradable at its
market price. The incomes of both types are not predictable and
assessed through valuation of the asset financed at the end of the
agreed duration. Third, Derivatives: the risk management tools, which
have undergone controversial debate by scholars and researchers
regarding the legality of such instruments.

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4.1. Debt-based Contracts
Since exchanging money-for-money on a deferment basis becomes a
Riba transaction, debt-based instruments therefore have to be
structured on a money-for-goods basis. The most common derivatives
that assist the financing needs are: (i) qard hassan (debt without
interest); (ii) cost-plus sale, or what is usually referred to as mark-up
financing of purchases `Murabahah with differing receipts of the
instalments; (iii) leasing Ìjarah.
The common issue between these instruments is that the beneficiary is
either committed to paying back the borrowed funds, and most
importantly without interest as in qard hassan, or the beneficiary is
committed to paying for the use of the commodity or services through
instalments as in the case of Murabahah and Ijarah respectively. Such
contracts are debt- (dayn-) based in the sense that the borrower is
liable to settle his liabilities/compensation (dayn thabit fi al-dhimmah)
towards the lender/financial institution. The latter two types of contracts
are - in principle - mimicking exactly the short- and long-term
borrowings that are obtained from conventional financing, which are
interest-based. However, there are three main distinctions in Islamic
debt-based instruments: First, the existence of a physical asset (object
being financed), to which the implicit interest rates are linked. In other
words, Islamic finance is an àsset-based approach, i.e. `money-for-
asset using the same asset as collateral. While in contrast, the
conventional finance model is based on the `money-for-money concept.
Second, the financer, not the customer, bears the risk associated with
the asset financed (Gamal, 2003). Third, the Islamic credit facilities are
non-recourse in general, secured only by the underlying assets; while,
in contrast, the conventional loans are backed by all the assets of the
borrower (Ebrahim and Tan Kai, 2001). The latter two types of credit
financing are discussed in further detail below.
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54

4.1.1. Murabahah
Although the profit-loss sharing concept is the prime base of financing
in Islamic law, the Shariah holds the view that, as far as the parties do
not operate in a prohibited transaction, people have a wide freedom of
contracts. "The radix is legality, unless otherwise stated (al-asl fee al-
omoor al-ebaha). This flexibility gives the permission to engage in
finance dealing as long as it does not contain any element of Gharar,
Riba or getting involved in any other forbidden activity. Although
Murabahah is not a profit-loss sharing method, it is considered as one of
the most widely spread short-term financing instruments replacing the
short-term loans in the conventional system. Murabahah can be defined
as the sale of an asset for the price/cost the seller has acquired it plus a
percentage of profit; thus it is sometimes labelled as the cost-plus-profit
financing method. In most cases, the buyer knows the price of the asset
at which the seller obtained it, and agrees to pay the premium for the
deferred settlement. The asset is utilized by the borrower throughout
the financing period subject to a lien on it. The rationale that can be
observed behind the financial institution claiming such a premium
(mark-up) is: (1) servicing the client by purchasing the asset from the
market on the spot and selling it on deferment; (2) costs associated
with the transaction; (3) exposure to the `get stuck with the goods risk
and default risk (Al-Omar and Abdel-Haq, 1996).
The deferment payment ensures that an extra profit margin is collected
over a period of time. El-Gamal (2000) listed a few quotes in his article
"A Basic guide to Contemporary Islamic Banking and Finance for jurists
of various fiqh schools illustrating that the increment on the price is due
to deferment. Some of these quotes are as follows:
Al-Kasani: "the price may be increased based on deferment.
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55
Ibn Abdin: "a price is increased if it is deferred.
Ibn Rushd: "He has given time a share in the price.
Al-Nawawi and Taqiyuddin Al-Subki: "deferment earns a portion of the
price.
All these medieval Islamic scholars give emphasis to the time factor,
which is a clear evidence of Islam concurring with the notion of `time
value of money, as the increase over the initial price + all recognized
expenses + spot price is accounted in order to compensate the deferred
payment. Above all, the Prophet Muhammad (PBUH) said "There is no
harm in selling for eleven what you buy for ten, and you are allowed to
take a profit for expenses (narrated by Abdul Wahab in Sahih Bukhari
Volume 3, Book 34, Number 411).
The linkage of the percentage of mark-up (Ribh) in Murabahah to the
same interest index used by conventional banking makes the
Murabahah contract not only close, but identical to interest-based loans
used by the conventional banking operations. Calling such a transaction
Islamic is perplexing, and led to a disagreement among scholars. A
heated discussion in such contest is captured in the International
Journal of Islamic Financial Services, 2000 titled "Murabahah under
Scrutiny. Khalid in the discussion raised the case where the bank gives
the customer cash (x) and appoints him as an agent to purchase a car;
after he does so, the bank asks the customer to return the original cash
plus a premium (x + y) within future date in instalments. This is just a
`Riba in disguise. Ebrahim added that Islamic financial institutions price
their financing vehicles using the interest Ribawi index. This transaction
is just a kind of trick (hila) used by the contemporary Islamic banking
system to introduce Riba through the back door. It would become worse
if the Murabahah contract were linked to floatable LIBOR and then
Gharar was also introduced as the interest rates varied, as this would
affect the cost of funds as well as payments. The latter scenario
contradicts a true Murabahah sale contract in which selling for cost plus
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56
specified profit is known as ex-ante. This mimicking behaviour makes
Islamic banking coincide with the contemporary interest-based debt
financing operation except in terminology (Errico and Farahbaksh,
1998).
In contrast, some scholars viewed that the profit rate in a Murabahah
transaction can be set at any value agreed between the buyer and
seller. There is no reason or restrictions from Shariah that prevents
using conventional benchmarks. This is justified by that fact that
Islamically instruments should not be more or less expensive than
conventional instruments. Thomas and Ahmed (2000) declared (in the
above-mentioned discussion article) that there is significant need for an
Islamic pricing index to hurdle the dispute of the Islamic financing
instrument pricing. Yet, as Islamic benchmark rates do not exist, there
is no problem in using conventional banking indices for asset pricing. It
is the transaction that can be Ribawi, not the asset pricing; in other
words, if the underlying contract is permitted (halal) then using the
LIBOR index does not render the contract invalid. Additionally, it could
be argued that Murabahah profits are usually set by fixed LIBOR, not
floating interest rates, and are merely to identify the mark up
percentage; hence there is no element of Gharar here.
Though this allegation might be true, the financial institutions work in a
different manner in practice. A positive rate of return on the money
granted (to purchase a car) is agreed upon, mimicking the loan facilities
that are exercised in conventional financing. El-Diwany (2000) describes
this as a money-for-goods-for-money transaction. This practice is
further hindered by a promise-to-buy agreement, which restores it to a
money-for-money contract. Additionally, if the method of calculating the
interest rates charged on loans in conventional banking were compared
to the Murabahah mark-up scheme used in an Islamic banking unit, the
mathematical formula that computes the profit rates in both is almost
exactly the same. This method of financing, using the Murabahah term
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57
to provide interest-based financing under another name, is indeed a
form of `Hiyal.

4.1.2. Ijarah
Ijarah in many respects is equivalent to leasing in the modern finance,
in which the owner of an asset (lessor) transfers the usufruct of a
particular asset to another party (lessee) in exchange for a claimed
determined rent. It is worth noting that usufruct trade has been
mentioned in Quran and Sunnah, legalizing it in Islam. Allah (SWT)
said, in the Prophet Moses story, "And said one of them (the two
women): 'O my father! Hire him! Verily, the best of men for you to hire
is the strong, the trustworthy (S28: 26). He said: 'I intend to wed one
of these two daughters of mine to you, on condition that you serve me
for eight years; but if you complete ten years, it will be (a favour) from
you. But I intend not to place you under a difficulty. If Allh wills, you
will find me one of the righteous (S28: 27). Also established in the
Sunnah is that Allahs Apostle (PBUH) and Abu Bakr hired a man from
the tribe of Bani-Ad-Dil as an expert guide who was a pagan (follower of
the religion of the pagans of Quraish). The Prophet and Abu Bakr gave
him their two riding camels and took a promise from him to bring their
riding camels in the morning of the third day to the Cave of Thaur
(narrated by Aisha in Sahih Bukhari Volume 3, Book 36, Number 465).
Islamic leasing in many terms is similar to conventional leasing; the
most important difference between them is that, in Islamically-
permitted leasing, the lessor must own the leased asset, while it is not
the case in conventional terms. The reason for this being that it is not
allowed, Islamically, as mentioned in the previous section, to trade in
any asset/commodity not owned by the trader. Another Hadith in Sahih
Muslim stresses on this concept. Ibn Àbbas (Allah be pleased with
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58
them) reported: Allahs Messenger (PBUH) said: "He who buys food-rain
should not sell it until he has taken possession of it. Ibn Àbbas (Allah
be pleased with them) said: "I regard everything like food (so far as
this principle is concerned) (Book 10, Number 3642). Therefore,
whereas the entrepreneur could not bear the excessive initial capital
expenditure, the financial institution buys the asset and leases it to the
client. The client consequently, services the lease instalments from the
operating income.
Corresponding to the present need of mortgage financing, Islamic
finance modified the Ijarah to a new product called Ijara wal-Iqtina, an
alternative to the lease-to-purchase agreement in conventional
financing. In this case the lessee pays the lease amount plus an
additional agreed amount, which is aimed towards buying the leased
asset (residual value). To arrive at the rent, the total cost of the asset is
calculated plus mark-up (interest) to be recovered during the period of
the lease on a monthly or quarterly instalment basis. In this contract
the lessor promises to sell the asset leased at the end of the contract if
the lessee wishes to buy it. This procedure can be converted to the
reduced renting procedure. In practice, if a customer, for example, is
considering purchasing a house on an Ijara wal- Iqtina basis, the
Islamic financial institution buys the house specified by the customer
and holds the title deeds throughout the life of the contract. The lessee
makes a series of instalment payments over a specific time period, the
rental amount reduces and, at the end of the contract, a symbolic
payment is made; the house at this stage is fully owned by the
customer, rent is eliminated and the title deeds are transferred in
favour of the customer.
This form of financing is akin to an asset-backed risky asset, especially
in two aspects. First, the lessee is required to make a set of fixed
payments similar to a lease contract (Ebrahim, 1999). Second, several
benefits are associated with the contract such as tax saving, flexibility,
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59
asymmetric information cost, risk-sharing opportunities, etc.
(Schalleim, 1994). As in Murabahah, usually the lessee acts as an agent
on behalf of the bank to acquire the asset subject to lease. This is an
independent agreement. Once the asset has been acquired and the
ownership of the asset transfers to the lessor with all relevant risk, then
a second relationship is created, i.e. lessee and lessor under the Ijarah
agreement.
The structure of Murabahah and Ijarah is the closest to the conventional
money loan and leasing or mortgage respectively, conditioning having
the ownership of the asset being financed in Islamic financing form
(reducing further the fraud issue). Therefore, these Islamic instrument
prices mark-up asset rentals on an ex-ante basis and are benchmarked
to an interest index such as LIBOR rates as done conventionally. Having
said that, the leasing firms may not be able to realize the expected
return as the lessee may not pay on time, or default. It is further to be
noted that, if the customer delays the payment, there is no penalty
interest charge on the late payment. If the compound interest is
charged, it would become Riba. Gassner (2004) clarified that Islamic
finance deals with such an issue, whereby agreeing with the customer
penalizes a delay-fee which would be recovered and used for charitable
purposes. The amount of penalty cannot be taken as a source of further
return to the financial institution. Therefore, the client will not delay the
payment without a valid reason because he would have to pay the
penalty into a charity fund. In addition, Shariah guidelines demand
ethically delayed payments to be injustice and the person will be
questioned on the Day of Judgment. In Sahih Bukhari (Volume 3, Book
41, Number 585) Abu Huraira (radiallaho unho) narrated that Allahs
Apostle (PBUH) said, "Procrastination (delay) in repaying debts by a
wealthy person is injustice. However, the financial institution can claim
an award of solatium for the direct costs, indirect costs and opportunity
costs, which are determined by the court.
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60
Ebrahim (1999) simplified the understanding of the payoffs from
Murabahah and Ijara wal-Iqtina. He illustrated it in a diagram as shown
in Figure 1. The incremental payoffs are not fixed; in fact they are
random and dependent on the success of the project primarily, which
makes it a non-Ribawi transaction.

Figure 1: Murabahah/ Ijara wal-Iqtinaa Contracts
Source: Ebrahim (1999) "Integrating Islamic and Conventional Project
Finance
Where Q is the cost of the asset, S1 is the banks break even point, and
positive NPV is realized after the level S*c, below which the bank will
receive negative discount return.

4.2. Equity-based Contracts
The basic notion of Islamic finance is a form of business relationship
between those who provide the funds and those who use them being
based on sharing profits or losses as the case may be. The high implicit
interest rates in the debt-based contracts, justified by the lack of
control and availability of information, initiates accepting - hesitantly -
the external control under the basis of low implicit interest rates. This
equity-based financing is either a silent partnership `Mudarabah, or full
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61
partnership `Musharakah, in which the borrower receives a sum of
money from a financial intermediary/lender as their share in the firms
expenses. In exchange, the lender gets a share in the profits generated
by the firm being financed. These instruments are commonly used in
production cases, the investor/lender would be allowed to receive a
fraction of the profit if he also agreed to share the losses. It is injustice
on the part of the investor to ask for a fixed interest return irrespective
of outcome of the business. Similarly, it is unfairness on the part of the
entrepreneur to pay a small amount of predetermined interest rate to
the investor while he gets a fortune of the business shared.

4.2.1. Mudharabah
The Arabic term Mudharabah is a contract between two parties
(minimum): one of them is the investor (rab al-mal), called `severs,
with no investment plans in modern financial terms (sleeping partner);
the other party is the agent/trustee or the entrepreneur (mudharib), in
other words the party who lacks financial resources to obtain funding
and financial support for feasible ideas of a potential project (capital-
user). The Prophet (PBUH) himself, particularly, exercised this financing
method. During the Ottoman Empire, Muslims exercised this
Mudharabah, particularly in maritime projects, which played a vital role
in economic development (Cizakca, 1996). This is unlike the
conventional interest-based loans, where the lender is isolated from the
real investment outcomes; for example, if the project made great profit,
the lender would get only the interest agreed. Meanwhile, in
Mudharabah, both the lender and the borrower are equally exposed to
risk because of the fact that the lender shares profits with the borrower
and the ratio in which the profits will be distributed is determined ex-
ante. It is to be noted that the prespecification profit ratio is a
percentage of the overall investment, not a percentage of capital or on
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62
a lump sum return basis as it is in the conventional transaction. The
losses, on the other hand, in Mudharabah, are borne by the financer,
while the entrepreneur loses his effort. The basic idea of Mudharabah in
finance language is combining the investors wealth with the managers
expertise, precisely as described in modern language as the principal-
agent relationship, but bound by tenets of Islamic law.
Mudharabah is regarded as one of the most important Islamic tools
involving the contracting of capital and entrepreneurship to undertake a
joint venture. The financial institution provides all the capital of the
project and the client is fully responsible for the management. Some
Muslim economists, such as Masum Billah (2005) and Al-Suwailem
(2000), portrayed Mudharabah as the current `venture capital;
however, Ebrahim (1999) stated that this instrument is, instead,
equivalent to the participating preferred stock with no contractually
promised interest. The author again explained payoffs from Mudharabah
using Figure 2, below.

Figure 2: Mudharabah Contracts
Finance
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63
Below the state S1 the financer/bank suffers loss, while between S1 and
S
*
c
it is at break even point. Beyond the state S
*
c
the financer and the
entrepreneur share in O fraction of profit.
Since Mudharabah is a `risk sharing contract and the potential risk is
not low, the distribution of profit, as mentioned earlier, between parties
should be clearly defined on a percentage basis, and any ambiguity in
this regard will nullify the contract. In case of an unsuccessful
investment, the investor cannot escape his liabilities and faces the risk
of losing part or the total investment capital, conditioned in that the
losses are not due to agent negligence or misconduct on the part of the
entrepreneur. The agent, on the other hand, is exposed to the risk of
losing the effort he executed and his labour. Nevertheless, Ibn Qudama
in Àl-Moghni revealed that, if the losses were a result of misuse or
violation of the condition of the contract on the part of the
entrepreneur, then he alone is liable to cover it.
In the financial engineering section, we will see how Mudharabah can be
synthetically modelled for various financing purposes. It can be used for
a one-off project income, growth and income, or growth for new start-
up enterprises. In addition, it is to be noted that Mudharabah and Ijara
facilities are considered to be an ayn (unique object) as opposed to
dayn (debt obligations), which makes them easier to be securitized for
sale in the secondary markets (Ebrahim and Tan kai, 2001).
In the modern finance era, a Mudharabah contract can be synthesized
as a combination of Murabahah (cost-plus) and Options to determine
the profit sharing parameter. The profit from Murabahah in the good
economy condition offsets the price of the Call option (Ebrahim, 1999).
Despite this advantageous financially-engineered characteristic, and the
fact that Mudharabah is the prime method of Islamic alternative
financing for conventional interest-based financing, which all scholars
emphasize on, it is rarely practised in the Islamic market. El-Gari
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64
(2003) noted that debt-based instruments such as Murabahah reached
more than 90% of the operation of some Islamic banks. This is basically
due to four major factors:
1) Lack of development of the capital market in Muslim countries
accompanied by the Shariah restriction of debt sale (bay al-dayn bi-l-
dayn), which hinder assets securitization of Islamic financial institutions
(Vogel and Samuel, 1998).
2) Entrepreneurs and companies prefer fixed rate basis financing.
They would rather know in advance the percentage margin which they
will earn for themselves after calculating the project yield minus the
cost of capital. Islamic banks therefore, provide the demanded
alternatives, which are debt-based facilities.
3) Other instruments such as the Murabahah, which has a limited
degree of risk, can meet the financing objective of short-term need.
Therefore, the Islamic financial institutions do not bother entering into
Mudharabah contracts with high potential risk.
4) Difficulties in convincing financial institutions to become involved
in a Mudharabah contract, either due to their lack of knowledge about
the investment proposed, or the very limited feasible ideas for potential
projects. Beedham (1994) in such a context asserted "The banks may
know less about the business in question than the entrepreneur does,
so they can be taken for a ride.

4.2.2. Musharakah
This contract is referred to as the Profit and Loss Sharing (PLS)
contract, which is a partnership contract between at least two parties
where most aspects of the investment such as capital, management,
profits, etc. are shared on a percentage basis. Equity is the closest
conventional financial instrument concept to it. Musharakah is very
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65
similar to the former instrument discussed; however, it provides a
higher potential reward at the expense of higher possible risk and vice
versa. Figure 3 shows the payoffs from the contract, where the financer
(we have to remember that it is a partnership) gains the most under
the favourable economic conditions and loses the most under adverse
conditions (Ebrahim, 1999).

Figure 3: Musharakah Contracts
Finance
Below S
*
c
the partnership suffer losses, and S
*
c
is its break even point.
Beyond the state S
*
c
is positive NPV and the venture share in O fraction
of profit.
Another instrument promoted by Islamic institutions replacing the
conventional mortgage (apart from the leasing-to-purchase agreement
mentioned earlier) is the so-called Musharakah mutanaqisah
(diminishing partnership). In this contract, in contrast to the leasing-to-
purchase model, the ownership of the asset financed is explicitly shared
between the customer and the financial institution. The customer in this
model makes periodic payments in two parts: 1) the rental payment of
the usufruct for the part owned by the financial institution, which as in
leasing will be under promise that the lessor will sell his part of the
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66
leased asset at the end of the contract; 2) the buy-out payment of the
part the customer acquired from the financial institution. Eventually, as
seen from the name of the contract (diminishing partnership), as time
progresses the rental portion becomes smaller and the buy-out portion
gets bigger until the rent becomes zero and the customer owns 100%
of the asset. Again, the rental instalments in the partnership contract
are generally equal to the conventional system and benchmarked to the
market interest rates. This type of financing, in reality, is not practised
often due to lack of technical and professional expertise in different
investment areas such as manufacturing, agriculture, production, etc. in
the financial institutions.
In modern finance a new Musharakah model has been introduced,
where the companies issue Musharakah shares and sell them to the
bank at discount, or directly to the investors through the bank via a
Musharakah deposit. The bank in the former case resells the
Musharakah shares to the investors with a premium, while charging an
agent service fee in the latter scenario. If the project was successful the
investors will enjoy a capital gain; however, if the project failed the
investors will lose in their capital (Masum Billah, 2005). Moreover,
Masum Billah summarized four basic rules, which need to be spelt out
in equity-based financing:
1) Distribution of profit and loss - should be agreed upon contracting
(ex-ante) and should be based on actual profit/loss bases, not quantity
bases.
2) The Nature of Capital - should be in the form of money or
commodities, and the market value of the commodities determines the
share of each party.
3) Management - the rules of principal-agent are applied in such
regards even if the parties were active partners, as in Mudharabah.
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67
4) Termination - all partners have the right to terminate the
partnership at any time.
The increased control and information availability makes the rate of
return required by the lender lower than the risky debt-based financing.
However, Usmani (1998) claimed that Mudarabah and Musharakah
should be taken as the ideal Islamic finance tools and the debt-based
contracts should be restricted to an area where these two instruments
fail to fulfil. Gamal (2001, 2003) indicated in his paper that Moore
(1997) conducted a survey in Saudi Arabia on 222 companies in which
he found that more than 75% of respondents rejected Mudarabah and
Musharakah contracts in preference of sole ownership. The Islamic
financial instrument providers hesitate to adopt profit-loss sharing
contracts as they involve close and continued monitoring, which are
firstly not their core business, and secondly, it is very costly. On the
other hand, Khan (1998) believes the Islamic financial institutions feel
that the present accounting integrity and moral training of
customers/borrowers leaves much to be desired.
4.2.3. Financial Engineering of Mudharabah and Musharakah
In consideration of modern finance, financial engineering and
malleability of Mudharabah and Musharakah in two dimensions is
revealed in a study conducted by Ebrahim (1999):

4.2.3.1. Financial Objectives
The profitable Mudharabah financing project, based on economic
conditions and risk of the business venture, at its maturity encounters
two options; either it will be terminated and sold in the secondary
market; or the partners would desire to resume the enhancement. In
the former case, the principal amount is returned to the financer with
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68
the ex-ante agreed fraction of the profit, while, in the latter scenario,
the investors share the fraction of the net operating profit as well as
the appreciation of the venture. Nevertheless, if the venture chooses
the growth policy without paying any dividends, all the earnings are
returned to the business and distributed at the termination.

4.2.3.2. Risk Profile
In some ventures the financer (rubb-ul-mal) would be keen on
transferring part of the risk of the venture to the entrepreneur
(mushrik) in exchange for a lower profit sharing ratio or, on the other
hand, the mushrik would like to transfer part of the risk to rubb-ul-mal
in return for a lower sharing risk. This can be accomplished by
financially engineering the instruments in the sense of contemporary
time. The former desire can be achieved by combining Mudharabah with
the Put Option bought by rubb-ul-mal from the mushrik, where the
premium of the Put is offset by the premium of the Call. In this
transaction the mushrik bears extra risk in return for a higher
participating fraction, and vice versa for the latter requirement.
Having said that, the question is: Is this risk-return trade-off
transaction acceptable Islamically? Ebrahim (1999) in his study, though,
did not investigate such a query and left it for the Fiqh Acadimic to
answer. Nevertheless, he noted that this trade-off is derived from
synthesizing Mudharabah and Takaful (insurance policy in the form of
Put-Call Options), both of which are Islamically permissible instruments.
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69

4.3. Derivatives
4.3.1. Salam
Unlike the extreme flexibility in Western finance, the Islamic finance
rules forbid selling assets not owned or not existing at the time of the
contract due to Gharar (detailed discussion is examined in the Gharar
section). In Sahih Bukhari (Volume 3, Book 34, Number 343), Ibn Umar
(radiallaho unho) narrated that the Prophet (salallaho alaihi wasallam)
said, "He who buys foodstuff should not sell it till he has received it.
Furthermore, Islamic financing rules restrict the deferred part to either
the payment or the delivery, but not both. However, to facilitate certain
types of business transactions, a few exceptions were given, and one of
them is Salam contracting. In Sahih Bukhari (Volume 3, Book 35,
Number 443), Ibn Àbbas (radiallaho unho) narrated that the Prophet
(salallaho alaihi wasallam) came to Medina and the people used to pay
in advance the price of dates to be delivered within two or three years.
He said (to them), "Whoever pays in advance the price of a thing to be
delivered later should pay it for a specified measure at a specified
weight for a specified period. (A similar Hadith from the same narrator
is in Sahih Muslim Book 10, Number 3906).
This is considered to be an Islamic forward financial contract, in which
the buyer makes a full cash payment on the spot to the seller, who in
turns is obliged to deliver the asset sold on a future specified date. The
underling assets are normally available and traded in the market. The
buyer inspects the delivered asset/goods; in the case of any
discrepancies, he has the right to refuse to take possession if it does
not comply with the specified terms and conditions, leaving the loss
bearing to the seller. El-Gari (1997) considers this tool as a perfect
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70
alternative to the conventional contemporary derivatives; however, this
view is debatable, as shown below.
The rationale of the Salam contract is to enable the seller to have
leeway of liquidity to be able to arrange for the asset required. This is
one of the risk management instruments, particularly for future hedging
where the immediate payment is executed for future delivery. The seller
alone is fully exposed to the upward development in the price of the
asset. Yet, this financing vehicle has a few drawbacks in contemporary
finance. First, the possibility of default risk by the seller. Second, the
buyer cannot sell short; in other words, he cannot liquidate the asset
before he gets the full possession of it. It is to be noted that short-sales
are restricted to specified assets, not to immovable assets or fungible
assets which are readily available in the locality. Third, if the seller
defaults on delivery of the specified asset at the specified time, the
buyer bears the opportunity cost; all he could do is either recoup what
he had paid (without interest) or wait for the goods to be delivered
again (Vogel and Hayes, 1998).
In such regards, Ebrahim and Rahman (2005) assented on inefficiency
of Salam in comparison to financially engineered synthetic Future
instruments. This contract is a package combining a Future contract (on
Islamically permissible commodities) and a Murabahah contract. The
main difference between a Salam and a Future contract is timing of
payment. In the former type the full payment is on the spot (t=0),
while, in a Future contract, although the price is fixed on the spot, the
payment is delayed when the asset is delivered (if the contract was not
offset). In the synthetic Future contract the countervalues are pre-
negotiated at t=0, the producer gets his financing by Murabahah and
repays his financing at a time t=1 when the Future contract is mature
and output is sold. The authors demonstrated that, besides the
constraints imposed by a 100% cash margin deposit in Salam, synthetic
Future is pareto-optimal over Salam in the sense of the risk aversion
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71
and the payoffs from the synthetic Future package of unconstrained
optimization being better than constraint optimization as it in the case
of Salam. Therefore, Ebrahim and Rahman concluded "the welfare of
the emerging Muslim economies would be reinforced by substituting
modern Futures on Islamically allowed commodities for Bai Salam. The
ruling of Future contacts is discussed below.

4.3.2. Futures
In Future contacts the traders fix the price of assets, in which they
trade in advance, prior to making any physical delivery. This is a
hedging device against the volatile price movement, which facilitates for
better planning, eliminating the risk and determining the costs. The
traders who enter the Future contracts, whether as buyer or seller, are
required to pay a premium deposit (about 10%-15% of the contract
value), while the actual cash payment of price and the delivery of the
asset takes place on the maturity date if the contract is exercised.
However, the actual delivery rarely happens; instead mostly traders
enter a reverse transaction prior to maturity and settle their account.
The overall process is done through the clearinghouse, which interposes
itself between the buyer and seller while ensuring the settlements
without overdues and guaranteeing the transaction. Many late Muslim
jurists and non-Muslim researchers availed that Islam prohibited such
kind of transactions. These scholars debated over Futures trading in
several points. (1) It consists of a short-selling trade, which is
Islamically invalid as the seller does not own or possess the asset sold,
and therefore he/she cannot transfer the ownership. (2) It is not a
genuine sale, as the countervalues (asset and price) are absent;
Islamically, at least one of the countervalues should be present. (3) It
lacks taking the possession (qabd) of assets prior to resale, which is
unlawful in Islam. (4) Offsetting Futures positions is deemed to be the
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72
sale of debt-for-debt (Bai al dayn bi al dayn), which is a very
contentious issue in Islam. (5) It is a speculative activity and deemed to
be gambling.
Some of the writers who described the Future sales as a forbidden
contract are Al-Jaziri (1991) ". futures contracts in our time . when
someone buys cotton, for example, and then sells it prior to taking
delivery from the seller, the sale is voidable. Khan (1988) "future
trading is alien to Islamic law as it involves trading without actual
transfer of commodity or stock to the buyer which is explicitly
prohibited by the Prophet . all transactions in these chains are
unlawful. Abd al Basit (1985) and Wilson (1991) passed their
prohibitive judgment, incorrectly, on the view that Future sales do not
fulfil the Salam (forward) contract conditions, which, in their view is the
only framework involving a future delivery that can be concluded.
Makkah-based fiqh academy "Majalis al Majama al Fiqh al Islami
(1985) also shared the same view on the basis of non-genuine contracts
containing the Gharar element and selling things that the seller does
not own. All the above scholars, and others, referred the prohibition of
Future contracts to the Hadith narrated by Hakim Ibn Hizam, who said
"I asked the Prophet: Ò Messenger of God. A man comes to me and
asks me to sell him what is not with me. I sell him (what he wants) and
then buy the goods for him in the market (and deliver them). The
Prophet replied: `Do not sell what is not with you (Sunan Abu Dawud).
When a financial matter comes to technical issues it should be referred
to Muslim financial experts to be construed before adjudging if an
instrument is forbidden or permissible. Indeed, the Prophet (PNUH)
demarcated the authority of religious scholars to spiritual matters and
cited the technical issues to a technical specialist. In Sahih Muslim
(Book 30, Number 5831) Rafi b. Khadij reported that Allahs Messenger
(PBUH) came to Medina and the people had been grafting the trees. He
said: "What are you doing? They said: "We are grafting them,
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73
whereupon he said: "It may perhaps be good for you if you do not do
that, so they abandoned this practice (and the date-palms) began to
yield less fruit. They made a mention of it (to the Holy Prophet),
whereupon he said: "I am a human being, so when I command you
about a thing pertaining to religion, do accept it, and when I command
you about a thing out of my personal opinion, keep it in mind that I am
a human being. Siddiqi (2001) in such regards stated "We should
never lose sight of the reality that the divine part of modern Islamic
finance, though crucial, is very small. The rest is man-made resulting
from Ijtihad (efforts in understanding and applications). Furthermore,
jurisprudence is not a fixed body of ruling for all transactions. Most of
the financing products existed in the pre-Islam period and, when Islam
came, the majority of these methods, which were in compliance with
Shariah requirements, were permitted. If that were the case with the
pre-Islam instruments then it is fortiori that no contemporary financial
tools that meet human needs and the Shariah condition should be
pronounced as forbidden due to misinterpretation. Islam does not
prohibit us to explore genuine new solutions for human needs.
The scholars who proposed the prohibition of Futures did not tackle the
Hadith to its logical conclusion and did not look into the Hadiths
meaning and rationale. Future trading is a new mode of trading; did not
exist before. Life never remains constant and Shariah has provided
flexibility to respond to changes and diversity. This requires fresh
responses in light of the modern operative procedures of the market.
Kamali (1996) in a path-breaking effort analysed Future contracts in
sight of financial and Shariah compliance and described that the
scholars who forbade Futures have limited their understanding of Quran
and Sunnah only to the clear texts. The imitative (taqlidi) tendency
further stopped them from applying juristic calibre into the dynamics of
such a derivative. The author started the discussion by raising the issue
of the weakness in authenticity and transmission of the Hadith, as
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74
neither Bukhari nor Muslim recorded the Hadith, and one of the
narrators is obscure. Secondly, in accepting the Hadith, the legal value
of the Hadith does not espouse any warning; therefore his view is that
such trading is rated as a moral opprobrium (karahiyah). Going forward,
Ibn Taymiya (1398) interoperated the prohibition in the Hadith to the
uncertainty and doubt over a traders ability to deliver the commodity in
future, which is Gharar. This is evidenced by the marketplace of Hijaz
during that period being small enough that it could not guarantee the
supply at any given time.
However, Kamali (1996) illustrated that, in the modern market, apart
from the fact that Future contracts are bought and sold in standardized
quantities and packages, due to the extensive size the Future market
assures availability of identical contracts and the seller can find
indistinguishable assets at any time and make the delivery whenever
required: "Given currently available means and facilities, the fear of not
being able to find the goods and make delivery (the basic rationale of
the original prohibition), is now irrelevant. Moreover, short-selling
restricted by Shariah applies only to the sale of specified unique goods
(buyu al ayan) and not to fungible goods that are readily available in
the market. Similarly, a Salam transaction is valid even if the seller did
not own the object at the time of contracting. Additionally, the
clearinghouse guarantees the function, and supervises that delivery of
the exact quantity, and grade is assured; thus, possession of the asset
prior to sale is not a prerequisite in such dealing. Finally, describing the
offsetting transaction as Bai al dayn bi al dayn has no solid grounds.
Ebrahim and Rahman (2005) asserted that conveying a sellers
obligation as a `debt is incorrect understanding. The appropriate
interpretation is that it is selling equity in a production process.
"Although this (selling the underlying asset in future and forward
contracts) creates an obligation for the seller to deliver the commodity
in the grade and quantity negotiated and resembles a liability, it does
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75
not constitute a debt on the part of the seller as construed by Islamic
jurists (Ebrahim and Rahman, 2005). They reach the result: "If futures
contracts do not constitute such an exchange of debt for debt, then
there is no problem in trading them. Moreover, even if this nomination
(debt obligation) was accepted, it is a debatable issue and there is no
rigid support from Quran and authenticated Sunnah prohibiting
offsetting transactions. Consequently, the uncertainty and Gharar
element is virtually eliminated, which leaves no room for prohibiting
Futures on such a basis and Kamali (1996) concludes that Future
contracts are permissible as long as they exclude forbidden
commodities.

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76
5. Current Status and Future Prospective for Islamic Finance
5.1. Current Market Trend
Gradual independence of the colonized Muslim countries from the
Western political dominance after World War II has led to the revival of
Islamic finance aspiration in many Muslim countries. Mit Ghamr was the
first Islamic bank born worldwide. It was a local savings bank in Egypt,
operating based on two basic concepts of Islamic finance, profit/loss
sharing, and interest-free banking. The bank witnessed an unexpected
success, savings tripled in three years and the default ratio on loans
was zero percent (Ahmed, 1995). However, unfortunately, this success
did not last long: political pressure forced its foreclosure and the Mit
Ghamr experience fizzled out within three years. Thereafter, the oil
discovery in Muslim countries and the surge of oil prices in the 1970s
flushed billions of dollars into these countries. This dramatic change in
wealth promoted the Arab countries to transform the theoretical
concepts of Islamic finance into reality. Several Islamic banks were
opened: for instance, the Dubai Islamic Bank was established in UAE in
1975, the Islamic Development Bank in Saudi Arabia in 1975, the Faisal
Islamic Bank in Egypt and Sudan in 1977, Kuwait Finance House in
Kuwait in 1977, and Dallah Al Baraka in Saudi Arabia.
The Islamic financial market development surged a number of Islamic
banks. Islamization of financial services varies across countries: Iran,
Pakistan and Sudan, for example, are at one extreme, where the entire
financial sector has been made officially Islamic and totally compatible
to Islamic law according to their central banks, while Saudi Arabia,
other GCC countries, Malaysia, Indonesia, and some other Arab
countries have developed a hybrid of Islamic banking alongside
conventional banking (Tlemsani and Matthews, 2003). Islamic finance is
currently practised through two channels. 1) Specialized institutions:
these are Islamic intermediaries structured wholly on Islamic principles
_____________________________________________________________________________
77
and deal only with Islamic instruments, such as the Islamic Developing
Bank in Saudi Arabia, the Islamic Bank of Britain, the Bahrain Islamic
Bank etc. 2) Islamic Windows, on the other hand, were originally
conventional banking service providers, but they also offer alongside
special facilities of Islamic instruments to Muslims (or even non-
Muslims) who wish to engage in Islamic financing; for example, Al-
Amanah in HSBC, the Islamic Investment Banking in Citigroup, and the
Islamic Banking Division in ABN AMRO.
Historically, Islamic finance institutions attracted deposits from Muslims,
but these institutions lacked liquidity-enhancing instruments and
technical ability to invest efficiently. However, Iqbal (1997) argued that,
due to global awareness of the future of the Islamic market, the past
trend is changing, more liquid instruments have emerged, and Islamic
institutions have successfully integrated with the international market
which provided Islamic solutions for the investors and borrowers.

5.2. Issues and Challenges
While the Islamic finance concept and its practice are just departing the
third decade, and aside from the fact that three countries (Iran,
Pakistan and Sudan) have already adopted a fully Islamic financial
system and a large number of financial institutions are providing Islamic
instruments, the Islamic finance concept is still considered to be in its
early stages of development. It is common at this phase to face several
contests in the challenging environment. Muslim economists considered
a number of limitations that have to be addressed for the future of
Islamic finance:

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78
5.2.1. Regulatory Framework
Existing Islamic finance regulations, mostly, are based on the Western
conventional finance model. Evolution of such a regulatory and
supervisory framework is a hallmark of a well developed financial
infrastructure facilitating flexible integration of Islamic and international
markets and intensifying the stability of the financial system.
Additionally, it would facilitate operating of the Islamic financial
institutions in non-Muslim countries, which have a considerable Islamic
community seeking Islamic instruments.
Establishment of such a regulatory framework provides assurance that
the financial policies and strategic directions are compliant with the
Shariah principle. Meanwhile, the conventional banking system is
guided and regulated by Basel Accord guidelines, the Islamic financial
system also; in order to be fully integrated into the global financial
market, it needs to be regulated with the same principles, which have
to be reviewed from an Islamic banking prospective and consider the
risk involved in Islamic products and services (Akhtar, 2003). In other
words, in the conventional banking system, according to Basel II, a
minimum capital adequacy is required according to the risk of each
individual asset undertaken in each financing transaction. This frame
needs to incorporate the fundamentals of the Islamic concept, where
the debtor-creditor relationship converts to an investor-entrepreneur
relationship in Mudharabah, for example.
The establishment of the Islamic Financial Services Board (IFSB) in
Malaysia in November 2002, serving as an international standard-
setting body of regulatory and supervisory standards for Islamic
financial institutions and ensuring the soundness and stability of the
Islamic financial services industry, is considered a major step towards
international integration achievement. So far, prudential standards for
the Islamic financial services industry, namely Risk Management and
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79
Capital Adequacy, have already been established and Corporate
Governance standards are expected to be completed by the end of 2005
(www.ifsb.org). Since IFSB was established in 2002 and up to the date
of this dissertation, 16 full members from different countries, seven
associated members and 50 observer members have already joined,
which clearly illustrates the strong desire of financial institutions to
achieve a common regulatory and supervisory framework.

5.2.2. Slow Innovation and Solutions
The paces of Islamic instruments are characterized by two phenomena.
(i) Slow innovation. Innovation is the key to sustaining the industry
growth and market expansion. Innovation is about developing and
increasing the range of new Islamic products and services to meet the
newly sophisticated requirements of todays consumers and businesses.
The innovation of Islamic instruments is slow. For years the market has
offered the same instrument without the novelty of new ones: for
instance, Islamic finance provided short- to medium-term liquidity
solutions; nevertheless the maturities at the extreme are yet to be
yielded. As Mirakhor (2005) argued, while few banks operating on the
stated bases (short-to medium-term only) may not have discernible
impact on the overall economy, a total system operating on this basis
will have a considerable negative impact on the development and
growth. Islamic solutions should be more rapidly innovative rather than
constrained; for example, the asset portfolios of Islamic banks do not
have, so far, any strong compatible products based on a profit-loss
sharing model.
(ii) Follower. The financial practices in conventional banking are
increasingly becoming advanced and dynamic. Islamic banks started
from their earliest days to mimic the asset and product structures of
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80
conventional banks and reshaped them for Islamic financing seekers.
Islamic finance instruments approach the market as resolutions for
conventional instruments. Although there are few Islamic financial
instruments that are distinct from conventional financial instruments, in
most cases the Islamic products are repackages of the features of
conventional products by eliminating the elements that are not in
compliance with Shariah. This makes Islamic finance a follower of
conventional dealing in supplying alternatives to Muslims. Islamic
institutions need to design instruments that are compatible with
conventional tools. "This is done by modeling each potential investors
objective function and solving for Pareto-optimal contracts which
maximize the welfare of the agent in the economy (Ebrahim, 1999).
Yet Islamic finance is not the initiator of products for the newly public
demands. The Islamic scholars, regulators and practitioners need to
combine efforts to invent new products that will provide development in
the Islamic financial market. The financial institutions, also, need to
equip their business strategies with R&D to design new innovative
Shariah compliant products and services.

5.2.3. Uniform Global Guidelines
The presence of the Shariah supervisory committee as an Islamic
financial institution is another aspect that distinguishes them from the
conventional financial institutions. Nevertheless, recently, even the
conventional banks that provided Islamic finance also make sure to
consult an approved Shariah committee before launching any Islamic
product. The Shariah committee ensures that all financial instruments
provided are halal (lawful). The current practice is that each Islamic
financial institution has its own Shariah board for guidance and
approval. The lack of uniformity in the religious principles in Islamic
transactions globally entails that each Islamic institution seeks an
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81
approval from its own Shariah committee. It depends on each
institutions committee to decide what is Islamic and what is not.
Different interpretations of different schools may lead to different
opinions for an identical product: one institution might approve it while
the other rejects it, and thus the same product may not be acceptable
in all countries. For instance, Malaysian Islamic banking laws permitted
bai al-dayn (trading in debt), which facilitated them to develop the
Islamic Money Market. On the contrary, most of the Arab world and
Pakistan jurisprudence rejected this type of trading (Gamal, 2003). The
scale of the issue is vaster than it appears: in most countries each
bank/financial institution has its own Shariah board. This means having
a consensus of the different boards in a particular country is strenuous,
let alone the complexity of having a global consensus. On the other
hand, the absence of such a unified uniform religious body is one of the
causes of the slow innovation, as each Shariah committee has it own
view on any new Islamic product. Moreover, each fiqh school has a
different opinion, and having a conflict of interpretation between regions
is most likely to occur and consumes further time. For instance, Moore
(1997) cited that conservative Middle Eastern scholars often do not
accept financial fatwa issued by, for example, South-East Asian
scholars. Consequently, Islamic finance products have not yet been
standardized
It is worth indicating that some countries, such as Pakistan and Iran,
took the initiative of consenting the financial fatwa in the country, as
the government of these two countries regulated new rules and
appointed through the Central Bank a central religious board approving
the financial instruments and ensuring consistency. Saudi Arabia,
moreover, also appointed a specific Shariah board committee in the
country: all banks are obligated to appoint at least three member of this
board in their internal committee ensuring that all banks are applying
the same rules. Finally, one of the major roles of the IFSB is to
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82
harmonize the different fiqh schools interpretations for different
instruments. This body is insistently functioning to achieve universally
common guidelines in Islamic financial practice and achieve conformity
or similarity - to the extent possible - in concepts and applications
among the Shariah supervisory boards of Islamic financial institutions to
avoid contradiction and inconsistency between the fatwas.

5.2.4. Islamic Institutions' Size
Islamic financial institutions suffer from smallness in size and very few
of them operate in more than one country. All Islamic banks are
considered very small compared to the size of the mega conventional
banks. The scale of the difference is quite significant to the extent that
it did not stop Chapra (2000) from overstating by saying that assets of
each conventional mega bank are "far in excess of those in all the
Islamic financial institutions put together. Furthermore, the network of
correspondent banks globally to have a fully-fledged Islamic banking
system has not yet been established. Islamic financial institutions
suffer, for example, from the lack of an efficient capital market that
could suddenly demand large liquidity. The situation has changed with
the entry of some major conventional financial institutions into the field
through special vehicles. But this has also made things more difficult for
specialized Islamic financial institutions, obliging them to consider
mergers and consolidation.
For Islamic finance, in order to operate on a sustainable basis in the
highly competitive environment, integration of the financial market in
Islamic countries is necessary. Despite the effort needed for
development of Islamic instruments, plans are required for
establishment of an Islamic free market, which facilitates international
corporate and individual clientele requirements.
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83

5.2.5. Sound Accounting Procedures and Standards
In many cases the Western accounting procedures and standards may
not be adequate due to the different nature of the instruments and their
relationship (investor-entrepreneur vs. lender-borrower). The Third
Pillar of Basel II requires market discipline by increasing disclosure
requirements and enhancing the transparency. These information
disclosures need timely availability and to be explicable for analysis and
interpretation. Accurate Islamic financial reporting procedures are
required that would not only be in compliance with the international
accounting standards but would also be compatible with Shariah
principles. The availability of such high standard accounting procedures
and transparency is even more important for Islamic banking to acquire
consumers confidence due to the profit-sharing relationship.
Islamic institutions have a shortage in trained qualified personnel and
organizations in such an area. The establishment of the Accounting and
Auditing Organization for Islamic Financial Institutions (AAOIFI) in 1991
in Bahrain has made a significant development in formulating
international Islamic accounting and auditing standards. The AAOIFI,
within the Islamic Shariah rules and principles, has five objectives
(www.aaoifi.com):
1- Develop accounting and auditing procedures for the activities of
Islamic financial institutions.
2- Train personnel and organizations to disseminate the accounting
and auditing.
3- Harmonize the accounting policies and procedures adopted by
Islamic financial institutions.
4- Improve the quality and reach a uniformity of auditing and
accounting standards.
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84
The AAOIFI has made noticeable progress with preparation of
accounting standards in order to render the Islamic institutions
financial statements more comparable and transparent. So far 115
members representing 27 countries have already gained membership of
the AAOIFI, which reflects the strong desire from all financial Islamic
instrument providers to reach an internationally accounting conscience.
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85
6. Conclusion
The evolution of Islamic finance started with the birth of the Mit Ghamr
bank, in Egypt in 1963. Even though it did not last more than three
years, it sparked the unfolding, and paved the way for tremendous
growth of Islamic banking. A study conducted by the General Council for
Islamic Banks and Financial Institutions (GCIBFI) in December 2003
declared that an average annual growth rate is 10% per annum since it
first emerged in the 1970s (www.bankerme.com). Almost every month
a new Islamic institution enters the market, either a fully Islamic
licensed bank or a special vehicle of conventional institution (Islamic
window). Worldwide, currently, there are 267 Islamic financial
institutions and the assets managed by them or by conventional
institutions on Islamic principles have reached USD 260 billion
(Gassner, 2004). This rapid expansion must be surprising to those who
believed that the Islamic banking system would not be able to survive
in the face of the predominant contemporary finance. Furthermore, this
spread of Islamic banking had two repercussions. Firstly, it clearly
demonstrated the feasibility and viability of Islamic finance instruments
and the ability of the industry to develop and offer a wide range of
competitive products. Secondly, the wide application of Islamic finance
led the conventional financial institutions such as CitiGroup, HSBC, etc.,
even in developed countries, to start offering an Islamic banking service
through special vehicles `windows to the vast demand.
The different sources of Islamic contract law clearly emphasize that
income earned by Muslims must be halal (lawful). God mentioned in
Quran "O mankind! Eat of that which is lawful and good on the earth,
and follow not the footsteps of Shaitan (Satan). Verily, he is to you an
open enemy (S2: 168). Islamic finance was set up so that the
financing business can be pursued without involvement of Riba and
Gharar that violate Shariah rules. In Islam, exchanging money-for-
money (or any medium of exchange) at a fixed predetermined rate of
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86
return is forbidden and considered as a Ribawi contract. Islamic
instruments, therefore, are structured so that the exchange would
involve assets/goods-for-money. The Prophets Hadith, which declared
that "entitlement of return from asset vests on one bearing risk of it,
entails that in Islamic financing the financer should also be subject to
the risk entailed in the investment. Therefore, profits which are not
derived from efforts on permissible activities and risk sharing are illicit.
On the other hand, conventional financial facilities which are based on
fixed interest costs can severely pressure and strain the borrower
during the economy slowdown, as he is obligated to repay the
predetermined extra amount over the principal he borrowed. This leads
to financial fragility, bankruptcies and structural impairment of the
country.
Furthermore, profit making and risk management is encouraged in
Islam, while exploitation and excessive hazard is not permitted.
Therefore, deception contracts based on uncertainty and pure
speculation, which lead to social harmness and devouring of peoples
property, are another set of corrupted practices that Islam banned.
These types of contracts are described as Gharar contracts. Muslim
jurists consent that a contract may be null and void based on the
existence of Gharar, yet there are different opinions as to what degree
of Gharar is required to invalidate the contract. Islam desires to invoke
the sprit of risk sharing and hard work in permissible activities as a
criterion of lawful profits.
Murabahah (cost-plus) financing is not based on a risk sharing principle.
Experience, however, showed that fixed-income instruments (like
Murabahah) are the dominant modes of financing used by Islamic
institutions. The extensive use of this credit facility in contrast to the
other Islamic instruments is due to lack of Islamic capital market,
securitization restrictions, limited degree of risk involved in contrast to
other instruments, moral hazard problem, and the resembled fixed rate
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87
products overwhelming financing instruments in conventional banking
that are demanded by the vast majority of entrepreneurs and corporate
clients. On the other hand, the use of an interest-based index to
identify the rate of return for some Islamic instrument is a highly
controversial matter among the scholars. There is a fear that using
fixed-income instruments benchmarked to an interest rates index may
not be in the true sprit of Islam. This led some researchers to claim that
Islamic instruments are not free of interest. The discrepancy between
the theory and the practice in Islamic banking is due to the immature
theory of Islamic finance in the contemporary integrated global capital
market (Ebrahim, 2000). Moreover, the alliance between the
practitioners and the Islamic scholars, though, introduced changes in
the instruments, yet the basic structure of the Ribawi model is
unchanged (Ebrahim, 2005).
The Futures market, among the majority of Middle East ulama
(scholars) is yet considered as Haram (Islamically illicit). This is mainly
due to the limited understanding of Quran and Sunnah from one side,
while lack of training and knowledge of financial economics, financial
institutions and modern complex financial instruments on the other side
led to unfair and deficient interpretation of derivatives in general. The
imitative (taqlidi) tendency, furthermore, does not regard applying
juristic calibre to the dynamics of such a new derivative. However,
"Islamic finance is open to any innovation that is in congruence with its
fundamentals (Siddiqi, 2002). Therefore, other scholars such as Kamali
and Ebrahim are of the view that Futures are halal (Islamically lawful) if
traded on permissible goods/assets, especially, as demonstrated by the
latter, that Futures are more efficient than Salam (Islamic forward).
This viewpoint is of importance for Muslim nations to benefit from the
effects of modern financial intensity for the growing need of trading
vehicles that can absorb the surplus funds in the region. Absence of
Futures in Islamic banking, particularly in the oil-producing countries, is
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88
the major reason for the continuous funds flight from the Middle East to
the West in the developed international integrated capital and financial
market. Additionally, Futures as risk management facilities will enhance
the profitability of Islamic banks and reduce risk exposure. The
imprudent interpretation of Shariah rules and the restrictive approach
adopted by Islamic scholars in the name of eliminating Gharar and
blocking essential modern financial derivatives runs the greater risk to
Muslim societies which will lag behind in economic progress and
eventually lose out to the competitive advantage.
Islamic banks have grown recently in the Muslim world but are a very
small share of the global economy compared to the Western debt
banking paradigm. It would be unfair to compare the well-established
Western conventional financial structure with the more recent, only
three-decades-old, Islamic banking system. The future of Islamic
finance, though, is extremely bright: much has to be done in developing
new products and services, having uniform global standard guidelines,
and an elite regulatory framework to continue the growth and secure
the competitive advantage. In the era of global integrated financial
markets, many innovations need to be considered in the Islamic
financial sector. Shariah compliant products and services would not only
satisfy the needs of the 1.6 billion Muslims in the world but may also
attract ethically-motivated customers. Meeting these challenges is a
prerequisite; otherwise they may hinder the promotion of Islamic
finance at national as well as international level.

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89
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