FUNDAMENTALS OF ISLAMIC

BANKING:
PRODUCTS & INTRUMENTS

DR. AZNAN BIN HASAN

AHMAD IBRAHIM KULLIYYAH OF LAWS,
INTERNATIONAL ISLAMIC UNIVERSITY MALAYSIA
haznan@iiu.edu.my

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Outlines

 Framework of Islamic Finance

 Shariah, Fiqh & Mu’amalat
 Necessary Requirements of Islamic Finance
 Essential Contracts in Islamic Finance
 Products and Instruments
 Standardisation and harmonisation in Islamic
Finance

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Framework of Islamic Finance
 In general, the framework of Islamic finance is the
same framework used by the conventional finance
practices.
 These frameworks are, inter alia legal and
regulatory framework, taxation framework,
accounting and auditing standards, etc.
 Might have different or additional framework, such
as accounting and auditing standard, etc, due to its
peculiarity.
 In certain jurisdiction, Islamic banking and finance
might be regulated by different sets of regulations,
either separate or additional, e.g. IBA 1983

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Cont’d
 However, Islamic Finance, as the name
suggests, has another framework, which is
considered the major element that
differentiates IBF from the conventional
banking and finance.
 Any violation of this framework will definitely
effect the validity of Islamic finance itself.
 Shariah Compliance Framework

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The Shari’ah Framework of Islamic
Banking and Finance
 Three main interrelated terminologies:
Shariah, Fiqh & Muamalat
 Shariah, when viewed from legal perspective
is the fixed elements of Islamic law, i.e. what
has been clearly stipulated and mentioned in
the text. E.g. five time prayers, prohibition of
riba’, etc.
 As such, it is revealed in nature

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Shariah & Fiqh
 Shariah, in this sense, is wide and encompassing
various branches of Islam
 Normally, it comes in its generality and it emphasizes
only on the principles and not the detailed rules (not all
the time)
 It is the duty of the judge (qadi), mufti and jurisconsult
(ulama’) to exert their intellectual efforts in deriving
and applying these principles on certain given
scenarios.
 The result of human reasoning and understanding to
the shariah is known as fiqh
 Fixed v. Flexible
 Agreements v. Differences

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Fiqh Mu’amalat (Islamic Commercial
Law)
 However, in its general usage, it is called al-syariat
al-Islamiyyah (Islamic law).
 Islamic commercial law is one of the components of
Islamic law
 Other components of Islamic law include:
 Islamic law of purification and worship
 Islamic family law
 Islamic criminal law
 Islamic law of evidence and procedure
 Islamic law of inheritance, etc
 The main subjects of Islamic commercial law are
commercial contracts and the rules governing them

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Islamic Finance Paradigm
 Original rule of permissibility:
- Initial legal ruling in commercial contract is permissibility
- Contrary to acts of devotion (Ibadat)
- No legal injunction is needed in sanctioning new contract
- Every contract is considered lawful and acceptable if no
principle of shari’ah is violated
- Open a very wide door for further innovations

 Real Economic Activities

 Transactions-oriented not loan-based.

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What to do and what to avoid

 Conclusion of contract by mutual consent

 The avoidance of riba’
 The avoidance of gharar
 The avoidance of transactions involving
maysir (gambling)
 The avoidance of transactions involving
prohibited commodities

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Mutual Consent
 al-Qur’an (4:29): “ O you who believe, devour not
your property among yourselves by unlawful means
except that it be trading by your mutual consent.
verse: al-Nisa’ (4:29)
 Manifested through expression of the parties
 No certain formalities in concluding contract
 In general, mutual consent is achieved if it is
made freely by a competent person (puberty and
prudence)

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The avoidance of riba’

 Literally: excess, expand, increase, growth

 Any unjustified excess above and over the
capital, whether in loans (between creditor
and debtor) or in trade (with similar
commodities)

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DIVISION OF RIBA
Type of Riba

Riba’ al-Duyun Riba’ al-buyu’

(RIba’ in Loan (Riba in exchange
Contract) contracts )

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 Riba’ al-duyun
 The debtor borrowed money to be paid in certain
time, and the amount is more that the amount
borrowed
 A creditor gives a periodic loan and takes monthly
interest. The capital sum lasts until the expiration of
the period. Upon expiry, if the debtor cannot pay, the
period to pay back the capital will be extended and
interest will be charged
 Arising out of exchange contract, a buyer must pay a
consideration. If he failed to settle on time, the
period will be extended by increasing the amount
(principle + interest).

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Riba al-Buyu’

 Mainly based on the saying of the Prophet:

“Gold for gold, silver for silver, wheat for
wheat, barley for barley, dates for dates, and
salt for salt; like for like, hand to hand, in
equal amounts; and any increase is riba’”.

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Cont’d
 These commodities can be classified under two main
categories which make the illah (ratio decidendi) for
their prohibition:

- i- medium of exchange (currency): Gold and Silver

-ii- Staple foods: Wheat, barley, dates and salt

 Any other items, even though not mentioned in the

hadith but serve the same purpose will be considered
as having the same illah by way of qiyas (analogy)

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RIBA IN MODERN
FINANCIAL TRANSACTIONS
 Riba’ al-duyun in loans and certain
controversial contracts (bay’ al-’inah, bay’ al-
dayn, etc)

 Riba’ al-buyu’ mainly in bay’ al-sarf

(exchange of currencies)

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THE AVOIDANCE
OF GHARAR
 Meaning of gharar:
- Literally: risk, uncertainty, hazard
- The sale of probable item whose
existence or characteristics are not certain,
due to the risky nature which makes the trade
similar to gambling

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EXAMPLES OF THIS KIND OF SALE
IN HADITH
 Sale of fish in the sea, birds in the sky
 Sale of unborn calf in its mother’s womb
 Sale of runaway animal, slave
 Involve item which may or may not exist
 However, the Prophet did not lay down the
principles (qawa’id) for the prohibition of gharar.
 Examples given in the hadith were some of the
manifestations of the doctrine, but not principles.
 This has led to the dispute among jurists on the area
and coverage of gharar.

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Application of Gharar
 Broadly speaking, gharar will effect the validity of
contract if it occurs in these areas:
- gharar in kind / type / attribute / quantity of the
object
- gharar due to delivery time
- gharar due to the price/ mode of payment
- doubt over the ability to deliver

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The Benchmark
 Gharar is excessive (gharar fahish)
 Occurs in exchange contracts (‘uqud al-mu’awadat)
 Effects the subject matter of the contract directly, not
just the appendage
 No public need (al-hajah al-’ammah) for the contract in
discussion.

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Cont’d
 However, the subjectivity of this benchmark is very
obvious
 Demarcation on excessive and trivial gharar
 Determining the public need? To what extend
 Inevitably, this demarcation will be influenced by
differences in time, societies, individual taste and
preference, technology and the way certain
transaction is conducted as well as regulatory
framework.

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Cont’d
 To prevent gharar, the parties to contract must have
adequate knowledge and information on the subject
matter:
i- Their existence and deliverability
ii- Its quality, quantity and attributes are known
iii- Time –frame for payment and delivery

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Tolerable gharar
 However, gharar is tolerable if:
- i) it is trivial (gharar yasir)

- ii) It occurs in other than exchange contracts,such as in

gratuitous contracts.

-iii) It happens to the ancillary object (appendages) only

(not the principal and main subject matter of contract).

- iv) the economic need for the contract embodying

the risk is substantial

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The avoidance of transactions involving
maysir (gambling)
 Involves the creation of risk for the sake of risk
 A combative relationship between two contracting
parties, each of whom undertakes the risk of loss
and the loss of one means gain for the other
 Apply to all games of pure chance
 No economic activities are gained in the practice.
The gambler will simply seek to amass wealth
without efforts.
 Gambling is gharar in its worst scenario.
 Prohibited by al-Qur’an in Surah al-Maidah (5:90)

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TRANSACTION INVOLVING
PROHIBITED COMMODITIES
 It is also not allowed to conclude contract on
illegal commodities such as pork, liquor etc.
 Illegality of certain commodities has been
spelt out clearly in the texts of al-Qur’an and
Sunnah of the Prophet.
 E.g. :
- Surah al-Maidah (5:3)
- Surah al-Maidah (5: 90)

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Essential Contracts in Islamic Finance
 Underlying principles utilised in devising products of IBF is very
important as they separate IBF from conventional products.
 Contrary to conventional finance, which is specification driven
product, Islamic finance is more structure and principle based
product
 Rules and regulations will differ from one product to another,
depending on the structure employed
 In general, various underlying Shariah principles have been utilised
in devising products of Islamic Banking and Finance.
 They can be summarised as below:
- Sale based products
- Lease based products
- Participatory products
- Fee based products

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Examples of the products and underlying
principles
 Banking products
 IIMM products
 Capital Market Products

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Islamic Banking

ISLAMIC BANKING

SOURCES OF APPLICATIONS
FUND OF FUND

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SOURCES OF FUND
Sources of Fund

Current/ Saving General/ Special

NIDC SBBA
Account Investment

Wadi’ah Yad Bay’ al-Inah Bay’ al-Dayn

Mudarabah
al-Dhamanah

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Applications of fund

EQUITY DEBT FINANCING

FINANCING

Mudharabah Sale based financing Lease Based Financing Fee Based Services
Musharakah BBA / Murabahah -Ijarah Wakalah
‘Inah / dayn -AITAB Kafalah
Salam
Istisna

Comsumer Corporate
Banking Banking
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IIMM
IIMM

MII GII BNNN NIDC IAB IPDS

Q. Hasan al-’Inah Al-’Inah Bay’ al-Dayn

Mudh. Bay’ al-Dayn
Bay’ al-’Inah
Etc.

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ISLAMIC CAPITAL MARKET
ICM

Equity Bond Derivatives

Market Market Market?

-Future Contract
Musyarakah -Debt Based -Options
Mudarabah -ABS -Swap
-Equity Based

Mutual Fund / Islamic

REITs Islamic
Wakalah / mudarabah Hedge Fund
/ musharakah

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Shariah Differences

 Not all of these products and instruments are

accepted by all jurists.
 Some differences arise as to the acceptability
or otherwise of these products and
instruments
 But more convergence than divergence

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Examples of main divergence
 Utilisation of disputable contracts, e.g bay’ al-’Inah & Tawarruq
 Underlying Assets and its suitability in becoming SM, e.g. future
asset, deferment of both price and SM, financial right and its
tradaility), ect.
 Terms and conditions of contracts, e.g. cross default, liberty to
stipulate terms and conditions
 Purpose of Financing, e.g. Valid transaction but to be used for
unislamic purposes

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Reasons for divergence
 Differences of interpretation of the meaning of words
or intent of any particular injunction in the primary
text, either in the Quran or Sunnah: Human
Reasoning
 Different need base:
- Legal framework
- Incentive mechanism
- Cultural preference
- Etc.

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How Islamic Law Views Divergence

 Back to basic: Divergence is the nature of

human being. Small or big, principles or
branches, anything that involves human
thinking, understanding and reasoning, the
divergence is inevitable.
 Shariah vis-à-vis fiqh: Fixed and flexible
 Pluralism has been part and parcel of Islamic
law, since its very initial days.

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Cont’d

 Jurists considered it permissible as long as:

 there is no clear-cut texts (nas qat`i) on the matter
 the opinion is arrived at by using acceptable
methodology, such as, by way of analogy (qiyas).
 Good or bad: Depends on how it is dealt with

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Should We Have Full Convergence
 Arguably, it is the most desirable one, but
 Be realistic
 In certain circumstances, divergence might have its
advantages
 So, the more realistic approach  standardisation &
harmonisation
 Differences in preference should not be standardise,
- e.g. current and savings accounts (wadi’ah or mudarabah)
- Takaful structures: wakalah or mudarabah

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The Needs for Shariah Standard

 Universal trading.
 Issue of marketability
 Consistency & stability to the product
 It will facilitate other enhancement process

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Methods for standardisation/
harmonisation (Domestically /
Internationally
 Regulations and Guidelines (IBA, Guidelines on the
Issuance of Islamic Securities 2004, Islamic REITs
etc.
 Circular: Circular on Asset Pricing by SC
 Supervision: Central Bank Act 1958 (sec 16B)
 Basic Guidelines for main contracts: Guidelines for
the issuance of Islamic Securities 2004
 International Standard :AAOIFI Syariah Standard

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Case Study: AAIOFI
 The effort to create the standards has started with the
establishment of Accounting and Auditing Organization for
Islamic Financial Institution (AAOIFI) in Bahrain.

 AAOIFI has produced a number of Shari’ah standards for

Islamic financial institutions covering both products and
services

 Enforceability of these Shari’ah standards :

a) Bahrain and Sudan

b) Other jurisdictions

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Cont’d

 Members are representative from various

continents  can become a mechanism to
bridge the disagreement.

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Round-up Discussion on harmonization /
standardization
 Disagreement is inevitable
 Approach to harmonise and standardise is more
practical, rather than full convergence
 Administrative and regulatory approach
 Continuous interaction among Shari’ah Advisors will
help to close gap and standardise understanding
 Shariah Advisors: nurturing products which are
globally accepted.
 International Shariah Advisory Council?

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Conclusion
 Besides various frameworks applied to banking practices
(be it Islamic or conventional), Shariah framework is a
framework which is peculiar to Islamic finance alone
 Yet, it forms the very substance of Islamic finance, without
which Islamic finance will loss its Islamicity
 As such, in practicing Islamic finance, the do’s and don’ts
must be clearly observed
 Islamic commercial law, from the fact that it subjects to
human interpretation and understanding admits differences
of opinion, as long as these differences are grounded by
valid evidence, produced by capable personnel, done
according to the right methodology

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Cont’d
 Full convergence in all aspects might be too
idealistic
 More practical is to have standardisation and
harmonisation of opinions
 More efforts are needed in this aspect

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THANK YOU
WASSALAM

haznan@iiu.edu.my
03-61964201
012-2121536

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