ISLAMIC MODES OF FINANCE : AN INTRODUCTION

By Farrukh QUreshi

OUTLINES
Sources of the Shariah Framework of Islamic Finance Shariah, Fiqh & Muamalat Necessary Requirements of Islamic Finance Riba, Gharar, Maysir & Others Essential Contracts in Islamic Finance Products and Instruments

WHY ISLAMIC BANKING & FINANCE

Before explaining the concept what is Islamic Banking & Finance the elaboration of concept why Islamic Banking is very important. Islam is a complete code of life that provides guidance regarding each as pect of life.

WHY ISLAMIC BANKING & FINANCE

The primary objectives of Islamic Economic System are as under. Equal Distribution of wealth

Social justice
in

These objectives can never be achieved Interest/Riba based economic systems.

ISMALIC BANKING & FINANCE

Islamic banking has been defined as banking in consonance with the ethos and value system of Islam and governed by the principles laid down by Islamic Shariah, in addition to the conventional

good governance and risk management rules,

SHARIAH STRUCTURE

SOURCES OF THE SHARIAH

Primary Sources
The

Holy Quran

Sunnah

(the sayings, deeds and endorsements of Prophet Muhammad PBUH)

PRIMARY SOURCES OF THE SHARIAH

QURAN
source for discerning the laws of God.

-Primary

Example : God has permitted trade and prohibited Riba Reference : Surat Al Baqara
verse 275

PRIMARY SOURCES OF THE SHARIAH

SUNNAH

Literally means : Well-known path -Words or Acts of the Prophet -- Sayings of the Prophet (SAW) used to lay down and give moral guidance -Acts of the Prophet (SAW) which have a legal content (ex: method of praying) -- Tacit approval (silence) of the Prophet (SAW) on the action of one of his companions in his presence or in his knowledge

SOURCES OF THE SHARIAH

Secondary Sources
IJMA

(Consensus)
(Analogy)

QIYAS

IJTIHAD

(reasoning of a group of qualified scholars, which is aimed at adapting Islamic rules to the contemporary world)

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SECONDARY SOURCES OF THE SHARIAH

IJMA (Consensus)

-Literally

means agreement on a matter -- In its technical sense, it means the consensus of the independant jurists from the Ummah of the Prophet Muhammad (SAW) after his death - Example : Jurists have reached a consensus (Ijma) that the selling of goods by an party who doesnt own the goods and without the approval of the goods owner is void.
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SECONDARY SOURCES OF THE SHARIAH

QIYAS

Literally means measuring or estimating one thing in terms of another -Technically, it is the assignement of the legal rule of an existing case found in the texts of the QURAN, the SUNNAH, or IJMA to a new case whose legal rule is not found in these sources. -- Example : Jurist looked into details of the prohibition of alcohol. After analysis, it was decided that the underlying reason is intoxication . Once this has been defined, the scholars would look at other liquids that intoxicate and extend the legal rule
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SECONDARY SOURCES OF THE SHARIAH

IJTIHAD

Number of meaning of Ijtihad

-Islamic

scholars take into account the customs of a place that adress a problem but are not offensive to Sharia -- In some cases, Islamic Scholars develop their own preference from a solution to an apparently unique problem - Fundamentaly, it is a personal exercise until other scholars are able to agree with the solution proposed by the innovator.

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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.

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CONTD
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 SHARIAH 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 MUAMALAT (ISLAMIC COMMERCIAL LAW)

However, in its general usage, it is called al-syariat alIslamiyyah (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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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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WHAT TO BE AVOIDED

Riba prohibited in many Quranic verses and sayings of the Prophet s.a.w. Meaning: riba is every excess in return of which no reward or equivalent counter value is paid, in short, every unjust enrichment is riba

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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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PROHIBITION OF RIBA IN THE QURAN

4 STAGES

First Stage (30:39)

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

Second Stage (4:160-161)

Attaching the practice of riba with the Jews Consider the practice as an iniquity (zulm)

Third Stage (3:130)

Prohibiting the practice of charging double and multiple riba

Fourth Stage (2:275-281)

Conclusively prohibiting all forms of riba Any excess over the capital is disallowed
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(AR RUM 30: 39)

and that which you give in gift (to others), in order that it may increase (your wealth by expecting to get a better one in return) from other peoples property, has no increase with Allah

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4:160 - 161

and their taking of Riba though they were forbidden from taking it and their devouring of mens substance wrongfully. and we have prepared... a painful torment.

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3:130

O you who believe, Eat not Riba doubled or multiplied, but fear Allah that you may be successful.

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2: 275

those who eat riba will not stand (on the Day of Resurrection) except like the standing of a person beaten by Shaitan 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 passt; his case is for Allah (to judge); but whoever returns (to riba), such are the dwellers of the Fire they will abide therein forever.
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2: 276 - 278
Allah will destroy riba and will give increase for sadaqat (deeds of charity, alms). . 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

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2:279

And if you do not do it, then take a notice of war from Allah and hiss Messenger but if you repent, you shall have your capital sums. Deal not unjustly (by asking more than our capital sums), and you shall not be dealt with unjustly (by receiving less than your capital sums).

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2:280 - 281
And if the debtor is in a hard time (has no money), then grant him time till it is easy for him to repay; but if you remit it by way of charity, that is better for you if you did but know. And be afraid of the Day when you shall be brought back to Allah. Then every person shall be paid what he earned, and they shall not be dealt with unjustly.

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CONTD

There are also a number of narrations from the Sunnah on the prohibition of riba Some of the narrations give general prohibitions of riba, e.g.: The Prophet of Allah s.a.w. cursed the receiver and the payer of riba, the one who records it and the two witnesses to the transaction and said: they are alike (in guilt).

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CONTD

Under Islamic law, riba can occur in two main situations, i.e.:

riba al duyun (loan): the riba or excess which occurs in debt and loan transactions because of extension/delay in repayment riba al buyu` (exchange): the riba or excess which occurs in trading transactions involving the exchange of ribabearing commodities without observing the required rules

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PROHIBITION OF RIBA (LOAN)

Surah al-Baqarah, ayat 275
But Allah hath permitted trade and forbidden usury

Interpretative Efforts
What amounts to Trade
Criteria Fair exchange of goods or value Fair distribution of risk & return

Usury
Criteria Oppressive / unfair distribution of risk & return Unjustified enrichment at expense of others
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PROHIBITION OF RIBA (EXCHANGE)

Sunnah of the Prophet:
Gold for gold, silver for silver, wheat for wheat, barley for barley, dates for dates, salt for salt - like for like, equal for equal, and hand-to-hand (spot); if the commodities differ, then you may sell as you wish, provided that the exchange is hand-to-hand or spot transaction.

Interpretative Efforts Application Currency Rules

Same denomination At Par Spot Different denomination Spot

Staple Food Rules

Same Type At Par Spot Different Type Spot

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SUMMARY OF RULES UNDER THE HADITH

2 conditions:

money1 + money1 food1 + food1 money1 + money2 food1 + food2

Equality Hand-to-hand

2 conditions: =
Equality Hand-to-hand

= =

1 condition:
Hand-to-hand

1 condition:
Hand-to-hand

money + food
others + others

=
=

No condition free trading

No condition free trading
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CONTD

In contemporary finance, riba can occur in:

All interest-based lending activities (e.g. all conventional bonds) Fixed return on deposits in conventional banking (e.g. designated accounts for receivables of the bonds) In the secondary trading of debt securities if the transaction is not spot & if there is discounting (according to global Shari`ah standard)

Thus, to be Shari`ah compliant, all contracts in Islamic finance cannot be involved in any of the usurious activities mentioned above

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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
Riba al-Duyun (RIba in Loan Contract) Riba al-buyu (Riba in exchange contracts )

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RIBA AL-DUYUN

The debtor borrowed money to be paid in certain time, and the amount is more than 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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CONTD

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 mothers womb Sale of runaway animal, slave Involve item which may or may not exist However, the Prophet did not lay down the principles (qawaid) 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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GHARAR

Meaning: has a range of negative connotations, such as, uncertainty, deception, risk, hazard, ignorance etc. If there is gharar, the contracting party/ies do not really understand the attributes / consequence of the contract Under Islamic law, gharar is prohibited because its existence in the contract may deny the parties of equal bargaining power and they cannot make informed decisions; or if there is risks on deliverability of the object of the contract

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PROHIBITION OF GHARAR
Surah an- Nisa: ayat 29
squander not your property amongst yourself unjustly (batil) except it be a trade among you by mutual consent

Interpretative Efforts What amounts to Unjust (batil)

Trade by Mutual Consent

Criteria
All illegal & defective elements in contracts including gharar & uncertainty

Criteria
Offer & Acceptance, indicating consent Elimination of mistake, fraud etc
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PROHIBITION OF GHARAR IN THE SUNNAH

The sunnah uses the word gharar and its derivatives much more extensively than the Qur`an in the sense that several new meanings are added In relation to commercial transactions, the Prophet s.a.w. in many of his sayings directly prohibited the sale involving gharar (uncertainty) and jahalah (ignorance) Thus, the prohibition of gharar is made conclusive by the sunnah / hadith of the Prophet s.a.w. Examples: the prohibition of gharar sale (i.e., the sale contract affected by gharar), the prohibition of the sale of fish in the sea, bird in the air, unborn animals, lost items, etc.
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CONTD

In Islamic law, gharar can be of two degrees:

Excessive or major (gharar fahish) Minor and tolerable (gharar yasir)

Only major /excessive gharar will affect the validity of contracts, where it will render the contract void / voidable, depending on the degree of uncertainty Gharar affects trading and exchange contracts (mu`awadat); not charitable and unilateral contracts In banking & finance gharar can be triggered e.g. in the sale contract to create the indebtedness if the asset used is uncertain / vaguely identified; the trading of a securitised debt which is unconfirmed / not established, sale of insurance policy

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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 which is excessive (gharar fahish) occurs in exchange contracts (uqud almuawadat) 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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OTHER THINGS TO BE AVOIDED

Transactions involving the prohibited commodities, e.g., pork and liquor

Surah al Maidah (5:3) Surah al Maidah (5:90)

Transactions involving gambling or maysir/qimar

Surah al Maidah (5:90)

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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-Quran 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-Quran 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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SHARI`AH COMPLIANCE: MAIN PRINCIPLES

CONTRACTS

Mutual consent

Avoid

Lawful Contractual Objective

Interest (riba)

Uncertainty (gharar)

Gambling (maysir/qimar)

Other prohibitions e.g. Liquor, pork

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ENCOURAGEMENT OF TRADE BY MUTUAL CONSENT

The Quran encourages work and trade The Prophet (s.a.w.) himself was a trader The encouragement of trade is evidenced by the many instruments of trade available during the Prophet's lifetime and in Islamic history thereafter

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BUSINESS CONTRACTS RECOGNISED IN ISLAM

Contracts of sale and purchase (bay`), including all its subdivisions, like:

normal or spot sale mark-up sale (murabahah) deferred payment sale (BBA) sale with advance payment but deferred delivery (bay` al salam) sale for future delivery of goods with flexible payment of the price or manufacturing contracts (bay` al istisna`) sale of currency (sarf), etc.

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CONTD

Some controversial sales:

Sell and buy back (bay al `inah) Sale of Sale of debt (bay` al dayn)

Islam recognises partnership contracts which are mainly based on profit and loss sharing (PLS), e.g.:

mudharabah musharakah Musharakah mutanaqisah

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A relatively new invention in this regard is:

CONTD

Islam recognises public and private project financing, e.g.:

Leasing (ijarah) - private; Endowment (waqf) private/public; State treasury (bayt al mal) public. Operational lease Financial lease AITAB (hybrid contract)

Modern forms of private project financing:

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CONTD Islam recognises other additional contracts

to provide security to the parties in a contract, i.e., the contracts of security (`uqud al tawthiqat), e.g.:

suretyship/guarantee (kafalah): involves three parties mortgage (rahn): involves two parties

These security contracts are normally combined with other types of contracts, e.g.:

the contract of BBA may be secured by a contract of security involving collateral (rahn) contracts of trusts (al amanat), e.g.: safe-keeping (wadi`ah) contracts to do a specified task, e.g.: commision (ju`alah); agency (wakalah)

Other contracts recognised in Islamic law:

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Right positioning and definition of Islamic banking

Banking and finance needs

Principles sources Religious basic sources Ijma (jurist consensus) Qiyas (analogy) Ijtihad (reasoning)

Standart contracts Musharaka (Partnership) Mudaraba (Fund management) (Purchase-resale) ( Lease) ( Manufacturing contract) -(Forward sale) Murabaha Ijara Istisna Salam

Principles filter

Islamic banking and finance solutions

Prohibition on: Interest Speculation Prohibition of certain investments: Sectors (e.g.: alcohol, armaments etc.) Instruments (e.g. Leveraged interest products, toxic assets type of derivatives etc.) Asset-backed transactions with investments in real, durable assets Credit and debt products are not encouraged

Right positioning and definition of Islamic banking

Banking and finance needs
Principles sources Religious basic sources Ijma (jurist consensus) Qiyas (analogy) Ijtihad (reasoning) Standart contracts Musharaka (Partnership) Mudaraba Murabaha (Fund management) (Purchase-resale) ( Lease)

Principles filter

Ijara

Istisna
Salam

( Manufacturing contract)
-(Forward sale)

Islamic banking and finance solutions

With the development and boom of Islamic banking, it became clear that :
Islamic banking has roots in religion and ethics but it is not a religion activity and not confined to Muslim population Islamic banking is not something from and for GCC or Muslim world, it is a global concept Islamic banking has some limitations and border lines, but it is acknowledged that it can provide solutions in a wide scope of areas ranging from retail banking to investment banking.

KEY ISLAMIC COMMERCIAL CONTRACTS

Gratuitous Contracts

Trading Contracts

Investment Contracts

Supporting Contracts

Gift

Leasing

Sale

Mudarabah

Kafalah

Waqf
Loan Ibra Operational Lease Financial Lease Bay` Bithaman Ajil (BBA)

Musharakah

Rahn
Hiwalah Wadiah

Murabahah
Wakalah Salam Istisna etc. Jualah Muqasah
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Islamic Banking
ISLAMIC BANKING

SOURCES OF FUND

APPLICATIONS OF FUND

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Sources of Funds
EQUITY FINANCING DEBT FINANCING

Mudharabah Musharakah

Sale based financing BBA / Murabahah Inah/Tawaruq/dayn Salam Istisna

Lease Based Financing Fee Based Services -Ijarah Wakalah -AITAB Kafalah

Comsumer Banking

Corporate Banking
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Application of Funds

Islamic capital market

Equity Market Bond Market Derivatives Market? -Future Contract -Options -Swap

Musyarakah Mudarabah

-Debt Based -ABS -Equity Based

Mutual Fund / Islamic REITs Wakalah / mudarabah / musharakah

Islamic Hedge Fund

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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 dos and donts 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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