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ISLAMIC BANKING AND FINANCE

ISLAMIC BANKING AND FINANCE

CONTENTS

Sources of Sharia' law: legal basis for Islamic bankingIslamic Law of Contracts Six key Islamic banking principlesDefinition of asymmetric information, Adverse Selection, Moral hazardOrigins of asymmetric risk within Islamic bankingRIBA, ITS PROHIBITION & CLASSIFICATIONSFive reasons for the prohibition of Riba

SHARIA LAW

Shariaa: A Shariaa compliant product must meet all the requirements of Islamic law.To facilitate this, a Shariaa Supervisory Board is usually appointed. This board or committee is usually comprised of Islamic scholars available to the organization, for guidance and supervision, for the development of Shariaa-compliant products.The SSB guarantees, and certies, that the banking activities are halal (permissible).

Sources Of Sharia Law

Fiqh is an expansion of Shariah or Islamic law based on five sources which are classified into primary and secondary:Primary sources: The Quran SunnahSecondary sources: Ijma(Consensus of opinion) Qiyas Ijtihad

QURAN

QURAN

Quran literally means reading or recitation. It is a proof of the prophecy of Mohammed, the most authoritative guide for Muslims, and the primary source of the Shariaa. The main attributes are: it was revealed exclusively to the Prophet Mohammed it was put into writingit is all mutawatir (universally accurately reported)it is the inimitable speech of Godit is recited in salah (ritual prayer).

SUNNAH

SUNNAH

Sunnah is the actual embodiment of the will of Allah shown in the actions of His Messenger(PBUH).The Holy Quran being the word of Allah treats, major issues and often deals with subjects in brief terms, leaving details to be explained by Holy ProphetIn the Quran we are commanded to pay zakat by all Muslims. But the percentage and exact amount is unspecified. All these details were learnt by the Prophets deeds or words. The clarification of the Quran was provided by the Holy Prophet(PBUH) who himself participated in Shariah formation.

IJMA

Ijma can be dened as the consensus of opinion of the Companions of the Prophet (Sahaba) and the agreement reached on the decisions taken by the learned Muftis, or Jurists, on various Islamic matters Ijma represent authority. Once an Ijma is established it tends to become an authority in its own right

QIYAS

Qiyas means measuring or ascertaining the length, weight or quality of something Qiyas is the legal principle introduced in order to derive a logical conclusion of a certain law on a certain issue that has to do with the welfare of Muslims. In exercising this, however, it must be based on the Quran, Sunnah and IjmaIt is perfectly acceptable, in using Qiyas, to derive a logical conclusion in Shariaa law in as much as that conclusion does not go against the injunctions of the Quran or the Sunnah of the Prophet.

IJTIHAD

Ijtihad is the making of a decision in Islamic law by personal effort, independantly of any school of jurisprudence, following the decisions of religious expert without necessarily examining the scriptural basis or reasoning for that decision.Qualification of Mujtahid:A mujtahid is an Islamic scholar who is competent enough to interpret shariah by ijtihad. He should fulfill the following conditions to be a mujtihad, Upright character whose judgment people can trust. Knowledge of the Quran. Knowledge of Hadith. Knowledge of Arab linguistics Knowledge of Qiyas.

ISLAMIC LAW OF CONTRACTS

CONTRACTS

A voluntary, deliberate, and legally binding agreement between two or more competent parties. Contracts are usually written but may be spoken or implied, and generally have to do with employment, sale or lease, or tenancy.A contractual relationship is evidenced byan offer,acceptance of the offerA valid (legal and valuable) consideration.

Legal Definition Of A Contract Under Islamic Law

Contract in Arabic is called Aqd. Literal meaning of Aqd is to bind or to strengthen. The word Aqd is also used in Arabic in the sense of confirming an oath. As such, any covenant, pact, agreement and treaty will also be referred to as Aqd since all of them demonstrate firm resolve for execution. Plural of Aqd is Uqood.

PREREQUISITES

According to Sharia, a contract cannot be defined as such unless it has the following four pre-requisites.1)Existence of minimum two parties:A contract cannot be formed with the presence of a single party. Although a single intention may lead to various obligations, such as remission of a debt or declaration of donation, etc, these cannot be called contract in Sharia.2) Offer and acceptance: It is necessary for a contract to have consent by both parties over the purpose and content of the contract. In Arabic it is called Ijab wa Qabool, meaning 'Offer' (Ijab) and 'Acceptance' (Qabool).

PREREQUISITES

3) A condition that is against the contract and not in market practice but is in favor of one of the contractors or subject matter, the condition is void. For example if A sells a car with a condition that will use it on a fixed date every month, this contract will be void.4) A condition, which is against the contract, not in the market practice and not in favor of any contractor, that is not a void condition. For example if both A and B decide to give to charity, a certain percentage of both subject matter and cosideration, upon completion of sale.

Now a question arises what is the ruling of void condition, whether it invalidates the contract or not? VOID CONDITIONS AND VOID CONTRACTS:The contracts of compensation (Uqood Muawadha) like sale, purchase, lease agreements become void by putting void condition. Non-compensatory (voluntary) agreements (Uqood Ghair Muawadha) like contract of loan (Qard-e-Hasanah), do not become void because of void condition. The void condition, however, becomes itself ineffective.

SIX KEY ISLAMIC BANKING PRINCIPLES

KEY PRINCIPLES

Six key principles drive the activities of Islamic banks:Predetermined loan repayments as interest (riba) is prohibitedProt and loss sharing is at the heart of the islamic systemMaking money out of money is unacceptable (all financial transactions must be asset backed)Speculative behavior is prohibitedOnly shariaa-approved contracts are acceptableContracts are sacred.

Predetermined Payments are Prohibited

Any predetermined payment over and above the actual amount of principle is prohibiten. Islam allows only one kind of load and that is Qard-e-Hasanah(literally meaning good loan), whereby the lender doesnt charge any interest or additional amount over the money lent.

Prot And Loss SharingThe principle here is that the lender must share in the prots or losses arising out of the enterprise for which the money was lent.Islam encourages Muslims to invest their money and to become partners in order to share prots and risks in a business instead of becoming creditors.Islamic nance is based on the belief that the provider of capital and the user of capital should equally share the risk of business ventures, whether those are industries, services companies or simple trade deals.Translated into banking terms, the depositor, the bank and the borrower should all share the risks and the rewards of nancing business ventures.

Risk SharingOne of the most important features of Islamic banking is that it promotes risk sharing between the providers of funds (investors) and the users of funds (entrepreneurs). By contrast, under conventional banking, the investor is assured of a predetermined rate of interest.In conventional banking, all the risk is borne by the entrepreneur. Whether the project succeeds and produces a prot or fails and produces a loss, the owner of capital is still rewarded with a predetermined return. In Islam, this kind of unjust distribution of risk is not allowed.

Making Money Out of Money is Not AcceptableMaking money from money is not Islamically acceptable. Money, in Islam, is only a medium of exchange, a way of dening the value of a thing. It has no value in itself, and therefore should not be allowed to generate more money, via xed interest payments, simply by being deposited in a bank or lent to someone else.Muslims are encouraged to spend and/or invest in productive investments and are discouraged from keeping money idle. Hoarding money is regarded as being Islamically unacceptable. In Islam, money represents purchasing power, which is considered to be the only proper use of money

Uncertainty is ProhibitedGharar (uncertainty, risk or speculation) is also prohibited, and so any transaction entered into should be free from these elementsContracting parties should have perfect knowledge of the counter-values intended to be exchanged as a result of their transactions Also parties cannot predetermine a guaranteed profit.The rationale behind the prohibition of gharar is the wish to protect the weak from exploitation. Therefore, options and futures, considered to be very risky, are deemed to be forbidden as are forward foreign exchange transactions, given that forward exchange rates are determined by interest rate differentials

Only Shariaa-Approved Contracts are AcceptableConventional banking is secular in its orientation. In contrast, in the Islamic system, all economic agents have to work within the ethical system of Islam. Islamic banks are no exception. As such they cannot nance any project that conicts with the Islamic moral value system. For example Islamic banks are not allowed to nance a wine factory, a casino, a night club or any other activity prohibited by Islam or known to be harmful to society

SANCTITY OF CONTRACTThe basic principles of the law are laid down in the four root transactions ofsales (bay): transfer of the ownership or corpus of property for a considerationhire (Ijara): transfer of the usufruct (right to use) of property for a considerationgift (hiba): gratuitous transfer of the corpus of propertyloan (ariyah): gratuitous transfer of the usufruct of property

CONTINUEDThese basic principles are then applied to the various specic transactions of, for example, deposit, guarantee, agency, assignment, land tenancy, waqf foundations (religious or charitable bodies) and partnerships.Islam upholds contractual obligations and the disclosure of information as a sacred duty. This feature is intended to reduce the risk of asymmetric information and moral hazard, dened in the next section, which are potentially major problems for Islamic banks.

DEFINITION OF ASYMMETRIC INFORMATIONAsymmetric information can be dened as information that is known to one party in a transaction but not to the other. The classical argument is that some sellers with inside information about the quality of an asset will be unwilling to accept the terms offered by a less informed buyer. This may cause the market to break down, or at least force the sale of an asset at a price lower than it would command if all buyers and sellers had full informationLack of sufcient information creates problems before and after the transaction is entered into, which is potentially a major problem with Islamic prot-sharing nancial contracts. The presence of asymmetric information normally leads to adverse selection and moral hazard problems

DEFINITION OF ADVERSE SELECTIONThe term refers to the problem created by asymmetric information before the transaction occurs.It occurs when the potential borrowers are the ones most likely to produce an undesirable (adverse) outcomeBad credit risks are the ones who most actively seek out a loan and are thus most likely to be selected. This is potentially problematic with Islamic prot-sharing nancial contracts.

DEFINITION OF MORAL HAZARDMoral hazard is the consequence of asymmetric information after the transaction occurs.The lender runs the risk that the borrower will engage in activities that are undesirable from the lenders point of view because they make it less likely that the borrower will repay the loan.

Classification of Riba

Definition of Riba or InterestThe word Riba means excess, increase or addition, which correctly interpreted according to Shariah terminology, implies Any excess compensation without due consideration (consideration does not include time value of money). This definition of Riba is derived from the Quran and is accepted by all Islamic scholars.

(a) Riba-un-Nasiyah or Riba-al-Jahiliya(b) Riba-al-Fadl or Riba-al-Bai

Classification of Riba

Riba-un-Nasiyah or Riba-al-Jahiliyathat kind of loan where specified repayment period and an amount in excess of capital is predetermined. ( Imam Abu Bakr Jassas Razi)

Classification of Riba

Riba-un-Nasiyah or Riba-al-Jahiliya

Real and primary form of riba.Premium paid to the lender in return for his waiting/giving or taking of every excess amount in exchange of a loan at an agreed rate irrespective of whether it is low or high.

Classification of Riba

Riba-al-FadlExcess taken in exchange of specific commodities which are homogeneous.Legal definition differs in every fiqh.

Classification of Riba

Hadith prohibiting Riba-al-Fadlsell gold in exchange of equivalent gold sell silver in exchange of equivalent silver sell dates in exchange of equivalent dates sell wheat in exchange of equivalent wheat sell salt in exchange of equivalent salt sell barley in exchange of equivalent barley

Classification of Riba

Hadith prohibiting Riba-al-FadlSell barley in exchange of equivalent barley but if a person transacts in excess, it will be riba. However sell gold for silver anyway you please on the condition it is hand-to-hand(spot sales) and sell barley for date anyway you please on the condition it is hand-to-hand(spot sales) (Kanz ul Amaal)

Classification of Riba

Imam Abu Hanifa on Riba-al-FadlCommodities must have two common characteristics WeightVolumeIncludes all commodities having weight or volume and are being exchanged

Classification of Riba

Imam Shafi on Riba-al-FadlCommodities must have two common characteristics be a medium of exchangebe edibleIncludes all commodities that are edible or can be used as a medium of exchange(currency).

Classification of Riba

Imam Maalik on Riba-al-Fadlcommodities must have two common characteristics can be preservedbe edibleincludes all commodities that are edible and can be preserved

Classification of Riba

Imam Ahmad Bin Hanbal on Riba-al-FadlFirst citation conforms to the opinion of Imam Abu HanifaSecond citation conforms to the opinion of Imam ShafiThird citation includes three characteristics at the same time i.e. edible, weight and volume

Classification of Riba

Present day Islamic scholars on Riba-al-FadlIf two characteristics i.e. weight and use as medium of exchange is present then the following transactions are not alloweda deferred sale of goods having weight and homogeneous naturea sale of unequal goods having weight and homogeneous nature

Classification of Riba

First lawExchange of any of the six commodities with itself but differing in quality, is allowed only under certain conditions

The Laws of Riba Al Fadl

First Law CONDITIONS OF EXCHANGEAny difference in value/quality should be ignored The commodities should be exchanged in equal amounts (equal weight and volume). No direct exchange of commodities of the same kindA person should sell his commodity against cash at the market value and buy someone elses commodity in exchange of cash proceeds at the market value.

The Laws of Riba Al Fadl

Second lawExchange of a product with its raw material is allowed under certain conditions

The Laws of Riba Al Fadl

Second LawCONDITIONS OF EXCHANGEIf the characteristics of the product has been totally changed by the industry, then different amounts can be exchanged. If little difference has been made either the exchange should be in equal weights or one of the commodities should be sold in the market and the cash proceeds used to buy the then one.

The Laws of Riba Al Fadl

Third LawExchange of any of the six commodities with one another is allowed in unequal amounts but the payment should not be deferredProvided that the general conditions of a sale contract are fulfilled

The Laws of Riba Al Fadl

Tijarti Sood(Commercial interest)interest paid on loan taken for productive and profitable purposeSarfi Sood (Usury)interest paid on loan taken for personal need and expenses

Types of Riba

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Regarding validity of Commercial Interest there are two schools of thought on this issue.

A detailed analysis of their arguments is discussed as follows:

Riba-Present Day Arguments

50Islam when prohibiting something does not only prohibit one form of it that is prevalent, but all forms that might erupt in future. The changed state does not change the ruling for eg: Liquor (Khamar): Present day production is totally different but the ruling remains unchanged Pork (Khinzeer): Irrespective how clean the present day breeding of pigs in high class farms. Corruption/Immorality (Al Fahsha): Todays modern and sophisticated forms do not change the ruling.The same applies to interest and gambling. By claiming that it was in a different form during Prophets (SAW) time does not change its ruling.This claim is also wrong. If one glances through the Islamic and pre Islamic history of Arabia, it will be evident that the interest type at that time was not restricted to usury but loans were granted for commercial and profitable purposes. To quote some examples: a) The tribe of Umro bin Aamir used to take interest from the tribe of Mughairah. At the advent of Islam, Mughairah owed heavy interest to Umro bin Aamir.b) The tribe of Saqeef (a tribe of Jews) advanced cash as well as commodities on interest to the natives of Taif , the tribe of Mughairah as well as the business community of Makkah. c) Syedna Abbas bin Abdul Muttalib and Syedna Khalid bin Waleed formed a company with joint capital whose prime business was cash advancement on interest. d) Similarly Syedna Usman was one of the wealthy businessmen who lent money on interest. There were many other traders dealing full time in interest extending a network of interest based transactions.Quran has not only prohibited that one party faces a loss and the other gets profit. But it also prohibits one party getting confirmed profit and the other party unconfirmed profit from the same investment.Mutual consent is not the criteria to render anything prohibited or not in Islam. Would the act of adultery be allowed if the condition of mutual consent is fulfilled? Similarly, there are many transactions in business, which are rendered illegal even with mutual consent. For reference see Abwab ul Buyu al Batila where Muhaqila and Talqi al Jalab being forms of Bai where the mutual consent and satisfaction is present and is prohibited by Prophet (SAW).

Argument 1: Riba as practiced during the days of the Prophet (SAW) was only Usury.

Islam when prohibiting something does not only prohibit the prevalent form, but all forms that might erupt in future. The changed state does not change the ruling. E.g. Liquor, Pork, Corruption/Immorality: Todays modern and sophisticated forms does not change their rulings.The same applies to interest and gambling.

The Laws of Riba Al Fadl

51Islam when prohibiting something does not only prohibit one form of it that is prevalent, but all forms that might erupt in future. The changed state does not change the ruling for eg: Liquor (Khamar): Present day production is totally different but the ruling remains unchanged Pork (Khinzeer): Irrespective how clean the present day breeding of pigs in high class farms. Corruption/Immorality (Al Fahsha): Todays modern and sophisticated forms do not change the ruling.The same applies to interest and gambling. By claiming that it was in a different form during Prophets (SAW) time does not change its ruling.This claim is also wrong. If one glances through the Islamic and pre Islamic history of Arabia, it will be evident that the interest type at that time was not restricted to usury but loans were granted for commercial and profitable purposes. To quote some examples: a) The tribe of Umro bin Aamir used to take interest from the tribe of Mughairah. At the advent of Islam, Mughairah owed heavy interest to Umro bin Aamir.b) The tribe of Saqeef (a tribe of Jews) advanced cash as well as commodities on interest to the natives of Taif , the tribe of Mughairah as well as the business community of Makkah. c) Syedna Abbas bin Abdul Muttalib and Syedna Khalid bin Waleed formed a company with joint capital whose prime business was cash advancement on interest. d) Similarly Syedna Usman was one of the wealthy businessmen who lent money on interest. There were many other traders dealing full time in interest extending a network of interest based transactions.Quran has not only prohibited that one party faces a loss and the other gets profit. But it also prohibits one party getting confirmed profit and the other party unconfirmed profit from the same investment.Mutual consent is not the criteria to render anything prohibited or not in Islam. Would the act of adultery be allowed if the condition of mutual consent is fulfilled? Similarly, there are many transactions in business, which are rendered illegal even with mutual consent. For reference see Abwab ul Buyu al Batila where Muhaqila and Talqi al Jalab being forms of Bai where the mutual consent and satisfaction is present and is prohibited by Prophet (SAW).

First School Argument 2: Commercial interest did not exist in the days of Prophet (SAW).

This claim is wrong as both forms of interest existed in Islamicand pre Islamic history. Some examples: The tribe of Umr bin Aamir used to take interest from the tribe of Mughairah. (Dar ul Mansoor by Ibn Jareeh)

The tribe of Thaqeef advanced cash as well as commodities on interest to the natives of Taif, the tribe of Mughairah and the business community of Makkah. (Encyclopedia of Islam)

H.Abbas and H. Khalid bin Waleed (RA) formed a company with joint capital whose prime business was cash advancement on interest. (Jamai ul Bayan)

Hazrat Usman (RA) (pre-Islamic times) lent money on interest. (Tareekh e Tabree)

Riba-Present Day Arguments

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Second School :3) Argument 1: The present day banking since no-one is exploited or faces injustice, therefore it cannot be called Riba. Islam has not only prohibited that one party faces a loss and the other gets profit but also prohibits one party getting confirmed profit and the other party unconfirmed profit from the same investment.

Riba-Present Day Arguments

53

Second School:

4) Argument 2: There is a Quranic verse O believers do not devour one anothers possession wrongfully; rather than that, let there be trading by mutual consent (Al Nisa verse 29). Wrongful devouring only arise if the consent of one of the parties is absent but in commercial interest the mutual consent is present of both parties, so its not Riba.

Mutual consent is not the criteria to render anything halal which is haram.

Riba-Present Day Arguments

54Would an act of adultery be allowed if the condition of mutual consent is fulfilled? Similarly, there are many transactions in business, which are rendered illegal even with mutual consent. For reference see Abwab ul Buyu al Batila where Muhaqila and Talqi al Jalab being forms of Bai where the mutual consent and satisfaction is present and is prohibited by Prophet (SAW).

Riba al Nasiah is also classified as:Sood-e-Mufrad( Simple Interest)interest calculated only on the initial investmentSood-e-Murakkab(Compound Interest)reinvestment of each interest payment on money invested to earn more interest

Riba-Present Day Arguments

During the pre-Islamic era, when a borrower used to fail to pay back the principal and interest charged on him, then the lender used to extend the loan on the condition that the interest will also become part of the loan (essentially Compound Interest).

Quran

QuranSeized in this state they say: Buying and selling is but a kind of interest, even though Allah has made buying and selling lawful, and interest unlawful. Al Baqarah 2:275 : " " 2:

QURANO believers, take not doubled and redoubled interest, and fear God so that you may prosper. (Surah Al Imran, verses 130-1) . (Surah Al Imran, verses 130-1)

The following hadith also proves that both simple and compound interest are forbidden:

Listen! all Riba liable to you in the pre-Islamic days have been completely eliminated. You have to pay back the principal amount only. Neither hurt someone nor get hurt by someone. And the first riba to be completely eliminated is Abbas bin Mutalibs. (Ibn e Khatir)

Hadith

HadithFrom Anas ibn Malik : The Prophet, , said: "If a man extends a loan to someone he should not accept a gift." (Mishkat, on the authority of Bukhara's Tarikh and Ibn Taymiyyah's al-Muntaqa)

Asymmetric riskRisk an investor faces when the gain realized from the move of an underlying asset in one direction is significantly different from the loss incurred from its move in the opposite direction.

ORIGINS OF ASYMMETRIC RISK WITHIN ISLAMIC BANKINGThe principle of PLS stipulates that the partners are free to determine the extent of their prot-sharing ratio regardless of their capital contributions Collateral cannot be provided with PLS activities in the event that the project fails due to business risk. So in the event of the project failing the Islamic bank is exposed to nancial loss. The result is that Islamic banks are subject to asymmetric risk.

ORIGINS OF ASYMMETRIC RISK WITHIN ISLAMIC BANKINGTo ensure timely payment of the repayment obligations plus the institutions share of the prots (if any), the bank could impose a ne on those borrowers who do not pay on time. As per principles of the Shariaa these nes must be deposited with a charity So if the borrower defaults there is no explicit protection for the Islamic bank. Again this is asymmetric risk

ASYMMETRIC RISKSince PLS emphasises on risk sharingfinancer should worry about the protability of the proposed project for which the loan is requested rather than the credit-worthiness of the rm

ASYMMETRIC RISKThe Islamic, interest-free system, imposes the burden on depositors of gathering information about the safety, soundness, riskiness and protability of the bank. Again asymmetric risk is a problem

FIVE REASONS FOR THE PROHIBITION OF RIBA it is unjust; it corrupts society; it implies improper appropriation of other peoples property; it results in negative economic growth; it demeans and diminishes human personality.

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