Deal not unjustly, and you shall not be dealt with unjustly
2:279 The Qur'an
- The Islamic Financial System
- What is Islamic Banking?
- Islamic Banking Principles
- Rules of Permissibility
- Prohitbition of Interest
- Other Key Prohibitions
- Islamic Economics Order
- Wealth and Islam
- Profit-and-Loss Sharing
- Pricing Transactions Linked to Interest rate Benchmark
- Islam's Approach to Ethical Investment
- Shariah Authenticity
- Shari'ah Supervisory Board [Religious Board]
- Status of Islamic Banking
- Glossary of Financial Terms
While elimination of "Riba" or interest in all its forms is an important feature of the Islamic financial system, Islamic banking is much more. At the heart of Islam is a sense of cooperation, to help one another according to principles of goodness and piety (but not to cooperate in evil or malice). In essence, it aims to eliminate exploitation and to establish a just society by the application of the Shari'ah or Islamic rulings to the operations of banks and other financial institutions. To ensure compliance to the Shari'ah, Islamic banks use the services of religious boards comprised of Shari'ah scholars.
Islamic finance may be viewed as a form of ethical investing, or ethical lending, except that no loans are possible unless they are interest-free. Among the ethical restrictions is the prohibition on alcohol and gambling and the consumption of pork. Islamic funds would never knowingly invest in companies involved in gambling, alcoholic beverages, or porcine food products
Its practitioners and clients need not be Muslim, but they must accept the ethical restrictions underscored by Islamic values.
Islamic economic principles offers a balance between extreme capitalism and communism. It offers the individual the freedom to produce and create wealth, while surrounding the individual with an environment controlled, not by human rulers, but by Divine Guidance, which sets moral rules and norms of behaviour that must require the utmost sincerity of intention. When these rules and norms are internalised and acted upon by people, peace and prosperity result for the wider society.
The Qur'an (2:30) says that man was created as the representative of God on earth. This concept has a considerable effect on Islamic business, since the lack of a sense of absolute ownership promotes a sense working for society, especially the needy.
This is not some philosophical concept, removed from the daily life of the society. It manifests itself in all the different aspects of lives. What makes the trader, banker, agriculturist or research and development scientist perform his job to the best of his ability? In capitalist economies, it is the notion of competition. This involves the necessity to constantly produce more new things for profit to keep up with others and this makes for wastage and often generates unbridled greed. But in an economy based on Islamic principles, the idea of man representing God on earth gives businessmen a feeling of co-operating with others for the good of society as a whole, including himself. Thus Quranic guidance enables man to conserve and use prudently all the resources of the earth that God has given mankind.
Divine Guidance for the economy, as enshrined in the Qur'an and the Sunnah (the living example of Prophet Muhammad), can be summarised as follows:
The Qur'an (57:7) emphasises that all the resources of the earth belong to God, the Creator, who has made human beings a trustee for them. Humans are therefore accountable to God for the uses they make of these resources. The idea of trusteeship distinguishes the Islamic approach to economics from materialistic approaches such as extreme capitalism and socialism. It introduces a moral and spiritual element into business life and has been made practicable by creating rules to govern individual behaviour and public policy.
2. Care For Others
Care for others tempers self-interest, which is ingrained in human nature. It goes naturally with trusteeship, since, in caring for others, one also serves God, who created all humans. No one can have fulfilment or happiness in his life without interacting with others. Thus individual happiness and collective interests go hand in hand.
We gain through giving, since it would be impossible for everyone to acquire while giving nothing. The Qur'an states this in 30:39 and 2:276. It follows that Islam discourages indulgence in luxuries. One is expected to consider what is available to others before acquiring good things for oneself. Moderation in consumption is mentioned in the Qur'an 7:31.
People who believe that they can increase their wealth through charging others interest and by reducing charitable giving are under an illusion. The wealth and integrity of a society can only increase when the rich give part of their wealth to the needy for no other motivation than to please God. Those who have faith and a vision of their future life understand this.
To think only of how to gain profit for oneself leads to using others as mere instruments. In societies where unbridled self-interest is allowed to dominate unchecked, there is no protection for the weak against the strong. Thus exclusive pursuit of self-interest, when not tempered by charity, is self- defeating.
3. Productive Effort as a Means of Serving God
Islam emphasises the duty of every individual to work for his living. Productive enterprise is looked upon as a means of serving God (2:195).
Islam requires wealth to be spent in the cause of God. This realisation moves Muslims to greater efforts in their economic activities. The fourteenth-century thinker Abu Ishaq Shatibi, writing of the companions of the Prophet, said,
"They were expert in business enterprise, keen and persistent in a variety of economic pursuits. They did not do so to amass wealth or save it for themselves; rather their aim was to spend their earnings in good causes.” (Shatibi, Al-Muwafiqaat fi Usul al-Shari'ah, Vol. 2, p188, Cairo, Maktaba al Tijarah al-Kubra.)
In the west, it is now considered enough to merely to ‘enjoy life', work being an unfortunate necessity. But in Islam, it is seen that working for a living gives man a sense of worthiness in his society. To support a family and contribute to others with any surplus enables one to take one's part in consultations on practical, social matters, so that all can benefit.
4. Application of the Shari'ah Rulings to Business
The aim of the Shari'ah rulings is to make the transfer of goods safe and easy and to facilitate economic transactions by eliminating vagueness or misunderstanding in all types of contracts. It prohibits the charging of interest on loans as a form of injustice. The goal is to remove the causes of social tension or litigation and to promote a climate of peace and goodwill. Islam strongly recommends that the terms of financial agreements be put in writing.
5. Mutual Consultation
Men are free to make private economic decisions, but decisions concerning the public welfare must be based on consultation. The Qur'an describes Muslims as a people "whose rule (in all matters of common concern) is by consultation among themselves.” (42:39). Mutual consultation avoids society or local communities coming under the rule of a dictator and makes sure that reasonable decisions acceptable to all are made.
6. Treating Wealth as a Means and not an End
Islam regards economic well being as a means to peace, freedom from hunger and freedom from fear of others, except God. Beyond the satisfaction of basic needs, the ultimate objectives of earning and spending money are moral and spiritual. It is against Islamic rationality to hoard money (9:34, 35).
It follows that savings must be put to good use. One who cannot go into business himself can do so in partnership with others, or can supply funds on a profit-sharing basis. People can also borrow and lend, but it is forbidden for the lender to claim interest from the borrower as this is unjust (2:275). Islam prohibits gambling, cheating, exploitation, coercion, etc., but freedom to make financial arrangements is constrained only by these few prohibitions and by the Islamic tendency to treat money as a means to the good life.
Proper Functioning of the Market
Islam prohibits dishonesty, fraud and deception, coercive practices, gambling and usurious and injurious dealings. Hoarding, speculation and collusion among producers and traders against the interest of consumers, and such monopolies as are injurious to the socio-economic health of society are all ruled out. The basic principles regulating market operations in an Islamic state are:
a) A person should be free to buy, sell or dispose of his possessions and money within the framework of the Shari'ah.
b) There is no restriction on the percentage of profit which a trader may make. It is left to him and depends on the business environment and the nature of the goods. However, moderation, contentment and leniency must be taken into consideration.
c) The Shari'ah emphasises avoiding illicit acts detrimental to the wellbeing of society or the individual.
d) The State should not fix prices except where there are artificial factors in the market which may lead to excessive price increases or decreases or fraud. If there are such, the State should intervene to remove these factors.
7. Protection of Consumers
The State should insure that producers, manufacturers and traders do not exploit each other or the buyers. It should curb adulteration, under-weighing, encroachment of thoroughfares, unhealthy trades and unlawful professions and maintain good, firm employee relationships.
8. Monopolies and Cartels
Industrialists in a free and competitive economy can form cartels and monopolies and exploit people and a firm law is needed to control them. No unjust, oppressive or cheating business can be allowed to continue in an Islamic economy.
9. Zakat or Zakah
Zakat is a levy on certain categories of wealth. It can be collected and distributed by the government and is obligatory only on Muslims. It is applicable to income and savings, agricultural harvests, commercial goods, gold and silver over certain amounts, some categories of livestock, excavated treasures, mined wealth, etc.
In accordance with the Qur'an (9:60), the proceeds from zakat are paid to the poor, the sick and destitute and to travellers, especially those seeking education or going on pilgrimage.
The Islamic view of distributive justice is contained in the three points: a guarantee of the fulfilment of basic needs; equality of opportunity; and elimination of glaring inequalities in personal income and wealth. Zakat also acts as an excellent form of social insurance.
10. Qard Hasan
Qard hasan is a Quranic term meaning an interest-free loan. It was the primary source of financing introduced by the Prophet after entering Medina and was used primarily for productive economic purposes, such as setting up qualified, but poor, people in trade and agriculture.
Islamic banking refers to a system of banking or banking activity that is consistent with the principles of the Shari'ah (Islamic rulings) and its practical application through the development of Islamic economics. The principles which emphasise moral and ethical values in all dealings have wide universal appeal. Shari'ah prohibits the payment or acceptance of interest charges (riba) for the lending and accepting of money, as well as carrying out trade and other activities that provide goods or services considered contrary to its principles. While these principles were used as the basis for a flourishing economy in earlier times, it is only in the late 20th century that a number of Islamic banks were formed to provide an alternative basis to Muslims although Islamic banking is not restricted to Muslims.
Islamic banking has the same purpose as conventional banking except that it operates in accordance with the rules of Shari’ah, known as Fiqh al-Muamalat(Islamic rules on transactions). Islamic banking activities must be practiced consistent with the Shari’ah and its practical application through the development of Islamic economics. Many of these principles upon which Islamic banking is based are commonly accepted all over the world, for centuries rather than decades. These principles are not new but arguably, their original state has been altered over the centuries.
The principle source of the Shari’ah is The Qur’an followed by the recorded sayings and actions of Prophet Muhammad (pbuh) – the Hadith. Where solutions to problems cannot be found in these two sources, rulings are made based on the consensus of a community leaned scholars, independent reasoning of an Islamic scholar and custom, so long as such rulings to not deviate from the fundamental teachings in The Qur’an.
It is evident that Islamic finance was practiced predominantly in the Muslim world throughout the Middle Ages, fostering trade and business activities. In Spain and the Mediterranean and Baltic States, Islamic merchants became indispensable middlemen for trading activities. It is claimed that many concepts, techniques, and instruments of Islamic finance were later adopted by European financiers and businessmen.
The revival of Islamic banking coincided with the world-wide celebration of the advent of the 15th Century of Islamic calendar (Hijra) in 1976. At the same time financial resources of Muslims particularly those of the oil producing countries, received a boost due to rationalisation of the oil prices, which had hitherto been under the control of foreign oil Corporations. These events led Muslims' to strive to model their lives in accordance with the ethics and principles of Islam.
Disenchantment with the value neutral capitalist and socialist financial systems led not only Muslims but also others to look for ethical values in their financial dealings and in the West some financial organisations have opted for ethical operations.
The origin of the modern Islamic bank can be traced back to the very birth of Islam when the Prophet himself acted as an agent for his wife's trading operations. Islamic partnerships (mudarabah) dominated the business world for centuries and the concept of interest found very little application in day-to-day transactions.
Such partnerships performed an important economic function. They combined the three most important factors of production, namely: capital, labour and entrepreneurship, the latter two functions usually combined in one person. The capital-owner contributed the money and the partner managed the business. Each shared in a pre-determined share of the profits. If there was a loss, the capital-provider lost his money and the manager lost his time and labour.
Commercial Banks in Muslim Lands
Western commercial banks date from about two and a quarter centuries ago, when the western world was dispensing with moral and ethical considerations in economics. When the Muslim world came into contact with the west, Muslims had two choices:
a) To accept commercial banking, arguing that the interest charged by them did not contain the element of riba prohibited in the Qur'an; or,
b) To accept that interest charged was riba and try to develop an alternative system of banking.
But ancient Muslim institutions, such as the Shari'ah courts, had been made ineffective by the colonial powers. Muslims had no alternative but to work with the colonial institutions, including commercial banking.
Nevertheless, during the 19th century, several religious scholars argued that the term riba referred to loans for consumption, which people found it difficult to repay, and not to commercial banking loans, where the debtor can repay from the profits.
But the Qur'an makes no distinction between loans for consumption and loans for productive purposes. So their views were rejected. As a consequence, modern commercial banking did not make much headway in Muslim countries and to this day the presents of the conventional framework still dominates the national financial system.
Early Western PLS Proposals
Equity-participation systems had been proposed at various times of economic crises in the United States and Latin America. The most ardent proponent of these was American Economist, Henry Simons (1899 – 1946), who, in the 1930s, argued that the traditional fractional reserve banking system was inherently unstable and should be replaced by two separate financial institutions:
Deposit banks, which would maintain 100% reserves. They could not fail the depositors and could not create or destroy effective money. They would simply accept deposits.
Investment trusts, which would perform the lending functions of existing banks. Such companies would obtain funds for lending by selling their own stock.
Simons' call for a distinction between the payments and portfolio functions of banks, and for 100% reserve requirement in the former, was rejected at the time, but interest in Simons' ideas has remained.
Many reasons have been advanced for the possible instability of the traditional banking system. Simons suggested that the basic flaw was that as a crisis develops and earnings fall, banks make loans to increase reserves. However, each bank can do so only at the expense of other banks and thus some banks become insolvent.
The bank failures in the U.S. during the 1980s revived interest in equity-based proposals and the separation of the payment of deposits from the portfolio activities of banks. The proposals made were strikingly similar to the Islamic systems now being implemented, at least on the deposit side. But the Islamic system goes further, requiring that loans made by banks should also be equity-based.
Islamic Banks in the 20th Century
When, in the1960s, Muslim thinkers began to explore ways and means of organising commercial banking on an interest-free basis, economists dismissed their work as wishful thinking.
But, in 1963, in Mit Ghamr, in Egypt, the first Islamic interest-free bank came into being. Mt Ghamr was a rural area and the people were religious. They did not place their savings in any bank, knowing that interest was forbidden in Islam. In these circumstances, the task was not only to respect Islamic values concerning interest, but also to educate the people about the use of banking.
The following types of accounts were accepted:
- Savings accounts
- Investment accounts
- Zakat accounts
No interest was paid on savings accounts, but withdrawals could be made on demand. Small, short-term, interest-free loans for productive purposes could be made. Funds in investment accounts were subject to restricted withdrawals and invested on the basis of profit- sharing. The zakat account attracted the official amount of zakat.
The Mit Ghamr project was successful, as deposits increased from 1963 to 1966. The bank was cautious, rejecting about 60% of loan applications and the default ratio was zero in economically good times. But project was eventually abandoned for political reasons. Nevertheless, it had shown that commercial banking could be organised on a non-interest basis.
The Shari’ah prohibits the payment of charges for the renting of money (riba, which in the definition of Islamic scholars covers any excess in financial dealings, usury or interest) for specific terms, as well as investing in businesses that provide goods or services considered contrary to its principles (Haram, forbidden). While these principles were used as the basis for a flourishing economy in earlier times, it is only in the late 20th century that a number of Islamic banks were formed to apply these principles to private or semi-private commercial institutions within the Muslim community.
"While a basic tenant of Islamic banking - the outlawing of riba, a term that encompasses not only the concept of usury, but also that of interest - has seldom been recognised as applicable beyond the Islamic world, many of its guiding principles have. The majority of these principles are based on simple morality and common sense, which form the bases of many religions, including Islam.
"The universal nature of these principles is immediately apparent even at a cursory glance of non-Muslim literature. Usury was prohibited in both the Old and New Testaments of the Bible, while Shakespeare and many other writers, particularly those writing in the 19th century, have attacked the barbarity of the practice. Much of the morality championed by Victorian writers such as Dickens - ranging from the equitable distribution of wealth through to man's fundamental right to work - is clearly present in modern Islamic society.
"Although the western media frequently suggest that Islamic banking in its present form is a recent phenomenon, in fact, the basic practices and principles date back to the early part of the seventh century." (Islamic Finance: A Euromoney Publication, 1997)
Theoretical Basis for Islamic Banking
A popular belief persists that Islamic banking is simply an interest-free financial structure. But, in fact, Islamic economics is a complete system of social and economic justice. It deals with property rights, the incentive system, the allocation of resources, economic freedom and decision-making and the proper role of government.
Western bankers have said that savings and investments would soon dry up if interest were not paid. But this is due to identifying "rate of interest" and "rate of return". The Qur'an says: "God has permitted trade, but forbidden riba (interest)” (2:275). Therefore it is only the fixed, or predetermined, return on savings or transactions that is forbidden, not an uncertain rate of return, such as the making of profit.
Modern Justifications for Interest
Modern economists have developed many arguments to justify interest.
One argument is that interest is the reward for saving; a compensation that the creditor pays the debtor for the latter's temporary loss of the use of capital.
Another is that interest is the payment for the loss in value of money due to inflation. The goods the saver wants will cost more in the future, so he is justified in charging a rent for the use of his loan.
John Maynard Keynes (1883-1946) argued that money is the most liquid of assets, that is to say, it is the asset most readily exchangeable for other forms of assets and that interest is the price paid for loss of liquidity.
The theory that interest protects savings from inflation neither explains why the rate of interest is, nevertheless, always above the rate of inflation, nor does it question the proposition that inflation is the cause of interest. Nor do these theories answer the question as to why interest should be the market regulator for the supply and demand of money. Why should interest be paid for one's postponement of enjoyment of present goods, or paid for abstaining from diminishing one's present capital, which would otherwise be diminished by the ravages of time and consumption?
Basis of Islamic Banking
In order to be Islamic, the banking system has to avoid interest. Consequently, much of the literature on the theory of Islamic banking has grown out of a concern as to how the monetary and banking system would function if interest were abolished by law.
Another Islamic principle is that there should be no reward without risk-bearing. This principle is applicable to both labour and capital. As no payment is allowed to labour unless it is applied to work, so no reward for capital should be allowed unless it is exposed to business risks.
Consider two persons, one of whom has capital but no special skills in business, while the other has managerial skills but possesses no capital. They can co-operate in either of two ways:
Debt-financing (the western loan system). The businessman borrows the capital from the capital-owner and invests it in his trade. The capital-owner is to get back his principal and an additional amount on the basis of a fixed rate, called the interest rate, as his compensation for parting with liquidity for a fixed period. The claim of the lender for repayment of the principal plus the payment of the interest becomes viable only after the expiry of this period. This payment is due irrespective of whether the businessman has made a profit using the borrowed money. In the event of a loss, the borrower has to repay the principal amount of the loan, as well as the accrued interest, from his own resources, while the capital-owner loses nothing. Islam views this as an unjust transaction.
Mudarabah (the Islamic way, or PLS). The two persons co-operate with each other on the basis of partnership, where the capital-owner provides the capital and the other party puts his management skills into the business. The capital-owner is not involved in the actual day-to-day operation of the business, but is free to stipulate certain conditions that he may deem necessary to ensure the best use of his funds. After the expiry of the period, which may be the termination of the contract or such time that returns are obtained from the business, the capital-owner gets back his principal amount together with a pre-agreed share of the profit.
The ratio in which the total profits of the enterprise are distributed between the capital-owner and the manager of the enterprise is determined and mutually agreed at the time of entering the contract, before the beginning of the project. In the event of loss, the capital-owner bears all the loss and the principal is reduced by the amount of the loss. It is the risk of loss that entitles the capital-owner to a share in the profits. The manager bears no financial loss, because he has lost his time and his work has been wasted. This is, in essence, the principle of mudarabah.
There are at least three reasons for considering the mudarabah relationship to be more just than the creditor-debtor relationship:
- Both parties agree on the ratio in which profits will be shared between them.
- The treatment of both parties is uniform in the event of loss, since if the provider of the capital suffers a reduction of his principal, the manager is deprived of a reward for his labour, time and effort.
- Both parties are treated equally if there is any violation of the agreement. If the manager violates anyone of the stipulated conditions, or if he does not work, or is instrumental in causing loss to the business by negligence or bad management, he will have to bear the responsibility for the safe return of the whole amount in question. If, on the other hand, the provider of the capital violates any of the stipulated conditions, for example, by withdrawing his funds before the stipulated time, or by not providing part or full funds at the promised time, etc., he will have to pay the manager a reward equivalent to what he would have earned in similar work.
Mudarabah is the basis of modern Islamic banking on a two-tier basis.
1st tier: The depositors put their money into the bank's investment account and agree to share profits with it. In this case, the depositors are the providers of the capital and the bank functions as the manager of funds.
2nd tier: Entrepreneurs seek finance from the bank for their businesses on the condition that profits accruing from their business will be shared between them and the bank in a mutually agreed proportion, but that any loss will be borne by the bank only. In this case, the bank functions as the provider of capital and the entrepreneur functions as the manager.
Islam argues that there is no justifiable reason why a person should enjoy an increase in wealth from the use of his money by another, unless he is prepared to expose his wealth to the risk of loss also. Islam views true profit as a return for entrepreneurial effort and objects to money being placed on a pedestal above labour, the other factor in production. As long as the owner of money is willing to become a shareholder in the enterprise and expose his money to the risk of loss, he is entitled to receive a just proportion of the profits and not merely a merely nominal share based on the prevailing interest rate.
Thus, under an Islamic banking system, the cost of capital is not analogous to a zero interest rate, as some people wrongly assume it to be. The only difference between Islamic banking and interest-based banking in this respect is that the cost of capital in interest-based banking is a predetermined fixed rate, while in Islamic banking; it is expressed as a ratio of profit.
The records of banks that have been involved in PLS show that they have usually provided higher returns to their depositors than those who have used such transitory instruments as cost-plus and leasing. PLS is thus the real goal of Islamic banking.
Muslims believe that all things have been provided by God, and the benefits derived from them, are essentially for man’s use, and so are permissible except what is expressly prohibited in The Qur’an or Hadith. When guidance is not clearly given in he Qur’an there are several other sources of law. For example, guidance can be sought from Fiqh, which means ‘understanding’ and is the science of jurisprudence: the science of human intelligence, debate and discussion
Riba best translated today as the charging of any interest, meaning money earned on the lending out of money itself. The prohibition on paying or receiving fixed interest is based on the Islamic tenet that money is only a medium of exchange, a way of defining the value of a thing; it has no value in itself, and therefore should not be allowed to give rise to more money, via fixed interest payments, simply by being put in a bank or lent to someone else. The human effort, initiative, and risk involved in a productive venture are more important than the money used to finance it.
Money in Islam is not regarded as an asset from which it is ethically permissible to earn a direct return. Money tends to be viewed purely as a medium of exchange. Interest can leads to injustice and exploitation in society; The Qur’an (2:279) characterises it as unfair, as implied by the word zulm (oppression, exploitation, opposite of adl i.e. justice)
There is no real 'lending' in Islam since all 'lenders' obtain ownership interests in the assets that they finance, or earn a profit-share or purely fee-based remuneration. In order for an Islamic bank to earn a return on money lent, it is necessary to obtain an equity, or ownership, interest in a non-monetary asset. This requires the lender to also participate in the sharing of risk.
Individuals and the world as a whole probably know too well the burden of interest and misery and suffering that irresponsible lenders have inflicted on individuals and societies. It has become so completely institutionalised and accepted in modern economies that it is almost impossible to conceive that there are some who completely oppose it and refuse to enter into any transactions that involve interest.
Islam's prohibition of interest and usury was not unprecedented. The early Jewish and Christian traditions also forbade riba. Even the renowned Greek philosopher, Aristotle, condemned acquiring of wealth by the practice of charging interest on money.
“Very much disliked also is the practice of charging interest: and the dislike is fully justified for interest is a yield arising out of money itself, not a product of that for which money was provided. Money was intended to be a means of exchange; interest represents an increase in the money itself. Hence of all ways of getting wealth, this is the most contrary to nature." Aristotle, The Politics, tr. Sinclair, pg. 46, Penguin
“Do not charge your brother interest, whether on money or food or anything else that may earn interest.” (Deuteronomy 23:19)
“If you lend money to My people, to the poor among you, you are not to act as a creditor to him; you shall not charge him interest.” The Holy Bible (American Standard Bible)
[Jesus said], “If you have money, do not lend it at interest, but give [it] to one from whom you will not get it back.” Gospel St Thomas, V95
Islam not only prohibits dealing in interest and investment in unlawful activities that Islam deems harmful to society, but also transactions involving excessive uncertainty (gharar) and all forms of gambling (maysir).
Islamic banking is an instrument for the development of an Islamic economic order. Some of the salient features of this order may be summed up as:
- While permitting the individual the right to seek economic well-being, Islam makes a clear distinction between what is halal (lawful) and what is haram (forbidden or unlawful) in pursuit of such economic activity. In broad terms, Islam forbids all forms of economic activity, which are morally or socially injurious.
- While acknowledging the individual's right to ownership of wealth legitimately acquired, Islam makes it obligatory on the individual to spend his wealth judiciously and not to hoard it, keep it idle or to squander it.
- While allowing an individual to retain any surplus wealth, Islam seeks to reduce the margin of the surplus for the well-being of the community as a whole, in particular the destitute and deprived sections of society by participation in the process of Zakat (a tax on wealth that is distributed to the needy).
- While making allowance for the ways of human nature and yet not yielding to the consequences of its worst propensities, Islam seeks to prevent the accumulation of wealth in a few hands to the detriment of society as a whole, by its laws of inheritance.
- Viewed as a whole, the economic system envisaged by Islam aims at social justice without inhibiting individual enterprise beyond the point where it becomes not only collectively injurious but also individually self-destructive.
Islam has a unique dispensation on the theme of wealth, its ownership, distribution and social relationship. Islam enjoins wealth creation not for its own sake.
The theme of Islamic dispensation of wealth is treated as a deeply moral study of self and society. The true nature of wealth in Islam requires social preferences and market exchange mechanisms that are ethicised by human consciousness of the Moral Law. Islam gives precise moral injunctions as to what are, and are not acceptable kinds of wealth. They point out how individual preferences on wealth formation ought to be utilised within the social meaning.
According to Shaikh Yusuf Talal DeLorenzo, well-known and respected Shari’ah advisor and Islamic scholar as well as also author of the three volume “Compendium of Legal Opinions on the Operations of Islamic Banks” the first English reference on the fatwa (religious ruling) issued and published by the Institute, business, in the Qur'anic sense of "profitable trade" or tijarat'un rabihah is business that brings blessings to those who conduct it. Obviously, profits are important as ends, but the means by which those profits are earned are even more important. Indeed, the reason for the emphasis in the Shari’ah on proper transacting is that Islam accords great importance to the economic welfare of society.
While Islam employs various practices that do not involve charging or paying interest, the Islamic financial system promotes the concept of participation in a transaction backed by real assets, utilising the funds at risk on a profit-and- loss-sharing basis. Such participatory modes used by Islamic banks are known as Musharakah and Mudarabah. This by no means implies that investments with financial institutions are necessarily speculative. This can be excluded by careful investment policy, diversification of risk and prudent management by Islamic financial institutions.
The concept of profit-and-loss sharing in an enterprise, as a basis of financial transactions is a progressive one as it distinguishes good performance from the bad and the mediocre. This concept therefore encourages better resource management. The Islamic sukuk system is similar to bonds of capitalist system, but in sukuk, money is invested concrete projects and profit share is distributed to clients instead of interest earned.
Financing Modes of Islamic Banks
Islamic financing in its first stages used only the partnership modes of musharakah and mudarabah. Later it was realised that, to avoid moral hazards, yet compete successfully with conventional banks, it was necessary to use all permissible Islamic modes and so trade-based and leasing techniques were developed.
The general rule is that all financial arrangements that the contracting parties agree to use are lawful, as long as they do not include an element of interest. Equity-holding and commodity and asset-trading are an integral part of Islamic financing.
The two basic categories of financing are: 1) profit-and-loss-sharing (PLS), also called participatory modes, i.e., musharakah and mudarabah and 2) purchase and hire of goods or assets and services on a fixed-return basis, i.e., murabaha, istisna'a, salam and leasing.
Legitimate modes include financing trade, industry or budget deficits through domestic or foreign sources. Islamic banks may design diversified investment portfolios and instruments that generate profit with the required liquidity. To maximise its profits, a bank needs to look for investments that yield the highest return, minimize risks and provide adequate liquidity. At the same time, it is necessary for the bank's liabilities and assets to be matched.
A pyramid of financial assets can be built based on liquidity and profitability, which are the criteria of prudent banking. At the top would be high-risk and less-liquid assets, such as long-term investments out of its own equity or from deposits of its risk-accepting account-holders. At the bottom of the pyramid would be the least risky and most highly liquid assets, based on murabaha (leasing) or short-term (even overnight) Mudarabah Certificates (PLS).
Musharakah and mudarabah can be used for short, medium and long-term project-financing, import-financing, export financing, working capital financing and financing of single transactions. Diminishing musharakah can be used for large fixed assets such as houses, transport, machinery, etc. Murabaha can be used for purchases of goods needed by the bank's clients. Salam is useful for financing farmers, trading commodities for the public and private sectors and other purchases of measurable and countable things. But it must be kept in mind that buyback and rollover modes may not be used, because they are seen as a back door to interest.
With Islamic financing, the need to assess clients' acceptability is more important than it is for conventional banks. The bank needs to be vigilant and prudent by concentrating on the client's integrity as well as his status regarding property and particularly his willingness to comply with Shari'ah-compliant contracts.
Islamic banks, while functioning within the Shari'ah, can perform the crucial task of resource mobilization and efficient allocation on the basis of both PLS and non-PLS modes. Sharing modes can be used for short, medium and long-term financing, import financing, pre-shipment export financing, working capital financing and financing of single transactions. To ensure the maximum use of Islamic finance in the development of the economy, it is necessary to create an environment that can induce financiers to earmark more funds for musharakah- or mudarabah-based financing of productive units, particularly those of small enterprises.
The non-PLS modes acceptable to the Shari'ah not only complement the PLS modes, but also provide flexibility of choice to meet the needs of different sectors and economic agents in the society. Trade-based modes, such as murabaha, having less risk and better liquidity options, have several advantages over other techniques, but may not be as fruitful in reducing income inequalities and generation of capital goods as participatory techniques are.
Ijarah-based financing, that requires Islamic banks to purchase and maintain the assets and afterwards dispose of them according to Shari'ah rules, requires the banks to engage in activities beyond financial intermediation and are very much conducive to the formation of fixed assets and medium- and long-term investments.
On the basis of the above, it can be said that supply and demand of capital in an interest-free environment have the additional benefit of providing a greater supply of risk-based capital. There is also a more efficient allocation of resources and an active role for banks and financial institutions to play, as required in the asset-based Islamic theory of finance.
Islamic banks can not only survive without interest, but are also helpful in achieving the objective of distributive justice by increasing the supply of risk capital in the economy and facilitating capital formation and the growth of fixed assets and real-sector business activities.
Salam (forward purchase with prepayment of price) has a vast potential to finance productive activities in crucial sectors, particularly agriculture, agro-based industries and the rural economy as a whole. It also provides an incentive to enhance production, as the seller will spare no effort to produce at least the quantity needed for settlement of the loan taken by him as the advance price of the goods.
Salam can also lead to creating a stable commodities market, especially of seasonal commodities, and therefore to stability of their prices. It enables savers to direct their savings to investment outlets, without waiting, for instance, until the harvesting time of agricultural products or the time when they actually need industrial goods and without being forced to spend their savings on consumption.
Banks might engage in fund and portfolio management through a number of asset-managing and leasing and trading companies. Such companies can exist on their own or can be an integral part of some big companies or subsidiaries, as in the case of Universal Banking in Europe. They would manage Investors Schemes to mobilize resources on a mudarabah basis, and to some extent on an agency basis, and use the funds so collected on a murabaha, leasing or equity-participation basis. Subsidiaries can be created for specific sectors or operations and would enter into genuine trade and leasing transactions. Low-risk funds based on short-term murabaha and leasing operations of the banks, in both local and foreign currencies, would be best suited to risk-averse savers who cannot afford the possible losses of PLS-based investments.
Under equity-based funds, banks can offer a type of equity exposure through specified investment accounts where they identify possible investment opportunities from existing or new business clients and invite account-holders to subscribe. Instead of sharing in the bank's profits, the investors share in the profit of the enterprise in which the funds are placed and the bank takes a management fee for its work. Banks can also offer open-ended multiple-equity funds to be invested in stocks.
The small and medium enterprises (SME) sector has a great potential for expanding production capacity and self-employment opportunities in developing countries. Islamic banks may introduce SME-financing funds for various places. Enhancing the role of the financial sector in the development of the SME sub-sector can mitigate the serious problems of unemployment and the low level of exports of such countries.
There are continuing debates on whether the spirit of Shari`ah is being violated by the practice of "benchmarking" linked interest rate benchmark such as London Interbank Offered rate (LIBOR) plus an agreed mark-up in also pricing returns on Islamic finance transactions . At a very fundamental level, the reason for the debates is the lack of understanding to clearly discern the difference between the use of LIBOR as a benchmark for pricing and the use of non-Shari’ah compliant assets as a determinant for returns.
However, benchmarking touches upon the integrity of Islamic Finance as a whole, and the concept of Shari’ah-compliance vs Shari’ah-based approach in particular. There are practical challenges delaying a switch to participation-based structures, such as Musharakah and Mudarabah, that require financiers to participate in the underlying asset in a financing transaction.
Given that many ethical funds have similar characteristics as Islamic funds, it is important for ethical investors attracted by the appeal of Islamic principles as well as the performance of Islamic investments to understand that there are additional prohibitions that must be applied on the products offered. These restrictions which are essentially self-imposed based on belief and conviction act a moral compass; the monitoring of the prohibitions by a Religious (Shari’ah) Supervisory Board may have prevented Islamic financial institutions to deviate from a faith-based system and absorb the shocks within the conventional financial system.
The important principles for Islamic financial instruments for participation and investments that require strict adherence, while providing good returns, are:
Investments must be free of interest, speculation and gambling, all are considered as forms of exploitation
Investments are made in permissible activities
Investments must be separately approved by an independent Shari’ah supervisory board to ensure Shari’ah principles are strictly adhered to and deviations and wayward business practice penalised, for example in Islamic finance requires penalties to be paid to charity
"The ethical principles on which Islamic finance is based may bring banks closer to their clients and to the true spirit which should mark every financial service," the Vatican's official newspaper Osservatore Romano said in an article its latest March 2009 issue.
Shaikh Yusuf Talal DeLorenzo, Islamic scholar, position is that unless a financial product or service can be certified as Shari’ah compliant by a competent Shari’ah supervisory board, that product's authenticity is dubious. At that point, it will be the responsibility of the individual investor or consumer to determine on his or her own that the product complies with the principles and precepts of the Shari’ah.
Islamic financial institutions must adhere to the best practices of corporate governance however they have one extra layer of supervision in the form of religious boards. The religious boards have both supervisory and consultative functions. Since the Shari’h scholars on the religious boards carry great responsibility, it is important that only high calibre scholars are appointed to the religious boards.
An Islamic financial institution is required to establish operating procedures to ensure that no form of investment or business activity is undertaken that has not been approved in advance by the religious board. The management is also required to periodically report and certify to the religious board that the actual investments and business activities undertaken by the institution conform to forms previously approved by the religious board.
Islamic financial institutions that offer products and services conforming to Islamic principles must, therefore, be governed by a religious board that act as an independent Shari’ah Supervisory Board comprising of at least three Shari’ah scholars with specialised knowledge of the Islamic laws for transacting, fiqh al mu`amalat, in addition to knowledge of modern business, finance and economics.
They are responsible primarily to give approval that banking and other financial products and services offered comply with the Shari’ah and subsequent verification that of the operations and activities of the financial institutions have complied with the Shari’ah principles (a form of post Shari’ah audit). The Shari’ah Supervisory Board is required to issue independently a certificate of Shari’ah compliance.
The day-to-day application of Shari’ah by the Shari’ah Supervisory Boards is two-fold. First, in the increasingly complex and sophisticated world of modern finance they endeavours to answer the question on whether or not proposals for new transactions or products conform to the Shari’ah. Second, they act to a large extent in an investigatory role in reviewing the operations of the financial institution to ensure that they comply with the Shari’ah.
The concept of collective decision-making, in other words, decisions made by more than one scholar, is especially important. Shari’ah Supervisory Boards function is to ensure that decisions are not unilateral, and that difficult issues of finance receive adequate consideration by a number of qualified people.
Shaikh Yusuf Talal DeLorenzo, Islamic scholar, position is that unless a financial product or service can be certified as Shari’ah compliant by a competent Shari’ah supervisory board, that product's authenticity is dubious. At that point, it will be the responsibility of the individual investor or consumer to determine on his or her own that the product complies with the principles and precepts of the Shari’ah.
It is the role of the Supervisory Boards to supervise the activities of Islamic banks. To this end, several of them have drafted out model agreements for the modes of financing mentioned above and the banks concerned are bound to follow these forms in all their transactions.
Whenever a case arises where there are difficulties in applying any of these forms, the management of the bank is expected to bring the problem to the notice of its Supervisory Board, who will look into it, come to a decision and issue a decree (fatwa), which the management must obey. A large number of these decrees now exist, covering many of the current practical problems of Islamic banks.
Because today's problems do not appear in the original sources of classical Islamic financial law, dealing with problems has required innovative thinking by Supervisory Boards. This sometimes leads to differences of opinion, since the members of the boards specialise in different areas of Islamic learning. These differences are settled by discussion or, if necessary, further research may be undertaken. This process leads to valuable additions being made to the body of the law.
The Importance of Religion in Islamic Banking
Islam is a total way of life. Its system of laws permeates social, economic, political and cultural life. Islamic banks are thus one of the direct consequences of the resurgence of interest in Islam.
The primary source of all Islamic jurisprudence, the body of which is known as the Shari'ah, is the Qur'an and Sunnah. Thus it is the Quranic scholars to whom the leaders of Islamic economics and banking turn for guidance in setting up their internal compliance systems and processes.
Conformity to the Shari'ah
The Advisory Board (also known as the Religious Board) of an Islamic bank looks into the day-to-day running of the bank to check its conformity to the Shari'ah and also decides whether proposals for new varieties of transactions conform to the Shari'ah. It offers constructive advice as to how to address the integration of an Islamic bank's operations into today's world of financial information and technology.
Bringing uniformity to the practices of all Islamic banks would contribute much to the progress of interest-free banking in the world.
Preferably, members of Shari'ah boards should also have some knowledge about the law system within which their Islamic bank operates.
The Religious Board both protects the interests of investors in ensuring that their profits are legitimate according to the Shari'ah and helps the management to adapt its operations to today's financial world. The latter role, which is either to issue fatwas (decrees) on specific investment proposals or give precautionary advice, makes it an unwavering foundation supporting the very nature of the Group.
To some it may seem that the role of Supervisory Boards is solely prohibitive in that it proscribes certain forms of activity, yet the part played by them is really one of assistance and contribution. Just as the Shari'ah does not confine itself to what a Muslim may not do, the Advisory Boards of Islamic banks do not limit their role to prohibiting certain transactions, but play a large part in innovation, while still respecting all aspects of Islam itself.
The Innovative Role of the Supervisory Board
It was the ability of religious scholars and Islamic jurors to use the Shari'ah adaptability to develop an alternative to interest-oriented financial transactions that laid the foundation for the first Islamic banks. Islamic scholars and intellectuals from the world of Islamic law worked closely with entrepreneurs, businessmen, prominent Muslims and others and ultimately created a mechanism of finance which was completely different from the West's interest-based one.
Since the beginning of this alternative financing mechanism, development and refinement have never ceased. The methods and instruments of Islamic finance, being based upon risk and profit-sharing, require an ever-evolving adaptation within the pattern of economic relationships which are defined by the Shari'ah.
The present forms of financial transactions used by Islamic banks, such as mudarabah, musharakah, murabaha, ijarah and ijarah wa iqtina are concepts born of the past thinking of religious scholars and jurists.
So while the definition of the Islamic framework of economics does not change, the types of financial instruments required for the survival of Islamic banks necessitates the constant involvement of religious scholars.
The ideal way for Islamic banks and financiers to operate is to set up partnerships with entrepreneurs on a profit-and-loss-sharing (PLS) basis. This avoids the injustice of interest-based transactions, since, by this system, the profits are divided by agreement between the bank, the entrepreneur and the depositor.
For Islamic banks to be able to operate fully according to the Shari'ah, it is necessary for the interest-free Islamic economic system to be recognised by the state. Meanwhile, the Shari'ah Supervisory Boards have allowed the use of two instruments by which Islamic banks can exist in the present conventional banking environment without charging or receiving interest.
These two instruments are cost-plus sales (where the bank buys an asset required by the customer and sells it to him for a profit, by instalments) and leasing, which, although not the best Islamic means, are at least acceptable in that they are devoid of interest.
First, cost-plus and leasing can only serve their true purpose if the requirements of the Shari'ah are strictly observed. It must not be merely a matter of new names for conventional transactions. With cost-plus transactions, there must be a definite period during which the financier is the legal owner, bearing all the risks, liabilities and benefits of that position. He is then the genuine seller of the commodity to the buyer and is entitled to make a profit on the sale.
Second, these two types of transactions are not to be thought of as ideal Islamic modes. On the contrary, the goal of Islamic banks is to move towards PLS modes, that is, musharakah and mudarabah partnerships.
These two instruments have been criticised as being so similar to the interest-based instruments of conventional banks that they have not brought much real change to the banking system and this is true, as far as it goes. Yet their use does carry an element of risk for the financier and it is this element which makes them acceptable to the Shari'ah, for the Qur'an says that "God has permitted trade and forbidden usury" (2:275), and both cost-plus sales and leasing are forms of trade.
It is the risk in trading which makes it an acceptable way of making profit. Fixed interest, on the other hand, carries no risk for the bank and is therefore against Islamic principles as a way of making money, since it is the entrepreneur who takes all the risk of loss, while still having to pay back his loan.
Islamic banking is no longer a novel experiment. When the concept of Islamic banking with its ethical values was propagated, financial circles the world over treated it as a utopian dream. Having lived for centuries under the ‘valueless’ capitalist economic system, they asked what ethics had to do with finance?
Besides their range of equity, trade-financing and lending operations, Islamic banks also offer a full spectrum of fee-paid retail services that do not involve interest payments, including checking accounts, spot foreign exchange transactions, fund transfers, letters of credit, travellers' checks, safe-deposit boxes, securities safekeeping investment management and advice, and other normal services of modern banking. Islamic banking because of its value-orientated ethos enables it to draw finances from both Muslims and non-Muslims alike.
Islamic banks are evolving financial and investment instruments that are not only profitable but are also ethically motivated. The ever-increasing application and innovation of the methodologies associated with derivative instruments that revolutionised the global financial industry have also led to a global financial crisis because of the excess greed for profit and the immense uncertainty and risk associated with these types of transactions. There are doubts associated with the permissibility of derivative instruments under Islamic finance generally.
Addressing issues to resolve the global financial crisis world leaders called for a set up on the basis of capitalism of entrepreneurship where banks finance economic development in the real economy, as opposed to the set up on the basis of capitalism of speculation whereby banks derive excessive profit from speculative transactions that do not make any contribution to the real economy.
Integrity in Islamic Banking
Islamic banks need to give special care to their integrity and credibility. Some critics are disappointed that Islamic banks have deviated, to a great extent, from the philosophic and idealistic basis that inspired their originators in the 1970s.
Islamic banks come in all shapes and forms: banks and non-banks, large and small, specialized and diversified, traditional and innovative, national and multi-national, successful and unsuccessful, prudent and reckless, strictly regulated and free-wheeling, etc. Some, particularly the “Islamic windows” of conventional banks, are virtually identical to their conventional counterparts, while others are markedly different. Some are driven by real religious considerations, while others use religion only as a way of attracting customers.
There are considerable disagreements among scholars as to which institutions and instruments are religiously acceptable. For some, their legal structure does not allow them to carry out real Islamic business such as trading, leasing or construction activities and hence they end up doing only conventional financial operations with slight changes to appear Islamic.
There is a risk that Islamic banking ideals may get diluted with conventional banking unless Islamic banks do something to establish their distinctness as “Islamic banks”. Non-sharing Islamic modes such as murabaha, salam, istisna'a and ijarah also provide a link between financial transactions and real economic activities, such as trading in tangible assets. But there have to be some underlying goods and services to be the objects of such modes of financing.
Innovation and Research
An important area is development of products for meeting statutory liquidity requirements. A related, but more complicated, issue is that of products for Government financing. For the Islamic financial system to be adopted at national levels, the role of Islamic banks and financial institutions in monetary management and government financing, whether it is to cover budget deficit, refinancing or financing the activities of utilities, needs to be enhanced.
The lack of involvement of Islamic finance in government financing is due to lack of research and development (R&D) and differences in Shari'ah-compliance criteria between different countries. Problems arise and are not attended to owing to a lack of active jurists or their differences with regard to innovations. Different Shari'ah Boards interpret contracts differently.
R & D should therefore be attended to by Shari'ah experts under the guidance of the Organisation of Islamic Conferences (OIC) Fiqh Academy (Islamic jurisprudence) and AAOIFI (Accounting and Auditing Organisations of Islamic Financial Institutions). It is also imperative to find ways to block avenues of wilful default and delays by clients.
The institution of discussion (ijtihad) in this perspective is vitally important, because the Shari'ah has the flexibility to respond to changes and diversity. But it is not open to changing from Divine to manmade law. The concepts of custom, the general good, utility or necessity are taken into consideration, but they are relevant only when the clear texts of the Qur'an and Sunnah are taken as a basis for analogies. This still leaves a great deal of room for acceptable inferences to be made in regard to business and finance transactions.
Much research needs to be done on the securitization of assets and strengthening of the recovery/payment systems. In particular, there is a lack of alternatives for public debts and tools of monetary management. Well-defined products, standards and risk management tools to hedge against high volatility in markets are urgently needed.
Besides developing instruments and the framework, Islamic countries have to redesign their plans and priorities. The establishment of a permanent trade fair and an Islamic free market may facilitate the achievement of the objective by promoting intra-OIC trade. This can be achieved by increasing links and establishing an Islamic Monetary Fund by expanding the scope of the International Islamic Financial Market (IIFM) and Liquidity Managed Centre (LMC). The proposed Islamic Monetary Fund (IMF) can have a wider scope to tap excess liquidity with some of the Islamic banks through a mechanism which would encourage both governments and institutional subscribers to the fund to make efforts to promote Islamic finance.
In order to encourage international participation in the Fund, an adjustment mechanism through a coordinating institution such as the Islamic Financial Services Board (IFSB) will have to be introduced to provide a guarantee against exchange rate fluctuations which can cause a loss of principal invested by nationals in the international Islamic capital market.
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Articles by eminent scholars and practitioners in the field of Islamic banking and finance. You will find more information on Islamic banking and finance on the Institute's NEWHORIZON magazine website at www.newhorizon-islamicbanking.com
The Role of Central Banks in Islamic Banking
Dr. Iraj Toutounchian
Islamic Banking: True Modes of Financing
By Dr. Shahid Hasan Siddiqui,
Eminent Pakistani Banker & Economist
Issues and Relevance of Islamic Finance in Britain
By Iqbal Khan, Managing Director Head of Global Islamic Finance, HSBC Amanah Finance, UK
Islamic Investment Products Available In The UK
By Professor Rodney Wilson,
University of Durham, United Kingdom
Adequacy of Disclosure in Islamic Financial Institutions
By Muhammad Shabbir, Bank Analyst, Capital Intelligence, Cyprus
Hopes for the Future of Islamic Finance
Dr. Abbas Mirakhor, Eminent Islamic Scholar and Executive Director
International Monetary Fund (IMF)
Shariah Requirements for conventional banks
By Sheikh Nizam Yaquby
By Dr. Abdel-Rahman Yousri Ahmad
Institute of Islamic University
By Justice Muhammad Taqi Usmani
Justice of the Supreme Court of Pakistan