Islamic Finance - A Brief Introduction

Shariah is a set of rules that define certain prohibitions, obligations, recommendations and so on. 

Core five aims and objectives of that Shariah are preservation of:

1.   Religion, 

2.   Life, 

3.   Progeny and family, 

4.   Intellect & honor; and, 

5.   Wealth. 

So, Shariah lays down certain rules and principles to do this. 

Therefore, the rules of the Shariah uphold these while at the same time, lay down measures to defend them from any harm.

Primary sources of Islamic law are the Qur’an and the Sunnah. 

The Qur’an was revealed to the Prophet Muhammed (PBUH) in Arabic language.  The Qur’an is the Word of God and the final revealed book to the mankind. 

Muhammed (PBUH) would receive the verses of the Qur’an via the angel Gabriel (Jibreel). 

The Prophet (PBUH) would relate the verses he heard from the Angel and his scribes would record them. 

Over fifty scribes contributed to the recordings of the Qur’an during the Prophet’s (PBUH) lifetime. 

The Qur’an remains unchanged as it was revealed fourteen centuries ago. 

Although, the Qur’an covers details of beliefs, ethics, lessons from history, guidance, it also includes laws that relate to family, criminal law, state law, and trade business laws. 

The basic methodology to interpret the Qur’an relies on the following; 

1.    Understanding the Qur’an from other passages in the Qur’an; 

2.    Understanding the Qur’an by way of the Sunnah, (will cover next), or the teachings of the Prophet; 

3.    Understanding the Qur’an by the way of the companions of the Prophet, and; 

4.    Delving into the linguistic meanings of the Arabic words.

The Sunnah refers to the teachings or known practices of the Prophet Muhammad (PBUH), which have been recorded in the volumes of Hadith literature. These resources include many things that he said, did or allowed. 

During his lifetime, the Prophet's (PBUH) family and companions directly learned from him and observed him and related to others what they had seen and heard. 

People also asked the prophet directly for rulings on various matters and He (PBUH) would pronounce his judgment.

Although, the Sunnah complements the Qur’an and is used to further understand the Qur’an, it is also used as a source for many other rulings not explicitly mentioned in the Qur’an.

There are over forty verses in Qur’an that command believers to obey the messenger and follow his Sunnah (PBUH).  

Many scholars over the years gathered and compiled large compilations and we know some of them such as Muwatta of Imam Malik and Musnad of Imam Ahmed. 

Secondary sources of Islamic law.

Ijmah or consensus.  Many rulings do not require further interpretation. Ijmah (consensus) refers to the rulings that have been agreed upon and are established as truth. Such rulings are not eligible for re-interpretation.  Therefore, it is upon the scholars to know what has been established as law according to consensus.

Ijtihad or juristic opinion.  When the clear ruling cannot be directly found in the Qur’an and in the Sunnah, the Muslim jurist or Mujtahid may practice Ijtihad or juristic opinion. 

The main purpose of Ijtihad is to strive and deduct the correct ruling and comprehend the intent of the law maker. 

A common feature of Ijtihad is interpretation based on Qiyas or analogy. 

Ijtihad continues to answer many issues as they emerge. Specifically, we will see this in the world of Islamic finance where many of these contemporary arrangements are subject to Ijtihad and we will discuss some of them in this course.  

Scholars also take into consideration the aims and overall objectives of the Shariah.

Scholars have divided actions in Islam in two broad categories.  These two categories are known as Ibadat and Muamalat. 

Ibadat or what is commonly translated as acts of worship. These are the things and action that refers to anything that is done sincerely and solely to Allah, such as our prayer, fasting and Hajj (pilgrimage). 

Such acts of worship rely on proof within the sources of Islam, for their endorsement and conduct. We are looking for evidence in order to establish that act of worship and whenever we bring a practice or opinion when it comes to these acts, we look for the evidence. 

Muamalat refers to any type of interaction between people. This includes such things as trade partnership laws and Islamic finance.

Unlike Ibadat, a general principle that applies to Muamalat is that everything is allowed except for what has been prohibited.

A contract is a legally binding agreement.  It creates a legal relationship with regards to the subject matter.

If you agree to buy or sell something and one party does not want to honor that agreement, you can take that person to a judge for a ruling because a contract is a legally binding agreement between two or more parties.

When you look at any transaction we exchange ownership of thing(s) that we are buying and selling and there is consideration or payment.

When you look at the transactions for exchange of things, we can classify them in three very broad categories. (Sale, Loan and Lease)

There are three different categories of ownership. 

Firstly, you can own the asset.

Secondly you could be the owner of a debt.

Thirdly you can own the usufruct, the right to benefit from the good. 

For a contract to be valid all elements of the contract must be in order and valid.  

Conditions in a contract must be honored as long as they do not breach the Shariah. 

This topic will cover conditions within the contract.  An example of a permissible condition with a loaned item is the owner may require a security deposit until the item is returned or a photocopy of the borrower’s identification.  Another example of a contract condition is a lease with these options; the lessor of the car may have conditions for the lessee not to drive it off road.  Also, the lessor of a house may stipulate “no pets are allowed” as a condition.   

Some conditions can be unlawful.  Unlawful conditions refer to what is prohibited by Shariah such as sale and lease in one contract or interest-bearing penalties for late payments.  If the Shariah has stipulated a law that is binding, it may not be changed by a condition. 

One of the first traditional topics that we cover when we are talking about prohibitions is the prohibition of Riba. 

When we are looking at a language and the literal meaning of Riba simply means increase.

Now when we look at the more Shariah definition of this increase, we see that refers to this particular increase that is unlawful.  Or comes from a particular transaction where the increase is not desired.

One example of riba is a transaction where one amount of money (eg $100) is exchanged for a larger amount of money (eg $110) in a loan transaction. This example of increment in borrowing or lending money, paid above the amount of loan is riba. (For the full explanation of riba see one of our future courses that will specifically deal with these all types of riba and related issues)

In English translation we will usually find that Riba is translated as either Interest or Usury (excessive interest).   

If we look at history we will see that in Christianity, interest was also prohibited. But then people who wanted to make this particular profit permissible divided the increase into two categories. One that is a small amount (and they called it interest) and the second one is an increase that is a lot, excessive (and they called it usury).

This is the way people used logic and reason to go around the prohibition of interest. 

Now, in Islam, we do not make this distinction between a little bit of interest and a lot of interest.  There is nothing called ethical interest, or a little bit of interest is fine.  Any type of profit that results from these transactions (Riba transactions) is interest, that is prohibited, and it is haram (prohibited) regardless of amount. 

Some wisdom behind prohibition of Riba (interest):

Riba (interest) goes against mutual cooperation, generosity and spirit of partnership. 

Another wisdom behind prohibition of Riba is found in its possibility to facilitate injustice and exploitation and acquisition of the property by wrongful means, and to harm the needy. 

Riba drives the capital-owner away from enterprise and real economic activities that contribute to the welfare of the society, through commerce, manufacturing, construction and so on. 

Money in reality is meant to be medium of exchange and standards of value for other goods. 

Therefore, Riba violates this rationale for which we have money, as it diverts it from real economic activities and what it is meant to do.

In a conventional bank money is considered a ‘commodity’. 

Most of the conventional banking products are designed to sell you money like your credit card, bank loan, car loan and personal financing.

Subject matter of all of these contracts is actually money, and that for instance includes the home loan when the bank gives you money to buy a house. 

In reality, they are giving you a loan contract and a transaction between two of you is money for money. 

The house in this case is not the subject matter.  It's simply collateral in that transaction.  In case you are a faulty or something happens, there is the house to be sold. 

In an Islamic bank, money must be used as a medium of exchange only.

So, before we make a profit, money must be converted to some sort of asset, something that is useful. 

And we can sell this asset for the profit, and that is a legitimate business transaction. 

So, linking money to productive purposes brings into action labor and other resources to initiate a purchase from which goods and services are produced and benefits passed on to the society. 

We can see the difference between Islamic and conventional banks is really what they deal in. 

Islamic bank deals in goods and documents, not in money. 

Conventional banks deals in money and documents, not in goods. 

So, in an Islamic bank money is only used as a medium of exchange for purchasing the goods for the purpose of leasing or selling and so on and in the conventional bank money is considered as a commodity that can be sold or bought or rented against the profit.

One of the miracles of Islam are the rules of riba (interest, usury). Many students who for the first-time study these rules think they are a burden to the economy and question wisdom to why we exchange money for money in equal amounts and on the spot. Sometimes even ask if there is a place for such restrictions in a modern economy?  In this clip, we analyse the power of Islamic economic principles regarding the ban on riba by looking at the root causes of the Global Financial Crisis. Since these rules are very complex we hope in near future to organise new course just on this topic for Udemy students. Let us know if you think that might be of benefit for you.

Another prohibition is Gharar which is excessive uncertainty or risk. (Note: Not all forms of Gharar or risk are prohibited. Standard risk/uncertainty that is present in typical business transactions and ventures is permissible). 

Abu Hurairah stated that, “The Prophet PBUH forbade selling by way of tossing stones to settle a sale (Al-Hassah) and a sale of Gharar (Muslim). 

Whenever we have a contract or an arrangement or a business transaction, that makes someone believe something that is false or vague or puts someone in a dangerous position due to deception by showing something that looks attractive, but in reality, is not, we are talking about prohibited transaction that falls under the prohibition of Gharar. 

Some of the examples of these transactions include, ignorance for instance and the lack of transparency. 

Selling what we do not have is a situation where a person might engage in a transaction, where there is a high level of uncertainty in terms of delivery of the product.

Having unspecified price, dates or delivery, quality or quantity of the product that is not clear is not fair or allowed. 

Case of Insurance: If you look at the conventional insurance versus Takaful, (Islamic insurance), you can see conventional forms of insurance involves the elements of chance (Gharar), and often interest (Riba). 

So, when you look at the modes of financing, there are two areas. 

One mode of financing is based on partnership and the second mode of financing is debt based.

So, for example, a partnership mode of financing would involve a contractual arrangement with shared profit and loss. 

We enter together, we share (profit) from the underlying performance of the business if it performs well, or we share in the loss if it doesn't go so well.

Now, in a debt-based mode of finance, we have arrangement where I simply sell something to you let's say, and you owe me some money or I lease something to you and I know what to expect in terms of the cash flow in the future.

So, based on these two arrangements, profit and loss or non-profit and loss mode, we have two different types of financing. 

Now, when we talk about making money, we understand that you can only really make money by selling something or leasing or entering some sort of partnership arrangement.  

We will look at the sale and lease separately in order to understand what the rules regarding the lease and the sale are.

We will also look at different types of partnerships. 

So, if you are financing, let's say, homes or a vehicle through partnership like Musharaka, the same lease and sale rules will apply. 

·      How will you take ownership of the asset? 

·      How is the asset priced?

·      What are your responsibilities, liabilities, risk and so on?

So, as we said we have a number of different modes of financing such as Musharaka and Mudaraba and also Murabaha and Ijarah. But we also have other modes of financing, and there are number of different other ways that Islamic banks or the institutions might choose to make a profit from charging certain fees for the services or performance.

The following will cover 4 modes of finance.

a)    Equity partnership / joint venture which is known as Musharaka.

b)    Investment partnership (called Mudaraba) & Banking.

c)    Leasing (called Ijarah) & Leasing vs Sale

d)    Cost plus sale (Murabaha)

Musharak is commonly translated as joint venture partnership or equity partnership. 

The partners in this venture would share profit and loss from the business activities that they are undertaking. 

It is called equity partnership and the mode of financing is equity-based mode of financing. 

The idea of Musharaka is to join resources to generate profit.

One of the primary rules is that profit can be negotiated. 

Before we start we must agree on what is going to be the profit ratio. 

Different partners might choose to participate more or less in a business and so the profit ratio can be changed. 

For example if one partner chooses to be more involved in the business, comes with experience or adds additional value to this partnership then (Partly due to this increased involvement in the business) he might get higher share of the profit and this is to give incentives for the partners to work harder. 

If a party is a sleeping partner, then they cannot get from profit share than what was their capital contribution (ratio).

The profit ratio is something that must be agreed before we start the business. 

When it comes to the loss ratio this is fixed according to the capital contribution. We cannot negotiate. 

It is fair because if you could negotiate, usually the stronger party would negotiate in such a way, with the upper hand, to push more loss on to the weaker parties.

While at the profit side, the reason why we can negotiate is because of the potential for incentives. 

So, for example, if we increase performance of the business or a profit everyone gains more. 

So, it is better to have fifty percent of a business that makes, let’s say $5 million in profit, than ninety percent of business that makes just $1 million in profit.

So, this is something that is used to encourage innovation, competitiveness and performance. 

We also have “Diminishing Musharaka” which is a form of partnership, in which one of the partners’ promises to buy the equity share of the other partner gradually until the full ownership is completely transferred to him. 

Other type of partnership is what we call Mudaraba or investment partnership, and this is an arrangement where one party invests capital and the other party is like a manager and they provide the time, expertise and skills to manage the partnership. 

This is different to Musharaka where both of the parties invest some resources that are identifiable, and clear because if we have a situation where we have a loss, we have to know what the original capital contribution was. 

Banks deal with money but in general they mobilize the funds from people who have money surplus.

So, in this case, the bank is acting as a Mudarib (manager), that collects investments. For example, let's say we want to make an investment account. The bank would act as a Mudarib, to collect the money and do something with the money. 

In this case, people who open an investment account they would be those people who are like investors in Mudaraba. 

So, when the bank collects money acting as a Mudarib and all of these account holders are investors, then the bank would do something with that money to make a profit. 

So, in most cases this would be to provide financing. 

For instance, through Musharaka, for people to buy the homes. 

Any profit from that rent that is paid to the bank would be then split. 

So, for instance, the bank might take 20% and all of the rest of the 80% would be distributed between the depositors who have investment accounts. 

But the whole idea is that we mobilize the fund through Mudaraba for example and bank would use that money. 

The money is really connecting with the economy and providing benefits in society. 

So, we see that the Islamic idea of the bank or financial institution is to participate and transfer money from being a monetary asset into being an economic asset and benefiting the real economy in the process.

The legitimacy of Ijarah as very well established in the Qur’an. In the Sunnah also, we see reference to paying the workers before their sweat dries.  

In general, in jurisprudence when we talk about a lease or Ijarah, it is talking about employing somebody on wages.  To employ the services of a person on wages and lexically this means ‘to give something on a rent’. 

There is another type of lease related to the use of a property which is transferred in exchange for a rent.  This is similar to your normal lease that you engage in when you hire the car, or you lease the house. 

So, when you look at that contract we have the subject matter that we are transacting is usufruct or a right to use that particular property, and your rent is consideration or a payment.  

In a sale, the asset itself or the corpus of the property is transferred while in Ijarah, the ownership of the property remains with whoever is the owner, and what we transfer is only right to use to the lessee. 

This will bring different sort of liabilities and different risks to the person who owns the property. 

When you are leasing, as owner, you have certain rights and responsibility towards the property, and when you sell, you then transfer everything to the person who is buying because as you know the sale is instant transfer of ownership.

Another mode of financing is debt-based financing called Murabahah. You sell something at a markup, at some fixed price and it is very similar to a normal sale. 

All of the rules of the sale would apply to this particular transaction.  Sale in Shariah is defined as ‘exchange of things of value by another thing of value with mutual consent.’

When you engage in a sale, you immediately transfer ownership for the payment, and even if that payment is not on the spot, effect of sale is immediate. 

Some of the rules regarding the sale: 

1. The subject matter in a sale must exist at the time of the sale. You cannot sell something in this particular arrangement where the deliveries are not certain or there is some issues with the existence of this asset.

   
   

2. The subject must be in the ownership of a seller at the time of the sale. You cannot sell a car which you do not own at the time of the sale. That would not be valid because again you cannot guarantee that you get the car and the specifics of the car might be in question later on.

   
   

3. The subject of the sale must be in your possession whether it's physically there or some sort of constructive possession. 

You have taken the physical delivery of the commodity and it is coming to your control with all the rights and liabilities that comes with this. The best way we know this is whether the risk of destruction has also come to you. 

As soon as you sell something, that transfer of ownership of the asset is instant and absolute. 

The subject of the sale must be like any other contract of value and must satisfy all of the usual conditions. 

It must be known, identifiable and very clearly identified. 

We must be then also certain that we can deliver. 

We cannot sell something where there is uncertainty in terms of the price. 

But once we sell an asset, we cannot change the price. 

So, in the sale, always the price is fixed.  

Now, when we come to the Murabahah and sale on the deferred payment basis.  The scholars agreed that deferred price may be more than a cash price but it must be fixed at the time of the sale. 

So, we could have a price for the cash and we could have a price if person is paying in installments and there is no problem. 

As long as we fix this from the beginning and everyone is clear on the price and agrees.

So, as long as we agree at the end on the one price, it has become a process of offer and acceptance, and we agree on one price and on the set of conditions, this is valid sale.

So, this is the job of Shariah scholars to make sure that everything is transparent and clear and it's genuine.

There are a number of things we need to look at when it comes to choosing which Islamic product to select, whether we are investing in a partnership or taking financing from an institution or considering other Islamic finance or banking services. 

Some points to ponder.

An independent Shariah board exists to provide genuine feedback and information that the community can trust.

The role is critical because they can guide institutions, and they can lead research and development.

It is also important that the board have understanding and look beyond their local countries and can see real economic substance, what is really happening and the opportunities for Islamic finance and banking which will serve the community. 

Importantly the scholars involved should also have the opportunity to provide feedback independently that will guide the industry and serve the community. 

The role of the Shariah board can become an important tool for change, for developing, to making sure that we are always improving and learning for the benefit of the stakeholders. 

There are some legal and regulatory issues in different countries that will affect growth of Islamic finance and banking.  

The signals countries send to people, to investors in terms of changes specifically in taxation impact on the Islamic finance and banking market opportunities. 

Understandably lawmakers, governments and finance regulators are mainly trying to protect the customer and the community against unfair businesses and unfair business practices.

Islamic finance and banking also aims to protect the customer and community.  When people better understand Islamic finance and banking they will appreciate the positive approach of the sector for the community and business. 

This link between the law, Shariah and business is always important to understand. 

How the government regulates and does something, will highlight the approach and incentives for Islamic finance that will filter down to the business community and general community. 

Business run along Islamic lines and Shariah work on the principle that it only prohibits things that have a detrimental impact on society, business and the community.

Shariah is trying to remove all of the issues that might cause harm to the community and leave you with a level playing field where you can compete, to be the best, and the most useful to everybody. 

There is the global opportunity for western governments and law makers to remove the barriers, artificial barriers that will open more Islamic finance investment, more opportunities and associated growth that will in term support greater business and so on. 

The opportunity is to create an finance environment that benefits everybody and is supported by the laws of the land, open minded people can embrace, and it benefits the economy and community.

There is much current development and future opportunity and growth in Islamic Finance globally.