ISLAMIC FINANCIAL PRINCIPLES

Table of Contents:

Islamic law, in principle, recognizes contractual freedom. All contracts and contractual provisions are allowed unless explicitly prohibited in the foundation texts. The obvious and crucial questions, then, are what these explicit prohibitions are and how they pertain to financial transactions. The foundation texts identify two explicit prohibitions: (1) receiving and paying riba (interest or usury) and (2) gharar (uncertainty), to the extent possible.

Riba

Riba is often divided into three different forms: the riba al-jahiliyya, riba al-fadl, and riba al-nasi'a.[1] Riba al-jahiliyya is prohibited directly in the Quran, whereas riba al-fadl and riba al-nasi'a are prohibited in the Sunnah.

Riba al-jahiliyya refers to the riba of the pre-Islamic period.[2] According to the practice in pre-Islamic Arabia, interest was charged at the maturity of debts from interest-free loans or credit sales and compounded at later maturity dates. This form of riba has been prohibited in the Quran. The Quran also mentions that Muslims should abandon all remaining riba. One of the most discussed verses on the prohibition of riba in the Quran permits trade but prohibits riba:

Those who devour [riba] will not stand except as stand one whom the Evil one by his touch Hath driven to madness. That is because they say: "Trade is like [riba]," but Allah hath permitted trade and forbidden [riba]. Those who, after receiving direction from their Lord, desist shall be pardoned for the past; their case is for Allah (to judge); but those who repeat (the offense) are companions of the Lire: They will abide therein (forever). [3]

The prohibitions of riba al-fadl and riba al-nasi'a (defined later) originate from the Sunnah. There are several hadith that prohibit both, but the most quoted one is as follows:

[Ubada b. al-Samit] ([may] Allah be pleased with him) reported Allah's Messenger (may peace be upon him) as saying: Gold is to be paid for by gold, silver by silver, wheat by wheat, barley by barley, dates by dates, and salt by salt, like for like and equal for equal, payment being made hand to hand. If these classes differ, then sell as you wish if payment is made hand to hand.[4]

It appears from this hadith that the essence of riba does not concern interest on loans, but only sales—that is, delay or excess in exchange of certain types of property such as currency and foodstuffs. The phrase "equal for equal" in this hadith establishes that certain goods of a single type can be exchanged only in equal amounts.[5] This is riba al-fadl. The phrase "hand to hand" refers to riba al-nasi'a, in which the exchange of certain goods may take place only in the present as instant barter.[6]

Based on an explication of riba al-jahiliyya, riba al-fadl, and riba al-nasi'a, many contemporary Muslim scholars have argued that all forms of interest are forbidden as riba.

Under Shari'ah, granting a loan is considered an act of charity.[7] If that is the case, it would be improper to make a profit on a loan by charging the borrower interest. This does not mean that making a profit itself is forbidden in Islam—quite the reverse. Islamic law encourages the circulation of wealth, investment, and profit.

But profit must be made through trade and similar activities. A return on investment is justified only when the investor takes a commercial risk (i.e., shares in the risk of a venture before a return is sought). Lending money does not qualify as a commercial risk because the risk of nonrepayment (e.g., poor debtor creditworthiness) is deemed insufficient to warrant charging interest.[8] Profitability requires taking a real commercial risk.

Given the riba ban, the concept of sharing profit and loss is extremely important in Islamic finance.[9] Financiers generally do not receive interest on the funds they provide but instead participate in the project to the extent that they share in any profits or losses.[10] So unlike interest payments, charges for funding-based project participation can be justified, provided that the project yields a profit. Hence, Islamic debt instruments provide for profit-shared and risk-shared funding activities.

But the riba ban reaches much further. Shari'ah-compliant transactions preclude making money with money. Money itself may not be a source of profit because, many scholars of Islamic economics argue, money has no intrinsic value in Islam.[11] The ultimate purpose of money, from their point of view, is to help fulfill basic needs, such as food, clothing, and shelter. In this approach money must be seen (and used) as a means of exchange only, not as a basic need in itself.[12]

This position is at the heart of the bay' al-dayn doctrine (trade in debt claims).[13] Most Shari'ah scholars agree that the riba ban extends to this trade because trading in debt claims is similar to the forbidden use of money as a source of profit.[14] Sukuk must therefore be backed by tangible assets.

Typically (and unlike in conventional forms of funding), sukuk certificate holders should have a claim to one or more tangible assets. These certificates can be traded on the international capital markets because their holders are entitled to the underlying tangible assets, and it is not only debt claims that are traded.

Although the equation of riba with interest has become commonplace among Muslims, there are a significant number of scholars who do not believe that this equation is accurate. One such scholar, Mohammad Omar Farooq, notes that there are a number of problems with the orthodox understanding of riba as interest. He emphasizes the following points.

It is a misunderstanding that the prohibition on riba as interest is derived directly from the Quran.[15] There is no support from the foundational texts (the Quran and the hadith) for the notion that any conditions of an initial contract or agreement, including any stipulated excess over the principal, are covered by the Quran's prohibition of riba.

Nor is there ijma', or scholarly consensus, that riba equals interest, even though that view is widely held. The prohibition on riba, specifically pre-Islamic riba (riba al-jahiliyya), in the Quran (2:275) is primary, referring to loans—presumably a particular type of loan that existed in pre-Islamic times. Thus, the hadith concerning riba in the context of trade or credit sales cannot legitimately be used to broaden the scope of the prohibition on pre-Islamic riba.

Moreover, the discussion of riba and loans in the Quran occurs in connection with transactions or contracts characterized by zulm (injustice and exploitation), with the broader context of the verse discussing spending and sadaqa (charity). Thus, Farooq argues, it is a certain type of riba—one that renders a debtor financially vulnerable to poverty or need—that is specifically prohibited. Although this view has been supported by several scholars from a wide range of perspectives, it is not accepted in Islamic finance as a whole.[16]

Gharar

The second ban in Shari'ah in relation to Islamic finance is that of gharar, or excessive uncertainty and risk. In contracts, gharar must be avoided as much as possible. Shari'ah recognizes that ruling out uncertainty in financial transactions altogether is unrealistic.[17] For that reason, the gharar ban primarily concerns essential elements of contracts, such as price, deliverability, quality, and quantity.[18] That is, the essentials of a contract may not remain unspecified.

The gharar prohibition is also somewhat related to the Quran's ban on qimar. Qimar pertains to yields that depend solely on luck or chance, such as gambling.[19] Many Islamic economists would argue that excessive speculation and gambling are prohibited because the profits achieved through them cannot be justified. Yet ordinary entrepreneurial risks are not included in this ban. Conventional derivatives contracts are considered in this context to contain elements that are akin to speculation.

  • [1] N. A. Saleh, Unlawful Gain and Legitimate Profit in Islamic Law: Riba, Gbarar, and Islamic Banking (Cambridge, UK: Cambridge University Press, 1986), 13-14; M. A. El-Gamal, Islamic Finance: Law, Economics, and Practice (Cambridge, UK: Cambridge University Press, 2006), 49-50.
  • [2] Ibn Rushd, The Distinguished Jurist's Primer, vol. II: Bidayat al-Mujtabid wa Nibayat al-Muqtasid, trans. I. A. K. Nyazee (Reading, UK: Garnet, 1996), 158; Saleh, Unlawful Gain, 13-14; El-Gamal, Islamic Finance, 49-50.
  • [3] Ibid., 2:275. The translation I have used is by Yusufali, University of Southern California's Center for Muslim-Jewish Engagement, usc.edu/schools/college/ crcc/engagement/resources/texts/muslim/quran/002.qmt.html.
  • [4] Sahih Muslim, book 10, no. 3853, University of Southern California's Center for Muslim-Jewish Engagement, usc.edu/schools/college/crcc/engagement/ resources/text s/muslim/hadith/muslim/010.semt.html.
  • [5] Ibn Rushd, Distinguished jurist's Primer, 2:158; Saleh, Unlawful Gain, 13; A. Saeed, Islamic Banking and Interest: A Study of the Prohibition o/Riba and Its Contemporary Interpretation (Leiden, Netherlands: E.J. Brill 1996), 32.
  • [6] Ibn Rushd, Distinguished Jurist's Primer, 2:158; Saleh, Unlawful Gain, 13; Saeed, Islamic Banking, 32.
  • [7] U. F. Moghul and A. A. Ahmed, "Contractual Forms in Islamic Finance Law and Islamic Investment Company of the Gulf (Bahamas) Ltd. v. Symphony Gems N.V. & Others: A First Impression of Islamic Finance," Fordham International Law Journal 27, no. 1 (2003): 168.
  • [8] A. Hanif, "Islamic Finance: An Overview," International Energy Law Review 1, (2008): 10.
  • [9] D. Olson and T. A. Zoubi, "Using Accounting Ratios to Distinguish between Islamic and Conventional Banks in the GCC Region," International Journal of Accounting (2008): 47.
  • [10] This element is particularly noticeable in Islamic financial contracts, such as the musharakah and the mudarabah. For an account of Islamic financial contracts, see M. T. Usmani, An Introduction to Islamic Finance (The Hague, Netherlands: Kluwer Law International, 2002); El-Gamal, Islamic Finance; M. Ayub, Understanding Islamic Finance (Hoboken, NJ: John Wiley & Sons, 2008); and H. S. F. A. Jabbar, "Sharia-Compliant Financial Instruments: Principles and Practice," Company Lawyer 6 (2009): 176-88.
  • [11] This is not the same as denying the time value of money. On this distinction, see M. A. El-Gamal, A Basic Guide to Contemporary Islamic Banking and Finance (Plain-field, IN: Islamic Society of North America, 2000).
  • [12] Several baditb attest to this. On the interpretation of these baditb, see El-Gamal, A Basic Guide; H. S. F.A. Jabbar, "Islamic Finance: Fundamental Principles and Key Financial Institutions," Company Lawyer 1 (2009): 23-32.
  • [13] M. T. Usmani, "Principles of Shariah Governing Islamic Investment Funds," Albalagh albalagh.net/Islamic_economics/finance.shtml.
  • [14] Malaysia, which allows debt claims to be traded, is an exception. See A. H. Ismail, "A Malaysian View of Sharia," American Journal of Islamic Finance; A. Thomas, "Malaysia's Importance to the Sukuk Market," American Journal of Islamic Finance (March 2007); N. J. Adam and A. Thomas, Islamic Bonds: Your Guide to Issuing, Structuring, and Investing in Sukuk (London: Euromoney Books, 2004), 48-50; Securities Commission of Malaysia (SCM), Resolutions of the Securities Commission Shariah Advisory Council, 2nd ed. (Kuala Lumpur: SCM, 2006), 19.
  • [15] M. O. Farooq, "Toward Defining and Understanding Riba: An Outline Essay," Global Webpost, 2007, globalwebpost.com/farooqm/writings/islamic/intro_ riba.doc.
  • [16] Some of the scholars who support this view are Muhammad Abduh, Rashid Rida, Abd al-Razzaq Sanshuri, Doualibi, Muhammad Asad, and Fazlur Rahman.
  • [17] M. Fadeel, "Legal Aspects of Islamic Finance," in Islamic Finance: Innovation and Growth, ed. S. Archer and R. A. A. Karim (London: Euromoney Books and AAOIFI, 2002), 91; (IOSCO), Islamic Capital Market Fact-Finding Report (Kuala Lumpur, Malaysia: Islamic Capital Market Task Force, 2004), 8.
  • [18] S. Archer and R. A. A. Karim, "Introduction to Islamic Finance," in Islamic Finance: Innovation and Growth, (London: Euromoney Books and AAOIFI, 2002), 3; IOSCO, Islamic Capital Market, 8.
  • [19] Ayub, Understanding Islamic Finance, 112. 36IOSCO, Islamic Capital Market, 8. 37Hanif, Islamic Finance, 10.
 
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