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ECON 3430 - Islamic Banking and Finance

Philosophy of Islamic
Banking and Finance

Financial intermediation, financial markets
and banking
The need for Islamic banking and finance
The Shariah and fiqh
Maqasid al-Shariah and its implications to
Islamic banking and finance
Understanding riba and its types
The prohibition of riba
Addressing misconceptions about riba
Rationale for the prohibition of riba
Gharar and its prohibition
Concept of iwad


Consider these statistics

Total assets of Islamic banks and Islamic windows now exceed
USD1.02 billion ( year 2010)
Islamic mutual funds now exceed USD300 billion
Islamic sovereign and corporate sukuk have reached USD50 billion
Global market capitalization of the Dow Jones Islamic Index has
exceeded USD10 trillion
Islamic private capital investments are now valued at USD1.5

Notwithstanding such numbers, Islamic banking and finance is

still dwarfed by its conventional counterpart
Locally, total assets of BIMB (biggest Islamic bank in Malaysia) is
RM25 billion vs. total assets of Maybank (biggest conventional
bank in Malaysia) of RM250 billion
In a global context, total assets of Al-Rajhi (largest Islamic bank in
the world) is about USD28 billion vs. total assets of UBS of
Switzerland (largest conventional bank in the world) of USD1,533

Rationale for Financial Intermediation


Information gathering costs

Search costs

Transaction costs
More optimal allocation of resources

Better matching of surplus and deficit units


More centralized monitoring and control enables better

protection of vested interests
Governments economic policy

Substantial financial resources can be marshaled and

channeled to priority economic sectors

Markets in the economy

Flow of payment

Production of goods
& services

Producing units
businesses and

Consumption of
goods & services

Financial Markets

Consuming Units

(flow of financial



Flow of income

Flow of payment



Flow of income

Financial Markets
Financial Markets within a
Financial System

Direct Financial



Indirect Financial




Financial Intermediation
Savings &


Surplus Units

Return on
investment &

Banks Liabilities

Deficit Units
(e.g. bank)


Return on

Banks Assets

Why Islamic Banking and Finance?

No human endeavour is completely

Our values are derived from our
Given that the Islamic worldview is
different from the Western (Occidental)
Principles and practices of conventional
banking and finance (which are based
primarily on the Western worldview) may
be inconsistent with the Islamic worldview

What is Islamic Finance?

Islamic finance provides financial

services in accordance with the

Islamic financial services emphasize

ethical, social and dimensions of
financial transactions to enhance
equity and fairness for the general
good of society

The Shariah

Literal meaning path to watering place

Technical meaning

Path to tread for guidance in this world

Commands, prohibitions, values


Understanding of the Shariah

Practical Shariah laws, principles and values

derived from sources of knowledge

Product of human effort and aql

Objectives of the Shariah (maqasid al-Shariah)

Maqasid al-Shariah

Objectives and the rationale of the Shariah

The Shariah aims to protect and preserve public interest

(maslahah) in all aspects and segments of life
Many Shariah texts clearly state the reasoning behind
certain Shariah rulings

Elements that need to be protected

Faith (din), human self (nafs), intellect (aql), posterity

(nasl), wealth (mal)

Concept of maslahah often interchangeable with


Seeking benefit and repelling harm

Maslahah should not be over-emphasized, to the point

of rejecting or superseding definitive (qatiyyat) textual
Shariah sources

Need to recognize limitations of human perception and

cognitive ability

Maqasid al-Shariah Implications to IBF

A holistic view should be adopted in Shariah interpretation

Micro vs. macro maslahah (tree vs. forest)

Legal form vs. economic substance

Validity [meeting all contractual conditions and

requirements] (sahih) vs. permissibility [having legitimate
purpose and intention] (halal)
Purely financial goals (profit, growth, market share) alone

Need to develop proxies of spiritual well-being (e.g.

distributive justice, cooperation among economic agents,
equitable access to economic resources)

These complementary yardsticks should be incorporated in

the performance measurement of Islamic financial
Profit sharing schemes vs. fixed-return techniques
Critical appraisal of the infancy argument

Sustainability and viability vs. healthy direction of


Components of the Shariah

Islamic Shariah




Belief in
oneness of Allah

Rules and

Islamic code of

entrusted to man,
will be held
accountable for
its use

rulings related to

Ethics, morality
and positive

Some Important Points to Note

Islam provides a comprehensive solution, its prescriptions encompasses

all aspects of life

A specific discipline (such as banking and finance) must be viewed

and addressed within a larger context

Holistic approach
Role of the Shariah

As guidance and source of reference, not merely a tool

The Shariah should not be relegated to being a means to an end,

should be used to determine the end itself

Source of differentiation with (and advantage over) conventional

knowledge revelation

Reason and observation should not dominate over divine guidance,

avoid secularized practice of making science replace religion as
Conventional knowledge should not be completely rejected

There can be common grounds or areas of conventional knowledge

which are acceptable to Islam

Some general concepts can be adopted and amended

Economic growth


Literally means excess, increase, expansion, growth

Riba can be defined as every excess in return of which no reward or
equivalent countervalue is paid

Categorization of riba

Riba al Qard, or more generally Riba al dayn (debt)

Also known as riba al-Quran

Applies to a loan or to any debt regardless of the cause of

that debt (debt resulting from a loan contract or from a
deferred payment sale)

This kind of riba is the one commonly found in conventional

banking products

Riba al Bay (sale)

Also known as riba al-Sunnah

Applies to sale transactions in certain commodities

There are two types

Riba al nasiah - delay in paying or delivery of one or the
two sold items
Riba al fadl - exchanging one ribawi commodity for the
same commodity but unequal in amount

Riba al Qard

Riba al Qard can be present in a number of situations

Loan with interest or other benefits

Riba exists when there is a predetermined excess or surplus

over and above the loan received by the creditor conditionally in
relation to a specified time period

If one of you has advanced a loan and the debtor offers the
creditor a bowl (of food), he should not accept it, or if the debtor
offers him a ride of his animal (cattle) the debtor must not take
the ride unless this type of gift has been a usual practice
between them before advancing the loan
[ Anas Ibn Malik ]

Loan of usufruct (benefit/utility) of asset with stipulations

The lending of beneficial use of an asset but with stipulated

benefits in return implicates riba

Every loan that derives a benefit (to the creditor) is riba.

[ Sayyidina Ali ]

Penalty imposed on delinquent debt repayment or default

Before the Prophet s.a.w. brought the message of Islam, it was

very common for creditors to double the amount of debt
outstanding in the event that the debtor is not able to repay debt
on its due date

Such practice is termed riba al-jahiliyah

Riba al Bay

The basis for the prohibition of riba in the exchange of

commodities is the famous hadith of the Prophet on six

Gold for gold, silver for silver, wheat for wheat,

barley for barley, dates for dates, salt for salt like
for like, equal for equal, and hand-to-hand (spot); if
the commodities differ, then you may sell as you
wish, provided that the exchange is hand-to-hand
or a spot transaction.
[ Muslim ]


The Arabs used certain commodities like wheat,

barley, dates and salt (termed as ribawi items) as
medium of exchange to purchase other things, and
as such they were like money

Riba al Bay (2)

Summary of rules under the hadith



Money1 + Money1

Hand-to-hand (spot)

Food1 + Food1

Hand-to-hand (spot)

Money1 + Money2


Food1 + Food2


Money + Food

No conditions free trading

Money + Others

No conditions free trading

Food + Others

No conditions free trading

Others + Others

No conditions free trading

Riba al Bay (3)

Money1 and Money2 refer to different currencies

Food1 and Food2 refer to:

[Hanafi & Hanbali] Any commodity which is sold by

weighing or measuring

[Shafii] Either eatables or used as universal legal tender

[Maliki] Either food items or they can be stored

Modern day fuqaha would include staple food (such as

rice) in this category of ribawi items

What about non-food commodities such as oil?

Such restrictions are imposed upon the trading of these
ribawi commodities

Presumably, to curb price speculation on essential items

To discourage barter trading where injustices may occur

(resulting from information asymmetry and/or deception)
Some jurists have relied on this Hadith to render modern-day
currency derivatives impermissible

The Prohibition of Riba

Riba was prohibited gradually by the Quran in four stages

First stage (30:39)

Comparison made between riba and zakah & charity

That riba actually does not increase real wealth but zakah &
charity do
Approach prohibition of riba by way of moral persuasion

Second stage (4:160 - 161)

Associating the practice of riba with the Jews

Considering such practice as iniquity (zulm)
That those who practice riba will suffer the same fate as the

Third stage (3:130)

Prohibiting the charging of double and multiple riba (usury)

Compounding interest one of the worse forms of riba

Fourth stage (2:275 - 281)

The final prohibition of riba was made conclusively and

they say: trade is like riba, but Allah has permitted trade
and prohibited riba beware of war on the part of Allah
and His Apostle

The Prohibition of Riba (2)

The prohibition of riba is also evident in various

Sunnah of the Prophet s.a.w., for example,

The Prophet of Allah s.a.w. cursed the receiver and

the payer of riba, the one who records it and the
two witnesses to the transaction and said: they are
alike (in guilt)
[ Narrated by Abu Dawud on the authority of Ibn Masud and Jabir ]

There are seventy three types of riba; the least

sinful of which is equivalent in sin to a man
committing incest with his mother
[ Narrated by Al-Hakim on the authority of Ibn Masud ]

All jurists agree that riba is prohibited (haram)

Addressing Misconceptions about Riba

There have been a number of misconceptions about riba and its


Interest-based commercial transactions were invented by

modern day business thus not covered by the riba referred to
in the Quran
Bank interest is not riba because it is not excessive
Riba should be allowed under dharurah
Riba is only relevant to consumption loans, not commercial
Interest should be allowed because of inflation

Modern day interest is not riba


The prohibition of riba was revealed in the last days of the life of the
Prophet s.a.w.
The Prophet did not have the opportunity to elaborate the
interpretation and definition of riba
Such ambiguity in the meaning of riba falls under area of
Mutashabihaat, thus its prohibition cannot be extended to modern
day banking

Addressing This Misconception

The fact that the Prophet included the prohibition of riba in his last
sermon does not mean that the prohibition was only introduced at
that time

Given that his last sermon was attended by most of his

followers, perhaps he felt necessary to reiterate the prohibition
of riba
Other prohibitions were also not given elaborate definitions

E.g. prohibition of pork, liquor, gambling, adultery, etc.

These were well known to its immediate audience

Modern day interest is not riba (2)

Addressing This Misconception

Mutashabihaat refers to verses in the Quran, the correct meaning of

which is not known to anybody for sure, for e.g.

Some words used in the beginning of some surahs, e.g. Alif Lam Mim
References made to the hand of Allah in the Quran, e.g. in An-Nisaa

For the above examples, ignorance of correct meaning does not

affect the lives of Muslims because no precept of Shariah is
revealed through them
However, riba relates to prevalent economic and social practice
It is not imaginable that Allah the All-Merciful would wage war
against a practice, the correct nature of which is not known to
Allah never burdens a people with a command, the obedience of
which is beyond their control or ability

If it is not excessive, it is not riba


Al-Imran (3:130) - O those who believe do not eat up riba doubled

and redoubled
If rate of interest is not excessive (e.g. doubled) then it does not
constitute riba and therefore not prohibited

Addressing This Misconception

Verses of the Quran on the same subject matter must be studied in

relation to each other

Al-Baqarah (2:278) O those who believe fear Allah and give

up whatever remains of riba, if you are believers

Every amount, regardless of magnitude, over and above

principal is riba
The Quran is a book of guidance, not originally a book of statutes
and legal text

Embodies many expressions having persuasive value

E.g. Al-Baqarah (2:41) Do not sell My verses for a little price

does not imply that one can sell Verses for a high price
The expression doubled only meant to emphasized added severity
of the sin due to its excessiveness

Riba allowed under dharurah


Doctrine of Necessity under dharurah circumstances, the haram is

E.g. It is permissible to consume pork to save ones life from dying of

Addressing This Misconception

Is the necessity real or exaggerated by imaginary apprehensions?

Can the necessity be met with by any other permissible means?
At the individual (debtor) level

Is the purpose of the riba-based loan to protect an absolute

necessity? Have all other permissible alternatives been
exhausted? (Both questions to be answered with sincerity)
At the institutional level

Removal of riba from the economy does not imply that financial
institutions will have to give charitable (interest-free) loans

The role of loan-giving and taking in Islam must be understood

While giving a benevolent loan is highly commendable, the taking of
a loan is discouraged and limited to cases of absolute necessity

Islam provides means of financial intermediation in the form of

profit and loss sharing

Riba allowed for commercial loans




The common practice of riba during the time of its prohibition was
the charging of interest on consumption loans taken by poor people
to finance their basic needs
This form of exploitation is not present in production loans whereby
in many cases, the debtor is economically well-off

Loans taken by rich businessmen are used to generate profit

The basic cause of the prohibition of riba, zulm (injustice), is absent

Addressing This Misconception


To say that commercial or productive loans were not in existence

then is not accurate

There are evidences to substantiate that the practice of interestbased production loans dated back to much earlier times

As early as 2000 B.C. in Babylon

500 B.C. in Greece
During the time of Byzantine emperor Justinian (527-565 A.D.)
A number of Ahadith reporting on the practice of riba-based
commercial loans

Nature of Quranic prohibition - includes all forms of riba

regardless of whether or not prevalent at time of its revelation

E.g. prohibition of liquor and gambling

Riba allowed for commercial loans (2)

Addressing This Misconception (Continued)


Validity of a transaction is not based on the financial status of a party

Intrinsic nature of transaction itself should determine its validity

If one sells to the poor, the most that can be said is that some
concession should be accorded on humanitarian grounds, but
one cannot say that the profit derived is haram
A trader deserves reasonable profit for his investment and
Profit is the traders means of earning his livelihood

Similarly for prohibited transactions

E.g. Gambling and bribery are prohibited for both the rich
and poor

Subjectivity and relativity of financial status

Who will have the authority to determine exact degree of
poverty required for exempting of interest charges?

Consumption loans taken by the poor, Production loans

taken by the rich an erroneous presumption
Consumption of luxurious objects
Financing of business by poor entrepreneur

Riba allowed for commercial loans (3)

Addressing This Misconception (Continued)


Need to differentiate illat and hikmat

Illat Basic feature of the transaction

Hikmat Wisdom or rationale behind the rule or prohibition

Application of law depends on illat and not hikmat

The illat of a law is always determinable by hard and fast

definition that leaves little room for dispute

E.g. The philosophy behind the prohibition of liquor is that it

inculcates hatred amongst people and it prevents one from
remembering Allah

Can one consume alcohol if he claims that it does not promote

hatred and prevent him from remembering Allah?
E.g. Does it make it legal for a motorist to run the red light if he is
reasonably sure that there is no risk of accident?

Zulm (injustice) is relative, ambiguous and subject to manipulation

Possible rationale for making application of law based on illat

and not hikmat

For e.g., why does Islam provide a long list of prohibitions and
commands instead of issuing one single command to avoid zulm?
Human reason, despite its wide capabilities, cannot claim to have
unlimited power to reach the absolute truth
Reason often confused with desires, leading to disguised justice
Thus humans need guidance of divine revelations

Inflation justifies interest


Interest represents compensation for the erosion of the value of

money (due to inflation) during the period of borrowing
Loans should be indexed so that there is no injustice to the creditor

Addressing This Misconception

Rates of interest are not based on rates of inflation, although there

may be correlations
Indexation of loans is problematic due to the lack of precise
measures of inflation

Indices are, at best, aggregated generalizations about price


The effects of inflation differ from individual to individual

If surplus on loan amount is only attributable to actual value loss due
to inflation, there will be no commercial incentives to banks
Interest is one of the causes of inflation

Using interest to remedy inflation which is a consequence of

interest-based lending in the first place

A better solution is to not charge interest to begin with

Rationale for the Prohibition of Riba

For Muslims, the prohibition of riba as evidenced in the Quran and

Sunnah should be sufficient
However we can attempt to articulate some rationale or reasons for
its prohibition to better appreciate the wisdom behind the injunction
Some of the possible rationale for the prohibition of riba are


Element of injustice in financing productive activities


An interest-based production loan constitutes a contract with

unequal countervalues certainty of interest obligation vs.
uncertainty of business outcome
Injustice to debtor obligated to pay interest even if
business venture results in no profit or loss
Injustice to creditor in the event of substantial profits,
creditor receives a return disproportionate to amount of
generated profits

Element of exploitation in financing consumption

Riba assumes money as a commodity, one which the rich

has in abundance
The rich is able to generate more wealth without exerting
much effort or contributing to productive activity

Rationale for the Prohibition of Riba (2)


Riba inconsistent with Islams perspective on debt

In Islam, incurring debt is discouraged

The Prophet s.a.w. refused to offer salat-ul janazah of a
person who died indebted
Borrowing money should be limited to cases of dire
On the other hand, permitting riba enables lending to
become a viable business
Banks are motivated to lend as much as possible
Banks exploit mans inherent greed to spend beyond
their means by offering credit
Given that spending on credit is a product of human
greed, it will result in negative repercussions
The outcome is the proliferation of a credit society

Rationale for the Prohibition of Riba (3)


Negative effects of a credit society

Easy availability of credit cultivates a materialistic society

People have to work harder and harder in order to repay

bank debt

The banks in essence exercise control over economic

agents, people become enslaved to the banks
The quest for economic development clouds good moral
judgment and the Islamic value system

Unethical business practices

Degradation of the natural environment

Less emphasis on the institution of family leads to social ills

Longer working hours, multiple jobs, forced female and
teenage labour
Essentially, Muslims forget their roles as abd and khilafah
Social relations amongst the people are negatively affected

Members of society should help each other in times of need

Riba entails taking advantage of a mans inferior economic


Riba breeds hatred, jealousy and ill-will towards the rich

Rationale for the Prohibition of Riba (4)


Negative effects on production

Impediment to healthy growth of the economy

Riba-based lending is security oriented rather than growth


Lending is confined to established businesses with known

creditworthiness and adequate security (collateral)

Potential entrepreneurs without security to pledge are denied

Inefficient allocation of resources

Bank interest return does not vary with actual profits, no

incentive to give priority to ventures with highest profit

Lending based on creditworthiness, not profitability

Discourages Innovation

Interest obligation act as disincentive for experimenting with

new, unproven methods of production, especially for smallscale enterprises and agriculture
Leveraged financing favours large-scale businesses

Domination of big businesses over smaller entrepreneurs will

curtail competition and in turn will affect product variety and

Rationale for the Prohibition of Riba (5)


Negative effects on production (continued)


Inflexibility in a loss situation leads to bankruptcies loss of

productive potential and unemployment
Funding not channeled to deserving economic agents

Utility of certain projects is with reference to criteria other than


E.g. projects that benefit the public, poverty alleviation

Financing of luxurious or wasteful consumption and/or production

Rationale for the Prohibition of Riba (6)


Negative effects on distribution

Because the primary basis of interest-based lending is

creditworthiness, there will be disproportionate supply of credit to
the already affluent segments of population

Wealth inequality (in terms of purchasing power) is widened

The rich become richer, and the poor become poorer
Domination of large enterprises leads to demise of smaller
economic units

Lacking collateral and established economic standing, poorer

segments of the economy are at an economic disadvantage
when competing for credit to finance economic activities

As a result, wealth and income disparities worsens

Transfer of real assets to the lenders

Most debt financing requires some form of collateralization in

the form of real assets (real estate, equipment & machinery)

Given that with the current monetary system, bank debt is unrepayable in aggregate, loan defaults are inevitable

Interest-based lending will, by design, lead to transfer of real

assets from the borrower to the lender, in the long run

Wealth inequality (in real terms) becomes prevalent

The prohibition of gharar

Literal meaning covers a number of negative elements

Deceit, fraud, uncertainty, danger, peril, or hazard that might

lead to destruction or loss
Technical meaning

uncertainty and/or ignorance of one/both parties in a

contract over the substance or attributes of the object of
sale, or doubt over its existence and availability at the time
of contract
All jurists agree that gharar should be avoided in commercial
exchange contracts
Prohibition of gharar

Indirect references made in the Quran

Conclusively prohibited by the Sunnah of the Prophet s.a.w.

Classical examples of gharar sale

Sale of fish still in the sea

Sale of birds in the air

Sale of unborn animals

The prohibition of gharar (2)

Rationale for the prohibition of gharar

To ensure full consent and satisfaction of the parties in a


Without full consent, a contract may not be valid

Full consent can only be achieved through certainty, full

knowledge, full disclosure and transparency

Gharar in commercial contracts may lead to injustice,

exploitation and/or enmity among contracting parties
Types of gharar

Gharar yasir (minor or slight)

Tolerated and will not invalidate a contract

Gharar fahish (major or excessive)

Not tolerated and may result in contract voidability

The prohibition of gharar (3)

Examples of gharar elements in sale contracts

Material ambiguity in specifications, attributes,

quantity or quality of object

Material ambiguity pertaining to price, mode of

payment and delivery

Non-possession of object
E.g. Selling item owned but stolen

Conditional sales, insertion of extraneous

stipulations that introduce uncertainty
E.g. Will sell if rain falls

The prohibition of gharar (4)

There are a number of situations where uncertainty

exists, but they are allowed exceptions to the prohibition
of gharar

The uncertainty is slight or trivial (gharar yasir)

Contract is unilateral or charitable (al tabarruat) such

as gift or bequest

There is a public need for the transaction or contract

(consideration of maslahah)
E.g. bay al salam, istisna

Risk (ghurm) inherent in productive economic


Risk (Ghurm) and Gharar

Risk (Ghurm)


in Islam

Allowed in Islam, as per

Islamic legal maxim Al
ghurmu bil ghunmi (no
risk no gain)

Hadith gharar sales

prohibited (e.g. selling
fish in the sea, birds in
the sky)


Inherent in productive
economic activities

Unnecessary, avoidable,
intentionally created

Common day

Risks of trading, doing

business, making

Not stipulating price or

product specification in a
sales contract


entrepreneurial spirit and

Exploitation for self

interest, can lead to harm
and injustice

The concept of iwad

Islam prohibits riba but permits sale (bay)

The element of iwad (equal countervalue) in sale

promotes a sense of equity and justice in the economic
transaction, differentiating it from riba
The Shariah requires all legitimate exchange to contain iwad

Every increase, which is without iwad or equal

countervalue, is riba [ Ibn al-Arabi ]
Components of iwad
Risk (ghurm)

Market risk price risk, holding costs, obsolescence

Work and effort (kasb)

Services or activities that value-add

Liability (daman)

Product liability borne by seller, in the event of defects

Examples of valid countervalue (iwad )

Possible sources of iwad

1. Risk (ghurmi) of trade or ownership (daman milkiyyah)

TV manufacturer undertakes the risk that he might

produce TVs that customers do not like and do not end
up buying

TV retailer faces the risk of unfavourable market price

movements - he might have to sell his products in stock
at a price which is lower than the cost or accept
inventory buildup which would eventually be costly
2. Effort (ikhtiyar) expended or expertise rendered

TV manufacturer adds value to the raw materials that

make up a television set by contributing effort in putting
the TV set together as well as providing the expertise on
how to put a TV set together
3. Liability in the event of product defect

When the TV retailer sells a TV set, he provides a

product warranty against defects

In the event that a particular TV set is defective, the TV

retailer will assume liability and bear some costs

Is there iwad in conventional banking?




Banks face risk of default on repayment (credit risk)


Credit risk is not inherent in the contract itself

Risk of default is present in all contracts

In the event of default, the bank has recourse (collateral,

punitive measures by authorities)

Contrast with market risk associated with trading

Risk is inherent in trading activity itself

If downside risk materializes (e.g. cannot sell goods at
profit), trader has no contractual or systemic recourse

Is there iwad in conventional banking? (2)




Bank expends effort to act as financial intermediary,

evidenced by its costs of operation (wages, overheads)

The bank charges for, and earns profit from, bringing

together deficit and surplus units

The bank is merely providing a service


Banks efforts do not value-add the product itself

Effort cannot validate an underlying transaction/activity

which is prohibited (e.g. gambling)

At most, the bank can justify fee-based revenue but not

interest-based revenue

If the bank is charging for the service of matching deficit

and surplus units, its return should not be a function of
the amount of financing

The bank does not act as agent for both deficit and
surplus units but contracts separately with them

Is there iwad in conventional banking? (3)



The product in a conventional loan contract is money

Physical defects in currency do not permanently diminish its
value as legal tender

E.g. a torn or badly-soiled note can be exchanged at the

central bank
Therefore, product liability is not relevant