But Allah has permitted trade and prohibited riba (usury, interest)
(Baqarah, 275)
Islamic Economics
and Finance
Hajj Maulid Makokha
Islamic University of Al-Madinah Al-Munawwarah
2017-01-07
INTRODUCTION
1.0.0 Preface
Islamic economics is a comprehensive and independent economic theory which defines
economic principles in accordance with Islamic law and taking into account, all aspects of
human life: the spiritual, material, social and political aspects et cetera.
Like many other economic systems, the Shari'ah aspires to attain economic ideals such as
efficient and equitable use of resources, full employment and satisfaction of basic human
needs such as food, shelter and clothing. However, it differs fundamentally from man-made
laws in defining the economic problem by adding a moral and religious dimension as part and
parcel of the problem.
In fact, whereas, the conventional economic systems are based on principles such as scarcity,
self-interest, opportunity, cost-benefit and free functioning, Islam on the contrary allows
human beings to exploit the world's resources to the best of their ability in a spirit of justice
and brotherhood towards human beings and putting in consideration that profit should not be
earned to the detriment of the environment. It also accepts the basic commitments of market
economy, such as the right of ownership of enterprise and a competitive environment. Allah
the exalted says what means:
“And to [the people of] Madyan [We sent] their brother Shu'ayb. He said, "O my people,
worship Allah; you have no deity other than Him. There has come to you clear evidence from
your Lord. So fulfil the measure and weight and do not deprive people of their due and cause
not corruption upon the earth after its reformation. That is better for you, if you should be
believers. ” (7: 85)
So, Islam adopts a more balanced approach and considers that material pursuits should have a
spiritual dimension and that economic activity shouldn't be a mundane bustle or competition
among people but a key and means to a fair growth through participation, thus avoiding the
self-interest and individualism of conventional economics.
The Islamic framework is also based on certain pivotal features such as the prohibition of
interest, the spiritual-material mix of success, the private-public mix of property ownership,
Zakat, Waqf (endowment), swadaqah (charity), hiba (gifts) etc. Islamic economics works on
the general rule (alqaida al-`amma or al-asl ) of permissibility of all businesses unless there is a
direct ruling and its impermissibility. Also, contracts and investments should only support
practices or products that conform to the rules and guidelines of the Shari'ah.
1.1.0 The Shari’ah framework
The Shari'ah represents the legal framework of Islamic religious law within which all aspects of
life let be the public or the private aspects are regulated. It is based on divine principles
revealed in Islamic sources that deal with many aspects of day-to-day life, including politics,
economics, business, family, and social issues. This clearly shows the holistic nature of Islam.
The key objective of the Shari'ah is to promote human welfare, represented in the
fundamental objectives of the Shari‟ah (Maqasidu-sharia) namely, the preservation,
promotion and the enrichment of Muslim faith, the preservation of human life,
preservation of human mind, the preservation and protection of posterity, and
preservation of wealth.
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For that purpose, the Shari'ah offers prominent well founded dimensions for economic
activity where justice is the supreme purpose. It aims at establishing an ideal society based on
justice, equity and virtue, where social security and peace are promoted, and where individuals
and organizations are encouraged to cooperate in all activities in accordance with moral values
in matters of goodness and prohibition from evil deeds and in solidarity with the needy and
the deprived people. Allah says:
Indeed, Allah commands you to render trusts to whom they are due and when you judge
between people to judge with justice. (4: 58)
He also says:
And let there be [arising] from you a nation inviting to [all that is] good, enjoining what is
right and forbidding what is wrong, and those will be the successful. (3: 104)
He also says:
And hold firmly to the rope of Allah all together and do not become divided. (3: 103)
He also says:
If you disclose your charitable expenditures, they are good; but if you conceal them and give
them to the poor, it is better for you, and He will remove from you some of your misdeeds
[thereby]. (2: 271)
And when the Prophet (peace be upon him) sent Muadh ibn Jabal to Yemen, he directed him
to call people to Laa ilaaha illallah, wa anna Muhammadan rusuulullah, then if they accepted
that and abided by it he then to call them to withhold the five daily prayers, and when they had
accomplished that, he was directed to take from the wealth of the wealthy and disburse it
among the poor people of the society.
These objectives constitute the material and spiritual welfare of the people in this world as well
as the Hereafter. This welfare lies in complete justice, mercy and wisdom. It doesn't only
include the economic development and growth, but also human brotherhood, socio-economic
justice, mental peace, happiness, family, as well as social harmony.
These elements of the welfare function of Islam are virtually impossible to quantify. In fact,
the Islamic concept of welfare differs fundamentally from prevailing notions elsewhere in
believing that economic welfare is merely a part of the total welfare of mankind. The
interaction of spiritual and material concepts is representative of inner unity of Islam and
economics and the social model derived from its being free from the selfish values developed
in other economic systems.
Accordingly, efforts to satisfy personal needs must harmonize with obligations to the family,
neighbours and society at large and must avoid malevolence to others. Individuals are even
expected to observe in their dealings with others a climate of justice and fair play (Al-Adl); and
to go beyond their minimum obligations to others; to excel in fulfilling their duties and
achieving the highest standards of benevolence, kindness and sacrifice for others (Al-Ihsan).
Indeed, Allah orders justice and good conduct and giving to relatives and forbids immorality
and bad conduct and oppression. He admonishes you that perhaps you will be reminded.
(16: 90)
Al-Adl and Al-Ihsan result in social equilibrium, since there can be no justice without a
delicate balance obtained among the many social, economic forces that shape the basic
structure of the Society.
1.1.1 The ownership of wealth
Islam has a unique dispensation on the concept of wealth, its ownership and distribution.
Wealth in Islam is not an end in itself, but a means to higher values.
O you who have believed, let not your wealth and your children divert you from
remembrance of Allah. (63: 9)
He also says:
Wealth and children are [but] adornment of the worldly life. But the enduring good deeds are
better to your Lord for reward and better for [one's] hope. (18: 46)
This is because man was solely created to worship Allah:
And I did not create the jinn and mankind except to worship Me. (51: 56)
Wealth should be earned, invested and spent in the correct avenues, and it should reward the
individual, his family, and the society as a whole. Its rewards also span this life as well as the
hereafter, where Allah will increase it and make it even better than what was spent by His
servant.
And whatever good you put forward for yourselves, you will find it with Allah, it is better and
greater in reward. (73:20)
According to the Islamic concept, wealth is considered as an endowment or a gift from God
and human beings are considered as trustees on God's resources on earth. These resources
are to be wisely treated, not abused, destroyed, wasted or left to idle. This dual ownership
mitigates the selfish and unfair tendencies that often result from a mistaken notion of absolute
ownership.
Believe in Allah and His Messenger and spend out of that in which He has made you
successors. (57: 7)
As a result, man is answerable in from of Allah in terms of how he earned his wealth and
where he spent it. The prophet (SAW) said:
“Man will not move both his feet on the Day of Judgement until he is asked of three things:
His wealth; where did he earn it, and in what did he disburse it. His life; in what did he
consume it. His teenage; what he did in it”.
And as it is clear, Islam doesn't oppose any material pursuit, neither is it against the
accumulation of wealth. The only concern it puts forward is the danger of obsessive
preoccupation in accumulating and conglomerating wealth to the extent of sidelining
spirituality and forgetting the main objective of his being created.
O you who have believed, let not your wealth and your children divert you from
remembrance of Allah. (63: 9)
On this, Islam has provided a broad foundation of the distribution of income and wealth to
avoid its accumulation. It does not advocate equal distribution of wealth in the sense that all
individuals should have the same means from livelihood, but it guarantees a process of
distribution where all participants in the marketplace are rewarded for being exposed to risk
and liability. Land, labour and capital jointly create value and the capital owner has to share in
the profit as well as in the loss.
And what Allah restored to His Messenger from the people of the towns - it is for Allah and
for the Messenger and for [his] near relatives and orphans and the [stranded] traveler - so that it
will not be a perpetual distribution among the rich from among you. (59: 7)
He also says:
Zakah expenditures are only for the poor and for the needy and for those employed to collect
[zakah] and for bringing hearts together [for Islam] and for freeing captives [or slaves] and for
those in debt and for the cause of Allah and for the [stranded] traveler - an obligation
[imposed] by Allah. (9: 60)
Besides, Islam compulsorily retains a share of produced wealth by paying the Zakat (Charity)
to the needy and other charitable deeds; and therefore spreads out wealth in the community
as it is evident in the previous verses. The institution of Zakat is not only a source of alleviating
the sufferings of the poor, but also provides an incentive to invest the surplus wealth in the real
sectors of the economy. Muslims are yet encouraged to voluntarily give part of their income as
a waqf for social economic welfares.
Moreover, the abolition of Riba prevents unfair lending schemes which penalize the poor and
allows for those possible alternatives of investment which distribute the return on capital on a
broader basis.
Finally, the law of inheritance in Islam ensures that accumulated wealth and large holdings
would be divided into relatively smaller fragments.
1.1.2 Islamic versus materialistic perspective
The primary difference between Islamic economics and all materialist ones is that that
economic well being is not viewed in Islam as the ultimate end of human life and cannot be
the true purpose of life. Economic endeavours become a delusion if human beings lose sight
of the real purpose in their pursuit. Instead Islam insists on the concept of human Welfare
that has both a material and spiritual dimensions.
But seek, through that which Allah has given you, the home of the Hereafter; and [yet], do
not forget your share of the world. And do good as Allah has done good to you. And desire
not corruption in the land. Indeed, Allah does not like corrupters." (28: 77)
In addition, unlike the materialistic perspective, the Shari'ah considers that the main economic
problem that mankind will ever face is that of distribution of wealth and not of production.
In the eyes of the conventional economics systems, there is relative scarcity of resources
available on the earth, and people's demands for these resources are endless. Hence
individuals and organizations should concentrate on more and more production. Whereas,
Islam makes a distinction between basic needs such as food, clothing and shelter, and
comfortable wants that are not necessities in life. It considers that there are enough resources
to satisfy the basic needs of each and every individual and to satisfy some of their luxurious
wants and that economic problem is that of distribution and not production.
It is He who created for you all of that which is on the earth. (2: 29)
Islam advocates specific regulations by which wealth can be acquired, used and disposed of. It
is through that specific economic system that economic justice in society is maintained.
In the Islamic perspective, there are people who acquire wealth by engaging in the production
process and others who have an indirect access to wealth in the form of Zakat, Waqf,
inheritance, etc. which are given to the poor, the needy and later generations.
Notwithstanding this, Islam gives full incentives to individuals to fully participate in the
economy and it does not impose a maximum on the total of wealth that individuals or
organizations can own. Rather, it controls the means of ownership such that everybody gets
the right to wealth in a just manner. Through these ownership principles, Islam guarantees
that everyone gets what is rightfully due to him from God, unlike the capitalist system where
only those who take part in the production process have the right to wealth.
Additionally, Interest rates form the backbone of the capitalist system in many fields. It is used
as a tool to regulate economic growth and monetary supply by acting as an incentive for those
who have surplus money to save. In Islam interest is prohibited; Investment, according to the
Shari'ah, should offer individuals the opportunity to profit, not by lending at a guaranteed rate
of return, but by sharing in ownership, and thus committing to share in the risks associated
with ownership. The abolition of Riba avoids inequitable lending transactions which penalize
the deprived part of the society. By this means, Islamic economics seeks to provide for a just
and equitable distribution of wealth and aims at re-establishing a socio-economic balance, with
a clear bias in favour of the poor and the needy.
O you who have believed, fear Allah and give up what remains [due to you] of interest, if you
should be believers. (2: 278)
1.2 The Islam Economic System
Islam and socio-economic justice
The Shari'ah has laid down certain principles and limits for the economic activity so that the
entire framework of production, trade and distribution of wealth may conform to the Islamic
standard of justice and equity.
According to the Islamic perspective, God has created for mankind the earth and all its
resources. It is, therefore, the legacy of every human being to try to secure his share of this
world's wealth. The role of humankind is no more than that of caretakers. This concept of
dual ownership between human being and God is one of the special features of the Islamic
economic system. While, the personal right to own is protected and endorsed by Islam, the
Shari'ah tempers human ownership by the understanding that everything belongs to God.
What appears to be ownership is in fact a matter of trusteeship, whereby man has temporary
authority to handle and benefit from goods.
Believe in Allah and His Messenger and spend out of that in which He has made you
successors. (57: 7)
In addition, Islam aims at striking a balance between the individual and the community. In
fact, the Islamic framework has adopted a fair approach which promotes individual freedom
and at the same time ensures that such freedom is positively contributing to the welfare of the
community as a whole. This perspective is based on the maxim that:
It is legally allowed to bear the pain of a minor damage in order to prevent the occurrence of a
major damage.
Accordingly, the individual has freedom of enterprise and competition within an atmosphere
of morality, fairness and social harmony and where participants should be just and kind to one
another. The prophet (SAW) said:
Hakeem ibn Hizaam (may Allah be pleased with him) said: The Messenger of Allah (blessings
and peace of Allah be upon him) said: “The two parties in a transaction have the option (of
cancelling it) until they part. If they are honest and disclose any defects, their transaction will
be blessed, but if they lie and conceal defects the blessing of their transaction will be
erased.” (Narrated by al-Bukhaari (1973) and Muslim (1532)
Besides, there is great emphasis in Islam on social and economic justice. This justice is
possible only when all sections of society can fulfill their economic needs. Therefore, even
people who are unable to take part in the economic competition and those who need help to
get started in it should have their chances to exist as well. The goals of socio-economic justice
and equitable distribution of income and wealth are integral parts of the moral philosophy of
Islam. The poor and the needy are entitled to a share of the society's wealth. Thus, Zakat has
central importance in Islamic society. Everybody is permitted to accumulate wealth that is left
over after meeting one's legitimate and reasonable commitments and after giving a percentage
of one's income to charity. Another major tool for achieving socio-economic justice is the
prohibition of Riba to avoid any unfair advantage in exchange dealings between parties.
And He it is who causes gardens to grow, [both] trellised and untrellised, and palm trees and
crops of different [kinds of] food and olives and pomegranates, similar and dissimilar. Eat of
[each of] its fruit when it yields and give its due [zakah] on the day of its harvest. And be not
excessive. Indeed, He does not like those who commit excess. (6: 141)
1.3 Prohibition of Riba, Maysir and Gharar
1.3.1The rationale of prohibition of Riba
Riba in its simplest term is an advantage to one party at the expense of another for no
appropriate consideration (1). Riba, which means not only usury, but all forms of unearned
income, has been strictly prohibited by Islam. Although the Qur'an did not specify any
particular kind of riba, Muslim scholars have categorized it in two types: riba al-nasi'ah, and
riba al-fadhl. Riba al-nasi'ah, also known as riba by virtue of deferment (2), is the interest
charged on loans; its prohibition essentially implies that the fixing in advance of a positive
return on a loan as a reward for waiting is not permitted in Islam. Or say it is a type of riba that
exists in, or results from, a sale transaction which unduly benefits one of the counterparties in
the form of a surplus or extra amount due to delay of delivery of his side of the transaction.
Riba anasiah involves two types (3):
Increasing the debt on the insolvent person (by way of an interest rate). This is the origin of
riba which used to be practices in the Pre-Islamic Period of Ignorance. It means that a person
owes another person a sum of money that is to be paid at a certain time. So, when it is time
for paying back, the creditor gives the debtor the option either to pay the debt or allow him
much time in return for an interest on the borrowed sum. Therefore, if the debtor chooses
not to settle his debt, the creditor prolongs the period of payment against an interest, which
thereby results in the excessive increase of the debt. Allah prohibits this kind of dealing, and
instead he urges the creditor to give the debtor a grace period in case he is in hardship, hence
unable to settle the debt. We also understand from the prohibition that in case the debtor is
rich, then he only has to pay the borrowed sum without any increase.
And if someone is in hardship, then [let there be] postponement until [a time of] ease.
(2: 280)
1) It refers to the riba taken through selling usurious goods of the same type but with delayed
delivery. An example of this case is like when a trader exchanges gold for gold but one of
the parties doesn‟t receive his commodity on the spot.
“Gold for gold, silver for silver, wheat for wheat, barley for barley, dates for dates, and salt
for salt, like for like, equal for equal, hand-to-hand, if the commodities differ, then you may
sell as you wish provided the exchange is hand-to-hand.”
More specifically, riba al-nasi'ah arises in loan transactions (on the basis of future repayment of
more than the principal) as well as sale transactions (on the basis of deferred price). An
example of loan-based riba al-nasi'ah would be a loan with $1,000 principal on which $1,200 is
to be paid next year. An example of sale-based riba al-nasi'ah is a sale of 100 kg of dates to be
paid back with 120 kg six month later.
This type or riba is clearly forbidden in Qur'an. It existed in the pre-Islamic era in the Arabian
Peninsula, and thus was known as riba al-jahiliyah (riba of the era of ignorance).
Riba al-fadhl is the excess over and above the loan paid in kind. It lies in the payment of an
addition by the debtor to the creditor in exchange of commodities of the same kind.
(1) Anonymous: An introduction to Islamic finance, p11
(2) Anonymous: An introduction to Islamic finance, p11
(3) Swalih Al-Fawzan: A summary of Islamic Jurisprudence, Special Edition for Al_-daawah
foundation, Al-Maiman Publishing House, Saudi Arabia, Riyadh, 2005, v2, p39
“Gold for gold, silver for silver, wheat for wheat, barley for barley, dates for dates, and salt
for salt, like for like, equal for equal, hand-to-hand, if the commodities differ, then you may
sell as you wish provided the exchange is hand-to-hand.”
The Shari'ah wishes to eliminate not merely the exploitation that is intrinsic in the institution
of interest, but also that which is inherent in all forms of unjust exchange in business
transactions.
Despite the fact that interest occupies a central position in modern economic system and that
it became the very life blood of the existing financial institutions, Islam considers that the
principle of charging interest is quite opposite of that of business in the spirit of sharing and
cooperation and that lending on interest is not as a business in the real sense.
In legalizing trade and condemning interest, Islam considers that there are fundamental
differences between the nature of profit resulting from interest charges and that earned by
trade. In interest-based transactions, there may be no equitable division of profit between the
buyer who makes a profit on the sale of good purchased, and the seller who derives a profit in
consideration of the labour and time spent in procuring the goods. Moreover, there could be
no end for an interest-based transaction, since there could always be interests of unpaid
interests as long as the principle amount loaned is not fully returned. This could, in extreme
cases, create un-repayable debt for generations.
The rationale for the prohibition of interest the Islamic economic framework highlights how
the risk-reward sharing would be more conductive to the realization of equity and the
promotion of entrepreneurship. In fact, the interest-based banking system relies heavily on
collateral and gives inadequate consideration to the strength of the project or the ultimate use
of the financing. Even though collateral and cash flow are indispensable for ensuring
repayment of loans, giving them undue weight result in a relative misestimating of the purpose
for which borrowing takes place. Hence, that system tends to enforce the unequal distribution
of capital by allocating financial resources mainly to the rich, who have the collateral and cash
flow.
Islam considers even interest-based loans taken for investment in a productive activity as not
equitable because in the profits that may accrue from it is not required to be known forehand
and if there is a loss, the entrepreneur has to bear the entire loss in spite of all the risk and
engagement he took, whereas the money lender, who did less sacrifice than the entrepreneur,
gets an effortless profit determined by a positive rate. In Islam both risks and rewards should
be shared by the different parties.
And since the unrestricted power of the creditor to make profit from interest has no regard to
the financial ability of the debtor to repay indebtedness, middle-class consumers, as well as the
developing countries, could be caught up in a never-ending debt-trap. And because the Riba
system encourages living beyond one's means for both individuals and governments, it results
in an accentuation of macroeconomics, inflation and external imbalances in addition of
squeezing the resources available for development. This leads some poorer countries to the
over-exploitation of their earth's resources and thus to the destruction of the ecological system.
Moreover, the high degree of interest rate volatility in the modern economies injects great
uncertainty into the investment markets and makes it difficult for entrepreneurs to have a longterm investment vision and to make their decisions with confidence. This turbulence in the
financial markets and the rise to fictitious assets tend to aggravate economic instability.
1.3.2 The prohibition of Gharar and Maysir
The Arabic word Gharar is a fairly broad concept that literally means deceit, risk, fraud,
uncertainty or hazard that might lead to destruction or loss. Gharar in Islam refers to any
transaction of probable objects whose existence or description are not certain, due to lack of
information and knowledge of the ultimate outcome of the contract or the nature and quality
of the subject matter of it. For example, the Prophet (pbuh) has forbidden the purchase of the
unborn animal in the mother's womb, the sale of the milk in the udder without measurement,
the purchase of spoils of war prior to distribution, the purchase of charities prior to their
receipt, and the purchase of the catch of a diver.
Islam has clearly forbidden all business transactions, which leads to exploitation and injustice
in any form to any of the parties of a contract. It seeks protecting the different parties from
deceit and ignorance by forbidding gharar in any commercial exchange contracts that are not
free from hazard, risk or speculation about the essential elements in the transaction to either
party, or uncertainty of the ability of one party to honour its rights and obligations. It requires
that all Islamic financial and business transactions must be based on transparency, accuracy,
and disclosure of all necessary information so that no one party has advantages over the other
party.
The rationale behind the prohibition of Gharar is to ensure full consent and satisfaction of the
parties in a contract. Full consent can only be achieved in full disclosure and transparency and
through perfect knowledge from contracting parties of the counter values intended to be
exchanged. The prohibition of Gharar protects against unexpected losses and the possible
disagreements regarding qualities or incompleteness of information.
Instead, the Shari'ah promotes the principle of profit-loss sharing between banks and
entrepreneurs as an approach to encourage the spirit of brotherhood and cooperation in
business relationships. Mutual risk-sharing could help absorbing the weight of loss by sharing
it equitably between all parties. However, risk and uncertainty are conditioned by enough
adequacy and accuracy of information to make reasonable estimates of the outcomes.
Tolerable risk and uncertainties cannot exist in contractual obligations.
Notwithstanding the prohibition of gharar in trade transactions, there are several cases in
which gharar is overlooked, and not considered:
(1) Where the transaction has too small gharar. The Shariah overlooks the prohibition
when gharar is small, hence it cannot invalidate the transaction. An example of this is
in the case of public toilets where people who use them, use them in different degrees
as concerning the time spent and water usage. But this is termed as small gharar and it
is overlooked upon by the Shariah.
(2) When gharar itself is a matter of public need. This means that many people should
not be in need of the situation in which there is gharar. Hence, if it becomes a matter
of public need, then that gharar is overlooked upon by the Shariah, and it becomes
what scholars call a “necessity”. Sheikh Islam says concerning this type of gharar:
“And the law does not prohibit upon people what they are in necessity of trading with,
because of a type of gharar in it, instead, it allows them from it what they are in need
of”. An example of this is that the law prohibited the sale of fruits until they show their
ripeness, but it has allowed their sale when they redden or become yellow. Allowing
sale at this point is something of public need, but still there is a probability that some
of the fruits will not yet have ripened, which is considered to be gharar, but the law has
overlooked upon this type of gharar because it is a matter of public need.
(3) When gharar cannot be avoided but with great difficulty. And if this is the case, then
this type of gharar is overlooked upon. An example of this is the case of buying a
house or a pregnant animal. The buyer does not exactly know how the foundation was
built; he also does not know if the embryo will be male or female, is it alive or dead et
cetera. Also in the case of selling fruits when they start ripening, it is not clear whether
they will all ripen at the harvesting time. But the Shariah has overlooked at this type of
gharar because it cannot be a avoided except with great difficulty. This is because the
buyer cannot dig into the foundation to see how good it was built, nor can he split
open the belly of the animal to confirm the status of the embryo, in fact, the outcome
of doing so will be more hazardous than if he had bought the items with their gharar
status.
(4) That gharar should not be in non-exchange transactions. Gharar is only considered
when it occurs in exchange transactions. But if the transaction is non-exchange
transactions like gifting, endowment et cetera, then gharar here is overlooked. This is
the view taken by Imam Malik and preference of Sheikhul-Islam ibn Taymiyya. Other
scholars have a view that gharar is also prohibited in non-exchange transactions but
there evidences on the matter have been overweighed by the strong evidences held by
Imam Malik and Sheikhul-Islam ibn Taymiyya. And an example of an overlooked
gharar in non-exchange transactions is like when Zaid gifts someone by saying: “I have
gifted you all that is in my pocket”. Here, we do not know how much is exactly is in his
pocket. But this case is valid because gifting is not a bilateral trade, i.e it is not an
exchange type of trade.
Islam has also categorically and firmly prohibited all forms of gambling. Maysir and Qimar are
forms of gambling transactions that are considered as totally inequitable in Islam. Maysir refers
to the easy acquisition of wealth by chance, whether or not it deprives the other's right. Qimar
means the game of chance in which one gains at the cost of others.
“They ask you about wine and Maysir (gambling). Say, "In them is great sin and [yet, some]
benefit for people. But their sin is greater than their benefit." (Baqara, 219)
Even though, gambling consists in a form of speculation and that there should not be any
place for commercial operations in Islam as it is purely speculative. The prohibited
speculation under the Shari'ah is not that which relies on the analysis of a lot of economic and
financial data and which involves the investment of assets, skills and labour. Rather, it is one
involving an effortless gain similar to a gambling scheme or activity. This is because the buyer
is engaged in a transaction aimed at making profit through trading and not through dishonest
appropriation of the property of others.
1.4 Financial intermediation
1.4.1 Islamic Banks as financial intermediaries
Financial intermediaries are economic agents who specialise in the activities of buying and
selling (at the same time) financial contracts (loans and deposits) and securities(1) (bonds and
(1) Securities (also called financial instruments) are financial claims on their issuer’s future income or assets.
They represent financial liabilities for the individual or firm that sells them (borrower or issuer of the
stocks/shares) (1).The fact that Shari'ah strictly prohibits interest-based transactions does not
imply that it excludes financial intermediation. In fact, Islamic banks form a part and parcel
and interconnecting medium of the Islamic developmental framework. This intermediation
seeks to enhance the efficiency of the saving/investment process by eliminating the
mismatches in the requirements/availability of financial resources of borrowers/entrepreneurs
and the disparity in risk preferences between small savers and entrepreneurs.
The intermediation function of Islamic banks is very important. They are responsible for
identifying good projects for financing as well as for monitoring their progress and ensuring
proper accounting and auditing. But as an intermediary, they should play no part in managing
the project or in making policy decisions that is the exclusive domain of the entrepreneur.
This allows them to have a factual picture of the health of the projects in where they invest.
Besides, the profit-sharing principle being in the core, the Islamic financial model puts justice
and fairness in the midpoint of this intermediation since it contributes to a more equitable
distribution of income and wealth. This is not the case of debt-financing model that penalizes
entrepreneurship by obliging it to return the principal even when part of it is lost due to
circumstances beyond the entrepreneur's control. Besides, when a project fails and a business
person defaults, the financial intermediary must also default, and the ripple effects destabilize
the whole system. Islamic finance is more efficient in that it allocates funds on the basis of the
productivity of projects rather than on the criterion of the creditworthiness of project holders.
In addition, by applying general Shari'ah precepts, Islamic banks also aim to contribute
towards the economic development of the countries wherein they operate. By creating an
environment which would draw more funds for Musharakah /Mudarabah-based financing of
productive projects and by investing in real-sector businesses, implementing trading, leasing,
real-estate related contracts and using Islamic modes of financing that avoids interest and
speculation, Islamic banks lead to increases in production and employment and therefore
become agencies of sustainability of the socioeconomic order as much as they are investment
oriented financial intermediaries.
The PLS modes used by Islamic banks could be applied for project financing, import/export
financing, working capital financing and for financing of more specific transactions in short,
medium, and long-term. Socio-economic projects, such as infrastructure projects, could also
be developed on this principle. Banks could use a form a consortium or issue certificates to
the public for subscription if they need large amounts of money.
The PLS mode of financing could be complemented by non-PLS modes to provide flexibility
to meet the needs of different sectors and economic agents in the society. This could be done
through trade, Ijara and leasing or via other techniques such as Murabaha and Salam that
could help in job creation and liquidity needs fulfilment. These mark-up modes put side by
side with a profit-sharing system contribute to the growth of micro / SME sectors, to capital
accumulation in the economy and to the alleviation of poverty.
financial claim) in return for money and financial assets for the buyer (lender or investor in the financial
claim). By definition, therefore, the sum of financial assets in existence will exactly equal the sum of
liabilities. M. Buckle, E. Beccalli (2011): Principles of Banking and Finance, University of London
International Programmes, University of London, United Kingdom, London, p17.
(1) M. Buckle, E. Beccalli (2011): Principles of Banking and Finance, University of London International
Programmes, University of London, United Kingdom, London, p18.
1.5 Shareholding in Islam
Shareholding in Islam
It is permissible for a Muslim from the Shari'ah point of view to buy and sell ordinary shares
and benefit from dividends of a company that it is not involved in the manufacture or sale of
non-Islamic goods and whose business is not based on interest or gambling. However, there
are some objections among some Muslim scholars about the purchase of non-Muslim
companies' shares, on the ground that these companies borrow money on interest from
conventional banks and other financial institutions, though most opinion tend to consider that
in these cases interest is paid rather than received, and so the element of interest is not
included in the companies' profits. And even the amounts, that may be receivable from
interest accounts, are generally very small in comparison with the total profits and therefore
rather insignificant. In addition, buying and selling non-Muslim company shares is a crucial
channel where Islamic financial institutions should be involved to strengthen their activities
and diversify their offers. Dealing exclusively with Muslim companies or dealing with nonMuslim institutions on their own terms only necessitates Islamic banks to acquire an important
maturity and a significant level of development.
Besides, it is very rare in the contemporary stock markets to find companies in full conformity
with Shari'ah, in fact almost all the companies quoted in stock markets, even those whose
main business can be considered as halal, either borrow money on interest, keep their surplus
in an interest bearing account or purchase interest bearing bonds or securities. Some Muslim
scholars consider that it is not allowed for a Muslim to deal in the shares of such a company,
even if its main business is halal because as a shareholder of that company he becomes a
partner and thus an agent for the other partners in all aspects of the business. For that reason,
the purchase of a share of a company can represent an authorization from the shareholder to
the company to carry on non permissible transactions in its business. Moreover, when a
company is financed on the basis of interest, its funds employed in the business are impure,
and the impure interest received on its deposits and will be distributed to the shareholders
through dividends.
However, a large number of contemporary Shari'ah experts does not consider a joint stock
company as a simple partnership period. While all the policy decisions in partnership are
taken by the consensus of all the partners, the policy decisions in a joint stock company are
taken by the majority which overrule the opinion of an individual shareholder. Hence a
shareholder cannot be responsible of each and every action taken by the company, especially
if he unsuccessfully opposed to a particular action in an annual general meeting. Therefore,
Muslims are allowed to buy shares of a company engaged in permissible business activities,
but, which keeps its surplus money in an interest-bearing account, wherefrom a small
incidental income of interest is received.
1.6 Islamic Commercial Contracts
1.6.0.1 Introduction
A Contract in Islam is an engagement and agreement between two or more parties in a legally
accepted, impactful and binding manner. Islamic commercial law consists of many different
types of contracts to suit different needs and circumstances; the legal relationship in these
contracts involves a bilateral declaration from which flow legal consequences with regard to the
subject matter (muthman) and the price (thaman). This constitutes the actual transactions that
create liabilities and rights of the parties.
A Contract from an Islamic legal perspective is theoretically divided into two main classes,
namely unilateral and bilateral contract. While the former comprises of a transaction in favour
of the recipient normally called contract of irfaaq (doing good and ease to the other party)
such as Hadiah or Hibah, Ibra, Wasiyyat, Waqf and Qard, the latter normally called contract
of mu‟awadhwa (contracts of compensetion), is more bound to strict rulings and guideline
since it requires the consent of both the parties to a contract. It covers all other permissible
commercial transactions, such as contract of exchange that primarily concerns bay‟i (trading
i.e. buying and selling activities), contract of Security that deals with Kafalah, Rahn and
Hawalah, contract of partnership(companies/sharikah), contract of safe custody (wadia'h) and
contract pertaining to do a work such as Wakalah and Ju'alah. Also what is normally tolerated
in a unilateral contract would not necessarily be the case in a bilateral contract.
This classification is not meant to be exhaustive because contracts could be classified in
different categories with respect to their impact, effectiveness and validity. With respect to
validity, contracts are categorized as Valid, Void or Voidable. In fact, a contract would be
deemed valid if all its elements are found in order and all conditions have been met and if it
doesn't imply prohibited activities such as Riba or Gharar. It would be void if one of its major
conditions is not fulfilled. And it would be voidable, if conditions of lessor importance, such
as specifications of the subject matter, are not fulfilled. Contracts that involve prohibited items
or that are structured in a way that is illegal may in certain circumstances be rectified by
removal of the objectionable clause to make the contract valid. However, the underlying
principle in contracts, in Islamic commercial law, is permissibility and validity. Any contract or
stipulation is prohibited and void only if there is an explicit rule in the Shari'ah proving its
prohibition and voiding.
Most scholars are of this opinion; moreover there is a consensus of scholars on the
permissibility and validity of trade transactions, except for the case of Dhwahiriyya who have a
contradicting opinion on this.
Allah the Glorified says:
O you who have believed, fulfill [all] contracts. (5:1)
And this supports that it is allowed to fulfil all transactions and contracts, let they were in the
time of the prophets or not.
He also says:
Say, "I do not find within that which was revealed to me [anything] forbidden to one who would eat
it unless it be a dead animal or blood spilled out or the flesh of swine - for indeed, it is impure - or it
be [that slaughtered in] disobedience, dedicated to other than Allah.(6:145)
And here it is very apparent that anything outside these prohibited items it not part of the
prohibition.
Allah also states that He has already explained to us what He has forbidden upon us:
And why should you not eat of that upon which the name of Allah has been mentioned while He has
explained in detail to you what He has forbidden you. (6:119)
The prophet (swalallahu alayhi wasallam) was reported to have said:
The greatest in sin among people is that who asks about something not prohibited and hence
it becomes prohibited as a consequence of his asking.
This shows clearly that all contracts and transactions are valid and legal unless those that have
been already prohibited.
Contracts with respect to legality could be classified into five categories: prohibited (Haram),
reprehensible/detestable (Makruh), indifferent/permitted (Mubah), meritorious (Mustahab)
and obligatory (Wajib).
Contracts in Islam could also be classified as commutative or non-commutative: In
a commutative contract, one party could validly be remunerated or compensated in
consideration of what is done or given; like sale, purchase and lease. Whereas, in a noncommutative contract, there is no return or compensation as it is the case for Qard, Hibah,
Kafalah or Hawalah. Commutative contracts could be considered as void if they include any
void condition. While non-commutative contracts do not become void because of a void
condition such as Gharar; the void conditions itself become ineffective.
Although contracts in Islamic law of transactions are classified into different categories, the
basic contract essentially requires the existence of two or more parties, mature and sane, which
must be capable of entering into contracts; the existence of an offer and acceptance which
have to be with free mutual consent; a subject matter that should be in principle legal, existing,
valuable, usable, capable of ownership/title, capable of delivery/possession, specified and
quantified and the seller must have its title and ownership; and lastly, the contract must be free
from any prohibited activity and not contradict any statutory or common law rule.
Some scholars classify these conditions in a more clear way; that is grouping these conditions
as those related to the traders (buyer and seller) and those related to the commodity. Those
related to the traders are:
Offer and acceptance: They are any means used by the traders in a trade transaction that
expresses their consent. Offering is normally from the buyer‟s side while the acceptance is
normally from the seller‟s side. Scholars have classified offer and acceptance in two main
types: Verbal or anything that can represent it like writing or sending an agent. The practical
mode, where the traders show their consent by means of action without necessarily talking to
each other. An example of this is when a buyer enters a shop and picks a commodity that has
been specified its price, gives the clerk the specified price and leaves without a word. This can
be done when buying small things like sweets, bread, clothes or complicated things because
there is no difference. It is a condition that the offer equals the acceptance in all dimensions
like quantity, quality, specifications, the time of delivery...et cetera. So, when a seller tells a
buyer that "I have sold you this cloth for $15" and the seller says "I have accepted it for $10",
the contract is deemed not to have been sealed. It is also a condition that both offer and
acceptance are done in one session. Consequently, when one trader tells the other "I have sold
you this cloth for $15" and they part without the other party showing his acceptance, then the
contract is deemed not to have been sealed.
1.
Mutual consent: Where a trade transaction is deemed void if either the seller or buyer is
unjustly forced to conclude it.
O you who have believed, do not consume one another's wealth unjustly but only [in lawful]
business by mutual consent. (4:29)
Moreover, the prophet (PBUH) said:
“Selling and buying should be only by mutual consent.”(Ibn Hibban, Ibn Majah and others)
However, a transaction concluded through just compulsion is deemed valid, as in the case
when the ruler (or the one in authority) forces a bankrupt person to sell his remaining
property in order to pay off his debts.
2. Being free (not a slave), having reached puberty, being legally accountable, and being sane:
so, a trader‟s transaction becomes invalid if either of the seller or the buyer is a minor who
cannot distinguish things and does not know the consequences of a transaction, a foolish or
weak minded person, an insane person, or a slave who has not taken permission from his
master to conclude the transaction. The prophet (PBUH) said:
“Allah has waived the pen upon a minor until he reaches puberty, and upon an insane person
until he regains his senses, and upon a person asleep until he wakes up.” (Al-Bukharii)
A transaction concluded by a minor or a foolish or weak minded person who can distinguish
things and know the consequences of a transaction is deemed valid but cannot be executed
without the permission of their guardian in that specific contract.
3. Ownership (of the commodity or money): one is not allowed to sell something that is
not owned by him or has not been allowed to sell it by the owner.
Hakim ibn Hizam relates that the prophet (SAW) commanded him “Not to sell what he
does not own or what he does not have.” (Ibn Majah and Tirmithii who deems it a
swahih hadith)
And the following are the conditions that relate to the commodity:
1. Being absolutely lawful to use: It is impermissible to sell whatever is prohibited for a
Muslim to make use of, or that which does contradicts any statutory or common law
rule such as intoxicants, pork, musical instruments, and dead animals. The commodity
should be valuable and legally usable. The prophet (SAW) said:
“Allah and His Messenger prohibited the trade of intoxicants, dead animals, pigs and idols.”
(Al-Bukharii and Muslim)
He also said:
“Allah prohibited intoxicants and their (gained) prices, dead animals and their prices, and pigs
and their prices.” (Abu Dawd)
It is also illegal to sell an impure (najs) commodity or the ones affected by impurity
(mutanajjis)and cannot be cleaned. The prophet (PBUH) said:
“When Allah prohibits something, He prohibits the price paid for it.”
Also Al-Bukharii and Muslim related that the prophet (PBUH) was asked:
“O Allah’s Messenger! What about the fat of dead animals, for it is used for greasing the boats
and hides, and people use it (as oil) for lamps? He (PBUH) relpied, “No, it is haram
(prohibited)””
2. Availability of the price and the commodity when the trade transaction is concluded),
for any unavailable commodity is considered nonexistent and is illegal to be sold. The
commodity must be owned by the seller (except in the case of salam as we shall see)
and be that capable of ownership regarding the buyer, capable of delivery. For
example, it is illegal to sell a fugitive slave, a runaway camel, or a bird in the air.
3. The price and the commodity must be known to both traders in a way that prevents
future disagreements. This can be through seeing it or through clearly and fully
specifying its qualities and quantities, for any hiding is regarded as fraud (gharar) which
is prohibited in Islam. Thereupon, it is invalid for the buyer to buy something he does
not see or recognize, and for him to sell an animal embryo in its mother‟s womb or
milk in udders, separately. It is should also be noted that the contract should end with
the parties owning the exchanged items eternally.
1.6.0.2 Permission of Bai' and prohibition of Riba
Trade has been a morally acceptable activity in all civilizations since the earliest times and all
religions approved of it. In Islam, a great deal of emphasis has been placed on trade (Bai') as a
recommendable source for the acquisition of wealth. However, Islam distinguishes any
increase generated from Riba from the increase in one's wealth as a result of trading. In fact,
while both trading and Riba based activities generate return and increase in capital, the profit
in Bai' is permitted, and the increase in Riba is forbidden. Therefore, the rules of trading
should be identified to make trade transactions different from Riba-based transactions.
But Allah has permitted trade and prohibited riba (usury, interest). (Baqarah, 275)
Trade in Islam covers sales on credit as well as sale for cash price. It also covers sale of a
commodity to be delivered in future against price to be paid in cash, on the spot. While, Riba
comes from the benefit that the debtor has to pay a return to the creditor along with the
principal amount regardless whether this return is a fixed or a variable amount, not
considering whether it should be paid in advance or on maturity, and even if it is a service
received as a condition for loan. Therefore, there is a significant difference between the trade's
profit and Riba, since the former is the result of real investment and economic activity that
creates value and in which the business risk is allocated more evenly among all involved
parties. Whereas, in Riba-based operations reward is guaranteed to only one party and the
business risk is not evenly shared. For all this reason, Riba-based transactions do not fulfil an
important Shari´ah principle that associates profit to business risk and it does not conform to
the principle that the earning of profit should be legitimized by engaging in a productive
economic activity and thereby contributing to development of resources and society. In
addition, trade is subject to profits as well as losses. That implies that even the recovery of the
capital invested in trade is not assured. A Riba-based transaction, on the other hand, ensures
the recovery of capital and seeks a positive return. Also, profits in trade are not predetermined
as regards to their size, even in the case of a credit sale, unlike interest whose size is part of the
contract. This is contradictory to the Shari'ah principle that stipulates that a definite return for
example would be considered unfair and unlawful.
1.6.0.3 Exchange in Bai' versus Loan
The main contract of exchange in Islamic commercial law is the contract of Bai'. Bai' involves
an exchange of one thing with another; one thing being the subject matter (muth-man) and the
other being the price (thaman). Transactions in Bai' require the transfer of complete and
instant ownership of the commodity at the time of sale/purchase and the transfer is irreversible
once executed. In the case of loans, there is a temporary but complete transfer of ownership
of the loan amount or the object, along with usufruct and the ownership of the commodity
which is money is transferred for specified period and exactly its similar (equivalent) has to be
paid back.
However, not all types of exchange' contracts are necessarily permissible, as those which give
rise to Riba are unanimously prohibited by Islamic law. As such, the contracts of interestbased loans are excluded from the definition of valid Bai´. For that reason, instead of dealing
in Riba-based operations, Islamic banks undertake a number of transactions for conducting
real sector business, by serving as intermediaries and getting a return in the form of trade
profit, lease rentals or profit from partnership based operations.
In addition; in Islamic loan transactions, instead of loaning the buyer money to purchase the
good, banks might buy the good itself from the seller, and resell it to the buyer at a profit,
while allowing him to pay the bank in installments. Banks also provide financing facility on the
basis of Mudarabah, Musharakah partnerships and create debt by way of trading and leasing
operations to earn a profit; these financial transactions should be associated with productive
economic activity.
1.6.0.4 Options to rescind a contract of sale
A sale is an exchange of an asset for another or the exchange of an owned commodity for
another in return for money or by barter. Both the buyer and seller may be given an option to
cancel a transaction during a given period after conclusion of that transaction. This concept is
known in the Shari'ah under the caption of Khiyar, meaning to exercise the option to rescind
the sale or to finalize it. Such option stipulation can be reserved by either of the parties. This
gives the party that is disadvantaged of the necessary facts and information at the time of
entering into the contract, the option to cancel the contract within a specified period. Some
have used Khiyar as the theoretical basis for modern day Islamic option products.
Although, all Muslim Jurists agreed about the validity of the concept of Khiyar, they
differentiated between various types of options:
1. Khiyar-al-Shart: Any of the parties would have option to rescind the sale within an agreed
period of time. If the buyer exercises this option, then the seller is required to refund the
price, if taken. Even when a sale is duly concluded, it still may not be absolutely binding on
the parties involved if the condition of option is stipulated in the contract.
2. Khiyar-e-Majlis: The parties have the right to withdraw from a contract as long as the parties
do not leave the place of contract.
3. Khiyar-e-Naqdh: The seller has the right to cancel the contract if the buyer does not make
payment at the specified date.
4. Khiyar al ´Aib: The buyer could dissolve the contract if one of the goods is found defective,
the defect was not brought into notice by the seller at the time of contract and the defect
caused visible decrease in value of the goods.
5. Khiyar al Ro'yat: The option of inspecting the goods and return them if they don't concord
to their specification in the contract.
6. Khiyar al Wasf: The parties have right to exercise this option in case of the absence of a
desired quality in the sold or exchanged goods.
7. Khiyar al Ghabn: The buyer could cancel the sale if the seller has sold the goods at price far
higher than the market price.
8. Khiyar al Tayin: The buyer can make a selection of goods out of the available stock in a
stipulated period.
Hakeem ibn Hizaam (may Allah be pleased with him) said: The Messenger of Allah (blessings
and peace of Allah be upon him) said: “The two parties in a transaction have the option (of
cancelling it) until they part. If they are honest and disclose any defects, their transaction will
be blessed, but if they lie and conceal defects the blessing of their transaction will be
erased.” (Narrated by al-Bukhaari (1973) and Muslim (1532)
1.6.1 Valid sale transactions
Transactions in Islam could be classified in five categories with respect to their legality:
prohibited (Haram), reprehensible (Makruuh), indifferent (Mubah), meritorious (Mustahab),
and obligatory (Wajib). Islam recommends avoiding reprehensible transactions and
encourages meritorious acts; indifferent acts (Mubah) are Shari'ah neutral. While, prohibited
activities have to be avoided in every respect, obligatory acts must be carried upon and never
to be ignored;
And whatever the Messenger has given you - take; and what he has forbidden you - refrain
from. (59: 7)
However, the underlying principle in Islamic contracts is permissibility and validity. And since
most of the new banking and financial transactions did not even exist as such when classical
law held sway, any of these transactions would be considered as valid unless there is an explicit
text or religious rule proving its prohibition and voiding. Therefore, Islamic banks use
different concepts while doing the business, namely promises or contracts.
Islamic banks use the concept of promise, made unilaterally by the client or the seller, in
many types of transactions such as Murabaha to the purchase orderer, Ijara muntahiah
bittamlik, sale and lease back, diminishing Musharakah, Salam and Istisna´a. And according
to the Muslim jurists, a promise is morally binding on the promisor, unless there is a valid
justification. It would be also legally binding if it is made conditional upon the fulfilment of an
obligation, and if the promisee has already sustained costs on the basis of that promise. The
binding nature of the promise means that it should be either fulfilled or compensated for
damages caused by the unjustifiable non-fulfillment. In case of some promises, Islamic banks
take token or earnest money from the promisee to guarantee their sincerity in the purchase
the relevant asset.
Contracts in Islamic banking are used for trade, lease, partnership, agency, loans, guarantee,
etc. These contracts include Amānah, Qard, Mudārabah, Bai´, Ijāra, Sharikah, Ujrah,
Wakālah, Kafālah, Ju´alah, Hawālah, etc. Exchange of ownership in the form of trade
involves mutual exchange of property rights along with usufruct, the asset and its usufruct are
both transferred to the buyer following the sale agreement irrespective of cash payment having
been made immediately or in the future. In addition, the ownership of the asset and its
transfer from the seller to the buyer is an important aspect for Islamic banking transactions
since risk remains with the party who owns the asset at a point of time following the
transaction. For example, in the case of Ijāra, the lessor gives the usufruct against rental but
retains the ownership along with liabilities relating to ownership.
Moreover, Islamic banks should respect necessary conditions for a valid sale to legalize the
transaction. In fact, both the buyer and the seller must willingly agree to all details of the
transaction, both participants should be allowed to engage in the transaction, both parties in
the transaction must own the property they are trading or have the permission of the owner to
sell the asset on behalf of him, sold goods must be permissible and should be handed over at
the time of the sale and both the goods and the price must be something clearly known to
both participants in a sale.
The
underlyin
g
principle
in Islamic
contracts
is
permissibi
lity and
validity.
1.6.2 .1 Loans and Debts in the Sharia'h
There are different ways through which funds could be raised to meet individuals and
organisations needs and funding requirements. Raising loans is one of the various ways these
requirements can be fulfilled. In the terminology of Islamic framework, Qard and Dayn relate
to the giving or taking of loans. However, the word Dayn has a broader connotation than the
word Qard. Dayn incurs in any way which leaves a debt as a liability to another party to be
paid later without any profit over the principal amounts. Whereas, Qard could be defined as
an interest-free loan for needy borrowers extended on a goodwill basis; in particular Qard al
Hasan provides funds for humanitarian and welfare purposes without any profit accruing to
the lender. In fact, Qard consists of giving ownership of anything having value for the benefit
of another by way of virtue.
The ownership of the loaned objects is transferred to the borrower who can use, buy, sell, or
donate them as the borrower wishes. Qard is only applied when one gets obliged to return the
equivalent of the thing taken and repayment is for the same amount as the amount lent.
Goods of the same kind will be paid back on demand or at the settled time. Qard should not
bring any return or addition to the lender because that would be equivalent to taking Riba.
However, a borrower can pay more than the amount borrowed, but it must not be stipulated
in the contract. Further, the date of payment of the loan may or may not be included in the
Qard contract as the lender can demand repayment at any time. And the loan should not be
conditional upon any other contract, such as Bai´ and vice-versa.
O you who have believed, fear Allah and give up what remains [due to you] of interest, if you
should be believers. (2: 278)
Abu Hurairah (r.a) reports that the Prophet (PBUH) took a loan of an animal and when he
repaid, he repaid with an animal with a bigger age than that he had taken, and then he said:
"The best of you are the best of you in recompensing." (Swahih Muslim, 4195)
Aariyya is another structure of borrowing goods in a virtuous act. However, in the case of
Aariyya, the exact borrowed commodity has to be returned to its owner, not any replacement.
It is a condition for a commodity to undergo an aariyya contract that it should not be a
commodity that gets consumed on use. In other words, it is the gift of usufruct of a property or
commodity that is not consumed on use and no return should be taken on it.
Have you seen the one who denies the Recompense? *For that is the one who drives away the
orphan *And does not encourage the feeding of the poor. *And withhold [simple] assistance.
(107: 1-7)
While in Qard, the same kind of the loaned commodity with essentially the same nature or
character could be paid back. On the other hand, a Dayn is the result of any contract or
credit transaction. The created debts ought to be returned without any profit over their
principal amounts.
Salaf is a form of Dayn that is similar to Salam. It is used for a loan of fixed tenure and in that
sense it is closer to Dayn; Salaf includes loans for short, intermediate and long term loans and
the price of the commodity is paid in advance at the place of concluding the contract, while
the commodity itself which is conditioned to be clearly defined is delivered at a future date.
The amount given as Salaf cannot be called back before its due date. Therefore, this creates a
liability for the seller to supply the commodity in the future. Allah says:
O you who have believed, when you contract a debt for a specified term, write it down. (2: 282)
Ibn Abbas (r.a) relates: "I testify that Allah had made lawful to us (Muslims) to pay in advance
for the price of a thing to be delivered after a specified term. He then recited this above
mentioned verse." (Al-Haakim 3189)
When the Prophet (PBUH) arrived at Madinah and found its people paying in advance the
price of fruits to be delivered later after a year, two or three, he said:
"Whoever pays in advance the price of a thing to be delivered later, he should pay it for a
specified measure or a specified weight and for a specified period." (Al-Bukhari ans Muslim)
In addition, in all credit transactions, Islam recommends witnesses and documentation. This
provides safeguards against disputes and allows credit transactions for a fixed or known time
period.
O you who have believed, when you contract a debt for a specified term, write it
down.........And take witnesses when you conclude a contract. (2: 282)
And since Islamic banks can neither pay interest nor charge any return on loans, they have the
right to ask for collateral to ensure recovery of the loan amount. In fact, the client cannot
refuse to repay the loan or debt in case he has incurred loss in the business conducted with
the bank's loan. Also, The Shari´ah puts a great deal of emphasis on repayment of loans/debts
and the borrower also has a moral obligation to repay a loan. For that reason, banks can
include, with mutual consent of the clients, a penalty clause in the credit contract to mitigate
the risk of default, but the penalty charged on any default has to go to charity.
With regard to a possible rebate that could be given to the debtor for repaying the loan earlier
than the due date, the Shari´ah considers that as a reduction of interest in the financing costs
arising from prepayment of the amount that would be stipulated in a contract. And, there is
unanimity about the illegality of remitting a part of the debt payable by anyone and getting the
remaining part. However, Muslim jurists have differentiated between loans or debts that have
become due or can be called back at any time (Duyoon Haalah), and loans where time of
payment settled between the creditor and the debtor and the debt is not yet due (Duyun
Mu'ajjalah). Duyoon Haalah are allowed by almost all Muslim jurists on the rationale that in
such loans, delay is not the right of the debtor. In fact, rebate should neither be provided in
the agreement nor be made a condition in the loan contract. In opposition, remission of a part
of a debt not yet due involves Riba.
1.6.2 .2 Responsabilities of debtors and creditors
The fulfilment of one's obligation under all contracts is a religious duty in Islam. Therefore,
the Shari'ah defines specific rights and responsibilities of debtors and creditors. The most
important duty of the debtor is to repay the loan in fulfilment of the promise or contract made
with the creditor. God's punishment will be severe to the borrower whose intention is to
blemish or to usurp the loan. And the main duty of the creditor is not charge interest on the
principal amount of the loan because those who charge Riba are compared in Quran to those
controlled by the devil's influence.
O you who have believed, fulfill [all] contracts. (5: 1)
O you who have believed, fear Allah and give up what remains [due to you] of interest, if you
should be believers. (2: 278)
Those who consume interest cannot stand [on the Day of Resurrection] except as one stands
who is being beaten by Satan into insanity. (2: 275)
In fact, Islamic teachings stress that a borrower, when accepting loans, must be firmly
determined to make repayment. The debtor should not only pay the debt in time, but also
express gratitude to the creditor while repaying the borrowed amount. And if the debtor
refuses to pay even though he has the means, he would be a perpetrator of injustice who
exposes himself to possible punishment.
The delaying (in payment) of a rich person is injustice.
In fact, in Shari´ah, if a debtor default wilfully, he can be arrested, punished and dealt with
harshly. In addition, Islam condemns the person who delays the payment of his dues without
a valid cause. He could be admonished, disgraced or even jailed and if necessary could be
disposed of his asset to pay the debt. A monetary fine, on the other hand, wouldn't be a lawful
option, since this would amount to a monetary penalty for delayed payment, which is Riba.
However, Islam makes a distinction between debtors who default by Procrastination and those
who default by necessity. The Qur'an recommends that the latter deserves compassion and is
to be given be given respite until he is able to pay. In extreme circumstances, creditors are
exhorted to forgive the debt, which can be counted towards obligatory Zakat or as a donation.
And if someone is in hardship, then [let there be] postponement until [a time of] ease. But if
you give [from your right as] charity, then it is better for you, if you only knew. (2: 280)
However, Islamic jurists see no harm if it is agreed between the parties that some indirect
benefits do not involve any cost for the borrower. For example, debt could be paid in the
form of cheques and drafts or in some other currencies if it is in the interest of both the
parties.
In the case of a debt with a settlement date, the creditor is not entitled to ask for earlier
repayment, so long as the debtor does not transgress the terms and conditions. But, if the
creditor is not disposed to give more time for repayment, he cannot be compelled to do so
and the debtor would then be liable to repay the debt at the falling due from whatever he has
beyond his basic needs.
In addition, Shari´ah allows creditors to ask for collateral to ensure recovery of the amount in
the case of failure by borrowers to fulfil their obligation for the repayment of the debt. The
subject of the sale could be the subject of a pledge made to the extent of the debt. In fact, a
pledge is permissible in the Shari´ah, whether a person is on a journey or at home and even
between a Muslim and a non-Muslim.
And if you are on a journey and cannot find a scribe, then a security deposit [should be]
taken. (2: 283)
The ownership of the pledged goods remains with the pledger, who takes on the risk of losing
the pledged commodity while the pledgee holds the goods on trust. Hence, if the pledged
goods are lost without any fault of the pledgee, the loss would be that of the debtor. And if the
due debt is not paid, the pledgee can apply to the court to have the pledged good sold and the
debt recovered out of the sale.
1.6.3 Mudarabah
Among partnership contracts is Mudarabah which is a contractual relationship executed
between two parties, one party supplies the capital (rabbulmal) and the other supplying the
labour and skill as agent or manager (mudarib), for investing in a pre-determined activity,
which grants each party a share of the earnings as determined at the time of the investment.
This practice existed in the pre-Islamic period and Muslim jurists of all the major legal schools
have agreed on the legitimacy of Mudarabah transactions.
He has known that there will be among you those who are ill and others traveling throughout
the land seeking [something] of the bounty of Allah. (73: 20)
Sheikh Al-Fawzan comments on this verse saying: "The verse involves seeking bounty through
trade and striking of deals (1)."
It is also reported that this type of partnership was practical during the lifetime of prophet the
(PBUH) by his approval. Prominent companions like Umar ibnul Khatwab, Uthman ibn
Affan, Ali ibn Abi Twalib, Ibn Masuud and others also used to engage in Mudaraba, and
none of them was reported to have disagreed concerning the legality of this type of contract.
It is also in agreement with wisdom that Mudaraba contracts should be legal because people
need it; wealth can only be developed or invested through trade and transaction (1).
(1) Swalih Al-Fawzan: A summary of Islamic Jurisprudence, Special Edition for Al_-daawah
foundation, Al-Maiman Publishing House, Saudi Arabia, Riyadh, 2005, v2, p131.
Mudarabah business can be of two types: restricted, if the capital-provider specifies any
particular business in which the capital is to be invested, and un-restricted if the capitalprovider authorizes the mudarib to invest the funds in any business he deems fit.
Profit is shared between both parties according to a pre-determined profit sharing ratio. The
profit sharing ratio has to be mutually consented upon and explicitly stated at the time of
contracting and has to be a proportion of the profits. And the payment of profit to the
financier cannot be in the form of a fixed amount or any percentage of the capital employed.
Furthermore, the earned profits cannot be distributed until all the expenses have been paid, in
accordance with custom and the original agreement.
Being a manager to the financier, the mudarib undertakes the business and shares in the
profit. He is considered as a trustee with respect to the capital invested, his actions must,
therefore, be conforming to the overall purpose of the contract and within the recognized
commercial practice. The rabbulmal can also contribute his labor subject to the permission of
the mudarib. In addition, the mudarib does not share in any financial losses which are borne
solely by the rabbulmal. The mudarib's losses are deemed to be the opportunity cost of the
manager's workforce which has failed to generate sufficient revenues for a business the profits
of which are shared by both in accordance with agreed terms.
It is impermissible for an entrusted mudarib to work as a partner for another capital owner if
that will negatively affect his first partner, unless the latter gives him permission.
The Mudarabah contract can be terminated by either of the two parties at any time as long as
a notice, per the contract terms, is given to the other party. A maximum term of the
Mudarabah contract can be set automatically where after the contract is terminated.
Furthermore, for the purpose of periodic profit distribution in a running business before the
termination of business, the business has to be liquidated constructively by way of valuation of
the assets by the mutual agreement of the partners. A final settlement is only possible at the
time of the termination of the business.
(1) Swalih Al-Fawzan: A summary of Islamic Jurisprudence, Special Edition for Al_-daawah
foundation, Al-Maiman Publishing House, Saudi Arabia, Riyadh, 2005, v2, p131.
1.6.4 Musharakah
Musharakah is a type of Shirkatul Amwal which literally means sharing or company. In the
context of business, it refers to a joint enterprise in which parties share the profit and loss of
the enterprise. It plays a vital role in financing business operations based on Islamic principles,
which prohibit making a profit on interest from loans. Musharakah may sometimes include
Shirkatul Amal, where a joint partnership is formed to render some services without requiring
any capital investment. Musharakah allows each party involved in a business to share in the
profits and risks. Instead of charging interest as a creditor, the financier will achieve a return in
the form of a portion of the actual profits earned, according to a predetermined ratio.
However, unlike a traditional creditor, the financier will also share in any losses. The
relationship established between parties, in Musharakah, is by a mutual contract; hence, all the
necessary ingredients of a valid contract must be present. However, there are a number of
conditions that apply specifically to the contract of Musharakah. In fact, the capital to be
invested in a joint venture can be unequal between the partners and should preferably be in
cash. If it were to be based on commodities or other Shari'ah-compliant assets, the market
value prevalent at the time of the contract would have to be appropriately valued with the
mutual consent of all the partners in order to determine the share of each of them.
The commodity should be compensable by similar commodities or assets in quality or
quantity, in case it could be destroyed. Otherwise, its price should be paid. The capital may
also be in the form of equal units or shares representing currency. And if partnership capital
involves a variety of currencies, it must be translated into the currency of the enterprise at the
current rate. Finally, Debts or receivables alone cannot form part of the capital until they are
received, although, they may become part of the capital contribution where they become
inseparable from the other assets of the business. Moreover, the proportion of profit to be
distributed among the partners must be determined and agreed upon at the time of the
contract. Otherwise the contract wouldn't be valid. And it is necessary that each partner's share
in the profit is exactly equal to the proportion of initial investment into the partnership. The
ratio of profit distribution may vary, however, for non-active partners, who only contribute
capital. A party which has no capital invested in an enterprise does not have to share its loss.
The partnership would also be invalid if a partner were to receive regular payments of a fixed,
pre-determined amount as a percentage of its investment. In addition, a person can become a
partner in a running business having fixed assets by investing capital in cash or kind; it is also
allowed to merge various partnership businesses. Valuation of the fixed assets will be based on
their fair value agreed upon by the partners. Further, Musharakah is not a binding contract
and any partner may unilaterally terminate it unless provided otherwise in the contract.
It is agreed upon by the Muslim jurists that a partnership is terminated if one of the partners
terminates the partnership or if one of the partners dies or becomes insane. If the remaining
partners want to continue the business under any of these cases, it is possible with mutual
agreement. The remaining partners would have to purchase the share of the out-going partner.
Difference between Mudarabah and Musharakah
Mudarabah is a special kind of partnership where one partner (rabbulmal) provides the capital
to the other (mudarib) for investment in a commercial enterprise. A Mudarabah arrangement
differs from the Musharakah in the following major ways:
•The investment in Mudarabah; investment is the sole responsibility of rabbulmal, while in
Musharakah it comes from all the partners.
• Mudarabah, rabbulmal has no right to participate in the management which is carried out
by the mudarib except by his permission, while in Musharakah, all the partners can participate
in the management of the business.
•In Mudarabah the loss, if any, is suffered by the rabbulmal only, because the mudarib does
not invest anything. His loss is restricted to the fact that his labour has gone in vain, while in
Musharakah, all the partners share the loss to the extent of the ratio of their investment.
• In Mudarabah, the liability of rabbulmal is limited to his investment, unless he has
permitted the mudarib to incur debts on his behalf. Contrary to this is the case of
Musharakah, where the liability of the partners is normally unlimited. Therefore, if the
business goes in liquidation, and if all the partners have agreed that no partner shall incur any
debt during the course of business, then the exceeding liabilities would be borne by that
partner alone who has incurred a debt on the business in violation of the condition.
•In Mudarabah, all the goods purchased by the mudarib are solely owned by the rabbulmal,
and the mudarib can earn his share in the profit only in case he sells the goods profitably. In
the case of Musharakah, as soon as the partners put their capital in a joint pool, all the assets
of the Musharakah become jointly owned by all of them according to the proportion of their
respective investment. Therefore, each one of them can benefit from the appreciation in the
value of the assets, even if profit has not accrued through sales.
1.6.5.1 Diminishing Musharakah
Diminishing Musharakah is a form of partnership, which ends with the complete ownership of
a partner who purchases the share of another partner in that project by a redeeming
mechanism agreed between both of them. Diminishing Musharakah is used mostly when one
party who wants to own an asset or a commercial business which does not have adequate
funds to pay the full price; and takes the assistance of financing from another party. The share
of the financier is divided into a number of units and it is understood that the client will
purchase the units of the share of the financier one by one periodically, thus increasing his
own share till all the units of the financier are purchased by the client so as to make him the
sole owner of the asset. In this kind of partnership, all partners are co-owners of each and
every part of the joint property or asset on a pro-rata basis and one partner cannot make a
claim to a specific part of the property or asset leaving the other parts for other partners.
Diminishing Musharakah can be conducted through shirkah al-aqd; in that case, the ratio of
profit distribution for each partner can be disproportionate to the ratio of equity of both
parties and has to be stipulated at the time of execution of the contract. In case of loss, it
should be necessarily allocated in accordance with the ratio of equity at the time when the loss
was incurred. The lessee partner can promise to buy periodically the share of the financer
partner according to the market value or at a price to be agreed at the time of the sale. The
price of share units cannot be fixed in the promise to sell.
Diminishing Musharakah can also be conducted through shirkah al-milk, the ratio of profit
distribution doesn't need to be stipulated in the arrangement. Each partner will own the risk as
well as the reward in proportionate to their individual share in the property or asset. The
financing partner can lease its share to the other party and receive a rental for use of the leased
part. The other party goes on paying the rental and purchasing the share of the financier
partner in the form of ownership units, the rental payments will go on decreasing. He will also
get the benefit of having the use of his part without paying any rent. One partner cannot
purchase the ownership units representing the share of the co-partner at a pre-agreed price.
A contract of Diminishing Musharakah could take different shapes in different sub-contracts
which come to play their role at different stages: partnership by ownership between two or
more persons, leasing of the share of one partner in the asset to the other partner, and the sell
of the share of one partner to the others. These sub-contracts are considered permissible in
the Shari'ah given that one contract is not dependent on another and particularly when assets
are sold or leased to partners. If all these sub-contracts have been combined by making each
one of them a condition to the other, then this is not allowed, because it is a well settled rule in
Shari'ah that one transaction cannot be made a pre-condition for another. Thus, the
relationship between the parties in a Diminishing Musharakah arrangement in the first stage is
that of lessor and lessee and at the later stage is that of seller and buyer.
The proposed scheme, in case of Diminishing Musharakah, suggests that instead of making
transactions conditional to each other, there should be promises from the client, firstly, to take
share of the financier on lease and pay the agreed rent, and secondly, to purchase different
units of the share of the financier at different stages at the price prevailing at the time of the
sale. While the Islamic bank will be making a binding promise to offer a specific part of its
ownership of the project for sale on a specified future date, at a price that will be determined
at the time of the actual sale.
In addition, Diminishing Musharakah may be used in various cases of finance, particularly for
financing of assets that can be leased. And as a variable or floating rate of return is possible in
transactions involving leasing, Islamic banks can use it for long-term financing even in
economies having an inflationary trend. For example, financial institutions can use
Diminishing Musharakah for providing house financing, auto financing, plants and machinery
financing, factory/building financing and financing of all other fixed assets. Financing on the
basis of in thus form of partnership can take different structures depending upon the assets
involved. For example, in home financing, in house financing, the facility can be provided for
buying a house for occupation, for the construction of a house, for the renovation of a house
already occupied and for replacing interest-based housing mortgages with a balance transfer
facility (BTF). Moreover, the bank and the client bear the asset risk proportionately in
Diminishing Musharakah; And in case the client is not able to purchase the bank's units of
ownership for a certain period, the bank will not incur loss as the rentals will continue to
accrue.
1.6.5.2 The process of Islamic bank's financing through Diminishing Musharakah
Islamic banks can use Diminishing Musharakah in various cases: to provide house financing,
auto financing, plants and machinery financing, etc.
In the case of house financing for the purchase of a property, a joint ownership in
proportionate shares to the level of the Islamic bank investment in the purchased property is
created; a legal mortgage is taken on the client's beneficial share to secure the obligation to the
bank under the financing arrangement; the bank gives its undivided share on lease to the
client. While, the client pays rent to the bank for the usage of its share of the property until
the client has acquired the complete ownership. At that time the ownership of the property
will be transferred to the client as the sole owner. The steps involved in a Diminishing
Musharakah in the case of the purchase of a house are as follows:
Firstly, the client approaches an Islamic bank for the purchase of the property that he already
has identified; he agrees to invest a certain amount towards the purchase and applies to the
bank for financing the balance amount. If the bank is satisfied about the title to the house and
the future cash flow of the client, a Diminishing Musharakah agreement is created in terms of
which the client and the bank become co-owners in the house on the basis of shirkatulmilk.
The vendor of the property sells it directly to the bank, in which the legal title to the property
is vested; and the client as the eventual owner has immediate rights to occupation. The two
parties agree at the start that their respective shares in the property shall be pro-rata to their
contributions towards the purchase price paid to the vendor.
The parties also agree that during the course of their partnership, which has an agreed date of
termination, the client will purchase the financier's share in the property in instalments and for
the price that the financier had paid for such share on the initial date of acquisition. As the
client increases his share in the property, the bank's share correspondingly decreases by the
same amount. In parallel to the Diminishing Musharakah agreement, the bank grants to the
client a lease in respect of its share in the property. The lease is effective for as long as the
bank has a share in the property.
The arrangement also contains details about the nature of security / guarantee to be provided
by the client which is normally an equitable mortgage on the financed property that
encumbers the property as security for the repayment.
Finally, as security for the client's obligations to make payments of rent under the lease, the
bank may require any additional security to secure its interest, particularly in view of the
financial position of the client; this would be stipulated in the agreement.
The balance transfer facility (BTF) that replaces interest-based mortgage by a Shari'ah
compliant house finance, also involves Diminishing Musharakah since it includes a sale and
lease back. The fact that the client is already living in the house, the bank can start taking rent
for occupying the part in the bank's ownership from the first month after the first
disbursement of the amount is made to the client.
The client will sell some Units of the ownership of the house to an Islamic bank, against which
the client had previously availed interest-based finance; He will repay the interest-based
finance to the original lender bank; While, the Islamic bank will take rent on its share of the
joint ownership.
The client will regularly pay the rentals and will also periodically purchase the bank's units of
ownership by additional payments to the bank; the rental payment is reduced with the client's
ownership increasing over a period of time. This process will continue until the bank's share
of the ownership title in the house is completely transferred to the client. And if the client's
cash flow allows to purchase more Units, the Islamic banks may normally allow the purchase
of up to 3 Units at a time at the agreed price and if the client intends to purchase more than
that number, the bank will undertake a current valuation of the house and will share in the
appreciation on its part of the investment up to a limited extent, giving the remainder to the
client.
1.6.6 Murabahah
Murabaha is a form of sale where the cost of the goods to be sold as well as the profit on the
sale is known to both parties. The purchase and selling price and the profit margin must be
clearly stated at the time of the sale agreement. Payment of the Murabaha price may be in
spot, in instalments or in lump sum after a certain period of time.
Murabaha has been adopted as a mode of interest-free financing by a large number of Islamic
banks to finance the purchase of the consumer goods, intermediary or capital goods, real
estate, raw materials, machinery and equipment. It may also be used for trade financing needs
such as import of goods or pre-shipment export finance. However, the subject of Murabaha
must exist and be in the ownership of the bank at the time of sale in a physical or constructive
possession form; and these assets must be something of value that is classified as property in
Islamic jurisprudence and must not be forbidden commodities. Debt instruments and
monetary units that are subject to the rules of Bai´ al Sarf cannot be sold through Murabaha.
Islamic banks are required to take the genuine commercial risk between the purchase of the
asset from the seller and the sale of the asset to the person requiring the goods. The bank is
compensated for the time value of its money in the form of the profit margin. However, it is
not compensated for the time value of money outside of the contracted term. In fact, the bank
cannot charge additional profit on late payments; the asset remains as a mortgage with the
bank until the Murabaha is paid in full; and there must not be any reference to the time of
payment by the buyer to keep the transaction free from interest.
In addition, Islamic Banks should not simply provide funds through Murabaha; they have also
to be involved in the trading process of their client's business. They also need to ensure that
the transaction is genuine and avoid the possibility of misuse of the funds by the client. In fact,
the purchase price is paid directly by the bank to the seller or supplier, even though the client
may serve as the agent of the bank for onward. The purchase by the bank should be
evidenced by invoices or other documents provided by the supplier to ensure that all
conditions of a valid Murabaha have been fulfilled. Also the bank should arbitrarily inspect
the purchased goods at their place of storage to ensure that the supplier and the client do not
do any under-hand dealing, in fact, the client should not be a dual agent undertaking both the
purchase and sale in a transaction.
Murabaha is not a loan given on interest. It is a credit sale that enables banks' clients to make a
purchase without having to take out an interest-bearing loan. The parties negotiate the profit
Debt
instrume
nts &
monetary
units
subject
rules of
Bai´ al
Sarf
cannot
be sold
through
margin to be paid on the cost of the original purchase, and not the cost price. If payment of
the sale price is deferred, Murabaha becomes Muajjal, which is legal from the point of view of
the Shari'ah. This one of the features that makes Murabaha attractive as a mode of financing
in modern financing transactions: It is a sale transaction effected on the basis of deferred
payment. The price should be fixed at the time of the original contract of sale and the due
date of payment must be explicitly set. It has to be a fixed sum including the cost of goods to
the seller and an agreed amount of profit over the cost that can also be based on a percentage
of the cost price to the seller. The Murabaha selling price includes a mark-up agreed upon
and added to the actual cost incurred by the seller; No additional profit can be paid over and
above the contract price.
To determine the amount of profit on the purchase of the goods and onward sale to the client,
the bank may take into consideration different factors such as the period for deferred
payment. The difference in price is not meant as a reward for time to reflect sale in fact, the
jurists agree that a seller can indicate two prices, one for cash and the other for a credit
transaction, since it a genuine market practice ruled by supply and demand; but one of the two
prices must be settled on at the time of contract. In fact, the credit price of a commodity may
be more than its cash price at any one point of time, while, in a forward purchase, the price
for future delivery of the goods may be less than the cash price. This practice is quite different
from a loan or debt, on which any addition is prohibited.
A Murabaha transaction, as used by Islamic Banks is quite different from a traditional
Murabaha. In fact, Islamic banks do not normally maintain an inventory of goods; rather they
purchase the goods on the specific request of their clients. They take a binding promise to
purchase from the client that he would purchase the goods when the same are acquired by the
bank. This promise can be incorporated into the purchase request of the client to enable the
bank to purchase the goods for the client, either directly or through an agent. The bank can
keep an option to rescind the purchase for return of the goods within a specified period
(Khiyar-e-Shart) as a risk management measure in the event that the client fails to purchase the
goods from the bank. Khiyar can be used as a risk mitigation tool for the goods acquired at the
risk and cost of the bank until the goods are sold to the client or returned to the supplier. In
addition, Islamic banks can use different structures to provide financing by way of credit sales
to their clients. The bank may purchase the goods direct from the supplier for sale onwards to
the clients. Islamic banks can also conduct their trading activities either through the client
acting as an agent of the bank or through third party agents appointed by the bank. Islamic
banks may appoint qualified suppliers as third party agents to undertake the purchases as and
when required. They may establish specific purpose companies, a limited number of the
bank's employees with relevant specialised expertise may be entrusted to trade in the goods
required by their clients.
In the case of default by the client in the payment on the due date, the price selling price
cannot be increased. However, contemporary Muslim jurists agreed that banks can impose a
late payment penalty on delinquent clients. It may be a percentage on the overdue amount
which cannot compounded. The penalty amounts must only be used for charitable purposes.
Islamic banks can also ask for liquidated damages from the client through the courts, in case
of default; and they can sell any held collateral without the intervention of the court.
1.6.6 .1 Concerns
Shari´ah scholars generally consider Murabaha to be a border-line technique because its
transactions may give the appearance of a fixed-income loan with a fixed rate of profit
determined by the profit margin agreed by the parties. However, the fixing of a profit margin
per se is not a problem, as prices have to be fixed in all valid trade bargains and at no point
money is treated as a commodity in the Murabaha transaction, as it is in a conventional loan.
In fact, in Murabaha, the Islamic bank buys an item at one price and sells it to someone at a
higher price, allowing them to pay the client for it over time. While in Riba, conventional
banks lend someone some money and require them to pay back a greater value of money
than what they borrowed. Moreover, the exchange in respect of a loan, wherein any excess is
prohibited, occurs between a commodity and its like, while in a Murabaha transaction,
exchange takes place between two different commodities: money is first exchanged for goods
purchased and then goods are sold for money. Therefore, the difference between the
purchase price and the sale price does not amount to Riba and legitimizes the profit derived
from trading. Goods traded in Murabaha should be real, they must exist at the time of the sale
and in the ownership of the seller when selling to another party. Further, interest charged on a
loan is payable to the lender unlike in a sale contract where the price is liable to change; if it
rises, the purchaser gains on purchasing goods on deferred payment basis, but if the price
declines, it is the seller who gains on selling the goods on deferred payment basis at a higher
price. In addition, the use of Murabaha implies a risk of destruction or loss of goods occurring
during a period where the bank owns the goods acquired for their clients. Thus the mark-up
could be justified by the liability for the goods assumed by the bank until the client purchases
them at a higher price on a future date. Besides, the promise from the client to buy the
commodity from the bank is not a legal binding; therefore, the client may go back on his
promise and the bank risks the loss of the amount it has spent. The goods are also subjected
to no acceptance by the client if there is any hidden defect.
Another concern in the light of the Shari´ah for using Murabaha is the pre-payment rebate. In
fact, Shari´ah scholars may consider it similar to interest-based installments sale techniques,
where the rebate allowed for early settlement of a financing is intended to reflect a refund of
unearned interest. In Murabaha, the rebate shouldn't be already stipulated in the contract.
Therefore, there is no commitment from the bank in respect of any discount in the price of a
Murabaha transaction, the bank has discretion on whether to allow a rebate or not if the client
makes an early payment. In any case, the profit on a Murabaha sale on a deferred payment
basis is not based on a monetary value of time.
1.6.6.2 Risk Management techniques
Murabaha mode of financing is adopted by the Islamic banks to satisfy a variety of financing
requirements of their clients in various and diverse sectors. It can be used to provide finance
for the purchase of consumer durable or to finance the purchase of machinery, equipment
and raw material for manufacture, etc. This mode is highly suitable for providing short-term
working capital in financing projects. It can also be used for import and export trade as well as
for local trade.
However, Murabaha may not be suitable for housing or other long term investments in
economies with a high rate of inflation. The reason for that is that the bank might face a
greater risk in the possible return if the general rate in the market increases owing to
inflationary pressures. Murabaha can still be used for mortgage financing for longer periods
ranging in economies where inflation is not a major issue. Also, Murabaha is not the right
mode to provide financing for the purchase of easily perishable items.
Nevertheless, Islamic banks must bear a certain amount of risk associated with Murabaha
transactions in order to legitimize their returns. They use some techniques to manage and
mitigate each type of the common risks. In order to ensure that the bank's gains are above all
suspicions of Riba, the bank reduces Shari´ah non-compliance risk by making direct payment
to the supplier, it requires the invoice from the seller for the goods purchased, the date of
which not before the offer and acceptance is carried out and not later than the declaration and
Murabaha
is suitable
in short
term
investmen
ts and not
in long
term ones
unless
inflation
is not a
major
issue
it also arranges for the random physical inspection of the goods. This technique seeks to avoid
that the client has already purchased the goods and subsequently wants the financing to make
payment to the supplier. The bank can also obtain Takaful Insurance to reduce in-transit risk
of destruction or loss of goods occurring without the agent's negligence. The bank may ask the
client to provide security through any assets of the client and stipulates a penalty payment
clause in the contract in the event of payment defaults. Murabaha does not allow additional
charges in case of instalments. The amount of the Murabaha price remains unchanged. Longterm Murabaha may be avoided to guard against rate of return risk.
Moreover, the bank may obtain a performance bond from the supplier to prevent from nonperformance risk by the supplier where he may not perform an obligation to supply the goods.
The client can undertake to guarantee the performance of the supplier. Similarly, for the nonperformance risk by the client where the he may refuse to purchase the goods when acquired
by the bank at the client's request, the bank should secure a promise from the client to
purchase the goods. Furthermore, the bank can ask for Hamish Jiddiyah to recover its
possible loss. Hamish Jiddiyah can also be used to prevent from a legal risk in case the client
does not purchase the goods, as the initial agreement is only a promise by the client to buy
and for the bank to sell; the bank who purchases the goods required by the client, may have to
be involved in litigation.
In addition, there is a greater fiduciary risk where the client is appointed as an agent to
purchase and take possession of the goods on behalf of the bank; this could result in the client
failing to administer the trust and agency accounts. To guard against such risk, bank may
provide in the Murabaha contract that the client would be liable for any such loss. There is
also a liquidity risk, since Murabaha receivables are debts payable on maturity. Therefore,
they cannot be sold at a price different from the face value in a secondary market if the
repayment date has to be extended. Similarly, if the client is unable to pay the amount on
time, which is essentially a credit risk, it can give also rise to a liquidity risk for the bank until
the payment is made by the client.
1.6.7 Salam
Salam is a forward financing transaction, where the financial institution pays in advance for
buying specified assets, which the seller will supply on a pre-agreed future date. What is given
in exchange for the advance payment of the price should not in itself be in the nature of
money, or else it will definitely lead to the exchange of currency together with deferment. For
the payment in advance, the contracting parties stipulate a future date for the supply of goods
of specified quantity and quality.
"Whoever pays in advance the price of a thing to be delivered later, he should pay it for a specified
measure or a specified weight and for a specified period." (Al-Bukhari ans Muslim)
Salam may be considered as a kind of debt, because the object of the Salam contract is the
liability of the seller, up to the agreed future date, to deliver the object for which an advanced
payment of the price has already been made. There is consensus among Muslim jurists on the
permissibility of Salam, notwithstanding the general principle of the Shari´ah that does not
permit the sale of a commodity which is not in the possession of the seller, because the object
of the contract is that the goods are a recompense for the price paid in advance, just as the
price is recompense paid for getting the goods in advance. The transaction is considered
Salam if the buyer has paid the purchase price to the seller in full at the time of sale. The idea
(1)
of Salam is to provide a mechanism that ensures that the seller has the liquidity
they
expected from entering into the transaction in the first place. Muslim jurists are unanimous
that full payment of the purchase price is key for Salam to exist. However, Salam cannot take
place in money or currencies as these are subject to rules relating to bai al-sarf, wherein
exchange has to be simultaneous.
Because the Salam contract deals with the delivery of an asset which is not in existence, the
Shari´ah highlights that strict rules must be adhered to in order to ensure that the right of all
parties are protected. In fact, it is necessary that the quality of the commodity is fully specified
leaving no ambiguity which may lead to a dispute. All the possible details in this respect must
be expressly mentioned. Salam can be effected only in those commodities that their quality
and quantity can be specified exactly. The commodity should be generally available in the
market at the time of delivery. And all goods that can be categorized as belonging to the same
species can be the subject of Salam.
However, Salam cannot take place between identical goods. Besides, the time and place of
delivery of the goods should be precisely fixed; and the quality and the quantity of the goods
should be clearly specified. The specification of goods should particularly cover all those
characteristics which could cause variation in price.
Other rules applied to Salam contract, is that the seller in Salam need not be the manufacturer
or producer of the asset. The seller may be an agent to deliver the asset. Furthermore, a Salam
contract can stipulate that, in the event of late delivery of the goods, the supplier pays a certain
amount as a penalty to the buyer, which amount must be used for a charitable purpose; it
cannot be taken into the buyer's income. The buyer has also the right to demand security or
collateral from the seller to ensure that the seller delivers the goods on the agreed date, the
buyer has the right to dispose of the security and purchase the specified goods from the
market; the buyer is entitled to deduct the advance payment from the proceeds of the security
realised and return any surplus to the seller.
(1 ) The state of being in cash or easily convertible to cash, or the state of a company being able to pay its
debt
Istisna´a, like Salam, is a special kind of sale contract where a sale is transacted before the
goods come into existence. However, there are several points of difference between Istisna'a
and Salam. In fact, the subject of Istisna'a is always a thing which needs manufacturing, while
Salam can be effected on anything, no matter whether it needs manufacturing or not. Also, it
is necessary for Salam that the price is paid in full in advance, while it is not necessary in
(1)
Istisna'a where payment can be made in staggered basis . And the object of the Salam is a
liability on the seller to deliver, thus should be in the form of fungible. Under the Istisna'a, the
asset manufactured must meet specification of the order and the buyer has the right not to
take possession of the asset if the specifications are not met. In addition, the time of delivery is
an essential part of the sale in Salam while it is not necessary in Istisna'a that the time of
delivery is fixed. Any penalty charged for late delivery can reduce the price of an Istisna'a
contract but in a Salam, the penalty amount is paid should not be taken as benefit for the
buyer.
1.6.7.1 Parallel Salam
Selling the goods purchased in a Salam contract prior to taking delivery is not generally
allowed in Shari´ah. Instead, it is allowed for the Islamic bank to make parallel Salam
contracts for the same goods to be delivered even at the date and time of delivery of the
original Salam. In this arrangement, there must be two different and independent contacts;
one where the bank is a buyer and the other in which it is a seller. The two contracts cannot
be tied up in a manner that the rights and obligations of one contact are dependent on the
rights and obligations of the parallel contract. And each contract should have its own force and
its performance should not be contingent on the other.
For Example, if A has purchased 100 tons of wheat from B by way of Salam to be delivered
on 31st December, A can contract a parallel Salam with C to deliver to him 100 tons of wheat
on the same date (31st December). But while contracting Parallel Salam with C, the delivery
of wheat to C cannot be conditioned with taking delivery from B. Therefore, even if B did not
deliver wheat on 31st December, A has the duty to deliver the agreed quantity of wheat to C.
He can seek whatever recourse he has against B, but he cannot rid himself from his liability to
deliver wheat to C. Similarly, if B has delivered defective goods which do not conform to the
agreed specifications, A is still obliged to deliver the goods to C according to the specifications
agreed with him. After purchasing a commodity by way of Salam, the Islamic Bank may sell it
through a parallel contract of Salam for the same date of delivery. The period of Salam in the
parallel transaction being shorter, the price may be a little higher than the price of the first
transaction, and the difference between the two prices shall be the profit earned by the
institution. Generally, the shorter the period of Salam contract, the higher the price and the
greater the profit.
Parallel Salam is allowed with a third party only. The seller in the first contract cannot be
made purchaser in the parallel contract of Salam, because it will be a buy-back contract, which
is not permissible in Shari´ah. Each one of the two contracts entered into by a bank should be
independent of the other, but the bank, as seller, can sell the goods on parallel Salam on
similar conditions and specifications as previously purchased on the first Salam contract
without making one contract dependent on the other. If the purchaser in the second contract
1
( ) It should be noted that in this case where the two exchanged things (the commodity and price) have been
delayed is not contradictory to the general principles of Shariah which prohibit both. Here in istisna’a, it is not
the case because the commodity to be provided by the seller is just but a service, and services according to
many scholars, are things that it is not easy to avail them all at once.
is a separate legal entity, but it is fully owned by the seller in the first contract, the arrangement
will not be allowed, because in practical terms it will amount to 'buy-back' arrangement. For
example A has purchased W quantity of wheat by way of Salam from a company B. C is a
subsidiary of B, which is a separate legal entity, but is fully owned by B, then A cannot contract
the parallel Salam with C. However, if C is not wholly owned by B, A can contract parallel
Salam with it, even if there are some common shareholders between B and C.
However, some parallel contract arrangements may not be an attractive mode of disposal of
goods for Islamic banks, as the advance payment of the price in the first Salam contract would
be disinvested when the buyer in the parallel contract made the advance payment to the bank
for the purchase of the goods under the parallel contract.
1.6.7.2 Risk management in Salam
Islamic banks need to take special care in Salam operations. They face a number of risks.
Counter-party Risk is one of some common risks in Salam-based financing; in fact, the client
may default after taking the payment in advance. Commodity Price Risk, where at the time the
goods are received the price may be lower than the price that was originally expected, is
another risk associated with Salam contracts. There is also Quality Risk, low investment
Return or Loss, which occurs when goods received are not of desired quality or unacceptable
for the potential buyer. The bank might also not be able to market the goods in time, resulting
in possible asset loss for the unsold goods and locking funds in the goods until they are sold,
this is Asset-Holding Risk that implies possible extra expenses on storage and Takaful. And in
case the Islamic bank has to purchase goods from the market in parallel Salam, where the
third party fails to supply the specified goods under the parallel contract, the bank faces an
Asset-Replacement Risk. Finally, parallel Salam, if original Salam seller has not delivered the
goods as expected, it is considered as Fiduciary Risk.
In order to manage and mitigate the above risks, Islamic banks need to take proper measures.
In fact Islamic banks purchase only goods that have good marketing potential; they take
proper security and a performance bond; they require from the prospective buyers a sufficient
amount of earnest money in deposit and a binding promise to purchase these goods; they also
insert a penalty clause in the Salam contract to protect themselves from a late delivery from
the supplier; and they accomplish the responsibility of parallel Salam by purchasing similar
goods from the market on spot to supply these to the buyer and recover the loss, if any, from
the seller in the original Salam.
1.6.8 Istisna'a
It is a contract in which a buyer buys on the spot an absent commodity that undergoes a
production process
(1)
using the seller's own materials
(2)
with specified qualities and quantities,
(3)
which (the produced commodity) is to be delivered by the seller at a later date . According to
1
( ) To know whether an item undergoes a production process depends on the prevalent tradition of that
commodity in relation to mean of availing of that commodity. However, Istisna´a cannot be used for natural
things or products that are not manufactured, such as animals, fruits, etc.
2
( ) This is because, when the materials are provided by the buyer, the contract changes to be an Ijara contract.
3
( ) some scholars like Imam Abu Hanifa have a view that there should not be a specified time of delivery
because if so, then the contract changes to Salam. But the view held by most scholars is that it is allowed to
specify or not to specify, though many recommend that there should be specification in order to mitigate
future disagreements.
some scholars, an Istisnaa contract includes both Salam and Ijara. This is so because the seller
will supply the specified commodity at a predetermined future date in case he receives the
payment in advance. While its inclusion of Ijara is that the seller has to do some work
(production) in a process that will enable him to get and supply the required commodity. In
other words we could say that the item of Istisnaa from the seller's side is the commodity in
trust and the work needed to produce that commodity. It is worth notice that it is not a
condition that he the seller be the producer of the commodity, in fact he can produce the
commodity through another producer.
Istisna'a is a Shari'ah mode of financing widely used by Islamic banks and financial institutions
to finance different kinds of projects such as housing, construction of buildings, plants, roads,
manufacturing of aircrafts, ships, machines , equipment etc. It can also be used for export
financing as well as to meet working capital requirements in industries where sale orders are
received in advance. Banks may undertake financing based on Istisna´a by getting the subject
of Istisna'a manufactured through another such contract. Accordingly, they can serve both as
manufacturers and purchasers. In particular, Istisna'a can be potentially used by Islamic banks
to finance industries where productions can be monitored by measurement and specifications,
such as in the food processing industry; or in high technology industries such as the aircraft,
locomotive and shipbuilding industries, and to provide financing for the various types of
machines produced in big factories or workshops. The Istisna'a contract can also be drawn-up
for real estate developments on designated land owned either by the purchaser or the
contractor, or on land in which either of them owns the usufruct. It involves the construction
of specified buildings such as factories, hospitals, schools and universities. For Buildings that
will be built and sold according to specifications, the contract of Istisna'a does not specify a
particular identified place.
Some scholars have a view that the contract is not binding before the production work is over
and after it is over but the buyer has not yet seen and observed it. However the most correct
view is that held by other scholars who see that an Istisna‟a contract is a binding contract when
the seller brings the product with the exact qualities and quantities that the buyer required and
the buyer in this case is obliged to take it.
Nevertheless, Islamic banks need to take special care in Istisna‟a-based financing. They face a
number of risks. These risks include Settlement Risk, Price Risk, Delivery Risk, Possession
Risk and Market Risk. They use some common techniques to mitigate these risks. For
example, Banks can request a proper collateral or a performance bond, they can get technical
expertise in the relevant areas, they adopt a timely and effective marketing ensuring cost
effectiveness, they cover themselves using Takaful insurance, or they choose creditworthy
clients and by adopting suitable capital budgeting and liquidity management policies. Also, for
early disposal of the goods purchased under Istisna´a contract, Islamic banks can take a
“promise to purchase” from a third party or make arrangements for sale through an agency to
reduce that risk.
In addition, the bank, in the position of manufacturer, must assume liability for the ownership
risk prior to delivering the object of the Istisna'a to the buyer, as well as the risk of theft or any
abnormal damage. It cannot absolve itself from any loss on this account.
1.6.9 Ijarah
Meaning and types
"Ijarah" is a term of Islamic Fiqh which lexically means 'to give something on rent'. In the
Islamic jurisprudence, the term 'Ijarah' is used for two different situations. In the first place, it
means 'to employ the services of a person on wages given to him as a consideration for his
hired services." The employer is called 'musta‟jir' while the employee is called 'ajir'.
Example: If A has employed B in his office as a manager or as a clerk on a monthly salary, A
is musta‟jir, and B is an ajir. Similarly, if A has hired the services of a porter to carry his
baggage to the airport, A is a musta‟jir while the porter is an ajir, and in both cases the
transaction between the parties is termed as Ijarah. This type of Ijarah includes every
transaction where the services of a person are hired by someone else. He may be a doctor, a
lawyer, a teacher, a laborer or any other person who can render some valuable services. Each
one of them may be called an 'ajir' according to the terminology of Islamic law, and the person
who hires their services is called a 'musta‟jir', while the wages paid to the ajir are called their
'ujrah'.
The second type of Ijarah relates to the usufructs (a legal right to use and derive profit from
property belonging to someone else provided that the property itself is not injured in any way)
of assets and properties, and not to the services of human beings. 'Ijarah' in this sense means
'to transfer the usufruct of a particular property to another person in exchange for a rent
claimed from him.' In this case, the term 'Ijarah' is analogous to the English term 'leasing'.
Here the lessor is called 'Mu‟jir', the lessee is called 'musta‟jir' and the rent payable to the
lessor is called 'ujrah'.
Both kinds of 'Ijarah' are thoroughly discussed in the literature of Islamic jurisprudence and
each one of them has its own set of rules. But for the purpose of the present book, the second
type of Ijarah – leasing - is more relevant, because it is generally used by Islamic financial
institutions as a form of investment, and as a mode of financing.
A binding agreement
Leasing (renting/hiring) is a binding agreement permitted by Islam in the Qur‟an, Sunnah and
the anonymous agreement of Muslim scholars.
…..They found there a wall on the point of falling down, but he set it up straight. (Moses) said: "If
Thou hadst wished, surely Thou couldst have exacted some recompense for it!" (18: 77)
And when in Madyan, Musa (A.S) was asked to work for eight years with a recompense of
marrying one of the daughters of the person he was living with:
He said, "Indeed, I wish to wed you one of these, my two daughters, on [the condition] that you serve
me for eight years; but if you complete ten, it will be [as a favor] from you. (28:27)
Ijarah as a leasing contract permits one party (the lessee) to use an asset or property owned by
another party (the lessor) for an agreed-upon price over a fixed period of time. It is a form of
asset finance which has the benefit of using assets without the requirements of ownership of
that particular asset or property. The lessee acquires the asset he needs without paying any
interest and receives the benefits of use, while the lessor receives the value of regular rental
payments for a specified period plus the residual value of the asset. The lease may be written
either for a short-term or for a long-term and its rules are similar to those governing sale
because in both cases there is a transfer of one thing between two parties for valuable
consideration (1).
However, leasing differs from sale in that in the latter case the corpus of the property and its
usufruct are transferred to the purchaser, while in the case of Ijarah, the corpus of the
property remains in the ownership of the transferor, but only its usufruct i.e. the right to use it,
is transferred to the lessee.
Types of leases in Islamic finance and banking
In Islamic finance and banking today, there are generally two types of leases: a finance lease
and an operating lease. A finance lease is mainly a method of raising long-term finance to pay
for assets. It provides the lessor with full recovery of its investment and a reasonable profit
over the initial non-cancellable lease term. This mode enables enterprises, especially SMEs, to
acquire assets, such as capital goods and high cost equipment, for which they do not have the
funds to make a large up-front payment that would otherwise be involved in a direct purchase.
In this type of lease, the lessor retains ownership of the equipment but transfers to the lessee
substantially all of the risks and rewards of ownership of the asset. The lessee is responsible
for the insurance, registration and maintenance of the equipment.
Financial leases have some similar features to secured loans. Both allow a business to use an
asset, such as equipment, over a fixed period, in return for regular payments. The business
client chooses the equipment it requires and the bank buys it on behalf of the business. After
all the payments have been made, the business client becomes the owner of the equipment.
The lessor's rate of return is fixed and is not dependent upon the asset-value, performance, or
any other extraneous costs. The fixed lease rentals give rise to an ascertainable rate of return
on investment. Therefore, by spreading payments out over the lifecycle of the asset, the
business is able to align the cost with the benefit derived from the use of the leased asset. The
lessor generally would not provide any services relating to operation of the asset. In addition,
financial leases are non-cancellable; in fact, the lessee cannot return the asset and cannot pay
the whole of the lessor's investment.
On the other hand, when a risk is involving other than a plain financial risk in a lease, it is an
operating lease. In fact, an operating lease is similar to a rental agreement, and is not a finance
lease for the purpose of acquiring assets; operating leases take innumerable forms based on
the risks the lessor takes or avoids, and the involvement of the lessor in operation of the asset.
Operating leases are also referred to as a “non-full payout” leases, because the amount of the
rental does not cover the lessor's full capital outlay for the expected economic life of an asset,
the minimum lease payments over the lease term are such as to secure for the lessor the
recovery of his capital outlay plus a market return on funds invested and the lease period is
always less than the working life of the asset.
(1 ) Maulana Taqi Usmani: Islamic Finance, Musharakah & Mudarabah.
The basic features that differentiate an operating lease from a financial lease are related to
whether the lessor or the lessee takes on the risks of ownership of the leased assets. In fact
operating leases do not put the lessee in the position of a virtual owner; the lessee is simply
using the asset for an agreed period. Also, there is always a dependence on the lessee's
commitment to pay, as a result, the lessor also takes is asset-based. Its rate of return in an
operating lease is dependent upon the asset value, performance, or costs relating to the asset;
and is always a matter of probabilities and uncertainty.
Therefore, in an operating lease, the lessor normally holds a stock of assets with high degree
of marketability to provide to other entities. He may also provide any services relating to these
assets, such as maintenance or operations. The assets remain property of the lessor who has
the option to re-lease them every time the lease period terminates. Accordingly, the lessor
bears the risk of obsolescence, recession or diminishing demand. In contrast, a financial lease
provider operates like a lender except that the lessor has the additional collateral of legal
ownership of the assets without any of the risks associated with ownership.
1.6.9.1 Valid lease
Since leasing is a variety of sale, it is lawful in everything that can lawfully be bought and sold,
and the rules of Shari´ah pertaining to sale are also generally applicable to leasing. In fact, any
Islamic financing mode should be asset-based. There has to be an element of risk taking. In
fact, the profit is generated when an asset having intrinsic utility is sold or offered for use; and
one cannot claim a profit without bearing the risk connected to the transaction. Therefore,
most of the rules relating to the contract of sale come into existence also apply to Ijarah or
Islamic leasing. Muslim jurists have, however, singled out some conditions of the validity of an
Ijarah contract with respect to the asset or service hired and the rental.
Basic rules of leasing
1) The two sides of the exchange (asset and price) must both be known and specified in such
a way that eliminates the possibility of disagreement and dispute. The rental must be
determined at the time of contract for the whole period of lease. It is permissible that
different amounts of rent are fixed for different phases during the lease period, provided
that the amount of rent for each phase is specifically agreed upon at the time of effecting a
lease. If the rent for a subsequent phase of the lease period has not been determined or
has been left at the option of the lessor, the lease is not valid.
Example (1):
A leases his house to B for a total period of 5 years. The rent for the first year is fixed as Rs. 2000/per month and it is agreed that the rent of every subsequent year shall be 10% more than the
previous one. The lease is valid.
Example (2):
In the above example, A puts a condition in the agreement that the rent of Rs. 2000/- per month is
fixed for the first year only. The rent for the subsequent years shall be fixed each year at the option
of the lessor. The lease is void, because the rent is uncertain.
The determination of rental on the basis of the aggregate cost incurred in the purchase of the
asset by the lessor, as normally done in financial leases, is not against the rules of Shari„ah, if
both parties agree to it, provided that all other conditions of a valid lease prescribed by the
Shari„ah are fully adhered to. The lessor cannot increase the rent unilaterally, and any
agreement to this effect is void.
2) The usufruct in question must have a financial or market value. The assets, from which it
is almost impossible to derive any benefit from its use, cannot become the subject of
Ijarah; and also the agreement should not involve unlawful activities and substances. The
contracted usufruct and the rent should be ascertained clearly and agreed in advance,
either for the full period of the lease or for a specified period in absolute terms.
3) Since leasing transfers the ownership of usufruct from the lessor to the lessee, the former
must not only own the assets involved but also be able to transfer the ownership of its
benefits to the lessee. Thus, anything which cannot be used without consuming cannot be
leased out. Therefore, the lease cannot be effected in respect of money, eatables, fuel and
ammunition etc. because their use is not possible unless they are consumed. If anything
of this nature is leased out, it will be deemed to be a loan and all the rules concerning the
transaction of loan shall accordingly apply. Any rent charged on this invalid lease shall be
an interest charged on a loan. If a particular asset is specified for Ijarah, the lease contract
cannot be executed before getting the asset or its usufruct. The lessee cannot use the
leased asset for any purpose other than the purpose specified in the lease agreement. If
no such purpose is specified in the agreement, the lessee can use it for whatever purpose
it is used in the normal course. However if he wishes to use it for an abnormal purpose,
he cannot do so unless the lessor allows him in express terms.
4) It is also a requirement of a valid Ijarah is that the lease period be specified and that the
lessor retains ownership of the leased asset during the entire period of the lease. The
lease period shall commence from the date on which the leased asset has been delivered
to the lessee, no matter whether the lessee has started using it or not.
5) If the leased asset has totally lost the function for which it was leased, and no repair is
possible, the lease shall terminate on the day on which such loss has been caused.
However, if the loss is caused by the misuse or by the negligence of the lessee, he will be
liable to compensate the lessor for the depreciated value of the asset as it was immediately
before the loss.
6) Liabilities arising from ownership of the asset/ property will be borne by the lessor, while
the liabilities relating to the use of the asset/property leased asset will be borne by the
lessee. The lessee is liable for any loss to the leased asset due to negligence, but he cannot
be made liable for loss caused by factors beyond his control.
Example:
A has leased his house to B. The taxes referable to the property shall be borne by A, while the
water tax, electricity bills and all expenses referable to the use of the house shall be borne by B,
the lessee.
7) The rental can be determined, with the mutual consent of the contracting parties, on the
basis of aggregate of the cost incurred by the lessor for the acquisition of the assets to be
leased and based on a reasonable rate of return by reference to an agreed benchmark. If
the lease is based on a floating rental rate, it is recommended to use a well known
benchmark or index to determine rentals of subsequent periods in a long-term lease to
avoid any dispute or injustice due to possible fluctuations in the market rate structure and
binding nature of the lease contract. The floating rate, however, should be subjected to an
upper limit in order to avoid the element of Gharar.
8) A stipulation may be inserted in the Ijarah contract making late payment by the lessee
over a period of time liable to a certain amount of charity. This may provide prevention
from late payment even though it does not compensate the lessor for his opportunity cost
over the period of default. The lessor may also approach a competent court to award
damages for any shortfall.
9) The lessor can also demand payment of an earnest money amount as advance payment of
rentals to ensure that the prospective lessee fulfils the commitment to take possession of
the asset on lease when purchased by the lessor.
10) If the Ijarah contract is not executed for any reason attributable to the lessee, the lessor
can recover from the earnest money the amount of the actual losses suffered loss incurred
in this agreement.
11) Unlike normal sale which cannot be effected for a future date, Ijarah for a future date
is permissible. The lease period and the lessor's entitlement to rent, however, begin form
the date on which the leased asset has been delivered to the lessee. The rent thereof may
be payable in advance before delivery of the asset to the lessee. Any advance rentals must
be adjusted against future rentals.
12) Either the lessor or the lessee can make a unilateral promise to buy or sell the leased
asset at the end of the lease period, or earlier, at an agreed price, provided that the lease
agreement shall not be conditional upon such a sale. On the other hand, the lessor may
make a promise to gift the asset to the lessee upon termination of the lease, provided the
lessee has fulfilled all the obligations under the contract. There must also not be any
stipulation in the contract purporting to transfer of ownership of the leased assets at a
future date.
13) A property jointly owned by two or more persons can be leased out, and the rental
shall be distributed between all the joint owners according to the proportion of their
respective shares in the property.
14) A joint owner of a property can lease his proportionate share to his co-sharer only, and
not to any other person.
1.6.9.2 Ijarah Muntahia-bi-tamleek
In the Islamic jurisprudence, one transaction cannot be conditioned by another transaction.
Ijarah and sale/purchase transactions are two different contracts and the transfer of ownership
in the leased property cannot be made by a sale contract on a future date along with the Ijarah
contract. Therefore a 'Hire-Purchase' agreement which combines both lease and sale at the
time of contract is not suitable for Islamic banks.
The method acceptable to Shari´ah is that the ownership remains with the lessor along with
all liabilities emerging from ownership. As a result, Islamic banks take the asset risk, bear the
ownership related expenses and give or take responsibility for transfer of the asset to the lessee
upon termination of the lease. This is done under Ijarah Muntahia-bi-tamleek which includes
a promise by the lessor to transfer the ownership of the leased property to the lessee. The
transaction basically remains that of Ijarah and the transfer of ownership is kept separate from
the main Ijarah contract. Under this arrangement, the bank purchases the asset for the client
who then leases the asset from the bank; at the end of the lease term, the transfer of the asset
ownership to the lessee is kept separate through a separate contract.
Ijarah shares many common features with financial lease and hire-purchase arrangements. It
involves a lessor purchasing an asset and renting it to a lessee for a specific time period at an
agreed rental and at the end of the lease period transferring the ownership of the asset to the
lessee. However, Ijarah Muntahia-bi-tamleek is different from the conventional leases where
the rentals start accruing as soon as the payment for purchase of the asset being leased is made
by the lessor. This is not allowed in Shari„ah, because it amounts to charging rent on the
money given to the customer which is nothing but interest, pure and simple. The correct way,
according to Shari„ah, is that the rent be charged after the lessee has taken delivery of the
asset, and not from the day the price has been paid. If the supplier has delayed the delivery
after receiving the full price, the lessee should not be liable for the rent of the period of delay.
In Ijarah Muntahia-bi-tamleek, rentals start at the time when the asset is supplied to the lessee
in useable form. Also, if the price of the asset is paid to the lessee instead of the supplier, there
must be an agency (Wakalah) agreement between the parties prior to the lease agreement that
gives authority to the lessee to purchase the asset on behalf of the bank. If the asset is
destroyed before its delivery to the lessee in useable form, the loss will be that of the bank and
not of the agent. Therefore, the risk of the asset will be that of the bank as long as the client
serves as its agent for purchase of the asset while in conventional lease all risks are borne by
the lessee.
In addition, it is different from a hire purchase and finance lease in the sense that it is an
arrangement that does not comprise two contracts in one bargain; in fact, leasing is the real
and the major contract; therefore, it is subject to all Shari´ah rules of an ordinary operating
Ijarah contract. The transfer of ownership is processed through a separate sale or gift contract.
This other part of the deal is only a unilateral promise not binding on the one promising and
as such it is not a transaction until actually entered into by the parties. In addition, Ijarah
Muntahia-bi-tamleek is a fair arrangement
based on justice for both the parties; the lessor recovers cost of the leased asset and also the
profit in the form of rentals while the lessee can get ownership title of the asset at the end of
the lease period. The lessee is also protected from the loss by the lessor who bears all
responsibility for loss of the leased asset, in case of absence of negligence on the part of the
lessee.
Expenses consequent to ownership
As the lessor is the owner of the asset, and he has purchased it from the supplier through his
agent, he is liable to pay all the expenses incurred in the process of its purchase and its import
to the country of the lessor. Consequently, he is liable to pay the freight and the customs duty
etc. He can, of course, include all these expenses in his cost and can take them into
consideration while fixing the rentals, but as a matter of principle, he is liable to bear all these
expenses as the owner of the asset. Any agreement to the contrary, as is found in the
traditional financial leases, is not in conformity with Shari„ah.
Liability of the parties in case of loss to the asset
As mentioned in the basic principles of leasing, the lessee is responsible for any loss caused to
the asset by his misuse or negligence. He can also be made liable to the wear and tear which
normally occurs during its use. But he cannot be made liable to a loss caused by the factors
beyond his control. The agreements of the traditional 'financial lease' generally do not
differentiate between the two situations. In a lease based on the Islamic principles, both the
situations should be dealt with separately.
Variable Rentals in Long Term Leases
In the long term lease agreements it is mostly not in the benefit of the lessor to fix one amount
of rent for the whole period of lease, because the market conditions change from time to time.
In this case the lessor has two options:
(a) He can contract lease with a condition that the rent shall be increased according to a
specified proportion (e.g. 5%) after a specified period (like one year).
(b) He can contract lease for a shorter period after which the parties can renew the lease at
new terms and by mutual consent, with full liberty to each one of them to refuse the renewal,
in which case the lessee is bound to vacate the leased property and return it back to the lessor.
These two options are available to the lessor according to the classical rules of Islamic Fiqh.
However, some contemporary scholars have allowed, in long-term leases, to tie up the rental
amount with a variable benchmark which is so well-known and well-defined that it does not
leave room for any dispute. For example, it is permissible according to them to provide in the
lease contract that in case of any increase in the taxes imposed by the government on the
lessor, the rent will be increased to the extent of same amount. Similarly it is allowed by them
that the annual increase in the rent is tied up with the rate of inflation. Therefore if there is an
increase of 5% in the rate of inflation, it will result in an increase of 5% in the rent as well.
Based on the same principle, some Islamic banks use the rate of interest as a benchmark to
determine the rental amounts. They want to earn the same profit through leasing as is earned
by the conventional banks through advancing loans on the basis of interest. Therefore, they
want to tie up the rentals with the rate of interest and instead of fixing a definite amount of
rental, they calculate the cost of purchasing the lease assets and want to earn through rentals an
amount equal to the rate of interest. Therefore, the agreement provides that the rental will be
equal to the rate of interest or to the rate of interest plus something. Since the rate of interest is
variable, it cannot be determined for the whole lease period. Therefore, these contracts use
(1)
the interest rate of a particular country (like LIBOR) as a benchmark for determining the
periodical increase in the rent.
This arrangement has been criticized on two grounds:
The first objection raised against it is that, by subjecting the rental payments to the rate of
interest, the transaction is rendered akin to an interest based financing. This objection can be
overcome by saying that, as fully discussed in the case of Murabahah, the rate of interest is
used as a benchmark only. So far as other requirements of Shari„ah for a valid lease are
properly fulfilled, the contract may use any benchmark for determining the amount of rental.
The basic difference between an interest - based financing and a valid lease does not lie in the
amount to be paid to the financier or the lessor. The basic difference is that in the case of
lease, the lessor assumes the full risk of the corpus of the leased asset. If the asset is destroyed
during the lease period, the lessor will suffer the loss. Similarly, if the leased asset loses its
usufruct without any misuse or negligence on the part of the lessee, the lessor cannot claim the
rent, while in the case of an interest-based financing, the financier is entitled to receive interest,
even if the debtor did not at all benefit from the money borrowed. So far as this basic
(1 ) LIBOR is the London Interbank Offered Rate, a financial benchmark based on interbank lending rates in
short, an interest rate-based measurement.
difference is maintained, (i.e. the lessor assumes the risk of the leased asset) the transaction
cannot be categorized as an interest-bearing transaction, even though the amount of rent
claimed from the lessee is equal to the rate of interest.
It is thus clear that the use of the rate of interest merely as a benchmark does not render the
contract invalid as an interest - based transaction. It is, however, advisable at all times to avoid
using interest even as a benchmark, so that an Islamic transaction is totally distinguished from
an un-Islamic one, having no resemblance of interest whatsoever.
The second objection to this arrangement is that the variations of the rate of interest being
unknown, the rental tied up with the rate of interest will imply Jahalah and Gharar which is not
permissible in Shari„ah. It is one of the basic requirements of Shari„ah to be considered in
every contract and must be known to the parties when they enter into it. The consideration in
a transaction of lease is the rent charged from the lessee, and therefore it must be known to
each party right at the beginning of the contract of lease. If we tie up the rental with the future
rate of interest, which is unknown, the amount of rent will remain unknown as well. This is the
Jahalah or Gharar which renders the transaction invalid.
Responding to this objection, one may say that the Jahalah has been prohibited for two
reasons: One reason is that it may lead to dispute between the parties. This reason is not
applicable here, because both parties have agreed with mutual consent upon a well defined
benchmark that will serve as a criterion for determining the rent, and whatever amount is
determined, based on this benchmark, will be acceptable to both parties. Therefore, there is
no question of any dispute between them.
The Second reason for the prohibition of Jahalah is that it renders the parties susceptible to an
unforeseen loss. It is possible that the rate of interest, in a particular period, zooms up to an
unexpected level in which case the lessee will suffer. It is equally possible that the rate of
interest zooms down to an unexpected level, in which case the lessor may suffer. In order to
meet the risks involved in such possibilities, it is suggested by some contemporary scholars
that the relation between rent and the rate of interest is subjected to a limit or ceiling. For
example, it may be provided in the base contract that the rental amount after a given period
will be changed according to the change in the rate of interest, but it will in no case be higher
than 15% or lower than 5% of the previous monthly rent. It will mean that if the increase in
the rate of interest is more than 15% the rent will be increased only up to 15%. Conversely, if
the decrease in the rate of interest is more than 5% the rent will not be decreased to more
than 5%. In our opinion, this is the moderate view which takes care of all the aspects involved
in the issue(1).
Penalty for Late Payment of Rent
In some agreements of financial leases, a penalty is imposed on the lessee in case he delays
the payment of rent after the due date. This penalty, if meant to add to the income of the
lessor, is not warranted by the Shari„ah. The reason is that the rent after it becomes due, is a
(1 ) Maulana Taqi Usmani: Islamic Finance, Musharakah & Mudarabah.
debt payable by the lessee, and is subject to all the rules prescribed for a debt . A monetary
charge from a debtor for his late payment is exactly the riba prohibited by the Holy Qur‟an.
Therefore, the lessor cannot charge an additional amount in case the lessee delays payment of
the rent.
However, in order to avoid the adverse consequences resulting from the misuse of this
prohibition, another alternative may be resorted to. The lessee may be asked to undertake
that, if he fails to pay rent on its due date, he will pay certain amount to a charity. For this
purpose the financier / lessor may maintain a charity fund where such amounts may be
credited and disbursed for charitable purposes, including advancing interest-free loans to the
needy persons. The amount payable for charitable purposes by the lessee may vary according
to the period of default and may be calculated at per cent, per annum basis. The agreement of
the lease may contain the following clause for this purpose:
Though this arrangement does not compensate the lessor for his opportunity cost of the
period of default, yet it may serve as a strong deterrent for the lessee to pay the rent promptly.
Termination of Ijarah lease
If the lessee contravenes any term of the agreement, the lessor has a right to terminate the
lease contract unilaterally. However, if there is no contravention on the part of the lessee, the
lease cannot be terminated without mutual consent. In some agreements of the 'financial lease'
it has been noticed that the lessor has been given an unrestricted power to terminate the lease
unilaterally whenever he wishes, according to his sole judgment. This is again contrary to the
principles of Shari„ah.
In some agreements of the 'financial lease' a condition has been found to the effect that in case
of the termination of lease, even at the option of the lessor, the rent of the remaining lease
period shall be paid by the lessee. This condition is obviously against Shari„ah and the
principles of equity and justice. The basic reason for inserting such conditions in the
agreement of lease is that the main concept behind the agreement is to give an interest-bearing
loan under the ostensible cover of lease. That is why every effort is made to avoid the logical
consequences of the lease contract.
Naturally, such a condition cannot be acceptable to Shari„ah. The logical consequence of the
termination of lease is that the asset should be taken back by the lessor. The lessee should be
asked to pay the rent as due up to the date of termination. If the termination has been effected
due to the misuse or negligence on the part of the lessee, he can also be asked to compensate
the lessor for the loss caused by such misuse or negligence. But he cannot be compelled to
pay the rent of the remaining period.
Insurance of the assets
If the leased property is insured under the Islamic insurance mode of Takaful, it should be at
the expense of the lessor and not at the expense of the lessee, as is generally provided in the
agreements of the current 'financial leases'.
The residual value of the leased asset
Another important feature of the modern 'financial leases' is that after the expiry of the lease
period, the corpus of the leased asset is normally transferred to the lessee. As the lessor
already recovers his cost along with an additional profit thereon, which is normally equal to
the amount of interest which could have been earned on a loan of that amount advanced for
that period, the lessor has no further interest in the leased asset. On the other hand, the lessee
wants to retain the asset after the expiry of the leased period.
For these reasons, the leased asset is generally transferred to the lessee at the end of the lease,
either free of any charge or at a nominal token price. In order to ensure that the asset will be
transferred to the lessee, sometimes the lease contract has an express clause to this effect.
Sometimes this condition is not mentioned in the contract expressly; however, it is understood
between the parties that the title of the asset will be passed on to the lessee at the end of the
lease term.
This condition, whether it is express or implied, is not in accordance with the principles of
Shari„ah. It is a well settled rule of Islamic jurisprudence that one transaction cannot be tied up
with another transaction so as to make the former a pre-condition for the other. Here the
transfer of the asset at the end has been made a necessary condition for the transaction of
lease which is not allowed in Shari„ah.
The original position in Shari„ah is that the asset is a sole property of the lessor, and after the
expiry of the lease period, the lessor shall be at liberty to take the asset back, or to renew the
lease or to lease it out to another party, or sell it to the lessee or to any other person. The
lessee cannot force him to sell it to him at a nominal price, nor can such a condition be
imposed on the lessor in the lease agreement.
But after the lease period expires, and the lessor wants to give the asset to the lessee as a gift or
to sell it to him, he can do so by his free will.
However, some contemporary scholars, keeping in view the needs of the Islamic financial
institutions have come up with an alternative. They say that the agreement of Ijarah itself
should not contain a condition of gift or sale at the end of the lease period. However, the
lessor may enter into a unilateral promise to sell the leased asset to the lessee at the end of the
lease period. This promise will be binding on the lessor only. The principle, according to
them, is that a unilateral promise to enter into a contract at a future date is allowed whereby
the promisor is bound to fulfil the promise, but the promisee is not bound to enter into that
contract. It means that he has an option to purchase which he may or may not exercise.
However, if he wants to exercise his option to purchase, the promisor cannot refuse it because
he is bound by his promise. Therefore, these scholars suggest that the lessor, after entering
into the lease agreement, can sign a separate unilateral promise whereby he undertakes that if
the lessee has paid all the amounts of rentals and wants to purchase the asset at a specified
mutually acceptable price, he will sell the leased asset to him for that price.
Once this promise is signed by the lessor, he is bound to fulfil it and the lessee may exercise
his option to purchase at the end of the period, if he has fully paid the amounts of rent
according to the agreement of lease. Similarly, it is also allowed by these scholars that, instead
of sale, the lessor signs a separate promise to gift the leased asset to the lessee at the end of the
lease period, subject to his payment of all amounts of rent. This arrangement is called 'Ijarah
wa iqtina‟. It has been allowed by a large number of contemporary scholars and is widely acted
upon by the Islamic banks and financial institutions. The validity of this arrangement is subject
to two basic conditions:
Firstly, the agreement of Ijarah itself should not be subjected to signing this promise of sale or
gift but the promise should he recorded in a separate document.
Secondly, the promise should be unilateral and binding on the promisor only. It should not
be a bilateral promise binding on both parties because in this case it will be a full contract
effected to a future date which is not allowed in the case of sale or gift.
Sub-Lease
If the leased asset is used differently by different users, the lessee cannot sub-lease the leased
asset except with the express permission of the lessor. If the lessor permits the lessee for
subleasing, he may sub-lease it. If the rent claimed from the sub-lessee is equal to or less than
the rent payable to the owner / original lessor, all the recognized schools of Islamic
jurisprudence are unanimous on the permissibility of the sub lease. However, the opinions are
different in case the rent charged from the sub-lessee is higher than the rent payable to the
owner.
Imam al-Shafi„i and some other scholars allow it and hold that the sub lessor may enjoy the
surplus received from the sub-lessee. This is the preferred view in the Hanbali school as well.
On the other hand, Imam Abu Hanifah is of the view that the surplus received from the sublessee in this case is not permissible for the sub-lessor to keep and he will have to give that
surplus in charity. However, if the sub-lessor has developed the leased property by adding
something to it or has rented it in a currency different from the currency in which he himself
pays rent to the owner/the original lessor, he can claim a higher rent from his sub-lessee and
can enjoy the surplus.
Although the view of Imam Abu Hanifah is more precautions which should be acted upon to
the best possible extent, in cases of need the view of Shafi„i and Hanbali schools may be
followed because there is no express prohibition in the Holy Qur‟an or in the Sunnah against
the surplus claimed from the lessee. Ibn Qudamah has argued for the permissibility of surplus
on forceful grounds.
Assigning of the Lease
The lessor can sell the leased property to a third party whereby the relation of lessor and
lessee shall be established between the new owner and the lessee. However, the assigning of
the lease itself (without assigning the ownership in the leased asset) for a monetary
consideration is not permissible.
The difference between the two situations is that in the latter case the ownership of the asset is
not transferred to the assignee, but he becomes entitled to receive the rent of the asset only.
This kind of assignment is allowed in Shari„ah only where no monetary consideration is
charged from the assignee for this assignment. For example, a lessor can assign his right to
claim rent from the lessee to his son, or to his friend in the form of a gift. Similarly, he can
assign this right to any one of his creditors to set off his debt out of the rentals received by
him. But if the lessor wants to sell this right for a fixed price, it is not permissible, because in
this case the money (the amount of rentals) is sold for money which is a transaction subject to
the principle of equality. Otherwise it will be tantamount to a riba transaction, hence
prohibited.
Securitization (1) of Ijarah
The arrangement of Ijarah has a good potential of securitization which may help create a
secondary market for the financiers on the basis of Ijarah. Since the lessor in Ijarah owns the
leased assets, he can sell the asset, in whole or in part, to a third party who may purchase it
and may replace the seller in the rights and obligations of the lessor with regard to the
purchased part of the asset.
Therefore, if the lessor, after entering into Ijarah, wishes to recover his cost of purchase of the
asset with a profit thereon, he can sell the leased asset wholly or partly either to one party or to
a number of individuals. In the latter case, the purchase of a proportion of the asset by each
individual may be evidenced by a certificate which may be called 'Ijarah certificate'. This
certificate will represent its holder's proportionate ownership in the leased asset and he will
assume the rights and obligations of the owner/lessor to that extent. Since the asset is already
leased to the lessee, the lease will continue with the new owner(s), each one of the holders of
this certificate will have the right to enjoy a part of the rent according to his proportion of
ownership in the asset. Similarly he will also assume the obligations of the lessor to the extent
of his ownership. Therefore, in the case of total destruction of the asset, he will suffer the loss
to the extent of his ownership. These certificates, being an evidence of proportionate
ownership in a tangible asset, can be negotiated and traded in freely in the market and can
serve as an instrument easily convertible into cash. Thus they may help in solving the
problems of liquidity management faced by the Islamic banks and financial institutions.
It should be remembered, however, that the certificate must represent ownership of an
undivided part of the asset with all its rights and obligations. Misunderstanding this basic
concept, some quarters tried to issue Ijarah certificates representing the holder's right to claim
certain amount of the rental only without assigning to him any kind of ownership in the asset.
It means that the holder of such a certificate has no relation with the leased asset at all. His
(1) It is a process of pooling and repackaging of financial assets into securities that are then sold to investors. It
may also be defined as the process of taking an illiquid asset (Not having enough cash, or not easily
converted into cash) or group of assets, and through financial engineering transforming them into a security
(a tradable financial asset).
only right is to share the rentals received from the lessee. This type of securitization is not
allowed in Shari„ah. As explained earlier in this chapter, the rent after being due is a debt
payable by the lessee. The debt or any security representing debt only is not a negotiable
instrument in Shari„ah, because trading in such an instrument amounts to trade in money or in
monetary obligation which is not allowed, except on the basis of equality, and if the equality of
value is observed while trading in such instruments, the very purpose of securitization is
defeated. Therefore, this type of Ijarah certificates cannot serve the purpose of creating a
secondary market. It is, therefore, necessary that the Ijarah certificates are designed to
represent real ownership of the leased assets, and not only a right to receive rent.
Head-Lease
Another concept developed in the modern leasing business is that of 'head-leasing.' In this
arrangement, a lessee sub-leases the property to a number of sub-lessees. Then, he invites
others to participate in his business by making them share the rentals received by his sublessees. For making them participate in receiving rentals, he charges a specified amount from
them. This arrangement is not in accordance with the principles of Shari„ah. The reason is
obvious. The lessee does not own the property. He is entitled to benefit from its usufruct only.
That usufruct he has passed on to his sub-lessees by contracting a sub-lease with them. Now
he does not own anything, neither the corpus of the property, nor its usufruct. What he has is
the right to receive rent only. Therefore, he assigns a part of this right to other persons. It is
already explained in detail that this right cannot be traded in, because it amounts to selling a
receivable debt at a discount which is one of the forms of riba prohibited by the Holy Qur‟an
and Sunnah. Therefore, this concept is not acceptable.
These are some basic features of the 'financial lease' which are not in conformity with the
dictates of Shari„ah. While using the lease as an Islamic mode of finance, these shortcomings
must be avoided.
The list of the possible shortcomings in the lease agreement is not restricted to what has been
mentioned above, but only the basic errors found in different agreements have been pointed
out, and the basic principles of Islamic leasing have been summarized. An Islamic lease
agreement must conform to all of them.
1.6.9.3 Potential of Ijarah
There are many Islamic finance structures where Ijarah can be used. Islamic banks use this
mode of financing with the purpose of enabling customers to use durable goods and
equipment such as ships, housing, heavy machines and plants in productive enterprises
because these customers may be unable to buy these goods for their production purposes.
Ijarah has also huge potential as a financing mode for retail, corporate and the public sectors
and can also play a crucial role in promoting Islamic finance industry. It can be used as
incentive to economic development as it is usually long term and offers potential for
stimulating productive industries.
Leasing is an attractive mode of investment for Islamic banks because assets acquired under
these contracts are usually of high quality, marketable and maintain their market value well
above book value; therefore, the bank does not have to depend so much on the
creditworthiness of the lessee, given that as a recourse, it can sell the asset to dispose for cash
in case of default. And since the Islamic bank acquires the desired asset only when a client
requests it and commits himself to enter into a lease contract with the bank, the possibility of
misuse of funds and assets is minimized and the bank can make a profit by setting the rent at a
level that covers, over the lease period, the purchase price, the expenses incurred during the
acquisition of the asset as well as a return in line with the current rate of mark-up. In fact,
Islamic banks can get variable and floating return on long term investments.
And although Ijarah is a longer-term financing instrument, a leasing contract can be reviewed
periodically. The financing party thus not tied down to a fixed return that may not be in its
investment goals.
Furthermore, Ijarah offers the advantage of not requiring collateral and thus of simpler
repossession procedures since ownership of the asset lies with the lessor. It also means that it
has greater in-built stability to contain inflationary pressures in the economy. The lessor is only
exposed to a low level credit risk from the lessee as the lease transaction is, by definition, assetbacked. Ijarah has also become popular due to a tax advantages as the rental can be offset
against corporate tax by the lessee.
Finally, Ijarah can be used indirectly for Sukuk issues by the corporate and the government
sectors. Ijarah Sukuk represent leased assets without actually relating the holders to any
corporate body or institution. Securitisation on the basis of Ijarah is an alternative tool to
interest based borrowing provided it uses durable and useable assets. For example, an aircraft
leased to an airline can be represented in bonds and owned by a number of Sukuk holders,
each of them individually and independently collecting their periodic rent from the airline
company. The Sukuk holders are not owners of a share in a company that owns the leased
asset, but simply a sharing owner of a part of the aircraft itself. Islamic banks are also able to
offer leasing certificates to their depositor clients as specific investment certificates as a form of
declining equity. These mechanisms facilitate the formation of fixed assets and can contribute
to long term economically beneficial investment.
1.6.10 Wakalah (Commissioning)
Literally Wakalah means protection or commissioning or remedying on behalf of others.
Legally Wakalah refers to a contract where a legally accountable person authorizes another
legally accountable to do a certain well-defined legal action on his behalf in matters in which
such authorization is permissible. It is a contract of agency which means doing any work or
providing any service on behalf of any other.
Now send ye then one of you with This money of yours to the town: let Him find out which is the
best food (to be had) and bring some to you . (18: 19)
An agent is someone who establishes contractual and commercial relations between a
principal and a third party, usually as per a fixed fee. An action performed by an agent on
behalf of the principal will be deemed as an action by the principal. Agency is necessitated by
the fact that an agent has to perform certain tasks which the principal has neither the time,
knowledge nor the expertise to perform himself. The need for agency arises where a person
has no ability or expertise to perform a certain action due, for example, to distance or size.
The main features of agency are service, representation and the authority to act for the
principal. An agent may obtain a certain wage for services rendered within the incentive
structure of the principal.
The contract of Wakalah is about the provision of service. Some of these services include sale
and purchase, letting and hiring, borrowing and lending, assignment of debt, guarantee,
pledge, gifts, bailment, taking and making payments, litigation and relinquishment, admission
and acknowledgment of rights. Islamic banks use the concept of Wakalah in various Islamic
products such as Musharakah, Mudarabah, Murabaha, Salam, Istisna´a and Ijarah. It is also
used in payment and collection of trade bills, fund management and securitization. Banks
normally charge fee for agency services rendered by them on behalf of their clients. An agency
contract could be specific or general; it could be both commutative and non-commutative; the
nature of activity to be undertaken should be clearly defined to avoid any disputes. For
example, if Wakalah is for the sale or purchase of specific goods, the kind, quality and other
necessary attributes of the commodity should be clearly mentioned. The principal should
have the power and competence to deal and own the property. For example, an insane or a
minor cannot appoint agents to act on their behalf. However, it is not necessary for the person
appointing an agent to have attained a minimum age. Also, a principal may appoint an agent to
conduct any business transaction activity that the person would be able to undertake.
However, Agency is not permissible in activities prohibited in the Shari´ah or acts of
dishonesty such as theft and usurpation of property or conducting Riba-based business. It is
also prohibited to appoint an agent for acts such as prayer, fasting, giving evidence, or for
taking an oath.
The agent must act in accordance with the instructions of the principal and exercise due care
and skill. If he is appointed to sell goods on behalf of the principal, he cannot purchase these
goods as a buyer. Similarly, if the principal restricts the agent to certain limits, the agent is
bound to observe them. An agent appointed to engage in buying and selling activities or to pay
and receive a debt is considered to be a custodian of the principal's property and in the
fiduciary position of a trustee. And in the absence of any instructions to the contrary, an agent
appointed to sell goods can sell them for cash or on credit; the agent can take a pledge of a
security for payment in the case of goods sold on credit. Besides, an agent is not allowed to
appoint another agent unless he himself is not capable to do it; in that case, he may appoint
another agent with the consent of the principal. He must also avoid any conflict of interest
such as selling goods to the principal without disclosing that such goods are owned by the
agent.
In the case of Wakalah of sales, the principal appoints an agent to sell a certain property for
him; the agent is responsible for making payment and receiving goods on behalf of the
principal. He has the authority for claiming the price, exercising the right of option of voiding
a sale on account of defective goods or inspection and returning goods as well as similar rights
and liabilities associated with sale transactions. Finally, Wakalah is a non-binding contract; the
principal or the agent may withdraw at any time by mutual agreement, unilateral termination,
discharging the obligation, destruction of the subject matter and the death or loss of legal
capacity of the contracting parties. If the agent concludes a contract that contravenes the terms
and conditions of the agency, the contract is not binding on the principal and its validity
depends on his approval. In case where an agent concludes a contract that apparently
contravenes the conditions, but the contract is beneficial to the principal, it is binding on him.
1.6.11 Tawarruq
Tawarruq is the mode through which Islamic Banks are facilitating the supply of cash to their
clients. The method consists of buying an asset and immediately selling it to a client, either
directly or indirectly, on a deferred payment basis. The client then sells the same asset to a
third party for immediate delivery and payment, the end result being that the client receives a
cash amount and has a deferred payment obligation for the marked-up price to the Islamic
Bank.
Islamic Banks use Tawarruq in the form of reverse Murabaha. Reverse where the client
requires a cash lump sum. The client buys an asset from the Islamic bank as in Murabaha, but
rather than the Bank retaining the asset for use in its business, it sells it to a third party.
Generally, banks deal with brokers who provide agency services and the commodity always
remain in the same place without transfer of ownership from the seller to the buyer; thus a
number of conditions of a valid sale may be lacking in such transactions. Furthermore, by way
of Tawarruq a person can obtain cash without taking an interest based loan. In fact, Tawarruq
is different from Bai al Inah that involves the sale and instant 'Buy-back' of an asset for a price
higher than that for which the seller originally sold it. Bai al Inah is not valid according to vast
majority of the Muslim Jurists and the mainstream theory of Islamic finance, as the goods are
sold back to the same person from whom they were bought. Whereas Tawarruq is considered
a halah way to get cash in the garb of trade using two contracts when the bank is really the
financier and not the seller. Trade profit is permissible because the parties undertake
commercial risks and add value in terms of facilitating the clients. Therefore, there must be a
known time-gap between the sale of the commodity by the bank to the client and the resale of
the same commodity in the market by the banks as agent of the clients. Otherwise, the
Shari´ah conditions for sale and purchase of goods such as possession, offer and acceptance,
etc. would not be fulfilled. If the sale and purchase are conducted in a single session and place
at pre-agreed prices without any time-gap, the element of risk would be eliminated; this would
contradictory to Shari´ah principles. Tawarruq is allowed by contemporary Shari´ah scholars
on the basis of Necessity provided that the commodity purchased is sold to any third party. If
sale and purchase are conducted under two separate contracts, legally the transaction would
not become usurious. However, resale to the same person is not approved by majority of the
Muslim jurists and Shari´ah scholars as it would deemed as a “buy-back” arrangement
prohibited under the Shari´ah rules. Another cautious condition could be required by some
jurists for a valid Tawarruq is that the process involved should not be pre-agreed among the
three contracting parties. However, in general, Islamic banks involve pre-agreement on
purchase, sale and resale of goods giving a fixed rate of return for banks without any
commercial risk. In fact, what happens, basically, is that the client makes the bank its agent to
resell the asset for cash in the market from where the bank had made the purchase.
1.6.12 Musawamah
Musawamah is a different form of Murabaha, in which parties bargain over the price of goods
to be traded without any reference to the price paid or cost incurred by the seller and where
the seller is not obliged to disclose the cost price. While the seller may or may not have full
knowledge of the cost of the item being negotiated, they are under no obligation to reveal
these costs as part of the negotiation process. This difference in obligation by the seller is the
key distinction between Murabaha and Musawamah. All other conditions relevant to
Murabaha are valid for Musawamah as well. Musawamah can be used where the seller is not
in a position to ascertain precisely the original cost of the commodities on sale.
Musawamah can also be either cash or a credit sale, but it is generally used as a credit sale, in
which banks negotiate with clients on the price of assets to be sold by the bank, and paid by
the client later. Banks add their profit margin to their cost but are not required to disclose the
details of their cost price and their profit margin in any transaction.
Musawamah is the most common type of trading negotiation seen in Islamic commerce.
Classical Muslim jurists generally preferred Musawamah over Murabaha for trading. It is
considered as easier because Murabaha implies a trust reposed in the seller and requires
detailed description to the buyer which could include a risk of some false. However,
Musawamah as a financing mode for Islamic banks is a not as efficient as Murabaha. The
absolute prices fixed for goods in the case of Musawamah, may lead to corruption and
mismanagement at a micro level. While, in Murabaha, the Islamic bank managers price the
goods by applying the profit margin or reference rate to their cost. Nevertheless, banks can use
Musawamah for large transactions, when it is difficult to determine the original cost of
particular goods or a service, or when the goods to be sold comprise a pool of products.
1.6.13 Kafalah
Kafalah is a contract whereby a person accepts to guarantee or take responsibility for a liability
or duty of another person. When it relates to an act, it is about ensuring the performance of a
certain act, the failure of which may render the surety liable and responsible. In finance, the
lender or the seller on credit can demand a security in form of Kafalah to which the seller
could have recourse in the event of failure by the borrower to fulfil the obligation of payment
for the goods.
»The guarantor (the surety) is responsible for (paying) the thing he guaranteed«.
(Ahmad
22195, vl5, pg267)
In Islamic banking, there are generally two forms of contracts for guarantee and safe return of
loans to their owners guarantee i.e. Kafalah and Rahn. They are both used to avoid any
iniquities to both parties in the contract of loan, especially to the creditor. Mutual
consent/agreement is the basis for validity of both the contracts as in other business
transactions. In the contract of Kafalah, a contract is made between the Bank and another
party whereby the Bank agrees to discharge the liability of a debtor in the case of default. As a
guarantor, the bank has the responsibility to honour the obligation of the debtor for whom a
third party is given. As a surety, the guarantee will give the bank some form of collateral and
pay a small fee for the services. The degree of suretyship in Kafalah should be known to all
parties. However, it is not necessary for the guarantor to mention the exact amount of the debt
guaranteed and it would be sufficient. Furthermore, Islamic banks can use different types of
guarantees to secure their receivables, such as, Letter of Guarantee, post dated cheques,
Promissory notes, Lien over cash deposits, Third party guarantee or Earnest money.
The creditor would have the right to demand payment from the debtor and the surety and if
the debtor does not pay, the surety will have to make payment to the creditor. In case the
surety is required to pay the liability, the debtor would then be bound to repay the surety. It is
lawful to become surety of a surety; and it is possible to have a joint guarantee consisting on
more than one surety for a single obligation. However, a person cannot furnish as guarantee
the goods that are pledged to that person or the assets taken by that person on lease.
In addition, Kafalah is a non-commutative contract and the Shari´ah scholars do not allow any
remuneration to be received for issuing financial guarantees. The reason why this is forbidden
in Shari´ah, is that guarantor's payment of the guaranteed sum will be similar to a loan
generating a profit to the lender, which would involve Riba. However, some Islamic banks
offers this service to its clients on a fee basis (Wakalah bil Ajr), they claims the right to seek
fees representing actual administrative expenses. These fees for the services rendered by the
banks should be commensurate with those charged by other banks. They will exclude the
interest which accumulates from the date of and the date of actual settlement by the client.
1.6.14 Istijrar
Istijrar is an agreement where a buyer purchases a particular product from time to time on an
on-going basis; each time there is no offer or acceptance or bargain. All terms and conditions
are finalized in one master agreement. There are two types of Istijrar: A type whereby the
selling price is determined after all transactions of purchase are complete; and a type whereby
the selling price is determined in advance but the purchase is executed from time to time.
In the first type, the seller discloses the price of goods at the time of each transaction and the
sale becomes valid only when the buyer possesses the goods. The sale and repurchase
transaction takes place regularly. The amount is paid after all transactions have been
completed. The seller may not disclose each and every time to the buyer the price of the
subject matter, if the other party knows that it is being sold on market value. In the second
type where the purchase price is not known, there may be a general acceptance between the
buyer and the seller that whatever the price may be at the time of possession, it would be
acceptable to the buyer.
As far as the use of Istijrar in Islamic banks is concerned, they are involved in four kinds of
activities, namely Ijarah, Mudarabah, Musharakah and Murabaha. Istijrar can work with
suppliers of the borrower. In this case, the Islamic bank enters into a Murabaha with the
suppliers on the basis of Istijrar. It will purchase assets from them at a market price.
Whenever the bank has a new client, it can purchase the assets from the suppliers on the basis
of Istijrar and sell it onwards to the client on the basis of Murabaha. The client may then
purchase the assets from the banks in tranches rather than at once and complete the whole
purchase within the specified time period in order to complete the agreement. The terms and
conditions of repeat sale could be of any normal cash or credit sales. An agreement may take
place between the buyer and the supplier, whereby the supplier agrees to supply a particular
product on an on-going basis, for example monthly, at an agreed price and on the basis of an
agreed mode of payment.
A typical Istijrar transaction could be implemented where, for example, a car production
factory approaches an Islamic bank seeking short-term working capital to finance the purchase
of a commodity such as air-conditioning units. The bank purchases the units at the current
price, and resells it to the factory for payment to be made at a mutually agreed date in the
future. The price at which settlement occurs on maturity is contingent on the air-conditioning
units' price movement from the day the contract was initiated to the maturity. Unlike a
Murabaha contract, where the settlement price would simply be a predetermined price, the
price of the Istijrar can be settled at any time before contract maturity. The price At the
initiation of the contract, both parties can agree on the predetermined Murabaha price or an
average price over the period. Normally, the bank would continue to deliver the specified
units at the price known to the client, and the client would make payment on a monthly basis
or as agreed between them. Separate offer and acceptance is needed for every consignment
based on a formal from the client to the bank.
1.6.15 Jua'la
Jua´lah is a unilateral contract promising a reward for the accomplishment of a specified task;
this mode of financing is permissible from the point of view of the majority the Muslim jurists;
it can be used for a number of banks' services and activities.
They said, "We are missing the measure of the king. And for he who produces it is [the
reward of] a camel's load, and I am responsible for it." (12: 72)
It is a relevant and useful contract for transactions where the subject not certain to exist or to
come under a party's control or where the required activity cannot be minutely. It can also be
used for undertaking various activities such the extraction of minerals, finding out any lost
asset or property, obtaining information or making a specific proposal for the offeror.
Generally, Islamic banks provide fee-based services to their client on the basis of Jua´lah that
include collection of debts, financing facility, asset management underwriting, Brokerage, etc
It is necessary to indicate the service and the reward in the Jua´lah contract. The reward
should be known, valuable, permissible and deliverable. The reward can also be portion of
the realised result. It can be paid in advance in full or in part before completion of the work.
Though, the service would not be a legal obligation upon the worker and the entitlement to
compensation for him will be contingent only upon execution of the contract, therefore, any
advance payment has to be treated as 'on account' and not as a payment for the
accomplishment of the specified task. Also, the worker is not entitled to a reward if Jua´lah is
terminated unilaterally by either party before the commencement of work. If the contract is
terminated by the one offering after the work is started, the one offering has to pay to the
worker a market standard wage.
Jua´lah is different from Ujrah and Ijarah where financial compensation, such as wages,
commission, rental, etc., is paid simply for using services or an asset. In fact, in Jua´lah, one
party offers specified compensation to the worker who may be any specified person or the
general public. In fact, an offer of Jua´lah can be issued to the general public in response to
which any person can undertake the work. He can be anyone who has to realise a determined
result in a known or unknown period. And while Ijarah contracts require that the work must
be specified, Jua´lah is relevant for transactions where the subject of the required activity
cannot be minutely specified such as bringing back a lost property from uncertain location.
Also, unlike in Ujrah and Ijarah, the worker will not be entitled to any compensation for effort
or time spent if the objective of Jua´lah contract is not realised.
Jua´lah can be comparable to Wakalah, when the worker is specifically designated; in that
case he will have to undertake the work and may also involve others with the express consent
of the offeror. The worker is considered only a trustee of any property or goods of the offeror
in the possession of the worker; he is not legally responsible for any loss with the exception of
any negligence, misconduct or violation of the terms of the contract. Moreover, an Islamic
bank may play the role of
the worker by signing a Jua´lah contract to provide a service. It may then carry out the work or
have it carried out through another parallel contract involving a third party provided the first
Jua´lah contract does not require that only the bank must undertake the work.
Part 2
Islamic Banking Operations
The ever changing consumer needs, intensified international competition, new regulations and
information technology upgrades are pushing banks to expand their product lines and
introduce new types of products and services to remain competitive in the industry. While
essential functions performed by financial institutions such as the provision of payment
services and facilitation of the allocation of economic resources over time and space have
remained relatively constant over the past years, the list of classic financial products is regularly
enriched by a number of new products, including short-term foreign currency advances,
factoring and securitization.
Some of the products that are the result of innovation process in commercial banks are longterm debt such as debentures, secured and unsecured notes, mortgages, floating rate notes,
leasing, project financing and derivative instruments. New securities traded by these banks
include ordinary shares, preference shares, bonds, treasury papers, debenture, secured and
unsecured notes issued by companies, exchange trade options and warrants. Banks also
innovate in derivative products such as interest-rate swaps, interest-rate futures, forward rates
agreements and options on future contracts. These derivative products tend to give a return
regardless to real-sector activities and even without the involvement of money. In a forwardrate agreement, for instance, no commitment is made between the parties to the FRAs to lend
or borrow the principal amount and the exposure of both parties is only to the difference
between the agreed interest rate and the settlement rate applicable at the date of settlement,
which reduces the risk for both parties compared to a classic load contracted in the future.
Similarly, interest-rate futures and options on future contracts can allow to reduce the
uncertainty of a future arrangement to both borrowers and lenders by locking interest rates at
present date. While interest-rate swaps allow companies to use their credit-standing to reduce
their overall cost. In this case, principal amounts are not physically exchanged. Only the
difference between the two operations is paid, which reduces the amount of exchanged cash.
The innovation in banking products also includes new market segments such as in
microcredit, where the traditional banking industry has begun to realise that these microcredit
borrowers should more correctly be categorised as pre-bankable; thus, microcredit is
increasingly gaining credibility in the mainstream finance industry and many traditional large
finance organizations are contemplating microcredit projects as a source of future growth.
SME oriented products is also another axis of development for banks where we see
specialized banks competing to offer comprehensive and integrated financial products as well
as business advisory services to SMEs.
INVESTMENT AND TRANSACTIONS
2.1.0 Islamic banks commercial transactions
Islamic banking has the same purpose as conventional banking except that it operates in
accordance with the rules of Shari'ah. The basic principle of Islamic banking is the sharing of
profit and loss and the prohibition of Riba. The main implication of the Shariah rules is that
Islamic banking is restricted to Islamically acceptable deals, which exclude those involving
alcohol, pork, gambling, etc. Thus, ethical investing is the only acceptable form of investment.
In addition, financial transactions are structured to reallocate risk-sharing and profits by using
the concepts such as Murabaha (cost plus), Musharakah (joint venture), Mudarabah (profit
sharing), Wadiah (safekeeping), and Ijarah (leasing).
Therefore, in an Islamic loan transaction, instead of loaning the buyer money to purchase the
item, an Islamic bank might buy the item itself from the seller, and re-sell it to the buyer at a
profit, while allowing the buyer to pay the bank in installments. However, the fact that this
profit cannot be made explicit and therefore there are no additional penalties for late
payment, Islamic banks use the concept of Murabaha to protect itself against default, by asking
for strict collateral. The goods or land is registered to the name of the buyer from the start of
the transaction. Another approach applied by Islamic banks is Musharaka where they lend
their money to companies by issuing loans in a way that the bank's profit on the loan is equal
to a certain percentage of the company's profits. Once the principal amount of the loan is
completely repaid, the profit sharing arrangement is concluded. Further, Mudarabah is
venture capital funding of an entrepreneur who provides labour while financing is provided by
the bank so that both profit and risk are shared. In this transaction, an owner entrusts funds to
a trustee, who returns the principal and a share of profits after using the funds for a specified
purpose. Such participatory transactions between capital and labor reflect the Islamic view that
the borrower must not bear all the risk/cost of a failure, resulting in a balanced distribution of
income. In the case of Musharakah, the joint venture which allows partners to share losses
based on the proportion of their capital contributions; And in Ijarah, the transaction allows a
bank to purchase equipment or machinery and lease it to clients who may ultimately take
absolute ownership;
Furthermore, Exchange transactions can be for immediate or deferred exchange. Yet, it is
recommended that future contracts be evidenced in writing.
O you who have believed, when you contract a debt for a specified term, write it down. And let a
scribe write [it] between you in justice. (2: 282)
Spot transactions need not be evidenced in writing but witnesses are recommended.
And let not the witnesses refuse when they are called upon. And do not be [too] weary to write it,
whether it is small or large, for its [specified] term. That is more just in the sight of Allah and stronger as
evidence and more likely to prevent doubt between you, except when it is an immediate transaction
which you conduct among yourselves. (2:282)
And the item for sale should be under ownership of the seller and in his physical or
constructive possession at the time of contracting the sale. However, Islamic banks may agree
to sell defined goods to the customers which they have not yet purchased provided that it does
not involve Gharar. Therefore, in Salam and Istisna'a transactions, where a price is paid at the
time the contract is formulated, but delivery takes place at a future date, goods must be
defined, quantified and available in the market at the agreed time of delivery.
2.1.1 Modes of investment and finance used by Islamic Banks
In recent times, Islamic financing services have increased phenomenally around the world.
Islamic banks now offer to their clients, different modes to investment their money and
finance their projects. These modes include solutions for short, medium, and long-term
project-financing and investments.
Profit-and-loss-sharing is the most common mode proposed by Islamic banks for import
financing, pre-shipment export financing, working capital financing and financing of all single
transactions. This mode could also be used in the case of socio-economic projects such as
infrastructure projects. Profit-and-loss-sharing (PLS) instruments include Mudaraba, an equity
participation contract under which one of the parties participates with capital (Rabbulmal) and
the other with know-how and work (Mudaarib). If the project ends in profit they share the
profit in a pre-arranged proportion and if it results in loss the entire loss is borne by the
financier, and the entrepreneur gains no benefit out of his effort, which was his part of the
investment.
He has known that there will be among you those who are ill and others traveling throughout the land
seeking [something] of the bounty of Allah. (73: 20)
PLS instruments also include Musharaka, an equity participation contract under which a bank
and its client contribute jointly to finance a project. Ownership is distributed according to each
party's share in the financing.
Besides, Islamic banks propose non-PLS modes of investment that include Shari'ah
acceptable forms of trade and leasing. Murabaha, salam and Istinasa are the most known
Trade-based techniques. Murabaha is a purchase and resale contract in which an asset is
purchased by the bank for its customer, with the resale price determined based on cost plus
profit mark-up. As opposite to Murabaha, Salam is a purchase contract with deferred delivery
of goods. While, Istisna is a medium-term contract, whereby the manufacturer, or the seller,
agrees to provide the buyer with described goods after they have been manufactured within a
certain time and for an agreed price.
Under, leasing-related financing, Islamic banks agree to purchase and maintain the assets and
afterwards dispose of them according to Shari'ah rules. Ijara, for example, is a leasing contract
whereby a party leases an asset for a specified rent and term. The bank bears all risks
associated with the item‟s ownership.
Finally, Islamic banks could use other schemes of financing such as the investment deposit
scheme that provides investors with an Islamic alternative to making short-term investments by
participating in the financing activities of the Bank. Under this scheme, the Bank accepts
deposits from both individual and institutional investors for use in its Import Trade Financing
Operations.
2.2.0 Deposits
Deposits from savers are an important source of financial strength for the Islamic banks. They
use it to increase their capacity for financing operations and thereby increase profit for the
shareholders. Islamic Banks raise funds generally based on Amanah or Wadiah arrangements,
on Mudarabah and on Wakalah for Fund Management. There are two main bases of
mobilisation of deposits by Islamic banks that are Current account deposits and Savings
deposits. Banks may also get permanent or redeemable equity capital through investment
deposits that practically take the form of a running partnership between the depositors.
Depositors in Islamic finance can be compared with investors/shareholders in companies,
who earn dividends when the investment makes a profit or lose part of their capital if the
investment posts a loss. The contractual agreement between depositors and Islamic banks
does not pre-determine any rates of return, it only sets the ratio according to which profits and
losses are distributed between the parties to the deposit contract.
In Islamic banks, Current Account deposits are based on the principle of Amanah / Wadiah
or that of Qard. In the first type, interest-free deposits are held by the banks either in trust
(Amanah), or in safe-keeping (Wadiah). Under Amanah arrangement, the Islamic bank treats
the funds as a trust and cannot use these funds for its operations; it does not guarantee the
refund of the deposit in case of any damage or loss to the Amanah resulting from
circumstances beyond its control. In Wadiah, the bank is deemed as a keeper and trustee of
funds and has the depositors' permission to use the funds for its operations in a Shari´ah
compliant manner. Deposits under Wadiah take the form of loans from depositors to Islamic
banks and the bank guarantees refund of the entire amount of the deposit at any time. While
these deposits can be withdrawn at any time, the depositors have no right to any return/profit
on such deposits. However, depositors, at the bank's discretion, may be rewarded with a
Hibah provided such gifts do not become a custom or a permanent practice.
It was reported by Abu Rafii that the Prophets (PBUH) took a loan of a young camel from a man.
When the charity camels came, he the Prophets directed Abu Rafii to refund the man his camel. Then
Abu Rafii came back to him and said that he couldn’t get except good seven years old camels. Then
the prophet said: "Give it to him, the best of people is the best in recompense". (Muslim, 4192)
In the second type, the client gives the bank authority to use current accounts funds to invest
in its operations, in that case, the deposit amount is considered as a non-interest loan by the
depositor to the bank. The bank has the obligation to return the credit balance upon demand
and the clients have no right to receive any profit on their balances. The liability to return a
Qard deposit is not affected by the bank's solvency or otherwise.
Savings deposit accounts operate in a different way. The depositors allow the banks to use
their money invested in profitable business ventures which are legal and Shari´ah compliant.
Generally, deposits in savings accounts are accepted by Islamic banks on the basis of
Mudarabah where the depositor is rabb-ul-mal (investor) and the bank is the Mudarib (fund
manager). The profit will be shared as per a pre-determined ratio upon, while loss will be
borne by the rabb-ul-mal. Profit distribution amongst the depositors and the shareholders will
be made according to the weightage assigned usually at the beginning of each month to their
investments. Savings deposits are generally paced in a joint investment pool with other
deposits mobilised by the Islamic banks.
Investment deposits are accepted for a fixed period of time or term and are governed by the
Mudarabah contract with the bank. When deposits are for an agreed fixed term, no
withdrawal is normally allowed until the end of the deposit term. However, some banks are
allowing early withdrawals in an agreed notice period. Term deposits are arrangement where
depositors seek some return on their investments; they are taken on a Mudarabah basis.
These deposits are allocated to a number of investment pools and the Islamic banks invest the
pooled amount in Shari´ah-compliant businesses. All direct expenses are charged to the
respective pools; the net proceeds are distributed between the bank and the pools and then
among the depositors represented by the pool. The profits from the assets are shared between
the depositors and the bank according to a pre-determined ratio agreed upon at the outset.
The profit sharing weightages are assigned based on the various tenures and the amount
invested under the arrangement. And as required under Mudarabah, depositors have to be
informed in advance of the formula used for sharing the net earnings of the investment pool
with the bank. In case of the unlikely event of loss, the depositors have to bear the loss on a
pro-rata basis while bank goes un-rewarded for all its efforts. If a bank contributes its equity
capital in a pool at the time of setting up an investment pool, the relationship will be a
combination of Musharakah and Mudarabah, and the bank would be entitled to a
proportionate profit on its own investment in relation to the total Mudarabah investment pool.
Islamic banks can also open announce Murabaha and leasing funds in which the risk-averse
investors may purchase units and be treated as rabb-ul-mal and get the quasi fixed-return from
profits or rentals earned by the respective funds from the trading and leasing activities.
2.3 ISLAMIC CREDIT CARDS
2.3.1 Halal credit cards
Credit cards are a very convenient method of making purchases without carrying cash. This is
a service that is provided by most banks as a form of consumer finance. Unlike conventional
credit cards that provide a revolving credit facility based on interest, Islamic financial
institution cannot issue credit cards that provide an interest-bearing revolving credit facility,
whereby the cardholder pays interest for being allowed to pay off the debts in installments.
In Islamic finance, a credit card is an instrument which provides the holder with the ability to
purchase goods and services from merchants, without requiring making immediate payment
of the cash price. It can be considered either as a guarantee given by the issuer to the seller
who accepts it or as a transfer of the debt by the debtor to the issuer. Hence, it falls within the
permissible transactions in Shari'ah. Payment is first made to the seller by the card issuing
bank, and the amount is then charged to the card holder who makes repayments according to
the agreement between them. The credit period is determined by the issuer of the card,
during which the amount due should be paid and no interest is chargeable. The cardholder is
also allowed to defer paying the amount due and is charged interest for the duration of the
credit. In the case of withdrawal, there is no free credit period.
The simpler model for the holder of a Shari'ah compliant credit card is to authorise the card
issuer (bank) to directly debit his bank account for amounts payable as billed by the card
issuer for the use of the card. This keeps him away from the possibility of default which may
in some cases, carry the risk of interest. The card holders can also deposit a sum of money
representing his own funds or savings with the card issuer as a guarantee for the stipulated
credit limit; no charge will be made for the use of the credit card up to that limit; therefore the
deposit is invested with the card issue on a non-interest basis, generally, on the basis of
Mudarabah. Otherwise, the payment to the card issuer can be made from cash funds obtained
from an Islamic bank through Tawarruq / Murabaha with the cash funds repayable on a
deferred payment basis.
Shari'ah credit cards consist of three permissible contract structures that make it different from
a conventional credit card, namely Kafalah (Surety), Wakalah (agency) and Qard (loan).
Under Kafalah, the card issuer guarantees payments on behalf of the cardholder to merchants
and other third parties; under Wakalah, the card issuer is considered an agent of the card
holder, he pays the merchants on behalf of the card-holder; with a promise to provide the
card holder with a loan to pay the amounts resulting from the use of the credit card; And
under Qard, the card issuer acts as the lender to the card holder withdrawing cash from the
card issuing bank and the card holder is liable to immediately return the amount of funds
utilised.
The card issuer may apply a Kafalah fee to cardholder as a membership fee to the cardholder
charged for certain services rendered by the card. This fee is determined
in advance and the term is fixed, the fee amount should not be linked to the amount actually
spent by the card holder. The card issuer may also apply an agency commission to the sellers
as a wage for acting as a financial intermediary in facilitating the settlement of transactions.
This commission should be a percentage of the purchase price of the items and services
purchased using the credit card. Cash withdrawal fee can be charged for any cash withdrawals
using the card; the charge should be a fixed amount per transaction. And late payment fee is a
fixed amount as penalty or compensation for late payment; it is calculated on the outstanding
balance and will be given to charity.
2.4 Fee-based services
Islamic banks offer a full spectrum of fee-based services similar to those offered by
conventional banks. These services may generate various types of fees and commissions, but
must not involve charging interest in any form or other non-permissible activities. The feebased services and operations of Islamic banks include bank transfers, issuing credit cards and
offering collection and safe-custody services. Like conventional banks, Islamic banks can
charge their clients a fixed fee/commission for providing a bank transfers service both inside
and outside the country; the fee charged must involve no interest and may vary greatly,
depending on the bank and its location. Sometimes, the remitting bank may issue its own draft
for the transfer amount and make a charge for this service; the draft is usually drawn on its
correspondent bank that will make payment from the funds held by the draft-issuing bank
when the draft is presented for payment. The Islamic bank can also charge a fixed fee if the
bank transfer is for payment in another currency. And if the bank transfer is in the currency of
the sender's country and the beneficiary requires the amount to be paid in local currency, then
the paying bank would charge an appropriate fee for converting the currency.
Issuing credit cards is another fee-based service offered by Islamic banks where no financing
or interest is involved. In fact the Islamic bank can charge a commission or fee for issuing the
card; all types of fees payable by the cardholder should be transparent and determined upfront between the bank, the card-issuer and the card-holder. A credit card-holder can claim
free credit if any amount paid by a credit card is settled before a certain date stipulated by the
issuer. If the amount is not repaid before the stipulated date, then the client should pay a fixed
commission as an interest charge on the outstanding amount. This commission charged is
normally not linked to the unpaid amount. The commission is also different from discounting
a bill of exchange, since it is determined irrespective of the time by which the cardholder
should pay the amount to the card-issuer. The card-issuer can receive fees derived from the
object price of the transactions or services rendered to a merchant, as a wage for being the
mediator, for marketing and billing collection and he can receive a cardholder membership
fee, as a service payment for the permissibility of using the card facility. The card-issuer is also
permitted to receive a fee from the cardholder on the basis of Kafalah, guaranteeing payments
for purchases made by the cardholder and to receive a fee for cash withdrawals as long as the
amount is fixed and not dependent on the amount of withdrawal. In addition, Islamic banks
provide safe custody services to their clients whereby it is possible for items of value, including
valuable documents and other possessions to be securely stored inside bank's premises. The
Islamic bank charges a fee for providing this service (1). However, the bank does not insure any
responsibility for, any items held in safe custody on behalf of clients. Islamic banks also collect
payments for their clients against trade related documents. Collections are documents received
by a bank from an exporter client to collect payment from the importer. Payment collected
from the importer against documentary bills are ultimately paid to the exporter less the bank's
handling commission. Commission charged is usually a flat amount, based on Wakalah, as a
service charge for handling such documentary collections and collecting payment for the
clients in the manner set out above. No financing or interest is involved in those services.
1
( ) Taking a fee on safe-keeping is allowed in Islamic law on condition that the fixed fee is well specified.
3.3 ISLAMIC ACCOUNTING
3.3.1 Financial accounting
Financial accounting plays an important role in Islamic banking in regulating and establishing a
harmonious integration among different parties involved in banking transactions. Islamic
accounting provides the information which users of the financial statements of Islamic banks
depend on in assessing the Islamic bank's extent of compliance with Shari'ah and determining
rights and obligations of all interested parties in accordance with the principles of Shari'ah.
There are many similarities between Islamic and conventional accounting, as both are about
providing useful economic information to permit users to make rational decisions by
facilitating comparisons and thereby minimising the cost of assessing alternatives investments.
However, the nature of transactions in Islamic organisations which deal within a Shari'ah
framework is different as Islamic organisations have a duty to contribute to socioeconomic
justice and stability.
While Conventional Accounting is based upon modern commercial law, Islamic accounting is
based upon ethical law originating in the Qur'an and Sunnah whose ultimate purpose is to
ensure that Islamic organisations abide by the principles of the Shari'ah in their dealings.
Information provided by conventional accounting focus on individuals who control resources
while Islamic accounting information concentrates on the community who participate in
exploiting resources. They aim at promoting efficiency, leadership and commitment to justice.
The differences lies also in the type of information needed in both types of accounting, and
how is it measured and valued, recorded and communicated. Conventional accounting is
based on economic events and transactions, while Islamic accounting is based socioeconomic
and religious events and transactions. In fact, conventional accounting mainly uses historic cost
to measure and values assets and liabilities; which restricts this model due to assumptions of
the monetary unit and its inflation. From an Islamic point of view, both financial and nonfinancial measures regarding the specific events and transactions are measured and reported.
To calculate the amount of Zakat, assets need to be measured in contemporary terms, not in
historical cost. The dual system of asset valuation using both historical cost and market selling
prices is likely to enable Islamic organizations to accommodate contracts and to discharge
their social obligations. For that purpose, Islamic accounting may also require different
statements for that in order to reduce the focus on profits by the income statement provided
by conventional accounting.
Another difference between conventional accounting and Islamic accounting is in the users of
the information. The management of Islamic corporations is accountable not only to the
shareholders it is accountable to the Society as a whole. These users need to evaluate that the
Islamic corporation makes money in an ethical way and in accordance with Shari'ah
principles, and deploy its resources in a profitable manner; hence Islamic organizations
should disclose additional information to their reporting, such as the liquidity, solvency, risks
taken, and contribution in fulfilling social responsibilities, such as protection of the
environment and contribution toward
charitable activities. Apart from the emphasis on the profit and loss statement, balance sheet,
and cash flow statement, a considerable amount of further information would be provided.
This would include a value-added statement and disclosure about social performance activities
of the firm.
3.3.2 Financial statements
Financial accounting plays an important role in Islamic banking in regulating and establishing a
harmonious integration among different parties involved in banking transactions. Islamic
accounting provides the information which users of the financial statements of Islamic banks
depend on in assessing the Islamic bank's extent of compliance with Shari'ah and determining
rights and obligations of all interested parties in accordance with the principles of Shari'ah.
There are many similarities between Islamic and conventional accounting, as both are about
providing useful economic information to permit users to make rational decisions by
facilitating comparisons and thereby minimising the cost of assessing alternatives investments.
However, the nature of transactions in Islamic organisations which deal within a Shari'ah
framework is different as Islamic organisations have a duty to contribute to socioeconomic
justice and stability.
While Conventional Accounting is based upon modern commercial law, Islamic accounting is
based upon ethical law originating in the Qur'an and Sunnah which ultimate purpose is to
ensure that Islamic organisations abide by the principles of the Shari'ah in their dealings.
Information provided by conventional accounting focus on individuals who control resources
while Islamic accounting information concentrates on the community who participate in
exploiting resources. They aim at promoting efficiency, leadership and commitment to justice.
The differences lies also in the type of information needed in both types of accounting, and
how is it measured and valued, recorded and communicated. Conventional accounting is
based on economic events and transactions, while Islamic accounting is based socioeconomic
and religious events and transactions. In fact, conventional accounting mainly uses historic cost
to measure and values assets and liabilities; which restricts this model due to assumptions of
the monetary unit and its inflation. From an Islamic point of view, both financial and nonfinancial measures regarding the specific events and transactions are measured and reported.
To calculate the amount of Zakat, assets need to be measured in contemporary terms, not in
historical cost. The dual system of asset valuation using both historical cost and market selling
prices is likely to enable Islamic organizations to accommodate contracts and to discharge
their social obligations. For that purpose, Islamic accounting may also require different
statements for that in order to reduce the focus on profits by the income statement provided
by conventional accounting.
Another difference between conventional accounting and Islamic accounting is in the users of
the information. The management of Islamic corporations is accountable not only to the
shareholders it is accountable to the Society as a whole. These users need to evaluate that the
Islamic corporation makes money in an ethical way and in accordance with Shari'ah
principles, and deploy its resources in a profitable manner; hence Islamic organizations
should disclose additional information to their reporting, such as the liquidity, solvency, risks
taken, and contribution in fulfilling social responsibilities, such as protection of the
environment and contribution toward charitable activities. Apart from the emphasis on the
profit and loss statement, balance sheet, and cash flow statement, a considerable amount of
further information would be provided. This would include a value-added statement and
disclosure about social performance activities of the firm.
3.3.3 Issue of taxation
Unfair taxation of Islamic products is an important issue for Islamic banks. In fact, Islamic
banking was build up in relatively tax free environment, and has now come to a maturity that
made many countries adapt their taxation laws to include specific provisions for Islamic
products and services. One of these countries is the UK, where, as a rule any interest
payments made by banks to its depositors is deductible from gross income before tax is
calculated, but interest payments related to the profit made by a bank considered as dividend
payments. As a consequence, its amount is not allowed to be deducted from gross income and
was considered as distribution of profit after tax. This resulted in a much higher tax charge for
Islamic banks and made some banks such as IBB economically unviable. There was also an
issue with double incidence of Stamp Duty on property financed using Islamic structures. In
fact, whenever property is purchased, the buyer is required to pay a government Stamp Duty.
The Islamic bank that buys the property before selling it on to the customer had a double
Stamp Duties payable.
To overcome this injustice and ensure that Shari'ah compliant products are taxed in an
equitable way than equivalent conventional banking products, the UK government amended
the Stamp Duty rules that excluded payment of double Stamp Duty on mortgage finance
arrangements and established a special Inland Revenue task force to review the taxation of
Islamic products. Islamic products were defined as “alternative Financial Arrangements” and
specific structures of the arrangements were added in the legislation. This only impacts the
specific structures of the products but not their principles. Profit and loss share agreements
that are economically equivalent to conventional banking products, but are not interest or
speculative returns are taxed no more or less favourably than equivalent finance arrangements
involving interest. Islamic deposits were taxed on the same basis as conventional deposits, and
the profit payments made for Islamic deposits are treated for tax purposes as any interest
payments.
The UK Finance Act 2005 defined the arrangements that give rise to profit share return in
case of Islamic deposit based on Mudarabah, as follows : a person deposits money with a
financial institution, the money, together with money deposited with the institution by other
persons, is used by the institution with a view to producing a profit, from time to time the
institution makes or credits a payment to the depositor, in proportion to the amount deposited
by him, out of any profit resulting from the use of the money, and the payments so made or
credited by the institution equate, in substance, to the return on an investment of money at
interest.
3.4 Financial Statements Analysis
The purpose of financial statement analysis is to evaluate the financial performance and
position of a company and define its strengths and weaknesses by analysing past and current
records of its financial activities. The major benefit of financial statements analysis is that the
investors get enough idea to decide about the investments of their funds in the specific
company. They are prepared to meet external reporting obligations and for decision making
purposes by estimating future risks and potential based on company's trends and relationships.
Financial analysis consists of an examination of financial statements of the company. This
includes notes to the financial statements that explain the accounting policies of the company
and provide details of how those policies were applied along with supporting details. The
examination also includes the auditor's report which indicates whether audited financial fairly
present the company's financial position in accordance with generally accepted accounting
standards. The information provided in the financial statements is not an end in itself as no
meaningful conclusions can be drawn from these statements alone. The information provided
in the financial statements can produce meaningful insights about a company's financial
information and its prospects for the future and can be used in making decisions through
analysis and interpretation of financial statements.
3.4.1 Asset, liability, revenue and expense in Islamic Banks
The general conceptual framework for the financial statements of Islamic banks is, by nature,
different from that of conventional financial institutions. Accounting concepts such as asset,
liability, revenue and expense may have specific grounds.
An asset is any item of economic value which could be converted to cash or have other
economic benefits. The asset side of an Islamic bank balance sheet may include various
instruments with different maturities and risk-return profiles. There are assets resulting from
short-term trade financing such as Murabahah and Salam; assets resulting from medium term
investments such as Ijarah and Istisna'a; and assets resulting from long-term investments such
as Musharakah. For an amount to be recognised as an asset in the balance sheet it should first
be recognized as valid from the Shari'ah point of view and the bank must be able to obtain
benefit from it and control the access of others to it.; assets as interest receivable in
conventional balance sheets are not considered as asset in Islamic banks' balance sheets. The
asset should also be capable of financial measurement with a reasonable degree of reliability
and should not be associated with an obligation or a right to another party. Liabilities are
obligation arising from a transaction or other event that has already occurred and that involve
the Islamic bank in a probable future transfer of cash, goods or services, or the forgoing of a
future cash receipt, the date of which and the settlement of which are measurable with
reasonable accuracy (Regulation and Supervision, Corporate Governance and Financial
Accounting of Islamic Banks; IIBI; 2009). Even an obligation that is not valid from the Islamic
point of view should be considered as a liability to the Islamic banks. By the nature of the
investment accounts of an Islamic bank, they are not considered as liabilities as they are in
conventional banks, because depositors of these accounts in Islamic banks are similar to
partners whereas depositors in a conventional bank create immediate claims on the bank. The
gross increase in assets or decrease in liabilities, during the period covered by the income
statement, represent the revenues resulting from legitimate investment, trading and other
profit-oriented activities of the Islamic bank. These revenues should not be the result of
investment by owners, deposits by investment account holders, deposits by current account
holders or the disposal of assets. On the other hand, the gross decrease in assets or increase in
liabilities, during the period covered by the income statement, represents the expenses
resulting from legitimate investment, trading and other activities of the bank, including delivery
of services. These expenses should not be the result of distribution of dividend to owners,
withdrawals by current account holders, withdrawals by owners or investment account holders
or acquisition of assets.
3.4.2 Risks to disclose in financial statements
Given the popularity of Islamic financial products as an alternative banking platform and the
increasing number of risks that Islamic financial institutions now take, they are obliged to be
transparent by making adequate disclosures to their financial statements. In addition, Shari'ah
compliance risk that should absolutely be taken into account IFIs, other types of risks should
be included into their financial statements. In that sense, the AAOIFI has issued guidelines for
accounting standards taking into consideration prudential rules to reflect the specific risk
characteristics of Islamic financial contracts. The AAOIFI has also clarified the assessment of
disclosures with regard to credit, market and liquidity.
Due to the high proportion of investments in equities in the financial position of Islamic
Financial institutions, AAOIFI standard gives an particular attention to the disclosure of
Investment / Market Risk by including in the financial statements of IFIs various information
regarding the classification of securities, their market value and the movement in provisions
for these securities. In the case of Mudarabah, disclosure may include an explanation of the
reason for not giving fair value, principal characteristics of the investment, and information
about the market for such investment. Regarding credit risk, AAOIFI standard require that
general disclosure in the financial statements of IFIs cover information on concentration of
assets risks by economic sectors and geographical areas, distribution of assets in accordance
with their maturity and disclosure of related party transactions. Disclosure regarding
Murabahah sales receivables focuses on the maturity profile of assets and liabilities, by
separating the bank's own assets from the assets managed for investment account holders. This
would facilitate the identification of maturity mismatches, and thus the estimation of liquidity
risk taken by the financial institution. The disclosure with regard to Liquidity Risk is another
important point despite the fact that liquidity of IFIs is generally good because of the
concentration of their financing operations in self-liquidating short-term Murabahah financing
and commodity backed placements with banks (Regulation and Supervision, Corporate
Governance and Financial Accounting of Islamic Banks; IIBI; 2009). And despite some
concerns regarding their macro level liquidity in the event of financial distress due to their
refusal of interest, most Islamic banks are keeping compensating balances with other
commercial or central banks, to meet urgent liquidity needs of the respective counterparties.
Furthermore, Islamic banks are subject to operational risk due to the particularities of their
contracts and the general legal environment where they operate. In fact, there are also
potential difficulties in enforcing Islamic contracts in a broader legal environment and
potential costs and risks of monitoring equity-type contracts and the associated legal risks. For
example, there is a cancellation risk in the non-binding Mudarabah and Istisna'a contracts.
There is also a risk due to the need to maintain and manage commodity inventories often in
illiquid markets. And any failure of the internal control system to detect and manage potential
problems in the operational processes and back-office functions could affect the banks activity.
3.5 THE ORGANISING GROUP
3.5.1 Starting an Islamic Bank
Requirements to start an Islamic bank often vary greatly from country to country. Many
difficulties may arise when establishing an Islamic bank in complying with rules originally
conceived for the regulation and supervision of conventional banks. These rules intend to
ensure the viability and strength of individual banking institutions to secure the entire banking
system in the country; they often include principles such as capital certainty for depositors and
certainty as to the rate of return on deposits. Therefore, it is important for sponsors willing to
establish an Islamic Bank to be aware for familiar with national banking laws and regulations
that would affect Islamic banking operations; they must ensure that the activity has been preapproved under existing law, or must seek a determination from the regulator to permit the
activity of the Islamic bank. Introducing new business practices of an Islamic bank may be an
unusual concern to a regulatory body which main activity is to regulate and supervise
conventional banks. Most Central Banks require commercial banks to follow a capital
adequacy ratio for liquidity purposes by investing a percentage of their liabilities in approved
securities which are often interest bearing. In addition, regulators do not generally authorize
banks to engage directly in business enterprises using depositors' funds. Islamic banks also
need an interbank money market not using interest bearing transactions or using dual system
off-loans their excess liquidity, which may not be available in the country. Therefore, there is a
need for some concessions to an Islamic bank in order to meet these legal requirements;
government intervention or active support is also necessary to establish Islamic banks working
under the PLS scheme by introducing or adapting legislation or by giving Islamic banks special
dispensation to conduct their activities.
In addition, it is important for sponsors wishing to establish an Islamic bank to look into the
corporate tax and personal tax structures and look for any available exemptions. Tax
implications are more imperative for an Islamic bank than for a conventional. In fact, profit
paid to Islamic bank's depositors should be treated as an acceptable charge for the bank, just
as interest paid by conventional banks to their depositors is. Besides, there could be an issue
of double taxation in the case of Islamic trade financing where goods are transferred twice,
which could decrease the profitability of the venture. The rates of personal taxes and other
statutory payments will also have an impact on charges on the total employees' costs and hence
on the cost of operations.
The organizing group should also study the foreign exchange position of a country, as it may
have a direct impact on the bank's foreign trade transactions and affects their processes and
profitability. In fact, in a country that places exchange controls restrictions on the free out flow
of foreign currency, most investment will have to be made in the locally in the local currency
equivalent; this will also negatively affect the volume of import financing; and in the case where
the Islamic bank had surplus liquidity in foreign currency it would not be able invest the
money on its own. Regulations for investment of resources in international markets and on the
repatriation of the bank's capital, dividends and profits are other important aspects to be
studied.
3.5.2 Education and training
While recruitment in the conventional banking sector is not difficult because of a well-oiled
assembly line of human resource capital churned out by universities and other professional
bodies, in the Islamic banking sector it is a different story. The Islamic finance sector has too
conveniently relied on the conventional sector to recruit their staff. These appointed persons
have no or limited previous Islamic banking experience; they are not generally very familiar
with interest-free banking and may fail to carry out proper Islamic banking operations or
follow Shari'ah Board's resolutions. Therefore, these staff must be given reorientation or
training in all Islamic banking practices. Islamic Banking brought in various training needs
regarding products and processes compliance to Shari'ah. In the absence of external; training
providers, some Islamic banks set-up their own in-house training arrangements with the help
of experts, to provide training in the different areas. Experienced staff also regularly assists
operations staff recruited from conventional banks in handling the new practices, regulations,
products and services.
The availability of competent Islamic scholars is also an important factor that would determine
the success or failure of the establishment of an Islamic Bank. Shortage of competent persons
to represent the Shari'ah Supervisor Board, in especially in the west, is the most important
problem in Islamic Banking human resources. In fact, Shari'ah scholars are essential for the
supervision of the Islamic bank and rule on Shari'ah compliance of products and services
offered. The qualifications and experience needed for that role is also a matter of conflict that
needs to be clearly defined. In most cases, an experienced Shari'ah scholar expert in Islamic is
hired to select members of to the Shari'ah Supervisor board of the bank.
In addition, staff recruited for marketing and sales positions should have the understanding
and the skills to widen the market for Islamic financial products and enhance the image of the
Islamic bank. Marketing could help Islamic banks attract a wide range of investors and to
diversify their revenues. The Marketing staff should perfectly know the unique features of
Islamic banking and use it to attract Muslim and ethically-minded customers and businesses.
3.6 RELATIONSHIPS WITH CENTRAL BANKS
Central Banks
Central Banks play the major role in supervisory activities applied on banks in different parts
of the world, their activities cover checking registers and books for the purpose of validating
sound assets and operations. They are also involved in developing rules and principles related
to bank operations in general, and establishing the range of dealing with specific activities and
clients. The cooperation between Islamic and Central Banks of states where they operate is an
important aspect to help foster the growth and development of Islamic banks and to assist
them in competing with conventional banks. In fact, the position of Islamic banks necessitates
that central banks facilitate the work of such units, and support them in performing their
positive role in sustainable development in the countries in which they operate. Islamic banks
need to be accorded equal treatment in regard to fulfillment of the requirement of building up
of general and special reserves, limitation on equity, voting rights, licensing and establishment
of new branches. Therefore, central banks in a number of Muslim majority countries have
established the Islamic Financial Services Board to promote establishment and development
of Shari'ah compliant financial services industry, characterized by prudence and transparency,
through the adoption of international standards compatible with Islamic banking principles
and methods.
The nature of the relationship between Islamic banks and central banks differs from one
country to another; it depends on the legal framework which regulates the status of Islamic
banks within these countries. Some states have issued special legislation for Islamic banks
besides the legislation for conventional banking system. Other states have had the initiative to
develop and enforce legislations which would allow establishing Islamic banks in accordance
with specific laws and regulations. Yet, there are three aspects of the central bank's relationship
with Islamic banks that are lender of last resort, a clearing house and supervisor in regard to
monetary policy. As a lender of last resort, the central bank can manipulate the supply of
money to the commercial banks and hence to the public, it can lend directly to banks to
provide liquidity support directly to a bank that cannot obtain finance from other sources.
And more generally it oversees the financial sector in order to prevent crises, protect
depositors, prevent wide-spread panic withdrawal, and thus to prevent the damage to economy
that may be caused by the collapse of banks. While, the central bank provides finance to
conventional banks in the form of an interest based debt, mostly short-term, or by
rediscounting commercial bills, which are prohibited in Shari'ah, it provides liquidity for
Islamic banks on the basis of form of Mudarabah or Musharakah capital. The central bank
would share in the profits from the Islamic bank's investment of the money over the period
for which the fund are advanced. As a clearing house, the central bank provides Islamic banks
with facilities for the settlement of cheques and other payments and services around
documentary letters of credit and guarantee in return for a commission. The Islamic bank
using the clearing system opens a current account with the central bank and limited short-term
temporary overdraft facilities exempted of interest are occasionally allowed to cover any
temporary shortfalls for settlement purposes. The central bank may allow limited short-term
temporary facilities free of interest in the case of Islamic banks on the basis that these banks
would place compensatory funds of the same amount for an equivalent duration, interest free
with the central bank, or on the basis of sharing in their profits for the period of the shortfall.
And as supervisor in regard to monetary policy, the central bank influence credit availability
and inflation through money to provide a stable economic growth. It should design patterns
and forms of regular data required from Islamic banks to be developed and approved by
central bank and Islamic bank representatives in order to comply with the nature of Islamic
bank operations. Some central banks have set a lower level for the liquidity ratios within
Islamic banks in comparison with their counterparts in other banks, taking into account the
specific nature of their dealings.
However, there are some areas where different controls need to be done between Islamic and
conventional banks depending whether they involve interest or not; these controls include
statutory cash reserve requirements, liquidity ratios, deposit insurance schemes, credit ceilings,
distribution of Islamic banks 'profits, inspection of banks, profit equalisation fund and
monetary assets. In fact, control of Islamic banks should take account of their specific
characteristics; the statute of an Islamic bank must be approved by the central bank before the
latter gives the bank permission to operate. Thus, control of the activities of an Islamic bank
and examination of its processes should be conducted in accordance with its statute. Central
banks should have a distinctive set of guidelines for the inspection of Islamic banks as well as
regulations to safeguard Islamic investors' interests. The central bank may also evaluate the
investment programmes of Islamic banks. For example, in cases where central banks pay
interest on cash reserves, the ratio of reserves required from Islamic banks could be reduced
on the grounds that they are not demanding any interest. Also a special consideration should
be applied by central banks when applying credit ceilings to Islamic banks. Also, the minimum
interest rates prescribed to commercial banks to pay on savings and time deposits should be
replaced in the case Islamic banks by a weightage system to be given to these deposits for the
purpose of profit distribution by the banks.
PART FOUR
CAPITAL MARKET OPERATIONS
4.0.1 Islamic approach for Financial Market
Islamic financial market is the market where the financial instruments are traded in ways that
do not conflict with the Shari'ah principles; it plays an important role in generating economic
growth and complimenting and broadening the Islamic banking. Islamic financial market
transactions are required to be carried out in ways that do not conflict with the Shari'ah so that
the market is free from activities prohibited by Islam such as excess encompassing Riba,
Maysir and Gharar. Therefore, there is a need to review the present practices prevailing in the
financial market to identify which of these practices needed to be reformed from an Islamic
point of view and which of them may be acceptable.
The objectives of the Islamic financial market are to ensure the equitable allocation of capital
to sectors which would yield the best of returns to the owners of capital and to ensure that
there exists sufficient investments opportunities to attract surplus funds in accordance with the
owners' preferences in terms of the extent of risk involvement, rate of return as well as the
period of investment. Equity-based securities that don't guarantee any return and don't include
forbidden businesses can constitute investments in line with Islamic financial law. Whereas
debt-based securities that carry a fixed return until maturity, such as debentures, bonds,
preferred stocks and commercial paper, are inconsistent with Islamic principles and it would
therefore be necessary for new instruments to be designed to replace them. Preferred stocks
can match within the Islamic framework by turning them into redeemable equities with an
element of participation in both earnings and the proceeds of liquidation.
However, debt and preferred stocks would be replaced by Islamic instruments. In fact, Islamic
financial instruments have particular characteristics to comply with the Shari'ah rules, they
should represent share in equity, real assets, usufruct or a combination of some or all of these,
they should not earn money on debt and their holders must be the owners of whatever rights
these instruments represent and bearers of all related risks. The tradability of an instrument
related to a debt must in accordance with Shari'ah rules and it should not be allowed to earn
any return. In addition, at the Issuance of Islamic financial instruments based on Mudarabah
or Musharakah, the issuers should keep separate accounts for each specific project
(ziaahmed.org; 09.2009), the prospectus should include full disclosure of the nature of the
activities, contractual relationships and obligations between the parties involved and ratio of
profit sharing and the profit and loss accounts must be declared at the date mentioned in the
prospectus and balance sheets; the Principle and expected return on investment cannot be
guaranteed. An example of fixed-return contract approved by the Shari'ah is Ijarah and it is
possible to raise funds by this mean through the Stock Market. Lease-stocks will give
ownership to the stockholders of the leased equipment, from which they will receive a known
flow of
rent. This is allowed in Shari'ah since they will have to borne the risk of the eventual value
being much lower than was estimated.
Furthermore, since the entire capital resources, both short-term and long-term, in Islamic
system are equity-based and not debt-based there is a need for a continuous pricing
mechanism to the Islamic financial system to prevent it from major shocks and crashes
(ziaahmed.org; 09.2009). For this purpose, there are three key areas of the market that need
to be constantly reviewed that are speculation, information disclosure standards and the
regulations guiding operations and trading practices. Speculation can cause wild swings in the
market through misallocation of resources resulting in losses and gains entirely unrelated to
real economic effects. Such results are like the results of gambling, involving transfer of
resources among the participants but adding nothing to the initial stock of resources. The
adequate flow of public information is what protects investors by ensuring that significant
changes in shareholding are not the result of some people having inside information not
available to the public. And the regulations guiding operations and trading practices require
restrictions to ensure an adequate flow of information about the business whose securities are
being traded and to control the trading practices in the market. These define the role of
brokers and dealers, set margin limits and control fees and commissions.
4.0.2 Stock market from the point of Sharia'h
Stock market is one of the most important sources for companies to raise money. It is simply
a central place where people come together to buy and sell stocks. Investors and security
issuers both participate in stock markets. Different sized entities participate in stock market
activities, ranging from small investors to the governments, corporations, large hedge fund
traders, and banks. The companies involved must be publicly held companies; which means
that they have to be companies that sell stocks to public investors on an open market. In
addition to acting as a market place for stock trading, stock markets also act as the
clearinghouse for each transaction, meaning that they collect and deliver the shares, and
(1)
guarantee payment to the seller of a security . This eliminates the risk to an individual buyer
or seller that the counterparty could default on the transaction. In addition, stock markets
provide an effective tool for controlling private sector performance, particularly that of public
companies, and offers the facility for the exchange of information about investment
opportunities to help improving investors' decisions
The Stock Market performs a number of useful functions in the economy, the most important
one is intermediation; in fact, stock market channels money from savers to investors, this
provides long-term capital to business through equity or debt and provides flexibility in the
mobilising of funds, giving diversity of risk. The primary market, where securities are sold for
a company's initial public offering, serves to help firms to raise new resources, while the
secondary market, which is where investors trade in companies that are already publicly held,
facilitates liquidity of investments through the trading of shares. Stock markets also perform
the function of valuation of Businesses. In fact, the value of a firm is determined by pricing its
securities on the basis of the present value of the expected stream of cash flow generated over
the life of the firm. The market value is influenced by various productive aspects of the
business, such as earnings potential, debt/equity ratio and entrepreneurial expectations
regarding future growth; as well as by the psychology of the buyers and sellers in the market
(marketminds.esecfutures.com; 09.2009), which can produce a market valuation, which is
totally detached from the real economic strength of the firm and is highly susceptible to
speculation. The stock market also provides the necessary infrastructure to ensure the
independence of the management from the owners of the firm. This independence enables
the management to pursue long-term policies and raise large amounts of capital. Finally, stock
market helps to overcome the inherent illiquidity external financial claims. These claims are
usually highly illiquid outside the market and can become highly liquid through being listed
and traded on the Stock Market.
The major activity in the Stock Market is the buying and selling of equity-based securities, that
are, shares in businesses. These investments do not guarantee any return and the investor has
an even chance of loss. Therefore, this activity is in line with Islamic financial law. But the true
Islamic spirit demands two other conditions for an investment: first, the business invested in
must not be one that is forbidden, and second, the entire capital structure of the firm must
conform to Islamic financial principles. Debt-based securities such as debentures, bonds,
(1) articlesbase.com/investing-articles; 09.2009,
preferred stocks and commercial paper also constitute an important proportion of the capital
market. These types of securities carry a fixed return until maturity and are inconsistent with
Islamic principles; it is then necessary for new instruments to be designed to replace them.
There also the Preferred stocks where, preference stockholders have priority in getting their
money back over ordinary share holders in case of bankruptcy. This can be easily adapted to
be conforming to profit and loss sharing principles in Shari'ah; however in some cases, after a
certain amount of dividend has been paid to preference stockholders, they share in the profits
with common holders, this is contrary to the principles of Islamic financing, in fact, any
priority in the matter of dividends or assets is completely unacceptable to Islam as no fixed
return can be paid to any of the parties in a participative arrangement. Preference holders
should be given an element of participation in both earnings and the proceeds of liquidation
to be acceptable in Islam. In addition, new types of Islamic instruments can be introduced to
stock markets to help mobilising more financial resources. Ijarah, for example, is a type of
fixed-return contract approved by the Shari'ah and it is possible to raise funds by this mean
through the Stock Market. Lease-stocks will give ownership to the stockholders of the leased
equipment, from which they will receive a known flow of rent. The terminal value of the
equipment will be shared by the stock holders, but meanwhile they will have borne the risk of
the eventual value being much lower than was estimated. Largely, there is need for innovative
structures for taking the Islamic stock markets forward without compromising the basic
Shari'ah principles at the expense of business rationality, the innovation which should
comprise knowledge of cutting-edge financial technology, deep understanding of Islamic
commercial law and awareness of the needs and trends in the Islamic financial industry. Some
concessions may be needed in certain circumstances; this should not become the norm.
4.0.3 Arbitrage, hedging (1), speculation and options
A Derivative is a financial product that is derived from some other asset; it can be used by
investors to hedge various types of risk by entering into a derivative contract whose value
moves in the opposite direction to their underlying position, they can also be used by investors
to speculate and to make a profit if the value of the underlying moves the way they expect.
Derivatives are generally zero-sum exchanges between two parties; they are not real
transactions since they are settled through price differences without delivery or ownership
transfer. Only money changes hands at the end of the contract, while the delivery of
underlying assets is very rare. Derivatives are used to distribute risk among market participants
in accordance with their ability to assume them. Risk is an inevitable challenge for economic
progress; however there is a need to reach a balance between the absence of risk and an
excessive risk. Islamic financial framework imposes to control by associating it to ownership of
real goods and services and to integrate it in real activities.
Practices such as speculation, arbitrage, hedging and options are associated to derivatives. In
fact, derivatives can be used to acquire risk, rather than to insure or hedge against risk
(wikipedia.org; 08.2009). Thus, some investors enter into a derivative contract to speculate on
the value of the underlying asset, betting that the party seeking insurance will be wrong about
the future value of the underlying asset. Speculators will want to be able to buy an asset in the
future at a low price according to a derivative contract when the future market price is high, or
(1) Any technique designed to reduce or eliminate financial risk; for example, taking two positions
that will offset each other if prices change. Arbitrage is a kind of hedged investment meant to
capture slight differences in price; when there is a difference in the price of something on two
different markets the arbitrageur simultaneously buys at the lower price and sells at the higher
price
to sell an asset in the future at a high price according to a derivative contract when the future
market price is low. Islam allows genuine speculation, but professional speculation, where the
intention is just to exploit the situation, is not allowed. Investors may also look for arbitrage
opportunities, as when the current buying price of an asset falls below the price specified in a
futures contract to sell the asset. Arbitrage consists on making money out of the very
temporary difference in prices at two markets; the one who is doing arbitrage plays an
economic role by stabilising the prices in different markets, as the difference in prices just
cannot stay for more than a few seconds in the highly sophisticated international markets.
Arbitrage is allowed in the Shari'ah if delivery is actually involved. Moreover, hedging is a
common practice designed to eliminate or reduce risk; it occurs when an investor buys an
asset and sells it using a futures contract. The investor has access to the asset for a specified
amount of time, and then can sell it in the future at a specified price according to the futures
contract. Of course, this allows the benefit of holding the asset while reducing the risk that the
future selling price will deviate unexpectedly from the market's current assessment of the
future value of the asset. Hedging naturally belongs to Islamic economic objectives as long as it
does not involve pure speculation and gambling-like activities. In addition, options can be
used as a risk-management device by hedging the risk. The idea of a stipulated sale with
penalty is quite old. However, as such it was not used for fixing current price to benefit from
future price movements, but for real trade transactions. Options are of three types: 'Call', 'Put'
and 'Put and Call'. In a Call option the buyer has the option of buying at any time during the
Call period at today's price by paying a small premium to the other party; the option will be
worth exercising if the price goes above today's price plus the premium paid. In a Put
option, the buyer has the option of selling at any time during the Put period at today's price, by
paying a small premium to the writer. A Put and Call option gives the right to sell or buy. The
buyer of the option also gets some time for assessing the benefits and costs of entering into the
transaction. The majority of scholars do not allow options trading as both the delivery as well
as the full price are deferred (ziaahmed.org; 09.2009), as it can be very speculative, but some
allow it as it involves a right for purchase/sale. The Shari'ah also does not allow any premium
for the option, as it is not an actual sale or purchase; it is only a right, which is an abstract
object. In Islamic banking, the closest to an option is the khiyar al-shart option. There is
general agreement that these contracts are valid if and only the contract itself cannot be bought
or sold.
4.1.1 Islamic Unit Trusts
A Unit Trust is an investment vehicle that allows investors to take advantage of investing in a
diversified group of stocks which manages risk and exposure to one or a few stocks. It also
offers the opportunity to participate in the long-term performance of the stock market. Islamic
Unit Trusts add other aspects that are a screening process to remove stocks of companies
deemed to be inappropriate for Muslim investors and cleansing or purification of a company's
profits by removing any income derived from non-Shariah complaint sources, such as interest
a company would earn on its bank accounts and donating them to charities. Therefore,
Islamic unit trust schemes are required to additionally appoint a Shari'ah committee or to
ensure that their operations are in accordance with Shari'ah.
Islamic Unit Trusts can invest in many financial products in conventional financial markets
which are not interest-based, or where the element of interest could be eliminated, such as
property funds, commodities, financial options and futures and forward transactions in foreign
currencies (Treasury and Capital Market Operations by IIBI; 2009). They can take advantage
of international markets growth by giving priority to equity investments in Islamic banks and
financial institutions, stock markets of Muslim countries; and companies managed under the
Islamic system.
The manager of a Unit Trust mutual fund would typically invest the pooled money in a
portfolio which may include the asset classes such as cash, bonds and deposits, shares,
property and commodities; tangible assets represent more than 51% of the portfolio. Islamic
Unit Trusts have also a wide range of investment options based on growth and income, openended, redeemable, etc. Their investments can cover international equity markets, currencies
and properties. A Mudarabah fund can invest in a specific business activity on the basis of
profit and loss sharing; Murabahah fund invest in companies whose transactions are
undertaken on a cost-plus basis; Through Musharakah the Unit Trust and the third party
contribute funds in a joint venture, producing equity participation; And in Ijarah fund, the
Islamic Trust finances equipment, building or entire project for a third party against an agreed
rental. Besides, there will be no restriction to stop non-Muslims investing in an Islamic Unit
Trust.
4.1.2 Islamic Unit Trusts / Ethical Unit Trusts
A good analogy with Islamic Unit Trusts is one of ethical and green Unit Trusts. Here the
universe of investable securities is limited by certain criteria based on moral and ethical
considerations (muamalah.com; 2009). An ethical investment is the principle of investing in
companies which make a positive contribution to the world and avoiding those which harm
the world, its people or its wildlife. Society's increasing awareness of its environmental and
social responsibilities is impacting on financial services, more and more investments based on
ethical principles are now available. Some may think that the restrictions imposed by ethical
investment with strict criteria may result in weaker performance; however ethical funds have
often matched or beaten their non-ethical counterparts.
Ethical investments are generally made through managed funds such as unit trusts which
speciality is to seek profits for investors while conforming to certain ethical criteria such as that
the company is not involved in activities like illegal armaments, gambling or pornography, or
that it doesn't produce or distribute alcohol, tobacco or drugs. Before buying shares of
companies in a chosen sector, an ethical fund manager will run checks on that company to
find out if it has interests in a number of areas according to pre-determined criteria.
Accordingly, clients who invest in ethical funds can be sure that their money will be invested in
companies that engage in legal and ethical activities.
Islamic Unit Trusts investments are also based on specific criteria based on morality, the main
criteria is to not deal in transactions which involve the paying and receiving of interest. Islamic
Unit Trusts should be run on a transparent and modern corporate basis and up-to-date
accounting and within a legal framework in conformity with the Shari'ah. In the same way the
decision to invest in the case of ethical unit trusts is made by the fund managers, based on
information received from various professional bodies and specially constituted committees of
reference, the decision in the case of Islamic unit trusts is conditioned by the a binding
approval from the Shari'ah Boards which consist of established religious scholars who make a
decision based on the interpretations of particular operations and contexts.
4.4 ISLAMIC MARKET INDEXES
4.4.1 Islamic Market Indexes
Islamic funds must appoint a Shari'ah board to provide guidance to the managers of the fund
on matters of Shari'ah law and, in particular, whether the proposed investments of the fund
are Shari'ah-compliant.
So ask the people of the message if you do not know. (21: 7)
The Shari'ah Board should be independent from trustee and portfolio manager. Its role
includes portfolio purification, selection and monitoring, working with fund management, and
monitoring of fund fees and fund documentation. Portfolio purification consists of deducting
the income from interest-bearing investments from total earnings and ensuring that the
portfolio doesn't include prohibited investment transactions. The supervisory board also
oversees the choice of investments by screening stocks that could allow the fund to subscribe
to an Islamic index. The selected stocks need to be continually monitored by Shari'ah boards
to check any context change and to remove stocks that fail to comply with the criteria from the
fund portfolio. In addition, fund managers may not always be clear on the application of
Shari'ah principles in certain situations or complex financial instruments and there is likely to
be lapses and mistakes with regard to non-compliance; especially when the fund manager is a
non-Muslim. Shari'ah Board should ensure that investors are made aware of the fund's fees
and how these are structured. It is also involved in the preparation and review of all pertinent
legal and business documentation as all documentation of the fund requires making
references to the Shari'ah and its interpretations.
4.4.2 Dow Jones Islamic Indexes
The Dow Jones Islamic Markets (DJIM) Index Shari'ah Supervisory Board was established to
advise on the methodology for screening securities for inclusion in the Dow Jones Islamic
Market Indexes and related matters relating to the Shari'ah compliance of the indexes' eligible
components. The independent Shari'ah Board consists of five eminent Shari'ah scholars from
around the world. The geographic diversity of the scholars ensures that diverse interpretations
of Shari'ah law are represented (1). The DJIM approach is a good example of Islamic
screening; it takes place at three levels: prohibited industries, acceptable financial ratios and
monitoring, removal and replacement. The companies in the DJIM are reviewed on a
quarterly basis for continued compliance. The first level of DJIM financial screens examines
the leverage ratios of the company in question. The debt/market capitalisation ratio
requirement was set by the DJIM Shari'ah supervisory board to at less than 33 per cent. The
DJIM financial screens then try to establish the level of non-operating interest income that
should be kept to a minimum; the Haram income must be purified by way of giving to charity.
The board does any purification methodology or formula to all Islamic transactions. In term
of liquidity screens, Muslim scholars consider that it is permissible for an Islamic investor to
purchase shares of a company whose accounts receivables do not exceed 45 per cent of total
assets. DJIM screening also stipulate that an Islamic investor may not purchase securities, with
a predetermined rate of return and a guaranteed principal, and he may not purchase the
shares of companies whose primary or basic business is unlawful. Instead he is encouraged to
seek out and examine the merits of special companies with pro-environmental policies, or that
provide humanitarian services.
(1 ) djindexes.com, Sept, 2009.
4.4.3 LIBOR Indexes
As more and more Islamic banks begin to operate globally, a benchmark for the Islamic
banking industry is needed to evaluate the performance of Islamic products. The LIBOR
index has been approved by Shari'ah boards for use as a benchmark for Islamic returns.
LIBOR is the London Interbank Offered Rate, a financial benchmark based on interbank
lending rates in short, an interest rate-based measurement. And, since Islamic banks cannot
charge interest on financing and leasing operations in pricing their profit mark-up and rental
income, some scholars will continue to be divergent about the pricing of Islamic products
linked to conventional interest rate benchmarks until the Islamic financial system can establish
its own benchmark.
Yet, LIBOR benchmark is widely used to determine the pricing of Islamic financing as well as
Islamic investment products. In fact, profit based on a rate of interest should not be as
prohibited as interest itself even though the use of the rate of interest for determining
permissible profit cannot be considered desirable and the appearance of Islamic valid
transactions to an interest-based financing should be avoided as far as possible.
Therefore, many institutions financing by way of Murabahah and Ijarah determine their profit
on the basis of current LIBOR rate, the mark-up on Murabahah can be equal to LIBOR or
some percentage above LIBOR. Similarly, rental income in an Ijarah agreement can be based
on LIBOR. Still, that the essential condition for the validity of Murabahah or Ijarah is that all
ingredients and consequences of a genuine sale are respected. And since as a mere
benchmark and that there is no participation by Muslim investors in LIBOR, it has nothing to
do with the transaction. Therefore, if a Murabahah or Ijarah transactions fulfil all the
conditions, the use of the interest rate as a benchmark for determining the mark-up does not
render the transaction as invalid because the deal itself does not contain interest. In fact, the
rate of interest is used only as an indicator or as a benchmark.
As a consequence, until a standard Islamic alternative that satisfies Shari'ah ban on interest
would be available, the use of LIBOR will still be a permissible option to evaluate the rate of
return on financing by Islamic banks.
4.6 Venture capital
4.6.1 Introduction
From an Islamic point of view, venture capital based on equity financing falls within the
framework of Islamic finance as long as it invests in permissible sectors and in companies
having a zero conventional debt capital structure. It therefore combines economic viability and
Islamic preference, which makes it a promising option for Islamic financial institutions. In
fact, the provision of equity-based capital for SMEs is in harmony with the Islamic goal for
wider economic development and a more equal distribution of wealth. That is why venture
capital financing is praised for its role in promoting growth while maintaining financial stability.
Although the details of practices of existing venture capital institutions that include prohibited
activities, such as, paying or receiving interest may not be totally consistent with Islamic rules,
these details can be easily modified without compromising the positive aspects of its
principles(1).The structures of Islamic banks and VC companies are very similar; they have
common roots and are both involved in PLS partnerships, generally in Mudarabah or
Musharakah; these partnerships are based on active management that leads to improved
corporate governance and overall alignment of stakeholder interests with that of the
management.
The most important similarities between Islamic banks and VC companies are at the level of
funds collection and agency configuration. In fact, investors in both Islamic banks and VC
companies are taking part in a profit-sharing process; they both share in the resulting profits
according to an agreed ratio. Islamic banks and VC companies also act as agents for their
investors/depositors; they invest the collected funds in different businesses and share a
percentage of the profits back to the investors. This is different in the case of conventional
banks who are not really actively participating in the businesses they invest in, nor are their
depositors. In addition Islamic banks and VC companies use the same criteria in evaluating
projects to invest in, in fact they both evaluate the ability of the entrepreneur and the profit
potential of his project, whereas, conventional banks use the criteria of past performance,
balance sheets and the credit-worthiness of the entrepreneur(2). Islamic banks also have the
same attitude as VC companies in case of loss that is the capital loss is only borne by the
lender, while the entrepreneur only loses time and efforts spend in labour. Islamic banks may
however be different from VC companies in the use of other forms of financing such as
Murabahah which is less risky than Profit-Loss Sharing, necessitates fewer resources, and can
enable Islamic banks to compete in fund mobilising with the conventional banks.
4.6.2 Islamic Venture Capital
Mudarabah is the core of Islamic financing and the Two-Tier Mudarabah model is the basic
theoretical model used by Islamic banks to structure Venture Capital(3); the Two-Tier
Mudarabah is an equity-based structure used to create asset and liabilities where the Islamic
bank is placed between investors and depositors who provide money and borrowers and
beneficiaries who require money. On the liability side, the Islamic bank plays the Mudarib
role for the suppliers of capital, while on the asset side it acts as the plays the Rabb-al-Mal
investor or venture capitalist role, and the business entrepreneur (Mudarib) is responsible for
all business operation. The two-tier Mudarabah can be compared to the conventional VC
funds. Profit sharing is predetermined to a set ratio between the Islamic bank, the depositors
and the beneficiaries. In this model, the bank is not authorized to participate in the
management of a Mudarabah project and the entrepreneur does not contribute to capital, and
(1 ) Venture Capital: A Potential Model of Musharakah by Sami Al-Suwailem; 1998.
(2 ) Venture Capital, Islamic Finance and SMEs by Grahame Boocock and Mansoor Durrani; 2008.
(3 ) Iqbal and Molyneux; 2005.
therefore he is not liable to incur any financial loss. In case of business venture fail the bank
loses its capital and entrepreneur loses his time and efforts. Musharakah is another important
equity-based form of Islamic financing that consists on a partnership where two or more
persons combine either their capital or labour together, to share the profits, enjoying similar
rights and liabilities(1) . The difference between Mudarabah Musharakah is that entrepreneurs
are allowed to contribute to the total funds requirement and the Islamic bank has right to
participate in management unless it deliberately waives the right to do so. If the business
venture fails, the partners incur financial loss, strictly in proportion to their capital
contribution.
However, Two-Tier Mudarabah and Musharakah is habitually ignored by many banks,
because Mudarabah represent a higher risk since they have less control on management and
the degree of their involvement in Musharakah would be too costly. To overcome these
issues, Mudarabah can be combined with Wakalah, whereby clients authorise a bank or fund
manager to invest funds on their behalf, in return for a predetermined fee. This structure is
widely used by Islamic mutual funds as it offers a suitable model for an Islamic Venture
Capital initiative. Another feasible option is to develop Islamic Venture capital using Shirka alinan, where two or more partners invest a certain amount of capital and share the benefits on
a pre-agreed basis. In Shirka al-inan the two parties are equally involved in any decision to
change the strategy of the investee company, even after the disbursement of funds (Siddiqi,
1985). This allows the investor to place any number of restrictive covenants on the functioning
of fund managers and entrepreneurs (Fethi, 2000). Besides, a hybrid form of Mudarabah and
Shirka al-inan can be used to give capital providers many of the powers available to established
venture capitalists; in fact, investors can include covenants in the contract and make postinvestment adjustments to ensure that the investee company achieves its objectives.
Mudarabah in conjunction with Wakalah can also provide a possible option for Venture
Capital, since the Wakeel (the agent) may be allowed to carry out business activities within
mutually agreed parameters.
(1 ) islamic-world.net; 09.2009
4.7 FOREIGN EXCHANGE
4.7.1 Islamic Forex
Foreign exchange (FX) is an important activity in modern economy. A foreign exchange
transaction is essentially an agreement to exchange one currency for another at an agreed
exchange rate on an agreed date, it provides protection against unfavourable currency
exchange rates and helps businesses associated with activities in a foreign currency to set a
form of currency risk exposure. And when using techniques such as foreign exchange hedging
capabilities, businesses can protect against adverse currency movements at a future date. FX
transactions cover foreign currency payment transactions and fund transfers involving different
currencies and countries and transactions such as travellers‟ cheques, foreign currency cash,
foreign currency drafts, foreign currency fund transfers/remittances, investments and trade
services.
4.7.2 Permissibility of FX transactions
In Islamic finance, there is a general consensus among Islamic scholars on the view that
currencies of different countries can be exchanged on a spot basis at a rate different from
unity, since currencies of different countries are distinct entities with different values or
intrinsic worth, and purchasing power. However, there were diametrically opposite views, in
the past, on the permissibility of currency exchange on a forward basis, that is, when the rights
and obligations of both parties relate to a future date. The divergence of views on the
permissibility of currencies exchange contracts can be traced primarily to the issue of existence
of the following elements; Riba (usury); Gharar (excessive uncertainty); and Qimar
(speculation/gambling). Regarding the comparison with Riba, some jurists compare paper
currencies with gold and silver; which were universally acceptable as principal means of
exchange in the early days of Islam. They refer to hadith of the holy prophet (peace be upon
him)
"Sell gold for gold, silver for silver... in same quantities on the spot; and when the commodities are
different, sell as it suits you, but on the spot."
However, the case of exchange involving paper currencies belonging to different countries, the
intrinsic value or worth of paper currencies cannot be identified or assessed unlike gold and
silver which can be weighed. Hence, the Shari'ah injunctions for Riba prohibition are not
applicable to paper currencies. Such exchange would be permissible as long as it is free from
any injunction regarding the rate of exchange and the manner of settlement.
Regarding Gharar and speculation, the prohibition of futures and forwards involving exchange
of currencies is justified by the fact that such a contract involves sale of a non-existent object or
of an object not in the possession of the seller. Some recent scholars have opined that futures,
in general, should be permissible, because the efficient cause, that is, the probability of failure
to deliver was quite relevant in a simple, primitive and unorganized market. However, this
should be no longer a cause for concern in today's organized futures markets where the
standardized nature of futures contracts and transparent operating procedures on the
organized futures markets are believed to minimize this probability of failure. Nevertheless,
such contention continues to be rejected by the majority of scholars; they underscore the fact
that futures contracts almost never involve delivery by both parties. On the contrary, parties to
the contract reverse the transaction and the contract is settled in price difference only. In
addition, regarding the forecastability of exchange rates, they are volatile and remain
unpredictable at least for the large majority of market participants. And any attempt to
speculate in the hope of the theoretically infinite gains would be a game of chance for such
participants.
4.7.3 Forex in Islamic banks
Islamic banks exchange currencies on the spot in transactions such as a bank transfer or
remittance expressed in a foreign currency, payment for goods imported from another
country, payment for services billed in a foreign currency, in the case of a sell or a purchase of
a foreign currency in cash or traveller‟s cheque or bank draft against another currency, or
when a client deposits a cheque or bank draft made out in a foreign currency and requires
payment in local currency.
In addition to spot transactions, an FX transaction may be undertaken by banks on the basis
of forward contracts, futures contracts, option contracts, swap contracts and currency arbitrage.
Even though, some of these transactions are controversial as Islamic financial instruments,
because it is arguable that the element of speculation and interest is built into these contracts.
Also, while there are normally no up-front costs involved with FX transactions, Islamic banks
still derive a financial benefit by incorporating a margin into the transaction or the contract
rate. This means that the bank's rate may be different from the market rate prevailing at that
time, whereby the bank makes a profit on a transaction.
4.7.4 Hedging tools
Today's currency markets are characterized by volatile exchange rates. In a volatile market, the
participants are exposed to currency risk and Islamic rationality requires that such risk should
be minimized in the interest of efficiency if not reduced to zero. Islamic Forex Exchange
hedging mechanisms are designed to achieve the objectives of the conventional currency
hedging contracts while being in conformity with the Islamic commercial jurisprudence
principles. This implies the need to ensure that the contract is free from Riba, Gharar and
Maysir. Some of these mechanisms are:
• A forward contract involving currencies allows one currency to be sold against another, for
settlement on the day the contract expires; it eliminates the risk of fluctuating exchange rates
by fixing a rate on the date of the contract for a transaction that will take place in the future.
• A futures contract involving currencies is an agreement to buy or sell a particular currency
for delivery at an agreed-upon place and time in the future; however, these contracts very
rarely lead to the delivery of a currency, because positions are closed out before the delivery
date.
• A foreign currency option is a hedging tool, similar to an insurance policy that allows one
currency to be exchanged for another on a given date, at a prearranged exchange rate, without
any obligation to do so; foreign currency options eliminate the spot market risk for future
transactions.
• A swap contract involving currencies is an agreement to exchange one currency for another
and reverse the exchange at a later date; it is based on a notional principal amount, or an
equivalent amount of principal, that sets the value of the swap at maturity but is never
exchanged; Currency swaps are used to gain liquidity.
• Currency arbitrage aims to take advantage of divergences in exchange rates in different
money markets by buying a currency in one market and selling it in another market to take
benefit of the differing interest rates.
From the Shari'ah viewpoint, the problem with the above structures arises when the parties
involved want to exchange currency sometime in future but already fixing a rate which is fixed
today while the contract is sealed today. This contravenes to the basic Shari'ah rules governing
the exchange of currency (Bai` Sarf). In Bai` Sarf, it is a requirement for an exchange which
involves two different currencies to be transacted on spot basis. Hence it is prohibited to enter
into forward currency contracts whereby the execution of a deferred contract in which the
concurrent possession of both the counter values by both parties does not take place.
Nevertheless, in order to minimize the risk of uncertainty of prices in the future, forwards,
futures, options and swaps markets for currency-trading have also emerged for Islamic banks
although the general ruling of Shari'ah scholars is that hedging is not permissible. Yet, these
objections may be arguable, since hedging helps to eliminate Gharar by enabling the importer
to buy the needed foreign exchange at the current exchange rate, since Islamic banks only
invest the foreign currencies purchased by them in a Shari'ah-compliant manner as far as is
possible and since the principle of protection of wealth is respected. In addition, genuine
speculation is allowed in Islam, as opposed to professional speculation, where the speculator
is not a genuine investor. Most of the Islamic financial contracts provided by Islamic banks
will be exposed to foreign exchange fluctuations arising from general FX spot-rate changes in
foreign operations and the resultant foreign currency receivables and payables. Islamic banks
can charge fees based on various Islamic contracts and to curb speculation and misuse,
hedging could be confined to foreign exchange receivables and payables related to real goods
and services only.
4.7.5 Islamic Foreign Exchange Swap
The swap introduced by Islamic banks, based on concepts such as Wa'ad, Murabahah,
Musawamah and Tawarruq is deemed by scholars as permissible as long as it is free from
elements that contravene the Shari'ah, and for the purpose of fulfilling the need for hedging.
Therefore Shari'ah parameters in structuring and executing swap are very important to ensure
market practitioners truly fulfill and adhere to the requirement outlined by Shari'ah. Two
broad categories of Shari'ah parameters on Islamic FX Swap are suggested, namely the
guidelines on combining various contracts in one single transaction and the other is on
guidelines of how to demarcate Islamic swap purposes either to hedge or to speculate. The
two commonly offered structures of Islamic FX Swap in the market are based on the contract
Bai` Tawarruq or the concept of Wa'ad (promise/undertaking). The arrangement based on
Tawarruq is structured with the application of two sets of Tawarruq (at the beginning) to
enable the same effect as FX Swap to be achieved. While the second structure based on the
concept of Wa'ad involves exchange of currencies at the beginning, and promise or
undertaking (Wa'ad) to carry out another Bai` Sarf at the future date based on the rate
determined today. At the expiry date, the second Bai` Sarf will be implemented to get back
the original currency.
PART FIVE
SECURIZATION AND SUKUK
5.0 Islamic Bonds
Sukuk is an Islamic financial certificate that provides an investor with ownership in an
underlying asset. Sukuk were broadly used by Muslims in the middle ages as papers
representing financial obligations originating from trade and other commercial activities.
However, the present structure of Sukuk are different from the Sukuk originally used and are
akin (Similar in quality or character) to the conventional concept of securitization, a process in
which a special purpose vehicle (SPV) is setup to acquire assets and to issue financial claims
on the assets, the ownership of the underlying assets is then transferred to a large number of
investors through certificates representing proportionate value of the relevant assets. The
AAOIFI standard indicates that the underlying business contract or arrangement for Sukuk
must be consistent with Shari'ah.
As an asset-backed security with a stable income, Sukuk may be seen as an Islamic equivalent
of bond (1). However, fixed income interest bearing bonds are not permissible in Islam, hence
Sukuk should comply with investment principles within the Islamic law, which prohibits the
charging, or paying of interest. The main condition for issuance of Sukuk is the existence of
assets on the balance sheet of the issuing entity that wants to mobilise its financial resources (2).
The issuer of a Sukuk sells an investor the certificate, who then rents it back to the issuer for a
predetermined rental fee. The issuer also makes a contractual promise to buy back the bonds
at a future date at par value. The claim embodied in Sukuk is not simply a claim to cash flow
but an ownership claim. A Sukuk basically represents either a proportional or an undivided
interest in an asset or pool of assets. The degree of asset ownership rights subsequent to
ownership interest carries the right to a proportionate share of cash flow or other benefits and
risks of ownership.
Sukuk may have similar characteristics to conventional asset-backed bonds but are structured
in accordance with Shari'ah and may be traded in the market. In fact, in conventional bonds,
the issuer is contractually obliged to pay regular interest to bond holders on specific dates; the
amount of interest is determined as a fixed or a floating percentage of the capital, and bond
issuer guarantee the return of principal when redeemed at maturity, regardless of whether the
enterprise was profitable or not; whereas Sukuk are basically investment certificates consisting
of ownership claims in a pool of assets where holders are entitled to share in the revenues
generated by the Sukuk assets and share in the proceeds of the realization of the Sukuk assets.
Expected returns on Sukuk are tied to the returns earned through the underlying assets.
Another distinguishing feature of a Sukuk is that in instances where the certificate represents a
debt to the holder, the certificate will not be tradable on the secondary market and instead is
held until maturity or sold at par.
In addition, Sukuk should not simply be regarded as a substitute or an imitation for
conventional interest-based securities, but rather as innovative types of assets that comply with
the Shari'ah. Sukuk should be considered as a new asset class with a relatively attractive
pricing. Income from securities must be related to the purpose for which the funding is used,
and not simply comprise income that may be attributed to any form of interest; and securities
should be backed by real underlying assets, rather than being simply paper derivatives. The
accountabilities of the respective parties involved in Sukuk transactions should be defined in a
transparent manner in the contract. Sukuk should be a means for the equitable distribution of
(1 ) Bonds are debts owed by their issuer to the investor. They are claims that normally pay periodic interest
(coupon payments) until the maturity date, and pay back the par value (face value) to the investor at the
maturity date.
(2 ) Treasury and Capital Market Operations; IIBI; 2009
wealth by allowing all investors to benefit from the true profits resulting from the enterprise in
equal shares.
5.1 Sukuk structures
The market for Sukuk is now maturing and different Sukuk structures have been emerging
over the years; they can be of many types depending upon the type of Islamic modes of
financing and trades used in its structuring. The AAOIFI issued standard for different types of
Sukuk, classifying some of these Sukuk as tradable and others as non-tradable based on the
type and characteristics of the issued Sukuk. There are also other diversified and mixed asset
Sukuk that emerged in the market such as hybrid Sukuk, where the underlying pool of assets
can comprise of Murabahah, Ijarah as well as Istisna'a. In any sukuk transaction, the issuance
of sukuk certificates will simply raise a cash amount required by an originator. The issuance
itself will not entitle the investors to a return on their investment and, therefore, must be
supplemented with another Islamic financing structure. Although it is possible to interpose a
sukuk issuance onto any Islamic financing structure, historically, the most prevalent structures
used in the sukuk space were Mudarabah, Musharakah, Murabahah and Ijarah, structures.
Mudarabah Sukuk are investment Sukuk that represent common ownership of units of equal
value in the Mudarabah equity; the holders of Mudarabah Sukuk are the suppliers of capital
(Rabb al-mal) and own shares in the Mudarabah equity and its returns according to the
percentage of ownership share. Mudarabah Sukuk holders have the right to transfer the
ownership by selling the deeds in the securities market. Mudarabah Sukuk should not contain
a guarantee from the issuer or the manager for the fund, for the capital or a fixed profit, or a
profit based on any percentage of the capital.
Musharakah Sukuk are investment Sukuk that represent ownership of Musharakah equity. It
does not differ from the Mudarabah Sukuk except in the organization of the relationship
between the party issuing such Sukuk and holders of these Sukuk, whereby the party issuing
Sukuk forms a committee from the holders of the Sukuk who can be referred to for
investment decisions. Musharakah Sukuk are ideal for borrowing to finance large commercial
ventures, such as a factory expansion or construction projects. A special purpose vehicle
company (SPV) can purchase, commission or construct Musharakah assets owned, or to be
bought or constructed by the issuing entity. The SPV pays cash towards the capital of the
Musharakah and then leases the underlying Musharakah assets to the issuing entity, for a
period equal to the maturity of the Sukuk, at agreed regular fixed or floating rentals. Upon
default or maturity, the issuing entity issues a promise to Musharakah units from the SPV at an
agreed price. Musharakah Sukuk can be treated as negotiable instruments and can be bought
and sold in the secondary market.
In the case of Murabahah Sukuk, the issuer of the certificate is the seller of the Murabahah
commodity, the subscribers are the buyers of that commodity, and they are entitled to its final
sale price upon the re-sale of the commodity. Murabahah Sukuk cannot be legally traded at
the secondary market, as the certificates represent a debt owing from the subsequent buyer of
the commodity to the Sukuk holders and such trading in debt on a deferred basis is not
permitted by Shari'ah.
However, in 2008, AAOIFI issued a statement criticising the use of fixed price purchase
undertakings to guarantee returns in Mudarabah and Musharakah structures. AAOIFI stated
that these structures are intended to be similar to equity-based instruments and therefore any
returns to the investors cannot be fixed at the outset – the investors must share any losses
arising out of the sukuk assets. Subsequently, this led to a significant decline in musharaka and
mudaraba based sukuk issuances as investors in the market were not prepared to invest in
instruments that exposed them to risks that are not normally associated with debt-based
instruments. As a consequence, since 2008, the Ijarah Sukuk structure has become the
predominant structure with other structures, such as Wakalah Sukuk, also being increasingly
utilised.
Ijarah Sukuk is a hybrid between an operational lease and a finance/capital lease with certain
'ownership' risks, such as the obligation to undertake capital maintenance of the leased asset
and the obligation to insure the asset, remaining with the lessor. The lessor may appoint an
agent, usually the lessee itself, to carry out these duties on its behalf under a servicing agency
agreement. In a simple Ijarah Sukuk the originator, or a third party connected to the
originator, will sell certain physical assets to a special purpose vehicle (SPV). The SPV will
finance this acquisition by cash raised by the issue of sukuk certificates. The SPV will then
lease the same physical asset to a third party, often the originator itself. The lease rental
payments will 'mirror' the coupon payments due under the sukuk certificates and the cash flow
from the lease rentals will be used to service those coupon payments represent ownership of
equal shares in a rented real estate or the usufruct of the real estate. Holders of Ijarah Sukuk
have the right to own the real estate, receive the rent and trade their Sukuk in the secondary
markets; in exchange they bear all cost of maintenance of and damage to the real estate. The
rental rates of return on those Sukuk can be fixed or floating depending on the agreement; it
does not need to be linked to the period of taking usufruct by the lessee. The issuance of
Ijarah Sukuk necessitates the creation of an SPV to purchase the assets, issue Sukuk to the
investor, and make payment for purchasing the asset. Upon default or maturity, the issuing
entity issues a promise to purchase the assets from the SPV at an agreed price.
Example of Wakalah sukuk structure
In a Wakalah Sukuk, an Islamic financial institution can package its Ijarah contracts,
Murabahah receivables and any shares or Sukuk certificates held by it into a portfolio which is
then sold to the investors. The income derived from the portfolio is used to service the
coupon payments due under the sukuk certificates. The trustee will typically appoint the
originator as its agent (wakil) to manage the portfolio. Unlike a musharaka or a mudaraba
where the managing partner or the mudaarib has some investment discretion, the wakil's role
in a Wakalah Sukuk is generally limited to collecting income generated by the portfolio,
maintaining the underlying assets comprised in the portfolio and acting on the instructions of
the Trustee to replenish the portfolio with additional underlying assets from time to time.
Given the limited nature of the wakil's role, the wakil is not held to be a partner or a mudaarib
in the arrangement for Shari'a purposes and therefore does not need to share the risk of loss
in the arrangement. As a consequence of this, the originator in its corporate capacity is
permitted, under Shari'a, to grant a fixed-price purchase undertaking to purchase the portfolio
on redemption of the sukuk certificates
Example of Wakala sukuk structure
Example of Ijaraha sukuk structure
Salam Sukuk
Salam Sukuk are certificates of equal value issued for the purpose of mobilizing Salam capital.
The issuer of the certificates is a seller of the goods of Salam; the holders are the buyers of the
goods; they are entitled to the sale price of the certificates or the sale price of the Salam goods
sold through a parallel Salam, if any. Investors pay in an advance funds to the SPV in return
for a promise to deliver a commodity at a future date. SPV can appoint an agent to market the
promised quantity at the time of delivery at a possible higher price. The profit of the holders
of the Sukuk is the difference between the purchase price and the sale price.
Istisna'a Sukuk
Istisna'a Sukuk are certificates that carry equal value and are issued to mobilize funds required
for production of goods products that will be owned by the certificate holders. The issuer of
these certificates is the manufacturer; the subscribers are the buyers of the intended product,
while the funds realized from subscription are the cost of the product. The Islamic bank
funding the manufacturer during the construction of the asset, acquires title to that asset and
up on completion either immediately passes title to the developer on agreed deferred
payment terms or, possibly, leases the asset to the developer under an Ijarah Sukuk. Shari'ah
prohibits these certificates to be traded in the secondary market.
5.2 Controversy around Sukuk
Although Sukuk represent Shari'ah compliant alternatives to traditional derivatives, they are
widely regarded as controversial due to their perceived purpose of evading the restrictions on
Riba. Conservative scholars do not believe that this is effective, citing the fact that a Sukuk
effectively requires payment for the time-value of money and offer investors fixed return on
their investments which is also similar in appearance to interest. The trading and selling of
debts, receivables, conventional loan lending and credit cards are not permissible in Islam;
and as Sukuk results in a debt, it could not be traded other than at face value as debt and
money cannot change value with passage of time.
Sukuk help Islamic institutions enhancing liquidity and balance sheet mechanisms, and
although the investor's return is not necessarily dependent on the risks of that particular
venture, Islamic banks that issue Sukuk are investing in real assets. The return on these assets
takes the form of rent, and is uniformly spread over the rental period. The asset underlying
the value of the certificate provides more security for the investors and the productivity of the
asset is the basis of the return on investment. The claim embodied in Sukuk is not simply a
claim to cash flow but an ownership claim. However, most Sukuk have been sold with a
repurchase agreement, stipulating the borrower will pay back the face value at maturity,
mirroring the structure of a conventional bond. Many Islamic scholars consider that the
promise to pay back the capital runs counter to Islamic law and that it is against the risk
sharing principle of Shari'ah but the avoidable business risks may fall into the category
maslahah that mitigates that position. Still that the bonds with repurchase agreements should
be made more Shari'ah-compliant; for that purpose, Sukuk should be issued for new
commercial and industrial ventures. If they are issued for established businesses, then the
issuers must ensure that Sukuk holders have complete ownership in real assets (1). In addition,
any resale of the assets must be undertaken on the basis of the net value of the assets, or at a
price that is agreed upon at the time of purchase and not at face value.
(1 ) Sukuk and their Contemporary Applications By Muhammad Taqi Usmani, 2005
5.3 Indexation of financial obligations
Indexation (1) of financial obligations is the adjustment of the liability of the borrowers in
money terms to reflect the change in the value of money during the period the loan, this value
is measured using a price index. The concept of indexation in conventional finance is often
used to make a provision for a floating rate in the agreements, in relation to any future
inflationary pressures. Applying new rates to the remaining period allows not to affect the
liability already accrued.
In the Islamic framework, transactions of loan or debt should involve equality. If a measurable
good is lent, it is necessary to return the same quantity, irrespective of any increase or decrease
in its price. And the borrower should pay the same coins or currency, irrespective of any
increase or decrease which has occurred in the currency. In addition, the difference in value
due to a time element is not prohibited in Islam except when the time-value of money is a
predetermined quantity calculable at a predetermined rate. In fact, the Shari'ah makes
difference between the valuation of a credit period based on the value of the goods or their
usufruct and the conventional concepts of opportunity cost or the time-value of money.
Therefore, indexation could be neither a substitute for interest nor it could control the
vagaries of inflation. In fact, while the intrinsic characteristics of money do not change during
an inflationary period, the relative characteristics, such as the future value of money in terms
of its exchange value, are continuously changing. Therefore, indexation in Islam excludes the
functions of measurement of value of money without providing a remedy for its failings, and
the function of standardizing value of money for deferred payment. The Islamic banks would
receive from their borrowers the same rate of return as they will have to pay to their
depositors, both being based on the rate of inflation. This would mean that no profit will be
left for the banks themselves. Regarding the impact of change in the purchasing power of any
currency on a debt, the Islamic Fiqh Academy considers that it is not permitted to attach fixed
debts, whatever their source, to currency fluctuation. Fixed debt should be repaid in the same
currency and not by its counter value. Therefore, the Academy approved that the parties may
agree on the day of settlement for the settlement of the debt in a currency other than the one
specified for the debt, provided the rate of exchange applied is that applicable on the
settlement date. No part of the subject of the currency exchange should remain outstanding.
The parties may also agree, at the time of contracting, to the settlement of the deferred cost in
a single payment or in installments, and to have it in a specific currency, in a variety of
currencies or against a given amount of gold. And a debt contracted in a specific currency
should not be recorded against the debtor in its counter value in gold or other currencies.
Therefore, Islamic banks are not allowed to link any debt or receivable for the purpose of
indexation. However, they are allowed to stipulate a floating or variable rate in certain financial
products. In fact, in order to settle pecuniary liabilities in the context of an inflationary
situation. In fact, banks can enter into Musharakah,
Mudarabah and diminishing Musharakah transactions wherein their return can automatically
be adjusted with an inflationary situation. The rental rate for a short duration can be fixed or
variable. Accordingly Islamic banks can charge rental in Ijarah at a higher rate, if already
provided in the agreement, for any remaining period of the lease. However the rentals for a
particular period, once accrued, cannot be indexed.
(1 ) Indexation is a system of economic regulation: wages and interest are tied to the cost-of-living index in order to
reduce the effects of inflation.
5.4 Risks underlying Sukuk
Risks adverse effect the competitiveness of an asset's pricing. The novelty of Sukuks inherently
entails a higher exposure to certain market and financial risks (Managing financial risks of
Sukuk Structures by Ali Arsalan Tariq; 2004). Sukuk are exposed to different types of risks.
The most important are the market risk, operations risk and Shari'ah compliance risk. And
the challenge for Sukuk issuing entities becomes to devise an effective risk management
strategy congruent to Shari'ah principles. Market risk is the risk on instruments traded in welldefined markets (Modern Banking in Theory and Practice by Shelagh Heffernan, 2003); it
includes a systematic risk that arises due to governmental and economic policy shifts and
idiosyncratic risk that arises due to different firm specific instruments that may be priced out
of correlation with other firms' instruments. Market risk is mainly composed of interest rate
risks and foreign exchange risks. As far as Sukuk are concerned, interest rate risks can be
considered as rate of return risks. Maturity plays a very important role in intensifying the
impact of this risk; the longer is the maturity, the higher is the risk for the investor. Sukuk
based on fixed rates are exposed to this risk in the same manner as fixed rate bonds because
the rise in market interest rates leads to the fall in the fixed-income Sukuk values. In fact,
Sukuk certificates are exposed indirectly to interest rate fluctuations through the widespread
benchmarking with LIBOR in their financing operations (Managing financial risks of Sukuk
Structures by Ali Arsalan Tariq; 2004). Adverse changes in market rates will also unfavorably
affect the credit worthiness of the issues and will lead to the increase in the credit risk of the
issue. Moreover, Sukuk are exposed to foreign exchange rate risks as any unfavorable
exchange rate fluctuations will undeniably have an effect on the assets in the Sukuk pool and
in the currency of denomination in which the Sukuk funds are accumulated.
Furthermore, there are many other risks specific to the operation of the Sukuk, which are
mainly inherent to the structure of the issuances. Default risk refers to credit risk that involves
the probability that an asset or loan becomes irrecoverable due to a default or delay in
settlements. Ijarah Salam and Istisna'a' are particularly exposed to that risk. The credit and
counterparty risks inherent in Islamic finance are unique owing to the nature of Islamic
financial instruments that become the foundation of the Sukuk asset pools (Corporate
Governance in Islamic Financial Institutions by Chapra Umer and Habib Ahmed; 2002).
Salam contracts are exposed to the risk that commodities will not be supplied on time or to
the agreed quantity and Istisna'a contracts involve performance risk. There is also a coupon
payment risk linked to Sukuk, in case the obligor fails to pay the required coupons on time.
The asset redemption risk may occur as the underlying assets may not be fully redeemed
when the originator has to buy them back from the certificate holder. There are also specific
risks related to the SPV, such as the notion of settlement risk involved with the SPV where the
originator will have to reimburse the certificate holders through a clearinghouse. Besides, the
Sukuk structures are exposed to a liquidity risk because there is currently no well structured
and sufficiently liquid secondary market and most of the certificates tend to be held until
maturity. The underlying assets of the Sukuk certificates are also subject to a risk of loss,
which is an important risk in the
case of equipment and large scale construction. Yet, there is a possibility to mitigate the risks
of asset losses by using provisions for insurance claims in the form of Takaful. Shari'ah
compliance risk refers to the loss of asset value as a result of the issuers' breach of its fiduciary
responsibilities with respect to compliance with Shari'ah (Managing financial risks of Sukuk
Structures by Ali Arsalan Tariq; 2004). Shari'ah jurists play an essential role in the formulation
of the Sukuk prospectuses; the dissolution clauses of these prospectuses define events that will
make the Sukuk deed null and void due to Shari'ah non-compliance. For example, in the case
of incidence of a Wakeel, the guarantor and the agent have to be separate entities to negate
any conflicts of interest and moral hazards.
PART SIX
Takaful (Islamic Insurance)
6.0.1 Introduction
All human activities are subject to risk of loss from unforeseen events. To alleviate this burden
to individuals, what we now call insurance, has existed since at least 215 BC. This concept is
not a new or modern phenomenon; it has been practiced in various forms for over 1400
years. The word Takaful is derived from the Arabic verb “Kafala”, which means to aid or help
out or "guaranteeing each other" or "joint guarantee". This forms the basis of Takaful that is
about shared responsibilities, solidarity and mutual cooperation. In those days there were
trade caravans that were exposed to the similar risks to those faced today in trading activities.
Muslim scholars acknowledge that the basis of shared responsibility in the system of Al
Aaqilah as practiced between Muslims of Makkah and Madinah laid the foundation of mutual
insurance. It consisted on contributions from tribes' members to share joint responsibility to
indemnify the victim or the victim's family and relatives against financial liability arising from
defined events.
That system was accepted by Prophet Muhammad (pbuh) under the principle of mutual
protection and cooperation in virtue and good deeds. Other early traditions practiced by
Islamic and pre-Islamic Arab tribes also constitute the origins of Takaful; these include Diya,
Kafalah, Aqd muwalat, Ju'hala, Daman Khatar Al-Tariq and Hilf.
Diya is the indemnity paid as “blood-money” to the next-of-kin or the injured party of a
murder victim.
And whoever kills a believer by mistake - then the freeing of a believing slave and a compensation
payment presented to the deceased's family [is required] unless they give [up their right as] charity .
(4: 92)
Kafalah is a suretyship whereby a third party guarantees the performance of another party
involved in a contract, it was used to assist victims of hazards on trade routes.
»The
guarantor
(the
surety)
is
responsible
for
(paying)
the
thing
he
guaranteed«.
(Musnad Imam Ahmad, 22195, vl5, pg267)
Aqd muwalat is a contract to bring an end to mutual enmity or revenge; Ju'hala is a contract to
be paid for a work that involves a significant part of uncertainty; Daman Khatar Al-Tariq is a
guarantee against travel hazards; and Hilf is an agreement for mutual assistance among people.
In all these agreements, Arab tribes and traders covered the losses and liabilities of individuals
in the form of solidarity and brotherhood, and provided mutual financial aid and assistance in
case of need.
The underlying features of Takaful primarily lie on solidarity and mutual protection. From
this joint benefit and shared responsibility culture, Takaful brings equity to all the parties
involved in the operation. The purpose of this system is not profits or gains but to uphold the
principle of mutual assistance and shared responsibilities to take precautions against risks and
misfortunes for all individual constituting the group. And by mitigating the burden of
individuals whose risks are divided among their fellow members of the society, Takaful brings
a peace of mind to all the participants and improves their quality of life. In addition, Funds
collected through Takaful premiums are channelled into Shari'ah compliant investments that
involve environmentally friendly and socially responsible business activities. Most of the
profits from these funds are shared among the participants. Besides, Takaful involves each
participant giving away as donation (Tabarru) a certain proportion of the full amount of the
contributions required to be paid. Therefore, by joining Takaful, every participant is indirectly
involved in charity and social welfare.
6.0.2 Differences between conventional insurance and Takaful
Takaful distinguishes itself from conventional insurance with many different features, the main
distinction being the fundamental principles that govern each practice. Takaful is governed by
the principles of Shari'ah, where transactions involving Riba, Gharar and Maysir are
prohibited. Riba in conventional insurance is found in both transactions involving unequal
exchange between contributions and indemnities and also in the income derived from interest
gained from interest-bearing investment. In fact, there is a disparate value of money between
premiums and compensations as payment received against the insurance may be higher than
premium. And the way insurance funds are managed can also originate an unknown part of
profits earned through investments of the premiums in interest-bearing financial instruments
such as bonds and savings accounts. Conversely, Riba is avoided in Takaful using contracts for
profit shares rather than fixed interest and investment in Shari'ah compliant schemes.
The practice of conventional insurance also involves the use of Gharar due to uncertainties on
how much will be paid, when it will occur and whether the payment will be accepted. When a
claim is not made the insurance company may even get all the profits while the participant
may not get any profit at all. Takaful contracts, on the other hand, have to follow specific rules
to avoid Gharar, such as making sure that the matter of insurance is a legitimate and essential
need, that the insurer is able to safeguard the interests of the insured and that the insurance is
transacted on a co-operative basis under which ownership of the premium is with all
contributors to the Takaful fund; they collectively bear the risk and can share profits or losses
from the pool.
Furthermore, conventional insurance is declared Maysir because the policyholders (the
insured) are seen to bet premiums on the condition that the insurer will pay indemnity on the
happening of a specified event. The gain of one party is contingent upon the loss of the other
because the insured would lose the money paid for the premium when that event does not
occur and the insurer would suffer a deficit if the claims happen to be higher than the
premium paid. In the case of Takaful, however, collected premiums are in a common fund. If
the participant draws out of it by way of benefit in the case of a claim, it is drawing out of a
fund of which he is a member and to which he has contributed.
Another essential difference is that conventional insurance by its conception is a risk-transfer
mechanism. In conventional insurance, the insured substitutes certainty for uncertainty. In
return for a predetermined payment, the premium, he/she transfers to the insurer the possible
economic losses from stipulated risks. Takaful on the other hand does not entail a risk
transfer mechanism, but rather a social function of mutual risk-sharing. The participants share
all risks mutually and no transfer of risk is involved. The contract of Takaful is not a sale or an
exchange driven by profit purposes as in conventional insurance which is mainly motivated by
the desire for profit, rather, it is a membership contract to a common pool, of which every
member is entitled to certain benefits but also exposed to some risks of loss. This is what also
makes Takaful system commercially more viable, as the remaining money after all claims does
not belong to the shareholders, but rather to the participants and it should thus be given back.
In addition, motivations of conventional and Islamic insurance companies are different; while
conventional companies are directed by the search of profit. Takaful companies are also
directed by ethical means for the overall benefit of society and the environment.
Regulation in Takaful is undertaken through Shari'ah supervisory bodies that ensure that all
operations are conducted in line with the Shari'ah principles and fulfil Islamic objectives of
social welfare. Besides, the distribution of profits in case of conventional insurance is a
managerial decision from the insurer company which is not necessarily favourable for all
parties. While, in case of Takaful, distribution mechanism is defined in advance and the
operator has no claims in underwriting surplus; this reduces the possibility of conflict between
shareholders and policyholders. Finally, in case of dissolution of a conventional insurance
company, reserves and surplus belong to the shareholders. While in case of dissolution of a
Takaful operator, capital is distributed back to participants or donated to charity.
The policy-holders in a conventional insurance company have no right to vote in the elections
of the directors of the company or to see the annual accounts of the company, while in Islamic
companies; these facilities are available to all participants who pay a certain stipulated amount
of premiums (contributions).
In the Takaful system, if the assured dies before the policy matures, the beneficiary is entitled
to the whole amount of the premiums, the bonus and dividend and a share of the profits
made over the paid premiums, plus a donation from the company out of the
participants/policy-holder's contributions given on the basis of Tabarru. Such a transaction is
seen as a mutual contribution towards the welfare of the helpless in society. Where the
insured is still alive on the maturing of the policy, he/she is entitled to the whole amount of the
premiums, a share of the profit made over the premiums, a bonus and dividends according to
the company policy.
In a conventional life insurance policy, the agent's payments are paid out of the insured's paid
premiums, whereas in the Islamic model, the agents work for the company and thus are paid
by the company.
The insurable interest in the conventional system is usually paid to the policyholder, if he/she
is alive at the expiry of the policy. If he/she dies before that date, the insurable interest is paid
to the beneficiaries, who may include family, servants, company, trustee, partners, mortgagor,
etc. But under the Islamic model, the insurable interest goes to the assured or his/her heirs,
according to the principles of Mirath or Wasiyyah.
Gambling and Insurance
Gambling and insurance are two distinct and different operations. Gambling is speculative in
its risk assessment whereas insurance is a pure risk and is non-speculative. In gambling, one
may win or lose by creating that risk. In insurance, the risk is already there and one is trying to
minimise the financial effects of that risk. Insurance shifts the impact of that risk to someone
else and relieves the person of risk. The risk nevertheless still remains.
While gambling promotes dissension, ruin and hatred, insurance based on cooperative
principles, enables the insured to lessen the financial impact without which it could drive the
individual and his dependents to poverty, thereby weakening their place in the society. There
is nothing in Islam that prevents individuals from making a provision for their dependents.
Seen collectively for large groups of insured population, insurance strengthens the financial
base of the society.
Islamic scholar, Yusuf Ali, in his translation of The Holy Qur‟an, comments on Surah
(chapter) Al-Baqara, ayat (verse) 219, “Insurance is not gambling, when conducted on
business principles. Here the basis for calculation is statistics on a large scale, from which
mere chance is eliminated. The insurers charge premium in proportion to the risks, exactly
and scientifically calculated”.
There are three main differences between a gambling contract and an insurance contract.
a) In a gambling contract, neither party has any other interest than winning a sum of money.
The gambler is not being indemnified against any loss. But, in an insurance contract, the
insured's right to be paid depends on his suffering loss from the insured peril. In other words,
an insurance contract is a contract of indemnity, which is non-existent in a gambling contract.
b) In the case of gambling, one party must win and the other loses. In insurance, on the other
hand, the event entitling the insured to compensation may or may not happen during the
period of the policy, but he pays a premium for being protected during that time.
c) If a gambler wins, he gets back not only his original stake but also an additional amount
without suffering any loss, whereas an insured person never gets back his premium and is only
indemnified to the extent that he has suffered damage
Basis and Principles of Takaful
Islamic insurance requires each participant to contribute into a fund that is used to support
one another with each participant contributing sufficient amounts to cover expected claims.
The underlying principles of Takaful may be summarised as follows:
Policyholders co-operate among themselves for their common good.
Every policyholder pays a part of the contribution (Tabarru‟) as a donation to help those
that need assistance.
Losses are divided and liabilities spread according to the community pooling system.
Uncertainty is eliminated in respect of subscription and compensation.
It does not seek to derive advantage at the cost of others.
Theoretically, Takaful is perceived as cooperative insurance, where members contribute a
certain sum of money to a common pool. The purpose of this system is not profits but to
uphold the principle of “bear one another's burden”.
6.1.1Takaful Agreements
Takaful agreements have specific characteristics and conditions that differentiate them from
conventional insurance agreements. In fact, Takaful agreements cannot be sales contracts as
such because of the element of uncertainty they contain; yet they should not include any
uncertainties about main characteristics such as price, time and modes of payment. Takaful
contracts should also include a subject matter upon which contracting parties mutually
agree by an offer and an acceptance. And as any Shari'ah accepted operation, Takaful
should avoid Riba, gambling and investing the fund in unlawful activities.
In addition, Takaful agreements should embody particular conditions that regard specialty, cooperative, mutuality, partnership, investment and management. The specialty condition
validates that the Takaful Operator manages the fund according to Shari'ah principles and
excludes prohibited activities such as Riba, Gharar and Maysir. Cooperative condition is about
the participants paying contributions to a common fund to insure themselves against risk and
help other members who suffer loss; they should pay a part of their contributions by way of
Tabarru'. Mutual condition is linked to the principle of membership where the insurers and
the insured are the same people managing and controlling their mutual security. Partnership
condition guarantees the participants the right to share profits and losses; in fact any surplus
goes back to the Takaful participants in proportion to their contributions; they also share
eventual losses by contributing additional amounts if premium reserves were not sufficient to
cover all the losses. The Takaful Operator shareholders receive their income in form of
agency fees and a percentage from the common fund, plus profits on investment of capital and
some particular funds. Investment condition specifies the scope of investment by the Takaful
Operator which should be within the Shari'ah framework. Finally, management conditions
represent the organization of Takaful Operator including the Shari'ah Supervisory Board
which aspires at protecting participants' interests.
6.1.2 Specifity
Takaful agreements have specific characteristics and conditions that differentiate them from
conventional insurance agreements. In fact, Takaful agreements cannot be sales contracts as
such because of the element of uncertainty they contain; yet they should not include any
uncertainties about main characteristics such as price, time and modes of payment. Takaful
contracts should also include a subject matter upon which contracting parties mutually agree
by an offer and an acceptance. And as any Shari'ah accepted operation, Takaful should avoid
Riba, gambling and investing the fund in unlawful activities.
In addition, Takaful agreements should embody particular conditions that regard specialty, cooperative, mutuality, partnership, investment and management. The specialty condition
validates that the Takaful Operator manages the fund according to Shari'ah principles and
excludes prohibited activities such as Riba, Gharar and Maysir. Cooperative condition is about
the participants paying contributions to a common fund to insure themselves against risk and
help other members who suffer loss; they should pay a part of their contributions by way of
Tabarru'. Mutual condition is linked to the principle of membership where the insurers and
the insured are the same people managing and controlling their mutual security. Partnership
condition guarantees the participants the right to share profits and losses; in fact any surplus
goes back to the Takaful participants in proportion to their contributions; they also share
eventual losses by contributing additional amounts if premium reserves were not sufficient to
cover all the losses. The Takaful Operator shareholders receive their income in form of
agency fees and a percentage from the common fund, plus profits on investment of capital and
some particular funds. Investment condition specifies the scope of investment by the Takaful
Operator which should be within the Shari'ah framework. Finally, management conditions
represent the organization of Takaful Operator including the Shari'ah Supervisory Board
which aspires at protecting participants' interests.
6.1.3 Distribution of surplus
Under a Takaful scheme, if the fund generates net surplus at the end of the year, then Takaful
operator distributes it to the participants and the company based on the pre-agreed profit
sharing ratio. A proportion of the surplus may be upheld as a contingency to protect
participants' interests, while the remaining part is distributed among the policyholders. The
surplus is calculated based on the total contributions paid by the participants to the Takaful
Fund less the total value of claims paid to cover assured losses, less Takaful Operator's
management fees and expenses, less commission paid to the intermediaries and the change in
the reserves. If the balance is negative and is insufficient to pay compensation and benefits,
then the Takaful shareholders may provide a bridging interest-free loan to make-up the deficit
that would be recovered from future surplus.
The distribution mechanism is decided by the board of directors of a Takaful operator and
should be approved by the Shari'ah board. In fact, at the end of each financial year the
Takaful operator undertakes an evaluation to determine surplus or deficit. The surplus is
distributed to participants only in the case of Family Takaful business which is associated with
protection for livelihood and is prohibited for General Takaful which is associated with nonlife forms of protection.
The surplus may be calculated separately for each class of risk or on a combined basis. It
could be distributed in cash, reduced form of future contributions, or credited to the
participant's investment fund. Moreover, depending on the Takaful Operator policy, surplus
may not be payable to participants whose paid claim exceeds the premium received plus share
of surplus, or those who simply were paid a premium during the year of account. Finally, a
proportion of the distributable surplus may be donated for charitable purposes after the
consent of Takaful shareholders and participants.
6.1.4 Tabarru'
Tabarru' is the agreement by a Takaful participant to donate a proportion of his contribution
to enable him to fulfil his obligation of mutual help and joint guarantee should any of the
other participants suffer an unexpected but defined risk that requires financial assistance. By
incorporating the concept of Tabarru' , where no return is expected, the elements of
uncertainty and gambling in the Takaful contract are minimized and the social cooperation
promoted by Islamic teachings is respected. The Tabarru' clause is included for all members
in participating in a Takaful scheme. However its percentage depends on the Takaful operator
based on technical and statistical parameters that take into account different expected risk
types.
Contributions paid by the participants are divided into two parts, the first part is put into a
Mudarabah investment fund and the other part is put into a common pool on the basis of
Tabarru' to protect the financial well-being of fellow participants in times of need. In essence,
the donation part of Takaful would enable the participants to perform their deeds sincerely in
protecting members of the community and assisting those who might suffer misfortune in life
or business. The sharing of the profit is allocated only after the obligation of indemnifying and
helping the unfortunate members has been completed. Income is shared on the basis of
Mudarabah principle between the participants and the Takaful operator.
How does Takaful Work
All participants (policyholders) agree to guarantee each other and, instead of paying
premiums, they make contributions to a mutual fund, or pool. The pool of collected
contributions creates the Takaful fund. The amount of contribution that each participant
makes is based on the type of cover they require, and on their personal circumstances. As in
conventional insurance, the policy (Takaful Contract) specifies the nature of the risk and
period of cover.
The Takaful fund is managed and administered on behalf of the participants (policyholders)
by a Takaful Operator who charges an agreed fee to cover costs. These costs include the costs
of sales and marketing, underwriting ( 1), and claims management.
Any claims made by participants are paid out of the Takaful fund (their contributions) and any
remaining surpluses, after making provisions for likely cost of future claims and other reserves,
belong to the participants in the fund, and not the Takaful Operator, and may be distributed
to the participants in the form of cash dividends or distributions, alternatively in reduction in
future contributions.
Operating Principles
An Islamic insurance company must have the following operating principles:
a) It must operate according to Islamic co-operative principles.
b) Reinsurance commission may be paid to, or received from, only Islamic insurance and
reinsurance companies.
c) The insurance company must maintain two funds: a participants (policyholders') fund and a
shareholders' fund.
The Participants (Policyholders') Fund
a) The assets of the policyholders' fund consist of: Insurance premiums received and Claims
received from re-insurers.
Such proportion of the investment profits attributable to policyholders as may be allocated to
them by the Board of Directors.
Salvages and recoveries, Consultancy and other receipts
b) All the claims payable to the policyholders, reinsurance costs, technical reserves,
administrative expenses, etc., excluding the expenses of the investment department, shall be
met out of the policyholders' fund.
c) The balance standing to the credit of the policyholders' fund at the end of the year
represents their surplus. The General Assembly may allocate the whole or part of the surplus
to the policyholders' special reserves. If a part, the balance will be distributed among the
policyholders.
d) When the policyholders' funds are insufficient to meet their expenses, the deficit is funded
from the shareholders' fund.
e) The shareholders undertake to discharge all the contractual liabilities of the policyholders'
fund, but this liability does not exceed their equity in the company.
The Shareholders' Fund
(1 ) It is to guarantee financial support of, or say it is to protect by insurance.
a) The assets of the shareholders' fund consist of: Paid-up capital and reserves attributable to
shareholders, Profit on the investment of capital and shareholders' reserves.
Such proportion of the investment profit generated by the investment of the policyholders'
fund and technical and other reserves as is attributable to them.
Miscellaneous receipts
b) All the administrative expenses of the investment department are deducted from the
Shareholders' Fund.
c) The balance of the shareholders' surplus, if any, is distributed among them.
Investment of Funds
The company may invest its funds only on a profit-and-loss-sharing basis, as approved by the
Shari'ah.
Products and Services Offered by Islamic Insurance Companies
Islamic insurance companies may offer competitively priced products, without curtailing the
scope and benefit of insurance coverage made traditionally available to the public by
conventional insurance companies.
As regards life insurance facilities, Islamic insurance companies have developed Islamic Trust
Funds for social solidarity, mortgage protection, student protection and employers' protection.
6.2.0 Takaful Models
There are various models of Takaful according to the nature of the relationship between
the company and the participants. There are Wakalah (agency), Mudarabah and a
combination of the two. Other business models such as Waqf model and Tabarru' model are
also adopted by some Takaful operators on a slighter extent.
In the Sudanese Takaful model, every policyholder is a shareholder in it. An Operator runs
the business on behalf of the participants and no separate entity manages the business.
Shari'ah experts consider this preferable. In other Islamic countries, the legal framework does
not allow this arrangement and Takaful companies work as separate entities on the basis of
Mudarabah (in Malaysia) and Wakalah (in the Middle East).
In the mudarabah model practised mainly in the Asia Pacific region, the Takaful operator
accepts payment of the contributions from participants on the basis of equity partnership that
is a risk-sharing mechanism where the profit is shared between the Takaful operator and the
participants in a predetermined manner. The contract specifies how the surplus from the
operations of Takaful is to be shared, in accordance with the principle of Mudarabah,
between the participants as the providers of capital and the Takaful operator as the
entrepreneur. The sharing of such profit is approved by the Shari'ah Supervisory Board for
each year; it may be in a ratio 50/50, 60/40, 70/30, etc. as mutually agreed in advance between
the contracting parties and depending on the developmental stage of the company. The
sharing of surplus that may emerge from the operations of Takaful is made only after the
obligation of assisting the fellow participants has been fulfilled. Shareholders of the Takaful
Operator as Mudaarib bear expenses for the investment activities and the participants as Rabal-maal bear the expenses for the underwriting operations. Financial losses are required to be
covered only by the participants, such as in form of a reduction in terms of their capital or by
paying higher contributions; while the Takaful Operator may only lose its time and effort of
labour spent in managing the underwriting operations.
Under Wakalah model, the group of participants can delegate their rights or business to the
Takaful operator (Wakeel), who then acts as their agent and representative. Shareholders of
the Takaful Operator provide the capital to establish the WakalahTakaful as a donation and
do not receive any share of the income generated from investing the Participants Takaful
Fund. The Takaful operator assumes the business risk in developing and operating Takaful
business on behalf of the participants but never participates in the mutual underwriting losses.
It generates its income by charging a Wakalah fee for managing the underwriting operations
and investing activities, based on the level of contribution, investment returns and generated
surplus. This fee rate is fixed annually in advance and should be approved by the Shari'ah
Supervisory Board of the Takaful Operator. All operating expenses are charged to the
Participant Takaful Fund, while expenses for the investment activities are charged to the
Takaful Shareholders Fund.
6.2.1 Choice of the model
There is no particular Takaful model that could be considered as the best that exists for both
the Takaful Operator and for the Takaful participants. Each model has its own strong and
weak points, and none can be exceptionally distinctive from the others as each meets specific
needs. Currently different Takaful models are prevalent in different contexts and regions; the
basic models being Mudarabah and Wakalah Models. However there are a number of finer
combinations of models that exist in practice. It is difficult to judge the degree of qualities of
each of these models which all serve their purpose in a definite way. For example, Mudarabah
practices are considered better for investment aspects of Takaful fund, while Wakalah is
preferred for its risk-sharing features in Takaful operations.
In Mudarabah model, the Takaful Operator can share in any operating surplus as a reward for
managing underwriting on behalf of Participants. This provides an incentive for the operator
to perform proper underwriting, to manage claims carefully and to limit unjustified. Besides,
under Mudarabah, the Takaful fund belongs to the participants and not the Takaful operator.
If there is a loss, participants may lose some of their capital and the Takaful operator loses
only in terms of effort. However, some scholars consider that some conditions for Mudarabah
may render it inappropriate for application to mutual insurance and risk-sharing. In fact, no
profit in form of excess capital is generated from Mudarabah Takaful; it is rather a surplus
resulting from collected premiums not fully spent. In addition; Mudaarib in Family Takaful
may not be free to invest the funds as in a typical Mudarabah arrangements; participants can
also choose themselves how to invest premiums into specific funds.
By contrast, the Wakalah model distinguishes between the Takaful fund and the Takaful
operator (Wakeel), the latter charges a fee deducted from contributions made by participants
and investment profits; this management fee is related to the level of performance. And since
the Takaful operator does not share in the underwriting result, the Wakalah model requires
that it negotiates all expenses on behalf of participants to provide the lowest possible costs. All
operational costs should be clearly reported to policyholders to guarantee the transparency of
all operations and reduce elements of conflict of interest between parties of the Wakalah
agreement. However, it is still not confirmed that when this model would be commercially
viable when it is fully implemented.
Compared to the profit-based previous business models, Waqf, as a non-profit model, would
look perfect as it operates on a non-profit basis and utilizes a contribution that comes totally
from Tabarru by participants who willingly give to the less fortunate members of their
community. Moreover, Waqf is more compatible with the cooperative concept of Takaful as
it is created for the very purpose of cooperation for the common good. Similarly, Tabarru
business model has a non-profit nature and all contributions from participants are treated as
donation. Under this model, there are no returns for the promoters, and for the
policyholders. However these two models have some limitations and are restricted to social or
governmental owned businesses and programs and cannot therefore be competitive in a global
market.
Therefore, a refinement of the previous models by combining Wakalah and Waqf models has
been evolved to enable participants to employ Takaful Operator instead of being their own
managers. As a Wakeel, it collects donations for the Waqf fund, manages the underwriting
operations and invests the participants' funds. The Takaful Operator is entitled to payment of
a defined fee and share as, a Mudaarib, in the income of the participants funds invested on the
basis of Mudarabah. There is also a hybrid Wakalah - Mudarabah business model where the
Wakalah contract is used for managing the Takaful underwriting operations and the
Mudarabah contract is used on the investment side for the participants Takaful Fund.
However, these combinations may also have some features where that can be more effective
than others and where they would need to be adapted to the specific context of the Takaful
required by participants.
Pricing Transactions linked to Interest-rate Benchmark
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 versus Shari‟ah-based approach in particular. There are
practical challenges delaying a switch to participation-based structures, such as Musharakah
and Mudarabah, which require financiers to participate in the underlying asset in a financing
transaction.
Shari'ah Authenticity
Shaikh Yusuf Talal DeLorenzo, Islamic scholar, sees 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.
Shari'ah Supervisory Board (Religious Board)
The role of Shari‟ah Supervisory Board members is to review the Takaaful / Retakaful
operations, supervise its development of Islamic insurance products, and determine the
Shari‟ah compliance of these products and the investments. The Shari‟ah Supervisory Board
have to carry their own independent audit and certify that nothing relating to any of the
operations involve any element that is prohibited by Shari‟ah.
Islamic financial institutions (IFIs) 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 Sharia‟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 acts 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, an Islamic scholar‟s 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.
Status of Takaful
As Islamic finance continues to expand, there is likely to be a huge takeoff of other products
such as pensions, education, marriage and health Takaful plans. There is also a huge scope
for mortgage Takaful.
Islamic principles strong emphasis in Takaful on the economic, ethical, moral and social
dimensions, to enhance equality and fairness for the good of society as a whole should also
have appeal for the ethically minded.
In modern society, insurance has become a necessity to trade and industry. Life insurance has
become the most effective vehicle for mobilising savings, for capital formation and for longterm investment, as well as for making provision for old age and bereavement in the case of
individuals.
In the west, the insurance sector is the largest single contributor to the capital market. Banks
and insurance companies now form international alliances for mutual benefit.
There is an increasing demand for a Shari'ah-compliant insurance system. Until recently, there
has been a low demand for insurance in Islamic countries, because Muslims believe that
insurance is un-Islamic. The development of Islamic insurance, therefore, requires extensive
education of the Muslim public, besides development of resources and expertise, a legal
framework for it, the harmonization of practices, development of new Shari'ah-compliant
instruments, accounting standards, and arrangements for Retakaful.
6.3 AREAS OF TAKAFUL
Family Takaful and General Takaful
The Takaful is broadly practiced under two main areas namely Family Takaful and General
Takaful. Family Takaful is the Islamic equivalent of conventional life insurance; it involves
solidarity between a group of individuals and their families pertaining to protect widows,
orphans and other dependents of the insured against an unforeseen specified tragedy such as
accident or permanent disability. While General Takaful is about insuring anything other than
human life; this may include for example property, belongings or vehicles against fire and
theft.
This area of insurance also works like a joint guarantee in which all participants mutually
contribute their shares of premiums into a pool to indemnify (Secure against future loss,
damage, or liability; give security for) any participant who suffers from an insured loss or peril.
In both areas and according to the nature of relationship between the Takaful operator and
the participants, there are various models for the management and investment of funds. In
Mudarabah model, Takaful operators normally divide the contributions into two parts, i.e.,
donations (Tabarru‟) for meeting liability or losses of the fellow policyholders and the other
part for investment. And as a Mudaarib, the Takaful Operator assumes the role of an
entrepreneur to manage the business on Mudarabah profit-sharing basis; it incurs
administrative expenses for the underwriting operations on behalf of the participants, while
general expenses are charged to the Participant Takaful Fund; it also shares in the risk of the
business and in case of loss or deficit, it does not receive any remuneration and bears losses in
terms of unrewarded labour. Returns from investment of participants Takaful funds are
distributed on Mudarabah principle between the participants and the Takaful operators as
mutually agreed.
In the Wakalah Model, the Takaful operator plays the role of an agent (Wakil); it manages
the Takaful business for both the underwriting operations (insurance) and the investment of
the participants Takaful Fund, as such the operator earns Wakalah fee from contributions that
covers most of the expenses of business; it does not share in any underwriting results as these
belong to participants in form of surplus or deficit. The fee rate is fixed annually in advance in
consultation with Shari'ah supervisory board of the operator. This fee may be an absolute
amount, but is generally determined as a percentage of the contributions paid by the Takaful
participants. Takaful operator's operations include payments of salaries, overhead, selling
commissions, sales and marketing expenses, etc; it bears expenses from investment activities
and charged them to the Shareholders Fund.
6.4 General insurance
6.4.0 Introduction
The Takaful business is divided into two major categories: Family Takaful and General
Takaful. General Takaful schemes are about mutual co-operation to offer all kinds of non-life
protections in accordance with the principles of the Shari'ah. It provides insurance to the
diverse needs of individuals and businesses to cover against unpredicted specified material loss
or damage threatening properties, assets or belongings of participants. General Takaful is a
short-term scheme, settled usually on an annual renewal basis, and as in Family Takaful, all
participants are expected to mutually contribute premiums into a common pool managed by
the Takaful operator and agree to indemnify those participants who suffer from an insured
peril. The amounts of participants' contribution are determined by the terms agreed in the
contract, by considering the nature and value of the insured asset and risk involved. The main
difference between the Family Takaful and General Takaful is the way contributions are
operated in fact; Family Takaful schemes are about risk-only joint-guarantee agreements while
General Takaful schemes are investment-oriented agreements. In fact, General Takaful
payments are not divided into two separate accounts. They are treated only as Tabarru'. The
Takaful operator raises the Tabarru' fund, and invest the remainder of the fund after
deducting the operational cost of the scheme. If any participant suffers a loss or damage, then
he will be compensated from this fund, by considering the level of occurred losses. Any profit
or return from the investment is returned back to the fund. And unlike Family Takaful, net
surplus in the General Takaful Fund is shared between the participants and the Takaful
operator. In addition, the profits sharing will exclude participants who get compensation from
their claims.
6.4.1 Aspects of General Takaful
General Takaful schemes are about meeting the needs for protection of individuals and
businesses in relation to defined events that may occur on a short-term basis. Like Family
Takaful, participants of General Takaful also enter into an agreement based on Wakalah,
Mudarabah or a hybrid combination of both. The participants pay all Takaful contributions as
Tabarru'; their contributions are credited to the General Takaful fund of the Takaful
company. This fund is invested by the Takaful operator as a Mudaarib or a Wakeel in line
with the virtues of Shari'ah and the profit generated from such investment is pooled back to
the fund.
The Takaful operator indemnifies participants who suffered a loss consequent upon the
occurrence of a catastrophe or disaster that is clearly defined in the contract. According to the
way participants' contributions are allocated internally, the General Takaful fund can pay for
operating costs of general Takaful business that may include fees, profit shares, re-Takaful
expenses in addition to provisions for setting up any contingency and special reserves. Any net
underwriting surplus resulting from the fund after deducting all these costs will be distributed
between the participants and the operator on expiry of each insured's insurance policy; the
distribution uses the ratio agreed in accordance with the conditions of the Mudarabah
contract.
This distribution may be replaced by a reduction in participants' installments to avoid the
element of Riba in the contract. Participants who may have incurred any claims or have
received any Takaful benefits are excluded from the profits sharing. If the total contributions
and the income from investments cannot cover all claims and expenses during the period, the
participants may be required to pay additional premiums.
6.5 Life insurance
Life insurance as a concept does not contradict the requirements of Islam. In essence, this
insurance is similar to the principles of compensation and shared responsibility among the
community where all participants guarantee each other against unpredicted future financial
risk that would alter the financial situation of participant's families. However, Muslim Jurists
are of the opinion that life insurance is haram because it distrusts in Allah's providence and
does not take into consideration that He has decreed the moment of death of all human
beings. However, it has been argued that what is being insured against is not death, but the
adverse material consequences of it on widows, orphans and other helpless members of the
community. In fact, life insurance ensures solidarity among participants and provides material
protection for the offspring of the deceased, which was encouraged by the Prophet (pbuh).
Indeed for you to leave your heirs rich is better than leaving them poor begging people (for help).
In addition, the operations of conventional life insurance do not conform to the rules of
Shari'ah as they may embody the elements of Gharar in the contract of insurance, Maysir as
the consequences of the presence of uncertainty and Riba in the investment activities of the
insurance companies. In fact, there are unknown or uncertain factors in operation of a
contract in life insurance contracts about whether the payment will be accepted as promised,
about how long the payment and about the exact amount the beneficiaries will get. And since
the insurance company may acquire all the profits if no claim is not made, this operation can
also be considered as Gharar which also occurs in any form of contract which is unbalanced in
favour of one party at the expense and unjust loss to the other.
However, some scholars consider that Gharar may be tolerated when the contract is
restructured on the basis of cooperation or mutuality instead of a profit motivated insurance
company. Maysir in the case of life insurance arises as the consequence of the presence of
Gharar. In fact, the participant contributes a small amount of premium in hope to gain a large
sum. If the life insurance policyholder does not die within the defined period, the participant
loses its contributions. And if he dies after only paying part of the premium his dependants
receive a certain some of money which the policyholder ignore the amount or the origin. Also
if claims are higher than contributions, the company will be in deficit. However, gambling is
remedied by the fact that it is a contract based on overwhelming statistical knowledge and the
application of the theory of probability. Furthermore, a conventional life insurance policy
premium may be invested in Riba-based assets and transactions. The element of Riba also
occurs when on the death of the insured, he gets much more than he has paid. The solution
would be to use policyholders contributions paid on the basis of profit-and-loss sharing system
that is free from elements of Riba.
6.5.1 Importance of Family Takaful
A family Takaful is a long-term savings and investment programme that provides mutual
financial assistance and protection among its participants and their families based on teachings
of Shari'ah. If the participant dies, his contributions could help alleviating the burden of his
family, and on survival, the participant is assured of a sum of money to cover his payouts
during periods of hardship such as retirement needs or medical expenses.
The importance of Family Takaful lies in the fact that it is an Islamic viable alternative to
conventional life insurance, its policies allow the policyholders to enjoy the same level of cover
provided by conventional insurance and at the same time to assist the unfortunate needy in
times of their need due to untimely death and other mishaps resulting in permanent injury or
disability.
Family Takaful plans can include the creation of funds to cover specific purposes such as
children's education, hospitalization, or business protection interest against key-employee's
death. Therefore, these plans can provide financial protection against various unforeseen risks
that could have devastating effects on both individuals and businesses. These plans are
therefore in line with the Islamic philosophy of cooperation, shared responsibilities and
mutual help and have healthy impact on the socio-economic stability of the societies where
they are operating.
And cooperate in righteousness and piety, but do not cooperate in sin and aggression. (5:2)
In addition to the risk protection proposes, Family Takaful is also a good attractive option for
investment, as insurance products tend to be more profitable compared to normal investment
schemes, plus the bonuses they propose. Insurance companies mobilise long-term funds in
the form of policyholder contributions and proceed to invest part of them in the capital
market, which gives them the status of major investors. Thanks to their investments they
contribute to the development of capital markets, especially for Islamic financial markets, and
thus they contribute to the economic growth of the country.
6.5.2 Takaful Funds
The Participants Takaful fund collected through the regular contributions made by the
participants is put into two accounts; Participants' Special account (PSA), which is treated as
charity for the purpose of mutual help according to the principles of Tabarru` or donation,
and Participant's account (PA), where the fund is meant for savings and investments only. The
proportion of the Takaful Tabarru' is determined based on actuarial values, such as the
expected claim rate; the incidence of claim; the basic cover; the provisioning basis for reserves;
the profit-sharing expectation between the Operator and participant; and any expenses or
commission loading (1). Participants contributions to cover potential future claims is credited
to both accounts will be pooled by the Takaful Operator to a single fund for the purpose of
investment activities according to the principles of Mudarabah and all returns on the
investment will be pooled back to the fund.
Mutual financial assistance such as Family Takaful benefits to fellow participants in case of
death, disablement or injuries is paid from the Participant‟s Special Account (PSA) fund;
whereas, the proportion of contributions that is put into Participant‟s Account (PA) fund is
destined for savings and investments only. With this separation between the two accounts, the
amount that has been relinquished as Tabarru' in the PSA account will not be refunded to the
participant, in fact, the participant has the right to claim only from the PA account. And if no
claim is made during the policy period, at maturity, the participant is entitled to a share of the
surplus in the PSA fund and well as the proportion of his Takaful installments that have been
credited into the PA fund including his share of investment profits.
(1 ) Family Takaful Business by Islamic Insurance and Banking Institute (IIBI), 2009
6.6 Reinsurance
6.6.0 Introduction
Frequently, the scale of insurance risks underwritten (insured) is too great for one insurer to
carry safely. In these circumstances, companies use reinsurance to mitigate their own risk
exposure.
Reinsurance is a form of company-to-company insurance whereby an insurer transfers part of
the risk to another insurer to limit the total loss it would experience in case of a disaster; the
insurer pays an agreed upon premium from the insurance fund to the reinsurance company,
and in return, the reinsurance company will provide security for the risk reinsured. Similarly,
Retakaful, which is the Islamic form of Reinsurance, has a close relationship with Takaful
operations and the same Shari'ah principles apply to both. The Takaful operator takes a
portion of policyholders' contributions in General and Takaful schemes and pays premium to
the Retakaful operator to get reinsurance protection to spread its risks.
The Retakaful operator plays the key function of risk carrier and fund provider to direct
Takaful operator; it also gives advice and assistance in the design and structuring of specific
insurance contracts to the direct insurers. Accordingly, Takaful operator can spread its risks
based on different criteria such as location and class of insured assets. This would enable the
Takaful operator to stabilise claims ratios from one year to another and would therefore be
able to hedge against possible insolvability or incapability to meet a large number of Takaful
indemnities that may occur simultaneously, by using the coverage of a financially capable
reinsurer. In addition to the important role of the risk mitigation played by Retakaful, this
mechanism enables the primary Takaful operator to raise its underwriting capacity over and
above the usual limitations imposed by statutory regulations. Retakaful operator can also help
new insurance companies who may reshuffle their contracts in reinsurance until they gain
enough experience and credibility. This will lead to greater Takaful capacity for Takaful
operators and thus to strengthening of the Takaful form of risk coverage. Besides, Retakaful
operator can use the additional financial resources and invest them in Islamic financial
markets in a Shari'ah compatible way using profit-sharing arrangements with Takaful
Operator.
6.6.1 Retakaful Operator
The two parties involved in Retakaful operations are the direct insurer, which desires to
relieve itself from a portion of risk burden, and the Retakaful operator, which accepts to cover
that portion of insured risk. The Retakaful Operator‟s role is mainly to strengthen the Takaful
sector by covering large accumulation of risks subject to possible loss for direct Takaful
operators and hence enabling them to raise their underwriting capacities without involving
conventional reinsurers that may propose mechanisms that do not adhere to Shari'ah
principles and could use a high degree of Gharar and Riba.
The Retakaful operator functions include carrying risk of ceding insurers by being a partner of
insurance contracts to take part of the insured risks and providing funding for the risk to allow
direct Takaful companies, especially new companies intending to offer new lines of business
products, to take on further payment obligations and hence protecting the Takaful operator
from the threat of insolvency (The lack of financial resources).
The Retakaful operator may enter into profit-sharing arrangements with the ceding companies
and would distribute the balance of the shareholders' surplus, if any, amongst them; it can also
allow their participants (Takaful operators) to utilize the retained deposit reserves of the
Retakaful fund in the interest of their policyholders without paying interest. Most importantly,
the Retakaful operator will provide the direct insurers with a wide range of technical advice
and support that may vary from helping in new reinsurance contracts design to assisting in the
structuring of the total reinsurance programme.
In case there is a need to cover a large amount of risks that is over the capacity of the Takaful
operator, the latter can enter into profit-sharing arrangements with other Retakaful operators
or even some conventional reinsurance companies. However, its reinsurance requirements
should be regularly reassessed in order to decrease its reliance upon the conventional
reinsurance to the maximum, until the Retakaful operator could be strong enough to put an
end to its relations with the conventional reinsurers or eventually replace them using other
coinsurance agreements with other available Retakaful operators.
6.6.2 Retakaful operations
As a Shari'ah compliant alternative to conventional reinsurance, Retakaful operations should
fully adhere to Islamic principles of co-operation, protection and mutual responsibility; it is
imperative that the Retakaful operator ensures that all transactions are dealt without involving
elements of Riba, Gharar or Maysir and that the arrangements do not include nonproportional clauses where risk is unfairly shared between the different parties; any nonproportional reinsurance arrangement should be based on a strict profit commission plan or
on a reciprocal basis. In addition, the Retakaful operator is required not to engage the invested
contributions in any prohibited activities.
If there is a need for more resources to cover large sums to help the primary Takaful
undertakings to spread the risk inherent in some segments of the Takaful business, the
Takaful operator can engage into profit-sharing arrangements with commercial insurance and
reinsurance companies. This is justified by the fact that currently there are not enough
Retakaful companies capitalised to the levels required by insurers and especially not enough
"A" rated Retakaful operators; this authorisation is conditioned by the unavoidable necessity to
protect the interests of its participants and its shareholders and not causing financial injury to
Muslims or destabilising the financial systems of Muslim countries. Furthermore, Retakaful
operators are not allowed to pay or receive any reinsurance commission from or to a
conventional reinsurance or insurance company, such a commission is only accepted in the
case of Takaful or Retakaful operators. The Takaful Operator should also regularly review its
reinsurance requirement with the conventional reinsurers to gradually reduce its dependence
on them.
In addition, in order to remain compliant with Shari'ah principles, Retakaful operators can
sort sorting to Shareholders or Islamic banks for Qard Hassan to serve as a deposit reserve for
the Takaful operator. This fund will be invested as a part of the Retakaful fund and will be
used to the best of the interest of all participants and can; this reserve can also be used to
cover any extraordinary losses. A Shari'ah Supervisory Board should be designated to control
and monitor all operations of the Retakaful operator in accordance with Shari'ah rulings, in
particular in regard to its reinsurance contracts with conventional reinsurance companies.
6.7 Corporate Governance
6.7.1 Corporate Governance in Takaful
There has been an increasing emphasis on corporate governance in recent years in a global
context. In the Takaful system as well, corporate governance became essential for maintaining
the efficiency and stability of this sector and for protecting the rights of policyholders,
shareholders but also the rights of other internal and external stakeholders. In fact, corporate
governance treatment organizes many aspects of the Takaful business that include the
necessary conditions to validate Takaful models and the relationship between policyholders'
and shareholders' funds. The corporate governance is intended to maintain the order of the
Islamic insurance industry regarding certain regulations and ethical values that Takaful
operators should respect and to help identifying and analysing of risks and opportunities in
this sector. This would enhance the quality and the credibility of the Takaful sector and allow
more loyalty and commitment from participants, shareholders and employees. Yet, the
Takaful market has some distinct features and challenges compared to conventional
insurance, as it has to match the service quality of the conventional insurance market and
convince the uninsured segment of the market to use its Shari'ah-compliant facilities. The fact
that this industry is quite new requires Takaful operators to adapt existing mechanisms and set
of laws to create their own corporate governance framework and to avoid any conflicts of
interest which may arise in the process of decision-making.
Moreover, the conceptual foundations of Takaful and the specific structures of Takaful
undertakings require Takaful operators to complete the basic concepts used in insurance
regulations such as capital adequacy and solvency, risk assessment and transparency, with a
range of specific control functions to ensure that Takaful funds are managed and invested in
accordance with Shari'ah rules and that all investments are undertaken ethically and
responsibly. The role of the Shari'ah Supervisory Board in overseeing the proper management
of policyholder funds should help to increase transparency in regard to Shari'ah compliance.
In fact, the board checks that transactions had taken place without the use of Riba, Gharar or
Maysir; it also controls that the financial accounting of the Takaful operator is presented in a
precise, accurate, and timely manner.
6.7.2 Sharia'h Auditing in Takaful
Shari'ah auditing in Takaful sector is about investigating all financial statements and accounting
procedures of the Takaful operator to evaluate its management efficiency and its compliance
with Shari'ah rulings and with established policies. Shari'ah audit guaranties the transparency of
the Takaful industry and would allow all stakeholders control the compatibility of all
operations of the company with the teachings of Islam. In fact, auditors from both the internal
Shari'ah Supervisory Board of and from outside the organization periodically examine the
Takaful operator's records and reports to assess its soundness and adherence to the Shari'ah
principles.
The Shari'ah Supervisory Board is an independent body that issues fatwas to certify that
financial instruments and transactions used by the Takaful operator comply with Shari'ah
rulings; it is also responsible of the calculation of Zakat and of determining the distribution of
income or expenses among shareholders and participants. Takaful operators can also establish
other internal Shari'ah review units to ascertain that all financial transactions implemented;
they perform tasks in parallel to those of audit departments. Both Shari'ah advisors and
reviewers should have access to all records and staff necessary to conduct the audit and should
have enough power to require formal responses and concrete actions from management of the
Takaful operator about their audit findings. The responsibilities of each Shari'ah body should
be clearly defined to safeguard their independence their independence to allow them to
conduct their assessment on large volumes of transactions and produce appropriate audit
recommendations.
Shari'ah Audit of Takaful can also be operated by external arrangements from regulators or
from external financial information services providers or rating agencies to offer
complementary assessments about compliance of instruments and processes with regulations
and to propose harmonisation actions. External arrangements can allow the Takaful operator
accessing a wide range of expertise with a broader independence vis-à-vis shareholders and
management and that the company may not afford to hire internally. Moreover external
Shari'ah audit can be used as arbitration in case of disagreement between members of the
same internal board.
6.7.3 Regulatory implications
There are many areas where the regulatory standards developed for conventional insurance
cannot automatically be applied to Takaful business. The distinctive aspects of Takaful
products and services pushed many jurisdictions to develop additional specific rules and
standards that take into account the nature of that business. In fact the insurance market
regulation should be reviewed to take into account the particular types of risks related to the
structure of Takaful products based on the Mudarabah, Wakalah and Waqf and other hybrid
combinations. The Takaful framework should incorporate conditions for the clarity and
consistency of how these regulations would be applied to the Takaful activities. The Takaful
in-house Shari'ah board would apply the defined regulatory and supervisory controls to ensure
that all aspects of the Takaful operations represented by The Takaful operator to
policyholders are compliant with Shari'ah principles.
Takaful funds cannot be invests in conventional interest-based bonds or in equities of
companies involved in prohibited activities such as weapons. The use of derivatives is also
extremely restricted. As a result, the asset risk profile in Takaful business is quite different
from that of a conventional insurance. Moreover, there may be issues in the overall risk
profile of the policies and assets managed by Takaful operators. For example, the risk profile
in Family Takaful is different from the conventional insurance product as the Takaful plan
generally operates on an agreed contribution basis rather than a guaranteed benefit. This
would impact both capital adequacy and disclosure to consumers which will depend on the
particularity of the chosen Takaful model. Therefore the Takaful regulators should adapt
capital adequacy principles to reflect the nature and allocation of the financial risks related o
the Takaful model. Similarly, the solvency regime needs to be based on the location of risk
and to represent how liability in Takaful fund can be extended to policyholders' investment
accounts, as policyholders are entitled also to share possible losses; so there is a need to
determine how their shares should be determined in both surpluses and deficits.
Glossary of financial terms
Aakhira
Aaqilah
Adl
Ahad
Ahkam
Ajr
Ajr-un-kareem
Al Adl
Al-Ajr
Al-bai
Al-Ghurm bil Ghunm
Al-Ihsan
Al-kharaj bil
daman
Al-mal
Al-Quran
Al-Rahn
Al-Sar-al-Adl
Al-Sarf
Al-wadia
Al-Wakala
Al-Wakala al Mutlaqa
Alim
Allah
Amanah
Life in the Hereafter.
Mutual Help, which was an arrangement of mutual help or indemnification
customary in some tribes at the time of the Prophet Muhammad (pbuh).
This is a foundation doctrine based on which Islamic insurance practices,
known as Takaful, have been developed.
A general term which conveys the meaning of justice, equity and fairness.
One. Inherently one (God).
Plural of Hukum.
A payment or compensation such as commission, fees or wages charged
for services.
A generous reward.
See Adl.
See Ajr.
See Bai.
The principle that one is entitled to a gain only if one agrees to bear the
responsibility for the loss. Earning profit is legitimised only by risk-sharing
and engaging in an economic venture. This provides the rationale and the
principle of profit-sharing in Shirkah (partnership) arrangements.
See Ihsan.
Link of exposure to risk, one can claim profit only if one is ready to bear
the business risk, if any. The principle in Islamic jurisprudence that
entitlement to return or yield ( al-kharaj) is for the one who bears the
liability ( daman) for something, say an asset, and one who does not bear
the liability has no claim to the yield.
See Mal.
See Qur'an.
See Rihn.
The just price.
See Sarf.
See Wadiah.
See Wakalah.
Absolute power of attorney.
One who knows. See Ulama.
The name for God in Islam. It is used by Arabic-speakers of all Abrahamic
faiths, including Christians and Jews. The concept of Allah, is the only real
supreme being, all-powerful and all knowing Creator, Sustainer, Ordainer,
and Judge of the universe. There is no plural, masculine or feminine form
of this word in Arabic. This denotes the One True God, the Almighty
Creator, Who is neither male nor female . Islam puts a great emphasis on
the conceptualisation of God as strictly singular ( tawhid). God is unique (
wahid) and inherently one ( ahad), all-merciful and omnipotent. Islam
teaches that Allah is the same God worshiped by the members of other
Abrahamic religions such as Christianity and Judaism.
Trust. Lit.: reliability, trustworthiness, loyalty, honesty. Technically, an
important value of Islamic society in mutual dealings; it also refers to
deposits in trust. A person may hold property in trust for another, it
entails the absence of any liability for loss, except for breach of duty. By exten
term can also be used to describe different financial or commercial activities
deposit taking, custody or goods on consignment. Deposits in current accou
non-interest bearing) with Islamic banks are regarded as Amanah. If the bank
authority to use the funds in the current accounts to invest in its business, Ama
transforms into a loan from the depositor to the bank and the bank is liable to r
amount in the current account, irrespective of profit or loss made by the bank
Ameen
See Amin.
Amil
Amin
Amwal
Aqd
Aqd Batil
Aqd-al-Bay
Aqd-al-Ijara
Aqd-al-Muawadah
Aqd-al-Qard
Aqd-al-Wadia
Aqd Ghair Lazim
Aqd Lazim
Aqd Tabarru
Aqidah
Aqilah
Aql
Ariya
Arbun
Assets
Awqaf
Aya
Ayah
Ayat
A'yaht
Ayn
Bai
Literally it means worker. One who perf
a task, an agent. One who deserves
compensation for performing a task, su
as the mudarib (manager) in a mudarab
contract or a zakat collector.However, i
Fiqh it also refers to the working partne
mudarabah contract. Under this contrac
one partner provides the capital and the
other provides the labour who is called
or mudarib.
One who holds honestly the trusts of ot
people; trustworthy.
Plural of Mal which means worldly
possessions including both property an
money (wealth).
Contract, Agreement, Bond. Synonymo
with the word "contract" in modern law.
See Batil.
A contract of sale.
See Ijarah.
A contract of exchange in which
compensation is given against the good
services received.
See Musharakah.
Aqd-al-Musharakah
A loan contract. Also known as Qard.
See Wadia.
A contract in which any one of the parties has a unilateral right to revoke it
with the consent of the other(s).
A contract in which none of the parties has a unilateral right to revoke it
without the consent of the other(s).
See Tabarru.
Belief, faith.
Kin or persons of relationship who share responsibility.
Intellect.
Loan, which means to give any non-fungible commodity to another for use,
without taking any return for its use.
A non-refundable down payment or deposit paid by a buyer for the right to
purchase goods at a certain time and certain price in future; if the right is
exercised, it becomes part of the purchase price. If the buyer does not
complete the purchase or backs out for any reason, the seller has the
option to forfeit the deposit. Also known as Urboun and Bai al-Arbun. Also
see Hamish Jiddiyah.
Anything of value which may be tangible or intangibe. Any interest in real
or personal property which can be appropriated for the payment of debt.
The Financial Accounting Standards Board (FASB) describes an asset as
having three essential characteristics: (a) it embodies a probable future
benefit that involves a capacity, singly or in combination with other assets,
to contribute directly or indirectly to future net cash inflows, (b) a particular
entity can obtain the benefit and control others‟ access to it, and (c) the
transaction or other event giving rise to the entity‟s right to or control of the
benefit has already occurred. See Fictitious Asset
Plural of Waqf, meaning trust. Also see Waqf.
See Ayat.
See Ayat.
A verse or passage in the Qur'an.
See Ayat.
Monetary wealth. A tangible (physical) asset. Also, refers to currency or
ready money. Ayn is often contrasted with Dayn
Stands for “sale” or contract of sale. It is often used as a prefix in referring
Bai al-Arbun
Bai Al Amanat
Bai al Inhah
Bai´ al khiyar / Kiyar
Bai´ al Mutlaq
Bai´ al Muqayaza
Bai al-salam
Bai Baatel
Bai Bithaman Ajil (BBA)
Bai Mu’ajjal
Bai Salam
Bai-sarf
Bai wafa
Barakah
Bay
Bay'al ayan
Bay al-dayn
Bay’ al-Gharar
to different sales-based modes of Islamic finance, such as Murabaha,
Istisna‟a, and Salam.
See Arbun.
Fiduciary sales like murabaha and wadi'ah.
Buying an object for cash then selling it to the same party for a higher price
whose payment is deferred so that the purchase and sale of the object
serves as a ruse for lending on interest. It equates to a double sale by
which the borrower and the lender sell and then resell an object between
them, once for cash and once for a higher price on credit, with the net
result of a loan with interest. Used by some Islamic banks, it refers to
selling of an asset to the customer through deferred payments. At a later
date, the bank will repurchase the asset and pay the client in cash terms.
Thus, Bai al Inah comprises two agreements; in the first agreement, the
bank sells an identified asset to the customer at an agreed price and the
customer can complete the purchase of bank's asset by payment in
installments over an agreed period; in the second agreement, the bank repurchases the same asset from the customer at a lower price and on
completion of the second transaction, the bank will pay the lump sum
amount in immediate cash at the price agreed between them. The
difference in the price is the bank's profit, which is determined in advance.
This arrangement is prohibited by the majority of Shari‟ah scholars as it
also equates to a sale and buy-back arrangement. Also known as Bay-al
Inah or Inah. Similar to tawarruq however, in tawwaruq a third party is
involved as an intermediary.
See Khiyar. Option to rescind the sale.
Conclude a sale without any option to rescind.
Exchange of goods with goods is called barter.
See Salam.
See Batil.
This contract refers to the sale of goods on a deferred payment basis; a
deferred payment sale. Islamic banks use it as a mode of financing for
purchase and sale or deferred payment of consumer goods. Technically,
this financing facility is based on the activities of buying and selling. There
is no interest charged. Equipment or goods required by the customer are
purchased by the bank which subsequently sells the goods to the customer
at an agreed higher price; payment is deferred and the customer is allowed
to settle payment either by installments or in a lump sum within a preagreed period. The deferred payment price which is the bank‟s sale price
includes a profit mark-up for the bank agreed by both parties. Similar to a
Murabaha contract, but with payment on a deferred basis known as
Murabaha Muajjal.
Lit.: a credit sale or deferred payment contract. Technically, a financing
technique adopted by Islamic banks, It is a contract in which the seller
allows the buyer to pay the price of a commodity at a future date in a lump
sum or in installments. The price fixed for the commodity in such a
transaction can be the same as the spot price or higher or lower than the
spot price. The concept is the same as Bai Bithaman Ajil (BBA).
See Salam.
See Sarf.
Buy-back, sale and repurchase, a contract with the condition that when the
seller pays back the price of goods sold, the buyer returns the goods to the
seller.
Blessing.
See Bai.
Sale of tangible objects such as goods (as opposed to sale of services or
rights).
Sale of debt. According to a large majority of fuqaha‟, debt cannot be sold
for money, except at its face value, but can be sold for goods and services.
See Gharar.
Bayu al-Gharar
Bay al-ina
Bay-al Inah
Bay al-kali bil kali
Bay al-mudaf
Bay bi thaman al-ajil
Bay muzayadah
Bayt-al-Mal
Trading in risk, where the Arabic word gharar is taken to mean "risk". See
Gharar.
See Bai al-Inah.
Also termed as Bai ah Inah. Buying an object for cash then selling it to the
same party for a higher price whose payment is deferred so that the
purchase and sale of the object serves as a ruse for lending on interest. At
a later date, the bank will repurchase the asset and pay the client in cash
terms. Similar to tawarruq however in tawarruq a third party is involved as
an intermediary.
A sale in which both the delivery of the object of sale and the payment of
its price are delayed. It is similar to a modern forward sale contract.
A sales contract in which delivery of both the commodity and the payment
is deferred - for example forward sales in modern times. Such contracts
are not permitted by the Shari'ah.
Another term used for Bai Mu'ajjal.
Sales by auction.
Public Treasury in the Islamic State.