Foundation of Islamic Finance ISF 1101
TOPIC 2.
BASIC PROHIBITIONS AND
BUSINESS ETHICS IN
ECONOMICS AND FINANCE
TOPIC CONTENT
1.The Basic Prohibitions
2.Islamic Business Ethics and
Norms
1.
The Basic Prohibitions
Three Basic Prohibitions
•
Islam does not recognize transactions that have proven
illegitimate factors
•
Three factors/elements identified
•
•
•
•
interest - riba
excessive ambiguity - Gharar
gambling - Maysir
Lead to contracts to be void/invalid/nullified
1. Prohibition of Riba
•
Literal definition
excess, increase, expansion, growth
•
Technical definition
–
every excess in return of which no reward or equivalent countervalue is paid
–
a predetermined excess or surplus over and above the loan received
by creditor conditionally in relation to a specified time period
–
A forced increase in value in amount being loaned out
Evidence for Prohibition of Riba
•
All jurists agree that riba is prohibited (haram) due to clear prohibitions
•
Various verses in Quran prohibit riba: al-Rum verse 39, al-Nisa: 161, alImran: 130, al-Baqarah: 275-281. For example:
–
(2:275) “… they say, trade is like riba, but Allah has permitted trade
and prohibited riba… beware of the war on the part of Allah and His
Apostle…”
•
Various sunnah on prohibition of riba, severity of its sin and its form. An
example:
“The Prophet of Allah s.a.w. cursed the receiver and the payer of
riba, the one who records it and the two witnesses to the transaction
and said: they are alike (in guilt)”
•
But, differences on meaning/what constitute riba
Rationale for Prohibition of Riba (1)
Rationale/reasons for prohibition of riba so as to better appreciate wisdom behind
injunction:
1. Element of injustice in financing productive activities
•
Contract with unequal countervalues
•
Injustice to debtor – obligated to pay interest even if business venture
results in no profit or loss; certainty of interest obligation vs. uncertainty
of business outcome
•
Injustice to creditor – in event of substantial profits, creditor receives a
return disproportionate to amount of generated profits
2. Element of exploitation in financing consumption
•
•
The rich is able to generate more wealth without exerting much effort or
contributing to productive activity
Riba assumes money as a commodity, one which the rich has in abundance
Rationale for Prohibition of Riba (2)
3.
Inconsistent with Islam’s perspective on debt
•
Incurring debt is discouraged
–
–
–
•
Prophet s.a.w. refused to offer salat-ul janazah of a person who died
indebted
Borrowing money should be limited to cases of dire needs
To practice moderation in consumption
However, permitting riba enables lending to become a viable
business
–
–
–
Banks motivated to lend as much as possible
Banks exploit man’s inherent greed to spend beyond their means
Result in negative repercussions
 The outcome is the proliferation of a “credit society”
Rationale for Prohibition of Riba (3)
4.
Negative effects of a “credit society”
•
Easy availability of credit cultivates a materialistic society
-People work harder to repay bank debt
-Banks exercise “control” over people: become “enslaved” to banks
•
Quest for economic development clouds good moral judgment and Islamic
value system

•
-Greed leads to unethical business practices: degradation of natural
environment (to reduce cost)
-Less emphasis on institution of family leads to social ills
Essentially, Muslims forget their roles as ‘abd and khilafah
Social relations amongst people negatively affected
-Members of society should help each other in times of need
-Riba entails taking advantage of another people
-Breeds hatred, jealousy, ill-will towards the rich
Rationale for Prohibition of Riba (4)
5.
Negative effects on production
•
Impediment to healthy economic growth
-Riba-based lending is security-oriented rather than growth oriented
-Lending directed to established businesses
=Creditworthiness and adequate security (collateral)
=Potential entrepreneurs without security to pledge are denied credit
•
Inefficient allocation of resources
-Bank interest return does not vary with actual profits, no incentive to give priority
to ventures with highest profit potential
-Lending based on creditworthiness, not profitability
•
Discourages innovation
-Interest obligations act as disincentive for experimenting with new, unproven
methods of production, especially for small-scale enterprises and agriculture
Rationale for Prohibition of Riba (5)
5.
Negative effects on production (continued)
•
Leveraged financing favors large-scale businesses
-Domination of big businesses over smaller entrepreneurs will curtail
competition and in turn will affect product variety and innovation
•
Anti-productive
-Inflexibility: in a loss situation leads to bankruptcies – loss of productive
potential and unemployment
•
Funding not channeled to deserving economic agents
-Utility of certain projects is with reference to criteria other than profitability
-E.g. projects that benefit the public, poverty alleviation
•
Financing of luxurious or wasteful consumption and/or production
Rationale for Prohibition of Riba (6)
6.
Negative effects on distribution
•
Disproportionate supply of credit to the already affluent segments of
population since lending is based on creditworthiness
•
•
•
Domination of large enterprises leads to demise of smaller economic units
•
•
•
Wealth inequality (in terms of purchasing power) is widened
Rich become richer and poor become poorer
Lacking collateral and established economic standing, poorer segments of
economy at disadvantage when competing for credit to finance economic
activities
Wealth and income disparities worsen
Transfer of real assets to the lenders
•
•
•
Debt-financing requires collateral in the form of real assets
In event of default, there will be transfer of real assets from borrower to lender
Long run, wealth inequality (in real terms) becomes prevalent
Types of Riba
1. Riba al-Qard (Riba al-Dayn- debt)
•
•
•
As being highlighted in Quran, thus also known as riba alQur’an
Any amount over & above principle on loan or any debt
regardless of cause of debt (debt resulting from loan
contract or from a deferred payment sale)
Common in conventional banking products
1. Loan with interest or other benefits: when there is a predetermined
excess/surplus over the loan received by creditor conditionally in relation to a specified
time period
2. Penalty imposed on delinquent debt repayment or default: Jahillians
doubled the amount of debt outstanding if payment is overdue = riba al-jahiliyyiah
Types of Riba
2. Riba al-Bay’ (sale)
•
Also known as riba al-Sunnah
•
The Arabs used certain commodities like wheat, barley, dates and salt
(termed as ribawi items) as medium of exchange to purchase other things,
and as such they were like money
•
Applies to sale transactions in commodities
Riba al bay’ (sale)(1)
•
Basis for prohibition of riba in exchange of commodities is based on
hadith of the Prophet on six commodities:
“Gold for gold, silver for silver, wheat for wheat, barley for barley, dates for
dates, salt for salt – like for like, equal for equal, and hand-to-hand (spot); if the
commodities differ, then you may sell as you wish, provided that the exchange
is hand-to-hand or a spot transaction.” [Muslim]
•
2 types:
•
•
Riba an-nasi’ah - delay in paying or delivery of one or two sold items
Riba al-fadl - exchanging one ribawi commodity for same commodity but
unequal in amount
Riba al bay’(2)
•
Summary of rules
Exchange
Condition
(Amount & Time)
Money1 + Money1
 Equality
 Hand-to-hand (spot)
Food1 + Food1
 Equality
 Hand-to-hand (spot)
Money1 + Money2
 Hand-to-hand
Food1 + Food2
 Hand-to-hand
Money + Food
 No conditions – free trading
Money + Others
 No conditions – free trading
Food + Others
 No conditions – free trading
Others + Others
 No conditions – free trading
Riba al bay’ (3)
•
Interpretation
–
In trading commodities of same group and same kind (gold for
gold), both commodities must be exactly equivalent and prompt in
delivery
–
In trading commodities of same group but different kind (gold for
silver), promptness of delivery a condition
–
In trading commodities of diff groups and kind (gold for wheat), no
condition imposed, free trading can exist.
Islam encourages earning of profits from trade but forbids charging of
interest
Misconceptions about Riba
•
Several misconceptions about riba and its prohibition,
resulting in confusion in its applications
1.
2.
3.
4.
5.
Interest-based commercial transactions were invented by modern
day business, thus not covered by riba referred to in the Qur’an
Bank interest is not riba because it is not excessive (usurious)
Riba should be allowed under dharurah
Riba is only relevant to consumption loans, not commercial loans
Interest should be allowed because of inflation
M1a: “Modern day interest is not riba”
•
Misconception
–
•
Prohibition of riba was revealed in the last days of Prophet’s life
•
Did not elaborate on interpretation and definition of riba
•
Ambiguity in meaning of riba (area of mutashabihaat): its prohibition
cannot be extended to modern day banking
Addressing Misconception
–
–
–
Including prohibition of riba in his last sermon does not mean that prohibition
was only introduced at that time
•
Emphasizing importance, last sermon was attended by most of his
followers, reiterate prohibition of riba
Prohibition of riba comes in 5 stages
Other prohibitions were also not given elaborate definitions
•
E.g. prohibition of pork, liquor, gambling, adultery, etc.
•
Impacts well known to its immediate audience
M1b: “Modern day interest is not riba”
•
Addressing this Misconception
–
Mutashabihaat: verses of Qur’an which correct meaning is not known clearly to
anybody/ambiguous
•
E.g. “Alif Lam Mim”; “hand of Allah” (3:73)
–
For these examples, ignorance of correct meaning does not affect the lives of
Muslims because no precept of Shari’ah is revealed through them
–
However, riba has substantial affects on well-being - relates to prevalent
economic and social practice
–
It is not imaginable that Allah would wage war against a practice where the
correct nature is not known to anybody
M2: “If it is not excessive, it is not riba”
•
Misconception
–
–
•
Al-’Imran (3:130) - “O those who believe, do not eat up riba doubled and
redoubled”
If rate of interest is not excessive (e.g. doubled), then it does not constitute riba,
therefore not prohibited
Addressing this Misconception
–
Other verses on same subject matter must be studied in relation to each other
•
•
–
Al-Baqarah (2:278) – “O those who believe fear Allah and give up whatever remains of
riba, if you are believers”
Every amount, regardless of magnitude, over and above principal is riba
Qur’an is a book of guidance, not a book of statutes and legal text
•
•
•
Embodies many expressions having persuasive value
Al-Baqarah (2:41) – “Do not sell My verses for a little price” – does not imply that one
can sell the verses for a high price
Expression “doubled” meant to emphasize added severity
M3: “Riba allowed under dharurah”
•
Misconception
–
–
•
Doctrine of Necessity – under dharurah circumstances, haram is permissible
E.g. It is permissible to consume pork to save one’s life from dying of hunger
Addressing this Misconception
–
–
–
Is the “necessity” real or exaggerated?
Can the necessity be met with by any other permissible means?
At the individual (debtor) level
•
–
Is purpose of riba-based loan to protect an absolute necessity? Have all other permissible
alternatives been exhausted?
At the institutional (creditor) level
•
Removal of riba from economy does not imply that financial institutions will have to
give charitable (interest-free) loans
M4a: “Riba allowed for commercial loans”
•
Misconception
1.
2.
3.
•
Common practice of riba during time of its prohibition was charging of interest on
consumption loans taken by poor people to finance their basic needs
This form of exploitation is not present in production loans whereby in many cases,
debtor is economically well-off
•
Loans taken by rich businessmen are used to generate profit
Basic cause of prohibition of riba, zulm (injustice), is absent
Addressing this Misconception
1.
To say that commercial or productive loans were not in existence then is not accurate
•
There are evidences to substantiate that practice of interest-based production loans
dated back to much earlier times
–
–
•
A number of al-hadith reporting on the practice of riba-based commercial loans
As early as 2000 B.C. in Babylon, 500 B.C. in Greece, in time of Byzantine emperor Justinian
(527-565 A.D.)
Nature of Qur’anic prohibition - includes all forms of riba regardless of whether or
not prevalent at time of its revelation
M4b: “Riba allowed for commercial loans”
•
Addressing this Misconception (Continued)
2. Validity of a transaction is not based on financial status of a party
•
•
•
•
Intrinsic nature of transaction itself should determine its validity
Selling to the poor does not make the profit haram
Similarly for prohibited transactions are haram for both the rich and poor
regardless of their financial status
Subjectivity and relativity of financial status
–
•
Who will have the authority to determine exact degree of poverty required for exempting
of interest charges?
Consumption loans  taken by the poor, Production loans  taken by the rich – an
erroneous presumption
–
–
Consumption of luxurious objects
Financing of business by poor entrepreneur
M4c: “Riba allowed for commercial loans”
•
Addressing this Misconception (Continued)
3. Need to differentiate/understand illat and hikmat
•
Illat – Basic feature of the transaction vs Hikmat – Wisdom or rationale
behind the prohibition
•
Application of law depends on illat and not hikmat
•
Illat of a law is always determinable by hard and fast definition that leaves
little room for dispute
– Zulm (injustice) is relative, ambiguous and subject to manipulation
•
Rationale for making application of law based on illat and not hikmat
– Human reason, despite its wide capabilities, cannot claim to have
unlimited power to reach absolute truth
– Reason often confused with desires, leading to disguised justice
– Thus humans need guidance of divine revelations
M5: “Inflation justifies interest”
•
Misconception
–
–
•
Interest represents compensation for erosion of value of money (due to
inflation) during period of borrowing
Loans should be indexed so that there is no injustice to creditor
Addressing this Misconception
–
–
–
–
Rates of interest are not based on rates of inflation, although there may be
correlations
Indexation of loans is problematic due to lack of precise measures of inflation
If surplus on loan amount is only attributable to actual value loss due to
inflation, there will be no commercial incentives to banks
Interest is one of causes of inflation
2. PROHIBITION OF GHARAR
•
Literally: Deceit, fraud, uncertainty, danger, peril, or hazard that might
lead to destruction or loss
•
Technically: uncertainty caused by lack of clarity regarding subject
matter or price in a contract of exchange
•
A sale of a thing which is not present at hand or whose consequences is
not known
•
Classic examples of gharar sale
–
–
–
Sale of fish still in the sea
Sale of birds in the air
Sale of unborn animals
Prohibition of gharar
•
•
•
All jurists agree that gharar should be avoided in commercial
exchange contracts
Contemporary scholars differentiate between minor and
major gharar
Types of gharar
1. Gharar yasir (minor or slight)
•
•
2.
Can be tolerated and will not invalidate a contract
If exist, contract still valid
Gharar fahish (major or excessive)
•
•
Not tolerated and may result in contract voidability
If exist, contract is nullify
Prohibition of gharar (2)
•
Rationale for prohibition of gharar
–
To ensure full consent and satisfaction of all parties in
a contract
•
•
–
Without full consent, a contract may not be valid
Can only be achieved through certainty, full knowledge, full
disclosure and transparency
Gharar in commercial contracts may lead to injustice,
exploitation and/or enmity among contracting parties
Differences: Risk (Ghurm) and Gharar
Ghurm
(Risk)
Gharar
(Uncertainty)
Permissibility
in Islam
Allowed in Islam, as per Islamic
legal maxim – Al ghurmu bil
ghunmi (no risk no gain)
Prohibited (e.g. selling fish in
the sea, birds in the sky)
Characteristic
Inherent in productive economic
activities
Unnecessary, avoidable,
intentionally created
Common day
example
Risks of trading, doing business,
making investments
Not stipulating price or product
specification in a sales contract
Effects
Encourage entrepreneurial spirit
and productivity
Exploitation for self interest,
can lead to harm and injustice
3. Prohibition of maysir/qimar
•
Definition: easily obtaining something without effort;
acquisition of wealth by chance
•
Applies to all activities where a person wins or losses by
mere chance; a form of gambling
•
Many direct references in Quran prohibiting gambling, e. g.:
•
•
“Satan intends to excite enmity and hatred among you with intoxicants and
gambling, and hinder you from remembrance of Allah, and from prayer…”
(5:90)
“They ask thee concerning wine and gambling. Say: ‘In them is great sin and
some benefits for people; but the sin is greater than the benefits’” (4:219)
Prohibition of maysir/qimar
•
Injustice elements in gambling:
•
•
•
•
Winner:
-Does not lawfully earn what he has won
-Consume/enjoy other’s property unlawfully/unjustly
Looser losses his money without a fair compensation
Result in hostility, hatred, enmity
In Islam, contracts involve elements of chance (maysir) are prohibited
•
Islam encourages one to earn living through honest effort and
prohibit injustices
Concept of ‘iwad
•
Definition: equal counter-value
–
promotes a sense of equity and justice in economic transaction, differentiating
it from riba
Islam permits sale (bay’) but prohibits riba
–
•
•
Shari’ah requires all legitimate exchange to contain ‘iwad
–
“Every increase, which is without ‘iwad or equal countervalue, is riba”
[ Ibn al-’Arabi ]
Components of ‘iwad
1.
2.
3.
Risk (ghurm): Market risk - price risk, holding costs, obsolescence
Work and effort (ikhtiyar): Services or activities that value-add
Liability (daman): Product liability borne by seller, in event of defects
Examples of valid counter-value (‘iwad )
1. Risk (ghurm) of trade or ownership (daman milkiyyah)
•
•
TV manufacturer undertakes risk that he might produce TV’s that customers do not
like and do not end up buying
TV retailer faces risk of unfavourable market price movements - he might have to
sell his products in stock at a price which is lower than cost or accept inventory
buildup which would eventually be costly
2. Effort (ikhtiyar) expended or expertise rendered
•
TV manufacturer adds value to raw materials that make up a television set by
contributing effort in putting TV set together as well as providing expertise on how
to put a TV set together
3. Liability in event of product defect
•
•
When TV retailer sells a TV set, he provides a product warranty against defects
In event that a particular TV set is defective, TV retailer will assume liability and
bear some costs
Is there ‘iwad in conventional banking?
1.
Risk (ghurm)
Argument
• Banks face risk of default on repayment (credit risk)
Counter-argument
• In event of default, bank has recourse (collateral, punitive
measures by authorities): no equal counter-value, bank always
win
• Different from market risk associated with trading
– Risk is inherent in trading activity itself
– If downside risk materializes (e.g. cannot sell goods at
profit), trader has no contractual or systemic recourse
Is there ‘iwad in conventional banking?
2.
Effort (ikhtiyar)
Argument
•
Bank expends effort to act as financial intermediary, evidenced by its costs of
operation (wages, overheads)
•
Bank charges for, and earns profit from, bringing together deficit and surplus
units
•
Bank is providing a service
Counter-argument
•
Bank’s efforts do not value-add the product itself
•
If bank is charging for service of matching deficit-surplus units, its return should
not be a function of amount of financing
•
•
•
At most, bank can justify fee-based revenue but not interest-based revenue
Bank does not act as agent for both deficit and surplus units but contracts
separately with them
Effort cannot validate an underlying transaction/activity which is prohibited
Is there ‘iwad in conventional banking?
3.
Liability
–
–
–
The product in a conventional loan contract is money
Physical defects in currency do not permanently diminish its value
as legal tender
•
E.g. a torn or badly-soiled note can be exchanged at central
bank
Therefore, product liability is not relevant
2.
Islamic Business Ethics and
Norms
1. Justice and Fair Dealings
• Fair dealing with all and keeping a balance
• Various evidence from al-Quran, e. g., 5: 8 and 4: 135
• Equal rights and obligations of every market player:
business rules are equally applied
• Ensure justice and fair play that result in harmony in the society
• Norms and good practices include:
• Honesty and gentleness: truthfulness and care for others
• Prohibition of najash (bidding up price without intention to take
delivery
• Prohibition of khalabah (misleading marketing): over-projecting
quality of commodity
• Disclosure, transparency and facilitating inspection: role of
information
TRANSPARENCY AND DOCUMENTATION
• IBs are required to adopt transparency, disclosure and
documentation
• Lack of transparency may render the transaction to be
non-shariah compliant
• The Quran requires to write down and take witness in
all business transactions
• The nature of IBs require full documentation and
transparency between the bank and the clients
• Hence, the possibility of IBs to engage in illegal
activities such as money laundering is lesser than CBs
2. Fulfilling of Covenants and Paying Liabilities
• Evidence in the Quran to fulfill covenants (17: 34)
• Business and financial contracts result in rights and liabilities of
the parties; must be fulfilled as per the agreement
• Fulfillment of contracts and promises (or unilateral contracts)
• Those who do not fulfill their promises: symbol of hypocrites
3. Mutual Cooperation and Removal of Hardship
• Mutual help, solidarity, and joint-indemnification of losses
and harm
• No cut throat competition, unethical practices like fraud and
forgery
• Mentioned in the Quran 5: 2
• This forms the basis of takaful
-Concept of aqilah (kin or persons of relationship) were validated by the
Prophet
-Principle of reciprocal compensation and joint responsibility
-To enable burden and losses being shared and distributed
4. Free Marketing and Fair Pricing
• Exchange is permitted only when undertaken in permissible
commodities and according to shariah rules and principles
• Islam envisages a free market where fair prices are determined
by the forces of demand and supply
• No interference in the free play of functioning of market forces
• Price is only fair if it is the outcome of genuinely market forces
• Pricing: price of commodity determined by the input and
production costs, storage, transportation and other costs
• Selling goods lower than market price and creates problem for
genuine business is not allowable
• Interference by authority is not allowed, unless to remove
market anomalies caused by impairing the condition of free
competition
5. Freedom from Dharar (Detriment)
• Definition: Harm, injury, damage
• Saving others from any harm due to a contract
between 2 parties
• Enforcement of rights with a provision that the
informationally disadvantaged party to reverse
its position
• Regulators are to ensure:
• Fair play and justice for all
• To take paternal approach to protect traders from
unhealthy practices of any market players
• Provide the general public with necessary
information about the nature of business activities
Concluding article
http://www.islamonline.net/servlet/Satellite?c=Article_C&pagename=Z
one-English-Muslim_Affairs%2FMAELayout&cid=1234631361330
References
1. Ayub (2008), pp. 43-70
2. Haron and Azmi (2003), pp.
3. Iqbal and Mirakhor (2007)