Doing Finance the Islamic Way
16th Private Sector Meeting for OIC Member Countries
Sharjah, UAE, 19-20 March 2014
Abdelaziz Chazi Ph.D.
Associate Professor of Finance
American University of Sharjah
Introduction
• The world has witnessed lately one of its worst
financial and economic crises since the 1929
great depression. This crisis, which started as a
subprime mortgage crisis, surprised everybody by
its magnitude and time span.
• Within six months, in 2008, giants of the US
finance industry were either taken over (Bear
Stearns, March 16th), nationalized by the US
Treasury (Fannie Mae and Freddie Mac,
September 7th), or simply filed for bankruptcy
(Lehman Brothers, September 14th).
• The excessive use of derivatives, market-based
trading on debt, short selling, as well as
speculation have been largely blamed for the
crisis.
• Given that all these transactions are not
permissible in Islamic law, voices are
wondering whether an Islamic financial
system could have survived the crisis better
than the conventional one.
Islamic Finance Principles
• Islamic finance is based on religious and ethical
premises that seek more social justice and
equality in the marketplace.
• According to these precepts, although efficiency
of the financial system is important, it is given a
lower order of importance compared to ethical
values.
• The priority given to seeking social justice does
not mean that the Islamic financial system would
be inherently inefficient; it only prioritizes the
goals of the market players.
Money in Islam
• The Islamic financial system treats money as a
mere medium of exchange that does not have
an intrinsic value.
• Thus, money should not be treated as a
commodity and cannot generate more money
without the involvement of physical
commodities in the process.
Defining Riba
• Therefore, all transactions where money is
sold (in the form of debt) or rented, at
negotiated prices, are deemed to be non
Shariah compliant and thus non-permissible.
• Shariah scholars condemn usury that results
from renting money and name the return on
money “Riba”.
Prohibition of Riba
• Islamic law (Shariah) disallows riskless profit,
which is, according to Islamic scholars, the source
of most conventional banks’ returns.
• Default risk alone is not considered enough risktaking by the lender to legitimate the banks’
returns.
• For returns to be legitimate, banks have to
engage in profit and loss sharing with their clients
by financing asset backed projects instead of
providing interest-based loans.
Defining Gharar
• Another basic characteristic of Islamic finance
is the prohibition of returns made while facing
excessive uncertainty (Gharar).
• Participants in the marketplace cannot
transact in situations of high uncertainty as
this would amount to gambling.
Information based Gharar
• Gharar can be caused by lack of information
by either or both parties, either intentionally
or unintentionally.
• The parties to a transaction have to have
complete and accurate information about the
subject of the transaction, the price, the terms
of payments and the like.
• Any perceived lack of information by either
one of the parties can void the transaction.
Settlement Risk
• Gharar can also materialize in the case of
settlement risk, i.e. when the seller may not
be able to deliver the commodity subject of
the transaction, or simply is not in possession
of the commodity at the time of the sale.
• Hence, short selling is not permissible under
Islamic finance as it involves elements of
Gharar.
Derivatives
• Derivatives are not permissible as well
because of the forward commitment from
both parties, which entails excessive
uncertainty with regard to the ability to fulfill
one’s commitment in the future.
Speculation
• Under the same principles, speculation is
deemed non-permissible because of the
amount of uncertainty it brings to the market
as a whole.
• Although speculation may benefit market
participants, it is believed that the damage it
carries is higher than its benefits.
Conclusion
• The major norms of Islamic finance relate to
the non-permissibility of usury (Riba) and
excessive uncertainty (Gharar).
• Thus, returns made in situations of zero, or
excessive, risk are not allowed in Islamic
finance. Some degree of risk is tolerated and
even required for returns to be legitimate.