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ThethreeprinciplesofIslamicfinanceexplained|IFLR.com

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ThethreeprinciplesofIslamic
financeexplained
Author:|Published:24May2005

Theprinciplethatincomecanbederivedfromthetimevalueof
money(thatis,byplacingmoneyatthedisposalofanotherperson
andreceivinganincreasedreturnatsomestageinthefuture)has
beenapartofconventionalfinancingfortimeimmemorial.We
knowitasinterestonloansandithasbeenasmuchpartofour
livesasearningadailyliving.
Interestonaloanremainspayable,irrespectiveofwhetherthe
causeorventureforwhichthemoneywasadvancedissuccessful
ornot.Itmeansthatapersoncanmakemoneyoutofthemerefact
thattheyhavemoneyandanotherhasnot.Somemaysaythat
thereisaninherentinjusticeinasystemwheremoneyisseenasa
merecommoditytomakemoremoney.Theoldadagethattherich
getricherwhilethepoorgetpoorercertainlydoesseemtoringtrue
ininstanceswheredebtorspayexhorbitantinterestratesduring
difficultfinancialtimes,whilebanksdeclarelargeprofitsinfavourof
aselectfewshareholders.
Theconceptthatmoneyisacommodityinitselfthatneednotbe
investedintoanunderlyingcommoditytoshowareturnhasalso
playedanimportantpartinthedevelopmentofaglobalfinancial
system,wherereturnoncapitalismeasuredonhowwellonecan
leveragepositionsaswellastheapplicationofderivativebased
financialmethodology.Theartofmakingmoneyoutofnothingat
allhasbeenperfectedinthisregardbutthereisnodoubtthatthe
uncertainty,thehighlyleveragedexposuresandthespeculative
natureofsomeofthesefinancialtoolshaveattimesledto
catastrophicresultsanddevastatingexperiencesformany.
ThesearesomeofthereasonsthatMuslimsallovertheworldare
turninginincreasingnumberstowardsIslamicfinancetoprovide
themwithamorereasonableanddivinelymoralapproachtotheir
financialaffairs.
Background
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Islamhasasetofgoalsandvaluesencompassingallaspectsof
humanlife,includingsocial,economicandpoliticalissues.Itisnot
areligioninthelimitedsenseoftheword,interestedonlyin
salvationinthehereafter,ratheritisareligionthatorganizesone's
lifecompletely.ThebodyofIslamiclawisknownasSharia,literally
meaningaclearpathtobefollowedandobserved.
TheShariaisnotacodifiedbodyoflaw.Itisanabstractformoflaw
capableofadaptation,developmentandinterpretation.TheSharia
doesnotprescribegeneralprinciplesoflaw,insteaditpurportsto
dealwithspecificcasesortransactionsandsetsoutrulesthat
governthem.
TheShariadevelopedthroughfourmainIslamicjuristicschools
(Hanafi,Maliki,ShafiandHanbali)andisderivedfromtwoprimary
sources,theQuran(thetranscriptionofGod'smessagetothe
prophetMohammed)andSunna(thelivingtraditionoftheprophet
Mohammed),inadditiontotwodependentsources:ijma
(consensus)andijtihad/qiyas(individualreasoningbyanalogy).
Islamicbanksmusthaveareligiouscommitteemadeupofhigh
calibrereligiousscholars.ThisShariaboardhasbothasupervisory
andconsultativedutytoensurethatthebank'spracticesareinline
withtheSharia.
Theprohibitionofallsourcesofunjustifiedenrichmentandthe
prohibitionofdealingintransactionsthatcontainexcessiveriskor
speculationareamongthemostimportantteachingsofIslamin
establishingjusticeandeliminatingexploitationinbusiness
transactions.Accordingly,Islamicscholarshavededucedfromthe
ShariathreeprinciplesthatformthebenchmarkofIslamic
economicsandthatdistinguishIslamicfinancefromits
conventionalcounterpart.
Theprohibitionofinterest
Theprohibitionofusuryorinterest(riba)isthemostsignificant
principleofIslamicfinance.RibatranslatesliterallyfromArabicas
anincrease,growthoraccretion.InIslam,lendingmoneyshould
notgenerateunjustifiedincome.AsaShariaterm,itreferstothe
premiumthattheborrowermustpaytothelenderalongwiththe
principalamount,asaconditionfortheloanorforanextensionin
itsmaturity,whichtodayiscommonlyreferredtoasinterest.
Ribarepresentsaprominentsourceofunjustifiedadvantage.All
Muslimscholarsareadamantthatthisprohibitionextendstoall
formsofinterestandthatthereisnodifferencebetweeninterest
bearingfundsforthepurposesofconsumptionorinvestment,
becauseShariadoesnotconsidermoneyacommodityfor
exchange.Instead,moneyisamediumofexchangeandastoreof
value.
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Profitandlosssharing
Profitandlosssharing(PLS)financingisaformofpartnership,
wherepartnersshareprofitsandlossesonthebasisoftheircapital
shareandeffort.Unlikeconventionalfinance,thereisno
guaranteedrateofreturn.IslamsupportstheviewthatMuslimsdo
notactasnominalcreditorsinanyinvestment,butaspartnersin
thebusiness(thatis,essentiallyanequitybasedfinancing).The
justificationforthePLSfinancier'sshareinprofitistheireffortand
therisktheycarry,becausetheirprofitwouldhavebeenimpossible
withouttheinvestment.Iftheinvestmentmakesaloss,theirmoney
islost.
Gharrar
Anytransactionthatinvolvesgharrar(thatis,uncertaintyand
speculation)isprohibited.Partiestoacontractmusthave
knowledgeofthesubjectmatterofthecontractanditsimplications.
Anexampleofanagreementtaintedwithgharrarisanagreement
tosellgoodsthathavealreadybeenlost.
Financingtechniques
Islamicscholarshaveapprovedcertainbasictypesofcontractsas
beingcompliantwiththeprinciplesofIslamicfinance,whichIslamic
bankscanusetoattractfundsandprovidefinancinginanIslamic
way.
Mudaraba(financebywayoftrust)
Mudarabaisaformofpartnershipinwhichonepartner(rabul
amal)providesthecapitalrequiredforaprojectwhiletheother
party(mudarib)managestheinvestmentusingitsexpertise.
Althoughsimilartoapartnership,acompanyneednotbecreated,
solongastheprofitscanbedeterminedseparately.Profitsfrom
theinvestmentaredistributedaccordingtoafixed,predetermined
ratio.ThecapitalprovidercarriesthelossinaMudarabacontract
unlessitwasduetothemudarib'snegligence,misconductor
violationoftheconditionspreagreedupon.
Inamudaraba,themanagementoftheinvestmentisthesole
responsibilityofthemudarib,andallassetsacquiredbythe
mudaribarethesolepossessionoftherabulamal.However,the
Mudarabacontracteventuallypermitsthemudaribtobuyoutthe
rabulamal'sinvestmentandbecomethesoleownerofthe
investment.
MudarabamaybeconcludedbetweenanIslamicbank,asprovider
offunds,onbehalfofitselforonbehalfofitsdepositorsasa
trustee(thishasadifferentmeaningtotheEnglishlawconceptof
trustee)oftheirfunds,anditsbusinessownerclients.Inthelatter
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case,thebankpaysitsdepositorsallprofitsfromtheinvestment,
afterdeductingitsintermediaryfees.Itmayalsobeconducted
betweenabank'sdepositorsasprovidersoffundsandanIslamic
bankasamudarib.
Musharaka(financebywayofpartnership)
Musharakaisoftenperceivedasanoldfashionedtechnique
confinedinitsapplicationtosmallscaleinvestments.Althoughitis
similartotheMudarabacontract,itisdifferentinthatallparties
involvedinapartnershipprovidecapitaltowardstheinvestment.
Profitsaresharedbetweenpartnersonapreagreedratio,but
lossesaresharedinexactproportiontothecapitalinvestedby
eachparty.Thisgivesanincentivetoinvestwiselyandtakean
activeinterestintheinvestment.Moreover,inmusharaka,all
partnersareentitledtoparticipateinthemanagementofthe
investment,butarenotrequiredtodoso.Thisexplainswhythe
profitsharingratioismutuallyagreeduponandmaybedifferent
fromtheinvestmentinthetotalcapital.
Murabaha(costplusfinancing)
MurabahaisthemostpopularformofIslamicfinancing.Withina
murabahacontract,thebankagreestobuyanassetorgoodsfrom
athirdpartyattherequestofitsclient,andthenresellsthegoods
toitsclientwithamarkupprofit.Theclientpurchasesthegoods
eitheragainstimmediatepaymentorforadeferredpayment.
Thistechniqueissometimesconsideredakintoconventional
interestbasedfinance.However,intheory,themarkupprofitis
quitedifferent.Themarkupisfortheservicesthebankprovides
seekingandpurchasingtherequiredgoodsatthebestprice.
Furthermore,themarkupisnotrelatedtotimebecause,ifthe
clientfailstopayadeferredpaymentontime,themarkupdoesnot
increaseduetodelayandremainsaspreagreed.Mostimportantly,
thebankownsthegoodsbetweenthetwosalesandsoassumes
thetitleandtheriskofthepurchasedgoods,pendingtheirresaleto
theclient.Thisriskinvolvesallrisksnormallycontainedintrading
activities,inadditiontotheriskofnotmakingthemarkupprofit,or
iftheclientdoesnotpurchasethegoodsfromthebankand
whethertheyhaveajustifiableexcuseforrefusingtodoso.
Ijara(leasing)
Ijaraisdefinedassaleofmanfa'a(thatis,therighttousegoods)
foraspecificperiod.Itissimilartoaconventionallease.Under
Islam,leasingbeganasatradingactivityandthenmuchlater
becameamodeoffinance.Ijaraisacontractunderwhichabank
buysandleasesoutanassetorequipmentrequiredbyitsclientfor
arentalfee.
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Duringapredeterminedperiod,theownershipoftheassetremains
withthelessor(thatis,thebank)whoisresponsibleforits
maintenancesothatitcontinuestogivetheserviceforwhichitwas
rented.Likewise,thelessorassumestheriskofownership,andin
practiceseekstomitigatesuchriskbyinsuringtheassetinitsown
name.Underanijaracontract,thelessorhastherighttore
negotiatethequantumoftheleasepaymentateveryagreed
interval.Thisistoensurethattherentalremainsinlinewithmarket
leasingratesandtheresidualvalueoftheleasedasset.
Underthiscontract,thelessee(thatis,theclient)doesnothavethe
optiontopurchasetheassetduringorattheendoftheleaseterm
becausethisisconsideredundertheShariatobetaintedwith
uncertainty.Butthisobjectmaybeachievedbymeansofasimilar
typeofcontract,knownasanijarawaiktina(hirepurchase).Ina
hirepurchasesituation,thecommitmentonthepartofthelesseeto
buytheassetattheendoftherentalperiod,atanagreedprice
(withtherentalfeespaiduptothepointofsaleconstitutingpartof
theprice),isestablishedattheoutset.
Salam(advancepurchase)
Salamisdefinedasforwardpurchaseofspecifiedgoodsforfull
forwardpayment.Thiscontractisregularlyusedforfinancing
agriculturalproduction.
Istisna'a(commissionedmanufacture)
Istisna'aisanewconceptinIslamicfinancethatoffersfuture
structuringpossibilitiesfortradingandfinancing.Onepartybuys
thegoodsandtheotherpartyundertakestomanufacturethem,
accordingtoagreedspecifications.Islamicbanksfrequentlyuse
Istisna'atofinanceconstructionandmanufacturingprojects.
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investorsandtheirprofessionaladvisers.Itisforinformationonly.
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