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Contents
Contents
Islamic Commercial Law
How to use this guide
What is nance?
Introduction
14
Chapter one
An introduction to Islamic nance
18
Chapter two
Shariah compliance
38
Chapter three
Sources of Islamic commercial law
54
Chapter four
Methodology of interpretation
of Islamic commercial law
Chapter ve
Formation of contracts
Chapter six
Classication of contracts
76
90
104
Chapter seven
Comparison of classications
of contract
124
Chapter eight
Traditional Islamic contracts
and Islamic nance
140
Chapter nine
Overview of Islamic banking,
Takaful and capital market products
152
Chapter ten
Application of Islamic
contracts in Islamic nance
166
Chapter eleven
Implementation of Shariah standards,
policies and rulings in Islamic nance
182
Sample Examination
198
Glossary
204
Index
216
How to use
this guide
You may choose to study the above modules in any order but we strongly
suggest that you begin with study guide one. Study guide one includes
an introduction to the subject of conventional nance and explains why
Islamic nance has become increasingly important in recent years and why
it continues to grow. Study guide one includes a glossary of the key terms
and contracts used throughout each subsequent guide. For easy reference,
this introduction and glossary can be found on the CIMA website at (www.
cimaglobal.com/islamicnance). It is vital that you read this introduction and
that you refer to it regularly as you work through each of the study guides.
It is also important that you appreciate the relevance of several key aspects of
the study guides. Each of these aspects is explained below and tips are offered,
where appropriate, as to how you can get the most from your studies.
4
Language
All four guides are written in English; however Islamic nance relies to a great extent on a large
number of Arabic terms and phrases as well as a few in Latin. Islamic nance is built on a foundation
of historic contracts, which have been used for centuries in Islamic commerce. These contracts, while
straightforward in terms of content, are known by their Arabic names. These names, many of which are
challenging to pronounce, will probably be new to you. The subtle differences between the meanings
of some of them need to be understood, as that understanding is the key to you pursuing a successful
career in Islamic nance. In addition to the actual contract names there are many other Arabic terms
used in the industry. You will in essence be learning to use words from the Arabic language, which will be
new to most of you. You cannot avoid this and need to be comfortable with these terms and phrases as
they are integral to the construction and delivery of the various contract types that underpin the whole
of Islamic nance. By referring back to the terms and phrases identied in the glossary you will soon be
comfortable with such terms as Qard, Wakalah, Musharakah and Murabahah, to name but a few.
Without any doubt, the most challenging aspect of the study of Islamic nance will be your
understanding of these terms and phrases, but, as with any new language, the sense of achievement
you will feel once you become uent in their use will make it worthwhile. You will also be able to
impress your family, friends and business associates with your new found language skills. After dinner
conversations and presentations during meetings will never be the same again.
Learning outcomes
At the start of each chapter we list the learning outcomes that you should have achieved by the time you
have worked through the chapter. These learning outcomes relate to the questions you will be required
to answer in the live electronic assessment, which you must pass to achieve a credit in this subject. It is
therefore vital to your success that you feel condent at the end of each chapter that you have achieved
these outcomes. A useful tip would be to return to the learning outcomes once you have come to the
end of each chapter and make sure that you are familiar with each of them. The questions and answers at
the end of each chapter have been created to test you in your achievement of these learning outcomes.
Getting the right answer to these questions at the rst attempt is a good sign that you are achieving the
learning outcomes, where inability to answer them is a sure sign that you need to return to the detailed
content of the chapter. The nal examination will include questions relating to each chapter and the
respective learning outcomes (see below for more details).
Key points
The authors have highlighted key points, which they feel you should remember. While the rest of
the text is important to your understanding of the subject in question, these key points indicate the
crucial element of the text which you need to remember.
Chapter summaries
At the end of each chapter we have included a summary that lists the important points that you should
have understood from your studies. These summary points help you to trace the important sub topics and
the key points discussed in the guide.
Mock examination
For a comprehensive pre-assessment of your learning experience, you will nd a mock examination
at the end of the study guide. In terms of the number and type of questions, this mock examination
exactly replicates the examination you will need to do in your nal live on-line examination. While
the live questions will be different to those tested here, the areas and weightings of topics covered will
be the same. If you can answer these questions correctly you can be fairly condent that that you will
be able to answer the live questions correctly and thus pass the test. You need to score 65% in the
examination to pass.
The questions asked have been created to test each of the learning outcomes, which were listed at the
start of each chapter. The revision questions at the end of each chapter also represent the type of direct or
analytical questions you will be asked in the live examination. You should use both sets of questions to
test your understanding of this challenging subject.
The future
You are embarking on a new journey, which for many of you will be a gateway to new knowledge and
experience. Like all journeys, you need to be properly prepared in order to meet all eventualities. This
guide, as part of the Certicate in Islamic Finance, is, we believe, a vital part of a successful career in this
exciting new development in global nance.
What is nance?
What is nance?
What is nance?
The nance industry has evolved over hundreds of years and covers a wide
range of subjects including banking, credit, investment and insurance. One
of its key functions is the allocation of resources between those who have
a surplus and wish to invest and those who need to borrow in order to
nance a project or purchase transaction. Simply put it is a mechanism
for reallocating funds between those who have and those who have not.
Finance can also be viewed as an opportunity to arbitrage when there is
disparity between price and value arising from a state of disequilibrium
of value expectations. Every level of risk or uncertainty, assumed by the
investor or nancier, is met with an expected or required return. The
nance industry also includes the insurance sector where individuals or
those in business safeguard themselves or their assets against injury or loss
by the transfer and pooling of risks.
Conventional or western nance has become a multi billion dollar industry,
where individuals or businesses can invest or borrow funds through
specialist markets around the world. With the exception of funds generated
for illegal activities, the nance industry does not concern itself with the
use to which funds are put or how the funds arise. There is almost no limit
to the variety of nancial products available for those with a need to invest
or borrow. As an individual, you will no doubt have interacted in some way
with the nance industry; most likely as a depositor, borrower or having
taken out some form of insurance.
Two factors underpin conventional nance: (1) the use of interest as the
form of return or benchmark for those investing funds and a cost to those
borrowing them and (2) almost all areas of nance involve an element of
uncertainty. Conventional nance has evolved into sophisticated products
to meet the nancing requirements of individuals and businesses with
funds to invest, funding requirements to be met and insurance cover to be
provided. Each of these products to some extent will involve an element
of risk or uncertainty and in the banking products will incorporate interest
charged as a form of remuneration or as a cost of borrowing or defaulting
on an agreement. Traditionally in nance interest rates rise in order to
compensate for increasing risk or uncertainty assumed by the lender.
Alternatively, measures to mitigate or reduce the risk or uncertainty can
anticipate a lower rate of interest.
What is nance?
Shariah compliance
A vital part of Islamic nancial activities is the requirement to achieve Shariah-compliant status
- to ensure that the nancial activities of the institution meet the requirements of the Shariah
principles and rules prescribed in the Quran and the Traditions of the Prophet Muhammad. To
achieve this, there is a need to establish adequate systems and controls in the form of an Internal
Shariah Control System (ISCS). The ISCS provides assurance that all nancial activities are conducted
in accordance with Shariah principles. An internal Shariah review is a prudent, if not a regulatory
requirement to self assess the degree of compliance the nancial institution adheres to in terms of
all Shariah principles prescribed in the form of standards, guidelines and best practices by relevant
governing bodies such as the Accounting and Auditing Organisation for Islamic Financial Institutions
(AAOIFI) and the Islamic Financial Services Board (IFSB).
What is nance?
Shariah compliance is critical to an Islamic Financial Institutions (IFIs) operations and must
permeate throughout the organisation, their products and activities. The implications of Shariah
non-compliance and risks associated with the IFIs duciary responsibilities towards different
fund providers would expose the IFI to fund providers withdrawals, loss of income or the voiding
of contracts. This in turn would lead to a diminished reputation and/or the limitation of business
opportunities.
10
What is nance?
lending-based institutions is replaced with trading and prot-sharing institutions that, are directly
involved in the nancing of transactions as well as engaging in equity partnerships.
Loans and advances are replaced by new nancing vehicles that are based around sales, lease and
equity contracts. The nancing of sales and purchases, as well as leasing, involves trade contracts.
Equity-based nancing involves Mudarabah and Musharakah nancing or investments. These contracts
vary in their application to suit the purpose of nancing, such as term or working capital nancing,
as well as matching customer requirements, such as retail or corporate, as well as the nancial
institutions funding objectives.
Fixed deposits are replaced with investment accounts where xed determinable interest paid to
depositors is replaced with prot sharing dividends. The latter involves a predetermined prot sharing
ratio mutually agreed by both the nancial institution and the investment account holder. For certain
types of investments, the investment account holder can specify the area in which the funds are to be
invested. In this respect the investment account holders share the prots with the nancial institution
for a given level of risk exposure. Other savings and current accounts are based on safe custody
contracts or loan contracts that do not involve interest payments. The nancial institution may
however, at its discretion, declare dividends in the form of a gift (Hiba) to the account holders.
11
What is nance?
The return to the investors in Sukuks is not xed or guaranteed but is subject to the performance of
these underlying assets. A Sukuk, which is performance based, does not promise any xed income.
Terminology
Many of the technical terms used in Islamic nance are derived from Arabic. You will already have
noticed the use of such words as Takaful, Shariah, Mudarabah, Musharakah, Hiba, Sukuk and Salam,
above, which are all Arabic terms. For those of you with no experience in Arabic, these words and terms
may prove challenging, but it is essential, if you are to succeed in understanding much that underpins
Islamic products and services that you master these concepts and terms. We have created a glossary of
terms for you to refer to and we have included a detailed explanation of the nature of the contracts, the
key to all of the Islamic nancial products and services. It is left to you to make the most of the glossary
and contract explanations to maximise the benet you gain from these guides.
12
What is nance?
Study guide two: Islamic Banking and Takaful (Products and Services)
In this study guide you will be introduced to the nancial systems, products and services offered by
IFIs in the Islamic banking and Takaful industries. The guide also provides an overview of the types of
nancial institutions operating within the system. It explains the various nancial products and services
provided by both banking and Takaful institutions in terms of product features and mechanisms. Finally,
it highlights pertinent risk management issues relevant to the nancial institutions involved in Islamic
nancial activities.
13
Introduction
15
Chapter eleven explains the objective of Shariah standards. It also highlights the attempts being
made by Shariah scholars to ensure harmonisation of standards across the industry and some of the
solutions proposed.
Learning outcomes
On completing this study guide you should be able to achieve the following learning outcomes
according to the following chapters:
Dene Islamic nance whether in the form of banking, insurance or capital market segments.
Illustrate how these features require the provision of different nancial products to those
supplied through conventional nance.
Explain how Islamic nance can satisfy nancial needs without violating religious prohibitions.
Distinguish between Shariah (Divine sources of law) and Fiqh (Islamic substantive law or
positive law).
Identify the most workable technique of law in developing contemporary Islamic commercial law.
16
Illustrate the exibility of Islamic commercial law to meet nancial need without resorting to
lending for an interest.
Describe the relationship between traditional contracts and Islamic nance products and
services.
Chapter nine: Overview of Islamic banking, Takaful and capital market products
Explain the reason(s) why some contracts are preferable over other contracts in Islamic nance.
Discuss briey product development in Islamic nancing using the traditional contracts.
Explain how to deal with different rulings arising from different interpretations of the sources
and techniques of law.
17
Chapter one
An introduction
to Islamic nance
Learning outcomes
On completion of this chapter,
you should be able to:
1.0 Introduction
Islamic nance has its roots in the past as well as the present. Its links
to the past relate to the fact that it is based on principles and features
that were established more than 1,400 years ago. Its links to the present
relate to the fact that these ancient features are now being presented to
contemporary society in a form that is both modern and innovative. Islamic
nance is distinct from conventional nance in many respects but has a
common goal in achieving the same economic benet as conventional
nance offers to society. In this chapter you will be introduced to the main
differences between conventional and Islamic nance, including the need to
exclude interest and uncertainty. You will also be shown how the features
of nance that are acceptable can be used on their own, or in combination
with Shariah principles to create useful Shariah-compliant products.
Islamic nance is essentially driven by principles and contracts that are
structured in a manner that is not only compliant to Islamic teachings
but is also capable of offering products and services comparable to and
compatible with those of conventional nance.
1.1 Islamic tradition
The essence of Islam is that it derives its principles and values from the Quran and Traditions of
the Prophet Muhammad. The history of Islamic law begins with the revelation of the Quran that
contains legal principles and injunctions dealing with subjects such as ritual, marriage, divorce,
succession, commercial transactions and penal laws. In contrast, the Traditions of the Prophet
Muhammad record the sayings, actions and tacit approvals of the prophet Muhammad. The literature
of the Traditions of the Prophet Muhammad covers a much wider range of topics than the legal
verses in the Quran.
Unlike other legal systems, Muslims believe that Islam starts from a given or self-evident premise,
namely the revelation. It was with the aim of directing and guiding humanity to the realisation of its
moral potential and worldly worth that Islam undertook to create a system known as the Shariah.
Muslims believe that Shariah refers to commands, prohibitions, guidance, and principles under
Islam and is the clear path for the believer to follow in order to obtain guidance in this world and
deliverance in the next.
Key points
The essence of Islam is that it derives its principles and values from the Quran and Traditions
of the Prophet Muhammad.
Muslims believe that Shariah refers to commands, prohibitions, guidance and principles under
Islam and is the clear path for the believer to follow in order to obtain guidance in this world
and deliverance in the next.
19
Shariah provides guidance in terms of belief, moral conduct and practical rulings or laws. The focus
in this study guide will be conned to the practical rulings or substantive law governing Islamic
nance. This does not negate the importance of moral values in Islamic nance. Essentially, a
complete system of life is based on both legal prescriptions and moral and good conduct. Moral
values have been incorporated as legal requirements in some specic contracts such as Amanah
(honesty) in Murabahah (mark-up) nancing. Other principles of moral values pertaining to
commercial transactions include:
(a)
timeliness in the payment of debt or delivery of an asset; the failure to observe this aspect
might involve legal consequences
(b)
tolerance in terms of bargaining, where the parties are encouraged to be considerate of each
others requirements and circumstances
(c)
mutual revocation of a contract on request by one party if he nds himself uncomfortable with
the outcome of the transaction
(d)
These principles are not meant to be exhaustive but rather to highlight areas where morality is
relevant in commercial dealings.
Key point
Islamic nance is a term that reects all aspects of nancial business that are not
contradictory to the principles of Shariah.
Exercise 1.1
Which of the following best denes Islamic nance?
(A) Financial products and services that are offered to Muslims only.
(B) Financial products and services that are offered by Islamic banks.
(C) Financial products and services that are conducted according to Islamic teachings.
(D) Financial products and services that were offered during the time of Prophet Muhammad.
20
Key points
Riba is dened as usury or interest.
In interest-based systems, money earns more money through lending.
The application of nancial interest or Riba is prohibited in Islam.
Money in Islam is a medium of exchange, a store of value and a unit of measurement.
1.2.2 Islamic banking the relationship between the user and the supplier of funds
The relationship of the Islamic bank with the suppliers of funds can be of agent and principal,
custodian and depositor, entrepreneur and investor as well as between fellow partners in a joint
investment project. Similarly, the relationship of the bank with the users of funds can comprise of
vendor and purchaser, investor and entrepreneur, principal and agent, lessor and lessee, transferor
and transferee, and between partners in a business venture. This is in sharp contrast to that of
conventional banking, which is simply a lender-borrower relationship.
Conventional banks will accept a deposit from a depositor and promise to repay the money plus
interest which is xed, let us say, at 3%. As a nancial intermediary, the bank will use this money
deposited to lend to customers who need a loan. Here, the bank will charge the customers interest,
let us say, at 4%. The spread or the difference between the interest rate paid and interest rate
charged, namely 1%, is the banks prot. The notion of interest has made this model of nancial
intermediary work well.
Table 1.1 Deposit/liability: contractual relationship conventional banks and Islamic banks
Conventional Banking
Islamic Banking
Lender-borrower relationship
Depositor-custodian relationship
Lender-borrower relationship
(but free from interest)
Investor-entrepreneur relationship
Islamic Banking
Borrower-lender relationship
Purchaser-seller relationship
Lessee-lessor relationship
Principal-agent relationship
Entrepreneur-investor relationship
21
The above illustrates that Islamic banking has departed from the concept of loans to use other
contracts that are compliant and free from the element of interest in both deposit taking and
nance provision.
With regards to Islamic insurance, better known as Takaful, the insurer, that is the insurance company,
is prohibited from providing indemnity to the insured, that is the policyholders, as this is not
acceptable to Shariah principles. This is because both the premium paid by policyholders and the
indemnity paid by the insurer are uncertain and therefore not permissible as they contain the element
of uncertainty or Gharar. A simple conventional insurance contact is based on buying protection.
David seeks to insure his life for 30 years. Let us say that the premium he has to pay is $100
per month for 30 years for the insured sum of $200,000. If David dies during the policy period,
his nominee or beneciaries will benet from this insured sum irrespective of when David died
during the thirty year period. He might have paid only $2,400. Alternatively, David could survive
until maturity and in this case, he will receive no benet at all. This leads to uncertain results
that are not acceptable under Islamic beliefs.
Conventional life insurance companies are prot seeking entities and need to allow for things like
average life expectancy and high risk customers when setting their premiums in order to ensure that
it prots from offering life insurance to its customers.
Takaful introduces the contract of donation among the participants/policyholders as a substitute
for the contract of sale of indemnity for a premium as practised in conventional insurance. This is to
make uncertainty irrelevant because in Islamic terms uncertainty is only tolerable in gratuity or in
a unilateral contract such as a donation. The presence of the element of uncertainty in a donation
contract, which is unilateral in character, does not render it invalid. A donation contract can accept
and tolerate any uncertainty because the purpose of any unilateral contract is not a commercial gain.
Key points
Takaful is a scheme that provides mutual contribution and mutual assistance to cover both life
and general policies.
Takaful is based on donation contract and not a sale contract. Thus, uncertainty in Takaful is
acceptable because the ultimate aim is merely to help one another and not to achieve any
commercial gain.
Exercise 1.2
Briey explain why:
(i) under Islamic commercial law, money cannot generate income by the mere act of lending it
out to a borrower?
(ii) Islamic banking cannot rely on interest earned on a loan?
22
Points to note:
under Islam, loans offered in return for interest earned are prohibited
prot must be generated from other contracts such as trade, lease or investment by
converting the money into a real asset prior to undertaking other contracts such as sale
or lease
money must be put into real business transactions to generate income; this might include
the purchase of goods at x and the sale of those goods to a customer at x + y on a
deferred payment scheme
the bank would arrange to supply the necessary capital equipment for Z on this basis
suppose Z approaches a conventional bank to borrow a sum of 100,000 to purchase
new equipment for his printing business and for this he is quoted 4% interest per annum
on the proposed loan; in contrast, an Islamic bank can offer him credit sale nancing
whereby the Islamic bank will purchase the equipment from the vendor at 100,000 and
sell it to Z at 100,000 plus a mark-up or prot, let us say of 4% per annum
Z would not incur interest but the bank would earn a prot on the transaction.
23
24
products and weapons. Non-involvement is not only limited to buying or selling but also includes
all chains of production and distribution, such as the packaging, transportation, warehousing and
marketing of these prohibited goods and services.
Exercise 1.3
A bank has been set up to offer Islamic nancial products and services. In order to attract new
customers. This bank advertises in the media that the rst 1,000 customers who open Islamic
saving accounts based on the principle of Qard / Hassan (interest-free loan) will be given a gift
worth $100 each. Does this product offering comply with Shariah principles?
Key points
Islamic banking comprises the following features:
interest free
the need for underlying assets
the avoidance of uncertainty
prot and loss sharing
rights and liabilities of banks and customers arising from commercial contracts other
than a loan contract
Shariah compliance
prohibition of unlawful goods or services
overriding principles of Islamic law.
Solution
(a) John will be required to pay 2% of $100,000 and 2% of $130,000 that is a total of
$4,600. Tom will only have to pay $2,000 that is 2% of $100,000 loan.
(b) In countries where relevant amendments have been made to the stamp duty act to
facilitate Islamic nancing schemes, John would only have to pay stamp duty on the
rst transaction only, that is 2% of $100,000 which is equivalent to $2,000 only. This
will render stamp duty paid under both Islamic house nancing and a conventional
house loan to be the same amount.
25
1.5.1 Riba
Riba is simply translated into English as usury or interest. Any premium charged on money borrowed
is tantamount to Riba irrespective of the amount paid. Riba in its simplest term is an advantage
to one party at the expense of another for no appropriate consideration. Islamic commercial law
addresses the issue of this unjustied advantage from two possible transactions, namely in a loan or
currency exchange contract as well as in a barter trading contract.
Muslim jurists have unanimously agreed that two separate classes of assets are susceptible to Riba,
namely currency or money and a few commodities, mainly food items. The requirements of an
exchange involving these two types of assets are the same.
It is explained in the tradition that the Prophet Muhammad was reported to have said: 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.
These requirements are only applicable when there is an exchange of one currency for another
currency whether it is the same currency or different currencies. The requirements also apply to the
exchange of a food item for another food item, be it of the same food item or of different types
and kinds.
A summary of the above tradition and its inherent requirements is depicted in the following table.
Subject matter
Shariah requirements
Subject matter
Shariah requirements
Same currency
(GBP for GBP)
Spot transaction
Spot transaction
Spot transaction
Equal amount
Equal amount
The above table clearly illustrates that Riba is conned to these categories of assets, provided they
are exchanged within the same class, that is, currency for currency. An equal amount of the counter
value is required in exchange of assets of the same class. Spot exchange, or the simultaneous
delivery of counter values, is also required when one currency is exchanged for another currency
or when a food item is exchanged for another food item, irrespective of whether these currencies
or food items are the same or different types. Any delay in the delivery will render the exchange
tantamount to Riba, known as Riba al-nasiah, that is, Riba by virtue of deferment in the exchange or
delivery of these two counter values.
26
Time of delivery
Remark
1,000 to 100
Spot
No Riba
1,000 to 100
Deferred
Riba
1,000 to $3,000
Spot
No Riba
1,000 to $3,000
Deferred
Riba
Spot
No Riba
Deferred
Riba
Spot
No Riba
Deferred
Riba
From another perspective, the exchange of these two assets is also subject to the same amount or
quantity of the two counter values if they are of the same type. The failure to observe this would
lead to the practice of Riba called Riba al-fadl, namely Riba by an excess of one of the counter values.
However, the requirement to have the same quantity is not applicable if they are of different types
such as GBP for USD or wheat for barley.
Amount
Remark
GBP to GBP
Same/equal
No Riba
GBP to GBP
Not equal
Riba
GBP to USD
Same/equal
No Riba
GBP to USD
Not equal
No Riba
Wheat to wheat
Equal
No Riba
Wheat to wheat
Not equal
Riba
Wheat to barley
Equal
No Riba
Wheat to barley
Not equal
No Riba
This tradition is the foundation of the permissibility of currency exchange, done on the basis of the
prevailing rate of exchange, for example to exchange 1,000 for $3,000, provided this is done on a
spot basis. Any deferment of the exchange or delivery as in the case of a forward currency exchange
is not in line with the requirements of the tradition, and is thus prohibited. The amount of exchange
is not relevant when the exchange involves two different usurious items such as USD for GBP.
The theory of Riba could therefore be summarised as follows:
RIBA(1) = exchange of two similar usurious item for different counter values and for deferred
exchange, for example, 1,000 for 1,200 being exchanged of one another on deferred basis
RIBA(2) = exchange of two dissimilar usurious items for deferred exchange, for example, 1,000
being exchanged for $1,000 on deferred exchange.
From the above, a loan in GBP provided by conventional banks and other institutions that imposes
on the borrower the requirement to repay the principal amount borrowed plus a premium in the
same currency would come under the purview of Riba (interest/usury). This practice of modern Riba
in the banking sector relates to both Riba al-nasiah (Riba by deferment) and Riba al-fadl (Riba by
excess) because the borrower is obligated to pay more than he borrowed and repayment will take
27
place in the future. This is the reason why conventional saving accounts and xed deposit accounts,
as well as all nancing modes based on loan-for-interest are not compliant to Shariah principles. The
theory of Riba also applies to currency exchange, which can only be done on a spot basis. Forward or
future currency transactions are not allowed.
It is important to explain one exception to the above principles of exchange involving either currency
or food items. Islamic commercial law does allow a loan contract, called Qard / Hassan but it must
be free from Riba in the repayment of the loan. However, Islamic commercial law tolerates the
requirement of having to exchange two counter values on a spot basis as this is illogical to the
concept and philosophy of a loan, which is essentially to allow the borrower to repay their loan
obligation in the future. If they have to repay the loan almost immediately after borrowing, then
the loan has no meaning. This exception is granted to allow the practice of lending of either money
or fungible goods for no premium. What is more relevant is the prohibition of any excess in the
repayment of the loan. The deferment in time can be tolerated if the loan is for the purpose of
helping the borrower who seeks nancial help in terms of money.
The theory of Riba could therefore be summarised as follows:
The stipulation of an excess for the lender in loan is prohibited, and it amounts to Riba, whether the
excess is in terms of quality or quantity or whether the excess in a tangible thing or a benet, and
whether the excess is stipulated at the time of contract or while determining the period of delay for
satisfaction or during the period of delay and, further, whether the stipulation is writing or is part of
customary practice.
Quran 2:275. AAOIFI Shariah Standard, No. (19), Qard (loan), 4.4/1
Exercise 1.4
An Islamic bank has provided two loans. The rst loan of $10,000 was made to a customer with
the requirement that $11,000 be repaid after one year. The second loan of $10,000 made to
another customer, had the requirement that $10,000 be repaid after one year.
Is either of these transactions Shariah compliant?
1.5.2 Gharar
Gharar is another element that is to be avoided in any transaction. Gharar simply refers to a lack
of knowledge or uncertainty that could result in an outcome detrimental to one party. This lack
of knowledge, as well as a lack of control of the outcome of any transaction, may stem from
misrepresentation, mistake, fraud, duress, or terms beyond the knowledge and control of one of the
parties to the contract.
There are many examples of Gharar-based transactions that are prohibited including the sale of the
off-spring in the womb of a pregnant animal as the outcome is obviously beyond the control of the
parties involved and therefore uncertain. In addition, the sale of sh in the water, birds in the sky or
a runaway horse are also prohibited. The reason behind this is that the ability of the seller to deliver
these items is uncertain.
Gharar in practice relates potentially to issues such as pricing, delivery, quantity and quality of assets
that are transactional-based and would affect the degree or quality of consent of the parties to a
contract. For example, one cannot buy an option at a certain price to have the right to purchase its
underlying shares, as an option is not ascertainable and is thus uncertain. An option is just a right. It
is not an asset whose specications are clear and attainable. In conventional insurance, the premium
paid by policyholders and the indemnity provided by the insurer upon a claim are equally uncertain,
thus making conventional insurance non-compliant from an Islamic legal perspective.
Unlike Riba, which is determined by a xed formula as previously explained, the determination
of Gharar is based on many aspects. This is because the parameter of knowledge or consent and
the risk tolerance by society is not xed. Above all, Islamic commercial law has accepted the
distinction between major uncertainty (Gharar Fahish), which is to be avoided at all times, and minor
uncertainty (Gharar Yasir), which is tolerated by society. The practice of paying a certain amount
of money for the use of a public toilet in some societies reects the tolerance level in that society.
The society accepts different levels of consumption of facilities that are uncertain for a standard
payment which is xed.
28
Key point
Gharar simply refers to a lack of knowledge or uncertainty that could result in an outcome.
Exercise 1.5
(i) Is prot and loss sharing distinctive to Islamic banks?
(ii) What type of Riba is involved where there is an increase of one of two counter values in the
exchange of two similar usurious items?
(iii) Is an exchange of 50,000 for $50,000 on a spot basis tantamount to Riba?
Shareholders
fund
Purchase of an
asset at x from
the vendor
x money
Islamic Financial
Institution
x money
Capital
investment in
x project
y% prot sharing
x% prot sharing
Customer/partner
The pool of money, collected through various Islamic accounts and or shareholders funds, is
channelled to nance trade, lease or investment activities. From a micro perspective, the money
has been transferred into real economic stock in order to generate more income. Thus, the prot
generated by IFIs is the outcome of dealing with a real asset rather than a monetary asset.
29
A simple illustration of this could be where a bank has allocated 100,000 to nance a customer to
purchase a house from a vendor at the cost of 100,000. This initial 100,000 will be used by the bank
to purchase the identied house from the vendor. By doing so, a monetary asset has been transformed
into a real asset i.e. a house. Subsequently, the bank will sell the same house to the customer. The selling
price, based on a Murabahah contract, is 120,000 which is payable over ten years. The whole process
is a total departure from the conventional practice of lending and borrowing. The bank in Murabahah
nancing has to purchase the house before it can be sold to the customer. There are real sale and
purchase transactions underlying this facility and in some jurisdictions, this would trigger a double
stamp duty on the two sets of documents. In those jurisdictions, relevant amendments have been made
to the relevant stamp duty acts to avoid double stamp duty for these two transactions.
House Financing
Conventional
Islamic
100,000 of loan
120,000 [Loan + Interest]
Points to note
There is more than one answer to this question. Many conventional textbooks on nance,
dene money as a medium of exchange, a unit of measurement and a store of value. In
medieval times, money was viewed by many as a commodity in as far as the owner of money
could claim a premium if the money was loaned to another party. This is the origin and
basis of modern interest. This view tends to be prevalent in the contemporary conventional
nancial market.
30
Exercise 1.6
(i) A bank has extended a Murabahah facility to a customer whereby the bank purchases from
the vendor an asset at x amount i.e. 200,000. The bank subsequently sells the asset to a
customer at x+y amount e.g. 250,000 payable within ve years. Why is this additional
payment permissible in Murabahah but not permissible in a loan contract?
(ii) A new Islamic bank has been established in your area. The bank accepts deposits on Islamic
principles. It has received an application for nancing except from a customer who intends
to purchase a factory that produces alcoholic liquor. This customer has put in an application
for Murabahah nancing, which has been declined. The customer has asked you to explain
why the application has not been accepted. How would you explain this to the customer?
1.9 Conclusion
This chapter introduced you to many of the key components that make up the subject of Islamic
nance. Specically, the chapter outlined the history and development of Islamic nance. It also
introduced the differences between conventional and Islamic nance. Having studied this chapter
you should now appreciate why such key aspects as the avoidance of interest and uncertainty in
Islamic transactions, the need to ensure Shariah compliance and the concept of prot sharing
underpin the need for the development of Islamic nance. The chapter also briey introduced you
to Islamic insurance or Takaful, concluding with an explanation of the critical matters relating to
Shariah compliance and the equity market. All of these components will be discussed again in more
detail throughout this and the other guides which comprise the Certicate in Islamic Finance.
The following chapter will examine the sources of Islamic Commercial law that underpin many of the
Shariah principles governing commercial transactions.
1.10 Summary
Having read this chapter the main points that you should understand are as follows:
1.
the essence of Islam is that it derives its principles and values from the Quran and the Traditions
of the Prophet Muhammad
2.
the principles of Islam as enshrined in both the Quran and the Traditions of the Prophet
Muhammad are known as Shariah
3.
Islamic nance is a term that reects nancial business that is not contradictory to the principles
of Shariah
4.
the giving or receiving of interest (Riba) is specically prohibited by Shariah, as is the existence
of uncertainty (Gharar)
5.
unlike conventional banking, where the relationship is simply lender-borrower, the relationship
in Islamic banking can be of agent and principal, depositor and custodian and investor and
entrepreneur, on the liability side of the bank; as for the asset side, the relationship could be of
seller and purchaser, lessor and lessee, principal and agent, as well as between fellow partners in
a joint investment project
6.
in order to remove the element of uncertainty from Islamic insurance (Takaful), the contract of
donation is introduced among the participants/policyholders in place of the contract of sale of
indemnity for a premium as practiced in conventional insurance
7.
all banking business based on sale or lease must have an underlying asset
8.
9.
Islamic nance must not be involved in any activities pertaining to unlawful goods and services
10. Islamic nance does not, and should not, deal with money directly; this is because money cannot
earn more money by itself, money must be put into real business activities to earn extra money
11. the distinction between the Islamic and conventional equity markets mainly concerns the
activities of the companies in which the capital through subscription of the shares are put; these
activities may include activities such as the sale or purchase of assets and services which are
disapproved by Shariah principles.
31
Chapter 1 Answers
Exercise 1.1
(C) Any types of nancial products or services, compliant to the requirements of Islam, fall
within the scope of Islamic nance. They can be offered to anyone and by anyone without any
restriction because Islamic nance is inclusive in character. The only restriction is with regard to
the products and services themselves. These must be structured according to the teachings of
Islam. For example, the payment or charging of interest is not allowed in Islam. Thus, products
of Islamic nance must be free of any element of interest.
Exercise 1.2
(i) Under Islamic commercial law, money must be put into a real business transaction to
generate income. This might include the purchase of goods at x and the sale of those
goods to a customer at x + y on a deferred payment scheme or credit sale.
(ii) Under Islam, loans offered in return for interest earned are prohibited. Prot must be
generated from other contracts such as trade, lease or investment by converting the money
into a real asset prior to undertaking other contracts such as sale or lease.
Exercise 1.3
The banks product offering is not compliant because Islamic nance must be free from interest
either in cash or in kind. Giving a gift, which is advertised prior to the opening an account, is
deemed as interest in kind. This is because the bank will borrow the money from the depositor
under this contract and therefore, any extra payment intended to be paid by the borrower to
the depositor/lender in the form of gift is tantamount to Riba.
Exercise 1.4
The rst transaction is not compliant. However, the second is compliant. Although Shariah
principles require the repayment of loans to be on a spot basis i.e. not deferred, Shariah
principles tolerate non spot transactions if the loan is meant to help the borrower and not to
provide any commercial advantage to the bank from its lending activities.
Exercise 1.5
(i) Yes. No such arrangement of prot and loss sharing is being practised in an interest-based
banking system.
(ii) The type of Riba is called Riba al-fadl or Riba by excess because of the premium in one
of the counter values in the exchange involving two similar usurious items, for example,
1,000 for 1,200.
(iii) No. There is no Riba involved as the requirement of equal amounts does not apply to an
exchange involving two dissimilar usurious items, that is, GBP for USD. The rate of exchange
is to be agreed by both parties with spot delivery. In practice, the exchange rate agreed will
be the same as prevailing conventional exchange rate (though in theory they could adopt a
different exchange rate).
Exercise 1.6
(i) Murabahah nancing to purchase an asset is permissible because it does not deal with
money directly. The nancier is selling the asset to a customer at a mark-up. The nancier
did not advance a loan and charge a premium on the loan.
(ii) Financing to purchase a factory that produces alcohol is not acceptable as alcohol is not
compliant. The factory therefore would be used for the production of prohibited goods.
Both the contract and subject matter (or the use to which it might be put) must be
compliant. If the factory was to be used in the production of a Shariah-acceptable product
then the nance could proceed.
32
33
Revision questions
Revision Questions
Question 1 Multiple choice
1.1 As well as being interest free, Islamic nance must also be free from:
(A)
Gharar
(B)
prot
(C)
loss sharing
(D)
equity.
(B)
(C)
By trading or leasing.
(D)
A car.
(B)
A house.
(C)
Printing equipment.
(D)
Non-slaughtered animals.
1.4 Fixed deposits, as practised by conventional banks, are not permissible because they include:
(A)
Gharar (uncertainty)
(B)
(C)
(D)
1.5 Which of the following is not a correct description of the prot sharing concept in a
Mudarabah investment account?
34
(A)
(B)
(C)
(D)
Identify which of the following descriptions reects Riba (Tick ), and which are free from Riba (tick )
1. A $1,000 is being loaned out to a person with a condition the repayment must
be made in the future for $1,000.
Revision questions
Question 2
Question 3
Match the following subject headings to the descriptions.
Subject Matter
Descriptions
1. Islamic nance
2. Riba
3. Shariah board
4. Gharar
5. Musharakah
35
Revision questions
Answers
Question 1 Multiple choice
1.1 (A) Gharar, as well as Riba, must be avoided as they may put one or other party in a
disadvantageous position.
1.2 (C) Money can grow if the owner of the money is willing to take risks. Among others risks, he
can use his money to purchase goods at a cost of x and sell them to another party at x+y. In
short, prot gained through a sale transaction is allowed by the Shariah.
1.3 (D) Non-slaughtered animals are deemed to be not pure or clean from a Shariah perspective.
1.4 (D) Both Riba al-fadl and Riba al-nasiah.
1.5 (B) The manager will not share the loss of capital under Mudarabah because he does not
essentially provide any capital. The investors will bear all of the loss of capital.
Question 2
1. A $1,000 is being loaned out to a person with a condition that the
repayment must be made in the future for $1,000.
(The deferment of time of repayment does not lead to Riba provided there is no
extra repayment amount).
(Forward Forex is not compliant as the exchange of the two currencies is not spot.
Currencies must be exchanged on a spot basis).
36
Subject Matter
Descriptions
1. Islamic nance
2. Riba
3. Shariah board
4. Gharar
5. Musharakah
Revision questions
Question 3
37
Chapter two
Shariah compliance
Learning outcomes
On completion of this chapter,
you should be able to:
Shariah compliance
2.0 Introduction
Shariah compliance is the key issue of Islamic nance. In this chapter
you will be introduced to the term Shariah compliance, the requirement
for Islamic nancial products to comply with Shariah principles and the
stakeholders interested in Shariah compliance. You will also be introduced
to methods used to ensure compliance, which is essential at both the
structuring and operational stages.
2.1 Meaning of Shariah compliance
2.1.1 The general meaning of compliance
The need for compliant behaviour for every society is based on established norms and values
that are adopted as the basis for particular laws, regulations, guidelines or principles. Compliance
or conformance is necessary to ensure the preservation of a social order which will facilitate the
achievement of societal objectives. In this respect compliant behaviour is universal and in Islam it
relates to Shariah principles and rules.
The policies and practices of nancial institutions and behaviour of market participants in the
Islamic nancial services industry are required to comply with Shariah principles and rules
expressed in the form of regulatory requirements, guidelines and standards. The scope for such
compliant behaviour includes all activities where reasonable assurance should be provided to the
investing public and society that such activities do not confound or violate Shariah principles and
rules. Any form of non-compliance will impair such assurance and affect investor condence in the
Islamic nancial system.
Exercise 2.1
Before proceeding, in your own words what do you understand by the term compliance?
Compliance essentially refers to the status of conforming to a certain standard, which subsequently
dictates the status of being compliant or otherwise. Compliance imposes on a person or corporation
the requirement to adhere to all those requirements that are prescribed by a certain point of
reference. This guides the process of compliance and sets a standard which those seeking compliance
are expected to achieve. Compliance with a standard can only be expected if the relevant standard
has been made known to all parties concerned.
Standards are usually set by experts in the eld and are determined after lengthy debate over what
should be included. Most standards are not legally binding but are expected to be followed by virtue
of the fact that they are supported by leading experts. It is normally left to the conscience of the
individual as to whether they adopt a standard. Not following a standard would be going against
that which was generally accepted as best practice and would need to be supported by evidence that
the standard did not apply in the given circumstances.
39
Shariah compliance
banner of Islamic nance must adhere strictly to the requirements of the Shariah principles in all
aspects pertaining to a nancial product or service. This means that compliance is not only limited
to the design and structure of the product or service, but also the terms and conditions, the legal
documentation, the accounting treatment, the standard operating procedures, IT aspects, through
to the marketing brochures relating to the product or service. To be Shariah-compliant requires that
each of these must conform to the requirements of Shariah principles.
Products that are in conict with, or depart from, Shariah principles are deemed to be noncompliant. Normally, any areas of non-compliance will be addressed and, if applicable, relevant
action will be taken to bring the products into compliance. In some jurisdictions, such as in Malaysia
as per the Islamic Banking Act 1983 (Section 4), non-compliant activities may lead to the revocation
of a license granted to an IFI. Although this is not specically mentioned in other jurisdictions,
this is a logical consequence for any licensing process because IFIs must adhere to their articles of
association that normally mention their duty to comply with Shariah principles. Mention should
also be made that, with the exception of Malaysia, other jurisdictions have no separate legislation or
act covering Islamic banking.
Compliance is a Shariah requirement of conducting Islamic nance activities. The availability
of Shariah standards is an important aid to facilitate Shariah compliance and to make Shariah
compliance measurable and comparable across jurisdictions.
Key points
Shariah compliance means total adherence to all Shariah principles.
Products and services coming under the banner of Islamic nance must adhere strictly to the
requirements of the Shariah principles.
The availability of Shariah standards is an important aid to facilitate Shariah compliance and
to make Shariah compliance measurable and comparable across jurisdictions.
(b)
(c)
Fullment of all
the necessary
requirements
Shariah
compliance
Continuous
compliance
Avoidance of all
prohibitions
This diagram shows that full-edged compliance should meet these requirements at all times,
otherwise there will be a breach of Shariah compliance. A possible breach may take place in one
of these areas or, in a worst-case scenario, in all three areas. However, the most likely breach is
40
Shariah compliance
normally a failure to sustain continuous compliance. A product such as house nancing may be
endorsed as compliant because it fulls all conditions and is free from all prohibited terms. However,
if a customer were to default, an IFI may wish to impose on the customer some additional payment
that would not be compliant.
Shariah compliance must be represented in both the process and the outcome. It should start from
the product design and go through to product implementation and, as stated above, relate to all
supporting services such as accounting, IT, marketing and advertisement, legal documentation, risk
management, application forms and all other documentation.
Shariah compliance
Product design and structure
Legal documentation
Accounting treatment
IT solutions
Recovery and restructuring
Risk management
As shown in the above diagram, Shariah compliance transcends the scope of product design and
structure to cover other relevant considerations. For example, a product may be compliant and
lawful in its product offering but it may contain a risk management tool that is not compliant, such
as an interest rate swap to hedge any asset liability mis-match of the bank. In this case, the Shariah
compliance requirements would demand the risk management tool to be equally compliant, such
as having a compliant prot rate swap instead of an interest rate swap. The concept of a prot rate
swap will be discussed in Study Guide Three.
Given this information, what are the key areas that the Shariah advisors of this Sukuk must
supervise to ensure strict compliance to Shariah principles?
Solution
One of the key areas would be the actual utilisation of the Sukuk proceeds. The proceeds
must be used to nance the projects as mentioned. Special attention must be given to the
development of a hotel as it may involve some services which are not compliant to Shariah
principles.
Exercise 2.2
Explain how information technology might impact on an IFIs ability to achieve Shariah
compliance?
41
Shariah compliance
Regulators
Banks
management
Stakeholders
of Shariah
compliance
Banks
shareholders
Customer
and public
42
Shariah compliance
its position is as good as a supervisory board. Likewise, the title of a Shariah supervisory board
does not necessarily reect the power of supervision and review unless this power is clearly
mandated in the terms of reference of the establishment of the Shariah board.
b.
The Shariah supervisory board is used to reect the comprehensiveness of Shariah advice
and reviews all the activities of an institution, whereas the Shariah advisory board is used in
some contexts and jurisdictions to reect the limited power and coverage that this Shariah
board has. If the institution being supervised is a full-edged IFI, Islamic insurance (Takaful)
or Islamic asset management company, then the term Shariah supervisory board is more
appropriate. The board members, consisting of qualied scholars, must ensure that all activities
of the institution, as explained in section 2.1.2, conform with Shariah principles. In the case of
an Islamic window operating from within a conventional bank, that is a conventional nancial
institution offering selected Islamic nancial products, Islamic insurance or Islamic funds, the
term Shariah advisory board would be deemed to be more appropriate. The function of the
scholars who are on this board is mainly to ensure that a particular product, scheme or fund
being offered by this Islamic window or conventional entity is in line with Shariah principles.
The design, structure and legal documentation of these products must be Shariah compliant.
Other dimensions of a full-edged IFI such as IT solutions, accounting treatment and risk
management methodologies should support Shariah compliant products and systems. The
Shariah board is not entrusted to endorse except on product design, structure and the main
activities, as well as on respective legal documents or prospectus, as the case may be.
Denition of SSB
A Shariah supervisory board is an independent body of specialised jurists in Fiqh al-Muamalah
(Islamic commercial law). However, the Shariah supervisory board may include a member other
than those specialized in Fiqh al-Muamalah, but who should be an expert in the eld of Islamic
nancial institutions and with knowledge of Fiqh al-Muamalah. The Shariah supervisory board is
entrusted with the duty of directing, reviewing and supervising the activities of the Islamic nancial
institution in order to ensure that they are in compliance with Islamic Shariah rules and principles.
The Fatwas, and rulings of the Shariah supervisory board shall be binding on the Islamic nancial
institution.
Governance Standard for Islamic Financial Institutions No.1. Accounting, Auditing and Governance
Standards for Islamic Financial Institutions 2004-2005, Shariah Supervisory Board: Appointment,
Composition and Report p.5
The Shariah supervisory services to be provided by a Shariah board are expected to guide the
Islamic bank in carrying out all of its activities according to Shariah principles. From a regulators
perspective this would probably be the best method to achieve compliance as the banks
management may not be able, academically and intellectually, to achieve this statutory requirement
without the assistance of a Shariah board. An Islamic banks licence may be revoked if the bank fails
to establish this Shariah board or fails to observe Shariah principles. Such a provision is included in
the Malaysian Islamic Banking Act 1983 section 4 (3), which states:
where a licence is subject to conditions, the Islamic bank shall comply with those conditions.
43
Shariah compliance
2.5.1 Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI)
The Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFIs) governance
standard on the appointment of the Shariah board is equally important as the standard is directed
to the appointing authorities and that may include the central bank and other agencies. Article 7 of
the standard provides:
The Shariah supervisory board shall consist of at least three members. The Shariah supervisory
board may seek the service of consultants who have expertise in business, economics, law,
accounting and/or others. The Shariah supervisory board should not include directors of signicant
shareholders of the Islamic nancial institution.
This is followed by Article 8, which notes:
The dismissal of a member of the Shariah supervisory board shall require a recommendation by the
board of directors and be subject to the approval of the shareholders in several meetings.
Exercise 2.3
An Islamic nancial institution has established a committee of three scholars to advise on its
operations. The main task is to issue the Fatwa and to review its operations for the purposes
of issuing a Shariah certication of compliance, to be included in the annual nancial report.
Does this reect the work of a Shariah advisory or Shariah supervisory board?
Solution
Advantages
44
Disadvantages