Principles of Shariah Compliance

for Islamic Financial Institutions

Dr. Abdullah Mohd Ayedh

(abdullah.mohammed@usim.edu.my)
 Main Sources of Shariah

Al-Quran

Qiyas
Shariah As-Sunnah
(analogy)

Ijma (consensus)
 Al-Quran

The revelation in the book is no doubt from the Lord of the worlds
(Allah) (Chapter 32 As-Sajdah: verse 2)

Lo, we reveal unto you the scripture with the truth that you may judge
between mankind by that which God showed you. And be not a pleader
for the treacherous (Chapter 4 An-Nisa: verse 105)
The verses of the Quran were revealed intermittently and gradually to
meet the requirements of events or the causes of revelation during the
time of the Prophet (SAW).

The period of revelation slightly more than 22 years (12 years in Mecca
before Hijrah and the remaining was at Medinah).

Meccan verses are mostly short and concise, deal with matters of
religion, about the nature of God etc.

Medinan verses are long and embody the detailed of Islamic legislation.
 As-Sunnah

Obey God and obey the Prophet (Chapter 5 Al-Maidah: verse 92)
The Sunnah consists of at least 3 types:
1. Al-sunnah al-qawliyah the statements and sayings of the Prophet.
2. Al-sunnah al-filiyah the traditions of the deeds of the Prophet
3. Al-sunnah al-taqririyah the tacit approvals or silence, regarding deeds
which had occurred with his knowledge

The compilations of the Sunnah are compiled by scholars and

among the authoritative one like the Musnad of Imam Ahmad
Ibn Hanbal; al-Muwatta by Imam Malik; Sahih al-Bukhari and
Sahih of Muslim.

There is a science of hadith of the prophet i.e. mustalah al-

hadith.
 Ijma

Ijma means Scholarly consensus.

Scholarly consensus is defined as being the agreement of all

Muslim scholars on a specific issue.

Given the condition that all such scholars have to agree to the
ruling, its scope is limited to matters that are clear according to the
Qur'an and Prophetic example, upon which such consensus must
necessarily be based.

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 Qiyas (Analogy)

Qiyas, is reasoning by analogy.

To apply a recognized rule of Shariah expressly mentioned in the

Holy Quran and Sunnah to a similar thing or situation by way of
analogy.

Legal analogy is a powerful tool to derive rulings for new matters.

For example, drugs have been deemed impermissible, through legal analogy
from the prohibition of alcohol that is established in the Qur'an. Such a ruling
is based on the common underlying effective cause of intoxication.

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Major Aspects of Islam

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 Goals of Shariah (Maqasid Ash-Shari ah)
According to Imam al-Ghazali

1. Securing of benefit (manfaah)

2. Securing the interest, preservation of interest and
repelling of harm (madharah)
The manfaah and madharah are according to judgement
of law giver (Quran and Sunnah).
The purpose are:
1. preservation of Deen (religion)
2. preservation of Nafs (life)
3. preservation of Aql (intellect)
4. preservation of Nasl (progeny or lineage)
5. preservation of Mal (wealth)
Goals of Shariah

The purposes are designated into 3 main categories:

i. Dharuriyaat (necessities)
ii. Hajjiyaat (needs / facility)
iii. Tahsiniyaat (ease / complimentary)

Priorities: Maqasid are always used as reference point for the

general principles of the law. It is applied within 3 main
rules.
i. The stronger interest (benefit) shall prevail.
ii. The public interest (benefit) is prior to the private interest.
iii. The definitive interest (benefit) prevails over the probable.
Islamic finance is the outcome of Islam as Ad-Deen
(comprehensive way of life)
Modern finance and banking needs

Fiqh al-Muamalaat contracts

Shariah sources
Musharaka - Partnership
Quran
Mudaraba - Partnership
Sunnah
Shariah Murabaha - Purchase-resale
Ijma (jurist filter
consensus) Ijarah - Lease
Qiyas (analogy) Istisna- Manufacturing
contract
Ijtihad (reasoning)
Salam - Forward sale

Islamic finance solutions

Prohibition on: Prohibition of certain investments: Asset-backed Credit and debt
- Riba Sectors (e.g.: alcohol, financial Transactions products are
services, gambling, pork,
- Gharar pornography, tobacco) with investments not encouraged
- Maisir etc. Instruments (e.g. no forward in real assets
transactions, limited option use,
no derivatives, short-selling)
 Basic Principles of Muamalat

Islamic financial contract i.e. buyer and seller; sighah (ijab and
qabul); subject matter (product/service) and price.
Prohibition of riba
Prohibition of gharar
Other prohibitions i.e. maysir (gambling), liqour, pork etc.
Adil (fairness)
Good manners (akhlak)
Rights of buyers and sellers
Honesty and integrity
 Basic principles of Iqtisad (Islamic economics)
1. Tauhid
Uluhiyah & Rububiyah - worshipping Allah and Allah as the
Master of Universe
Al-Falah success in this world and in the Hereafter
Khalifah - human beings as vicegerent of Allah and Allah
ultimate owner of wealth

2. Need fulfillment (e.g. food, shelter, clothing etc.)

3. Optimum growth and towards full employment
4. Equitable distribution of income and wealth
5. Economic stability
 The Prohibition of Riba
Meaning of Riba
Literally: excess, increase, expansion or growth

Definitions of Riba
Ibn al-Arabi: every excess in return of which no reward is paid
Mawdudi: predetermined excess or surplus over and above the
loan received by the creditor conditionally on relation to a
specified period
Haque: an increase or excess which, in an exchange or sale of
commodity, accrues to the owner (lender) without giving in
return any equivalent counter or recompense to the other party
 Foundation of Muamalat & Islamic Finance
they say: trade is like Riba, but Allah has permitted trading
and forbidden (haram) riba (usury) (Al-Baqarah 275)

O You who believe! Observe your duty to Allah and give up

what remains (due to you) from Riba, if you are (in truth)
believers. If you do not take notice of war from Allah and His
Messenger (SAW): but if you turn back, you shall have your
capital sums. Deal not unjustly, and you shall not be dealt with
unjustly (Al-Baqarah 278-279)

From Jabir the Prophet s.a.w cursed the receiver and the
payer of riba, the one who records it and the two witnesses to
the transaction: they are alike in guilt
 The Prohibition of Riba
In the Quran - 4 Stages:
1. Surah al-Rum: 39
compare riba with Zakat and charity
praising Zakat but not riba
2. Surah al-Nisa: 160-161
attaching the practice of riba with the Jews
Consider the practice as an inequity
3. Surah ali-Imran: 130
Prohibiting the practice of charging double and multiple
riba
 The Prohibition of Riba
4. Surah al-Baqarah: 275-281
Conclusively prohibiting all forms of riba
Any excess over the capital is disallowed
they say: trade is like riba, but Allah has permitted trading
and forbidden (haram) riba (usury)

Example in the Sunnah:

From Jabir the Prophet s.a.w cursed the receiver and the
payer of riba, the one who records it and the two
witnesses to the transaction: they are alike in guilt
 Types of Riba
1. Riba al-Buyu (exchange transaction)
Riba al-Fadl (due to excess)
Riba al-Nasiah (due to delay)
Example:
(a) Trading commodities of the same commodities (gold gold;
dates dates)
Both commodities must be equivalent
Prompt delivery
(b) Trading commodities of the same group but different kinds
(gold - silver; wheat barley)
Equality not a condition
Prompt delivery
(c) Trading commodities of different groups and kinds (gold
wheat; silver barley)
No conditions imposed i.e. free trading
 Types of Riba
2. Riba al-Duyun (loan/debt transaction)
Riba al-Nasiah (due to delay)

Characteristics of Riba al-Nasiah

3 Elements:
1. Excess or surplus over and above the loan capital;
2. Determination of surplus in relation to time; and,
3. Stipulation of surplus in the loan agreement.
 Riba vs Trade
Wisdom behind prohibition of riba
Elimination of injustice and encourage cooperation
Spirit of brotherhood

Riba is not trading:

Money loaned for self-generating or self-expanding value is
not sale
Growth or increase in money is inequitable
One party receives an increase without equivalent return
to the other party
In sale, there is productive exchange such as goods for
goods and money for goods
 Meaning of Gharar

Literally: In Arabic means negative elements e.g. deceit, fraud,

uncertainty, danger, risk, hazard etc. that might lead to
destruction and loss

Technically: uncertainty and ignorance of one or both parties of

a contract over the substance or attributes of the object of
sale or doubt over its existence and availability at the time of
contract
 Gharar in the Quran
The word Gharar appeared 27 times in the Quran
Refer to the need of believers to be aware of the deceptive
character of the worldly pleasures, and not to be deceived by
such temptations

Example in Surah al-Nisa (4:29):

O you believe! Eat not your property among yourselves unjustly
(bil batil i.e. by falsehood and deception) except in a trade
amongst you by mutual consent
Most jurists agreed that al-Batil refers in the above verse
includes illegal and deceptive elements in commercial contracts
 Gharar in the Sunnah

In commercial transactions, the Prophet s.a.w in many of his

sayikngs prohibited the sale involving gharar

Examples: The prohibition of sale of fish in the sea, bird in the

air, unborn animals, etc.

Gharar is prohibited with consensus of the jurists (ijma) since

the time of the companions, their followers (tabiin) and
subsequently until now.
 Reasons for prohibition of Gharar
To ensure full consent and satisfaction of all parties in a contract
Without full consent and satisfaction the contract is null and
void
Full consent can only be achieved through certainty, full
knowledge, full disclosure and transparency, and zero deceit or
fraud
Gharar also results in the risk being built into the contract at its
inception which may result in a profit for one party and
corresponding loss to other party (zero-sum game or gambling)
 Factors for Gharar in Contracts

None or incomplete ownership (do not sell if you do not have

or cannot legally guarantee delivery

Non-possession or cannot guarantee physical delivery to avoid

manipulation by the seller and protect the interest of buyer

Uncertainty in the contract or conditional sales

 Exceptions of Gharar

The uncertainty is too trivial or too slight and tolerable by both

or all parties

Charitable contracts (tabarruat i.e. Waqf etc.)

The real public need for the transaction or contracts even gharar
is excessive e.g. bay al-Salam (advance purchase), al-Istisna
(manufacturing contract )

To satisfy peoples immediate need and removal of hardship

makes Gharar an exception and need takes priority
 Exceptions of Gharar

Gharar is averted if:

Both the price and the subject matter are proved to be in

existence at the time the transaction concluded

The qualities are known and the quantities are determined

The contractual parties have control over them so as to ensure

the exchange can take place

Term of time can be precisely determined

 Islamic framework provides solutions for key weaknesses of
conventional financial system
Conventional finance issues
Growing consumer indebtedness
maximisation of wealth the ultimate
goal
Systemic conflict between
shareholders and credit-financed
customers
Speculation-fuelled crises
1997 East Asia Crisis
1998 Russia
1999 Argentina
2008 US Sub-prime crisis
Regulation often reactive and lagging
corporate misbehaviour
Collusion between different
stakeholders
An ethical grounding prevents a wide set of problems
Islamic Finance solutions
Asset/need-based approach to financing
Check on profit-seeking alone as sole
business motive
Investment channels towards ethical
activities
Equitable distribution of risk and reward
Prevention of speculation
Ownership is prerequisite of sale
Excessive risks are prohibited
The case for Narrow Banking
Shariah-based IFI is Taqwa-based
Prohibition of Riba, Gharar, Maisir
Regulation is reactive to corporate
innovation
Shariah-based system prioritises God
over regulators
 Islamic financial Industry has advanced
from niche to critical mass
Young industry
Mit Ghamr Savings Association (1963) & Tabung Haji Malaysia Islamic banking
(1967)
Islamic Development Bank (1974) & Dubai Islamic Bank (1975)
assets as proportion
Bank Islam Malaysia Berhad (1983) etc etc of total (%) *
Market-driven proposition
45%
Retail customers historically the backbone of the industry 40%
Tipping point in retail sector: Saudi Arabia, UAE, Bahrain and 40%
Kuwait
35%
Self-regulating organisations, Standards bodies (AAOIFI, IFSB) and
Research and Training Institutes 30%
30%
66%
Market size estimated at USD 750 billion globally1 25%
growth
Growing at 15 to 20% per annum1 20%

Within 8-10 years, industry estimated to capture half the savings of the 1.6 15% 20%
billion Muslim world2
10% 12%
Global scale 5%
More than 250 Islamic banks worldwide operating in over 75
countries 3 0%
2005 2010e
GCC accounts for two-thirds of global Islamic assets*
Malaysia leading industry maturity and sophistication GCC Malaysia
Islamic Development Bank: largest pan-OIC financial institution

Industry is fragmented, with slowly internationalising players

 Islamic Banking Operations in Malaysia
ISLAMIC BANKING OPERATIONS
SOURCES OF FUND
Current Accounts
Al-Wadiah (Guaranteed Custody)
Savings Accounts
Al-Wadiah (Guaranteed Custody)
General Investment Accounts
Al-Mudharabah (Trustee Profit-
sharing)
Special Investment Accounts
Al-Mudharabah (Trustee
Profit-sharing)
APPLICATIONS OF FUND
Equity Financing
Al-Musharakah (Joint-venture Profit-sharing)
Al-Mudharabah (Trustee Profit-sharing)
Term Financing
Al-Bai Bithaman Ajil (Deferred Instalment Sale)
Al-Ijarah (Leasing)
Trade Financing
L/C Al-Wakalah (Agency)
L/C Al-Murabahah (Deferred LumpSum Sale)
L/C Al-Musharakah (Joint-venture Profit-sharing)
Letter of guarantee (Al-Kafalah/Guarantee)
Al-Murabahah Working Capital Financing
(Deferred LumpSum Sale/Cost-plus )
Islamic Accepted Bill (IAB)
Investment
Al-Musharakah (Joint-venture Profit-sharing)