1. Foundation of Islamic Finance ISF 1101
TOPIC 2.
BASIC PROHIBITIONS AND BUSINESS ETHICS IN ECONOMICS AND FINANCE

2. The Basic Prohibitions Islamic Business Ethics and Norms
TOPIC CONTENT
The Basic Prohibitions
Islamic Business Ethics and Norms

3. 1. The Basic Prohibitions

4. 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

5. 1. Prohibition of Riba Literal definition
- excess, increase, expansion, growth
Technical definition
every excess in return of which no reward or equivalent counter-value 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

6. 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, al-Imran: 130, al-Baqarah: 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

7. Rationale for Prohibition of Riba (1)
Rationale/reasons for prohibition of riba so as to better appreciate wisdom behind injunction:
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
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

8. Rationale for Prohibition of Riba (2)
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”

9. Rationale for Prohibition of Riba (3)
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

10. Rationale for Prohibition of Riba (4)
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

11. Rationale for Prohibition of Riba (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

12. Rationale for Prohibition of Riba (6)
Negative effects on distribution
Disproportionate supply of credit to the already affluent segments of population since lending is based on creditworthiness
Wealth inequality (in terms of purchasing power) is widened
Rich become richer and poor become poorer
Domination of large enterprises leads to demise of smaller economic units
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

13. Types of Riba Riba al-Qard (Riba al-Dayn- debt)
As being highlighted in Quran, thus also known as riba al-Qur’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

14. 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

15. 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

16. Riba al bay’(2) Summary of rules Exchange Condition (Amount & Time)
Money1 + Money1
 Equality
 Hand-to-hand (spot)
Food1 + Food1
Money1 + Money2
 Hand-to-hand
Food1 + Food2
Money + Food
 No conditions – free trading
Money + Others
Food + Others
Others + Others

17. 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

18. Misconceptions about Riba
Several misconceptions about riba and its prohibition, resulting in confusion in its applications
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

19. 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

20. 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

21. 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

22. 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

23. M4a: “Riba allowed for commercial loans”
Misconception
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
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 ( A.D.)
Nature of Qur’anic prohibition - includes all forms of riba regardless of whether or not prevalent at time of its revelation

24. M4b: “Riba allowed for commercial loans”
Addressing this Misconception (Continued)
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

25. M4c: “Riba allowed for commercial loans”
Addressing this Misconception (Continued)
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

26. 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

27. 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

28. 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
Gharar yasir (minor or slight)
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

29. 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

30. Differences: Risk (Ghurm) and 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

31. 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)

32. 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

33. 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
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

34. Examples of valid counter-value (‘iwad )
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
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
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

35. Is there ‘iwad in conventional banking?
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

36. Is there ‘iwad in conventional banking?
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

37. Is there ‘iwad in conventional banking?
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

38. 2. Islamic Business Ethics and Norms

39. 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

40. 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

41. 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

42. 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

43. 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

44. 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

45. Concluding article

46. References Ayub (2008), pp. 43-70 Haron and Azmi (2003), pp.
Iqbal and Mirakhor (2007)