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Foundation of Islamic Finance ISF 1101

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1 Foundation of Islamic Finance ISF 1101

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

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)

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