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ISLAMIC BANKING AND FINANCE

ISLAMIC BANKING AND FINANCE

CONTENTS

Sources of Sharia' law: legal basis for Islamic bankingIslamic Law of Contracts Six key Islamic banking principlesDefinition of asymmetric information, Adverse Selection, Moral hazardOrigins of asymmetric risk within Islamic bankingRIBA, ITS PROHIBITION & CLASSIFICATIONSFive reasons for the prohibition of Riba

SHARIA LAW

Shariaa: A Shariaa compliant product must meet all the requirements of Islamic law.To facilitate this, a Shariaa Supervisory Board is usually appointed. This board or committee is usually comprised of Islamic scholars available to the organization, for guidance and supervision, for the development of Shariaa-compliant products.The SSB guarantees, and certies, that the banking activities are halal (permissible).

Sources Of Sharia Law

Fiqh is an expansion of Shariah or Islamic law based on five sources which are classified into primary and secondary:Primary sources: The Quran SunnahSecondary sources: Ijma(Consensus of opinion) Qiyas Ijtihad

QURAN

QURAN

Quran literally means reading or recitation. It is a proof of the prophecy of Mohammed, the most authoritative guide for Muslims, and the primary source of the Shariaa. The main attributes are: it was revealed exclusively to the Prophet Mohammed it was put into writingit is all mutawatir (universally accurately reported)it is the inimitable speech of Godit is recited in salah (ritual prayer).

SUNNAH

SUNNAH

Sunnah is the actual embodiment of the will of Allah shown in the actions of His Messenger(PBUH).The Holy Quran being the word of Allah treats, major issues and often deals with subjects in brief terms, leaving details to be explained by Holy ProphetIn the Quran we are commanded to pay zakat by all Muslims. But the percentage and exact amount is unspecified. All these details were learnt by the Prophets deeds or words. The clarification of the Quran was provided by the Holy Prophet(PBUH) who himself participated in Shariah formation.

IJMA

Ijma can be dened as the consensus of opinion of the Companions of the Prophet (Sahaba) and the agreement reached on the decisions taken by the learned Muftis, or Jurists, on various Islamic matters Ijma represent authority. Once an Ijma is established it tends to become an authority in its own right

QIYAS

Qiyas means measuring or ascertaining the length, weight or quality of something Qiyas is the legal principle introduced in order to derive a logical conclusion of a certain law on a certain issue that has to do with the welfare of Muslims. In exercising this, however, it must be based on the Quran, Sunnah and IjmaIt is perfectly acceptable, in using Qiyas, to derive a logical conclusion in Shariaa law in as much as that conclusion does not go against the injunctions of the Quran or the Sunnah of the Prophet.

IJTIHAD

Ijtihad is the making of a decision in Islamic law by personal effort, independantly of any school of jurisprudence, following the decisions of religious expert without necessarily examining the scriptural basis or reasoning for that decision.Qualification of Mujtahid:A mujtahid is an Islamic scholar who is competent enough to interpret shariah by ijtihad. He should fulfill the following conditions to be a mujtihad, Upright character whose judgment people can trust. Knowledge of the Quran. Knowledge of Hadith. Knowledge of Arab linguistics Knowledge of Qiyas.

ISLAMIC LAW OF CONTRACTS

CONTRACTS

A voluntary, deliberate, and legally binding agreement between two or more competent parties. Contracts are usually written but may be spoken or implied, and generally have to do with employment, sale or lease, or tenancy.A contractual relationship is evidenced byan offer,acceptance of the offerA valid (legal and valuable) consideration.

Legal Definition Of A Contract Under Islamic Law

Contract in Arabic is called Aqd. Literal meaning of Aqd is to bind or to strengthen. The word Aqd is also used in Arabic in the sense of confirming an oath. As such, any covenant, pact, agreement and treaty will also be referred to as Aqd since all of them demonstrate firm resolve for execution. Plural of Aqd is Uqood.

PREREQUISITES

According to Sharia, a contract cannot be defined as such unless it has the following four pre-requisites.1)Existence of minimum two parties:A contract cannot be formed with the presence of a single party. Although a single intention may lead to various obligations, such as remission of a debt or declaration of donation, etc, these cannot be called contract in Sharia.2) Offer and acceptance: It is necessary for a contract to have consent by both parties over the purpose and content of the contract. In Arabic it is called Ijab wa Qabool, meaning 'Offer' (Ijab) and 'Acceptance' (Qabool).

PREREQUISITES

3) A condition that is against the contract and not in market practice but is in favor of one of the contractors or subject matter, the condition is void. For example if A sells a car with a condition that will use it on a fixed date every month, this contract will be void.4) A condition, which is against the contract, not in the market practice and not in favor of any contractor, that is not a void condition. For example if both A and B decide to give to charity, a certain percentage of both subject matter and cosideration, upon completion of sale.

Now a question arises what is the ruling of void condition, whether it invalidates the contract or not? VOID CONDITIONS AND VOID CONTRACTS:The contracts of compensation (Uqood Muawadha) like sale, purchase, lease agreements become void by putting void condition. Non-compensatory (voluntary) agreements (Uqood Ghair Muawadha) like contract of loan (Qard-e-Hasanah), do not become void because of void condition. The void condition, however, becomes itself ineffective.

SIX KEY ISLAMIC BANKING PRINCIPLES

KEY PRINCIPLES

Six key principles drive the activities of Islamic banks:Predetermined loan repayments as interest (riba) is prohibitedProt and loss sharing is at the heart of the islamic systemMaking money out of money is unacceptable (all financial transactions must be asset backed)Speculative behavior is prohibitedOnly shariaa-approved contracts are acceptableContracts are sacred.

Predetermined Payments are Prohibited

Any predetermined payment over and above the actual amount of principle is prohibiten. Islam allows only one kind of load and that is Qard-e-Hasanah(literally meaning good loan), whereby the lender doesnt charge any interest or additional amount over the money lent.

Prot And Loss SharingThe principle here is that the lender must share in the prots or losses arising out of the enterprise for which the money was lent.Islam encourages Muslims to invest their money and to become partners in order to share prots and risks in a business instead of becoming creditors.Islamic nance is based on the belief that the provider of capital and the user of capital should equally share the risk of business ventures, whether those are industries, services companies or simple trade deals.Translated into banking terms, the depositor, the bank and the borrower should all share the risks and the rewards of nancing business ventures.

Risk SharingOne of the most important features of Islamic banking is that it promotes risk sharing between the providers of funds (investors) and the users of funds (entrepreneurs). By contrast, under conventional banking, the investor is assured of a predetermined rate of interest.In conventional banking, all the risk is borne by the entrepreneur. Whether the project succeeds and produces a prot or fails and produces a loss, the owner of capital is still rewarded with a predetermined return. In Islam, this kind of unjust distribution of risk is not allowed.

Making Money Out of Money is Not AcceptableMaking money from money is not Islamically acceptable. Money, in Islam, is only a medium of exchange, a way of dening the value of a thing. It has no value in itself, and therefore should not be allowed to generate more money, via xed interest payments, simply by being deposited in a bank or lent to someone else.Muslims are encouraged to spend and/or invest in productive investments and are discouraged from keeping money idle. Hoarding money is regarded as being Islamically unacceptable. In Islam, money represents purchasing power, which is considered to be the only proper use of money

Uncertainty is ProhibitedGharar (uncertainty, risk or speculation) is also prohibited, and so any transaction entered into should be free from these elementsContracting parties should have perfect knowledge of the counter-values intended to be exchanged as a result of their transactions Also parties cannot predetermine a guaranteed profit.The rationale behind the prohibition of gharar is the wish to protect the weak from exploitation. Therefore, options and futures, considered to be very risky, are deemed to be forbidden as are forward foreign exchange transactions, given that forward exchange rates are determined by interest rate differentials

Only Shariaa-Approved Contracts are AcceptableConventional banking is secular in its orientation. In contrast, in the Islamic system, all economic agents have to work within the ethical system of Islam. Islamic banks are no exception. As such they cannot nance any project that conicts with the Islamic moral value system. For example Islamic banks are not allowed to nance a wine factory, a casino, a night club or any other activity prohibited by Islam or known to be harmful to society

SANCTITY OF CONTRACTThe basic principles of the law are laid down in the four root transactions ofsales (bay): transfer of the owne

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