islamic banking and finance presentation

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ISLAMIC BANKING AND FINANCE

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Page 1: Islamic banking and finance presentation

ISLAMIC BANKING

AND FINANCE

Page 2: Islamic banking and finance presentation

CONTENTS•Sources of Sharia' law: legal basis for Islamic banking•Islamic Law of Contracts •Six key Islamic banking principles•Definition of asymmetric information, Adverse Selection, Moral hazard•Origins of asymmetric risk within Islamic banking•RIBA, ITS PROHIBITION & CLASSIFICATIONS•Five reasons for the prohibition of Riba

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SHARIA LAW•Sharia’a: A Sharia’a compliant product must meet all the requirements of Islamic law.To facilitate this, a Sharia’a 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 Sharia’a-compliant products.•The SSB guarantees, and certifies, that the banking activities are halal (permissible).

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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

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QURAN

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QURANQur’an 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 Sharia’a. The main attributes are:• it was revealed exclusively to the Prophet Mohammed• it was put into writing•it is all mutawatir (universally accurately reported)•it is the inimitable speech of God•it is recited in salah (ritual prayer).

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SUNNAH

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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 Prophet•In 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 Prophet’s deeds or words. The clarification of the Quran was provided by the Holy Prophet(PBUH) who himself participated in Shariah formation.

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IJMA •Ijma can be defined 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

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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 Qur’an, Sunnah and Ijma•It is perfectly acceptable, in using Qiyas, to derive a logical conclusion in Sharia’a law in as much as that conclusion does not go against the injunctions of the Qur’an or the Sunnah of the Prophet.

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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.

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ISLAMIC LAW OF

CONTRACTS

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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 by(1)an offer,(2)acceptance of the offer(3)A valid (legal and valuable)

consideration.

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Legal Definition Of A Contract Under Islamic

LawContract 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.

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PREREQUISITESAccording 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).

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PREREQUISITES3) 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.

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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.

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SIX KEY ISLAMIC BANKING

PRINCIPLES

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KEY PRINCIPLESSix key principles drive the activities of Islamic banks:•Predetermined loan repayments as interest (riba) is prohibited•Profit and loss sharing is at the heart of the islamic system•Making money out of money is unacceptable (all financial transactions must be asset backed)•Speculative behavior is prohibited•Only sharia’a-approved contracts are acceptable•Contracts are sacred.

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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 doesn’t charge any interest or additional amount over the money lent.

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Profit And Loss Sharing

•The principle here is that the lender must share in the profits 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 profits and risks in a business instead of becoming creditors.•Islamic finance 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 financing business ventures.

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Risk Sharing•One 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 profit 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.

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Making Money Out of Money is Not Acceptable

•Making money from money is not Islamically acceptable. Money, in Islam, is only a medium of exchange, a way of defining the value of a thing. It has no value in itself, and therefore should not be allowed to generate more money, via fixed 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

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Uncertainty is Prohibited•Gharar (uncertainty, risk or speculation) is also prohibited, and so any transaction entered into should be free from these elements•Contracting 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

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Only Sharia’a-Approved Contracts are Acceptable

Conventional 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 finance any project that conflicts with the Islamic moral value system. For example Islamic banks are not allowed to finance a wine factory, a casino, a night club or any other activity prohibited by Islam or known to be harmful to society

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SANCTITY OF CONTRACTThe basic principles of the law are laid down in the four root transactions of•sales (bay): transfer of the ownership or corpus of property for a consideration•hire (Ijara): transfer of the usufruct (right to use) of property for a consideration•gift (hiba): gratuitous transfer of the corpus of property•loan (ariyah): gratuitous transfer of the usufruct of property

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CONTINUED•These basic principles are then applied to the various specific transactions of, for example, deposit, guarantee, agency, assignment, land tenancy, waqf foundations (religious or charitable bodies) and partnerships.•Islam upholds contractual obligations and the disclosure of information as a sacred duty. This feature is intended to reduce the risk of asymmetric information and moral hazard, defined in the next section, which are potentially major problems for Islamic banks.

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DEFINITION OF ASYMMETRIC INFORMATION

•Asymmetric information can be defined as information that is known to one party in a transaction but not to the other. The classical argument is that some sellers with inside information about the quality of an asset will be unwilling to accept the terms offered by a less informed buyer. This may cause the market to break down, or at least force the sale of an asset at a price lower than it would command if all buyers and sellers had full information•Lack of sufficient information creates problems before and after the transaction is entered into, which is potentially a major problem with Islamic profit-sharing financial contracts. The presence of asymmetric information normally leads to adverse selection and moral hazard problems

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DEFINITION OF ADVERSE SELECTION

•The term refers to the problem created by asymmetric information before the transaction occurs.•It occurs when the potential borrowers are the ones most likely to produce an undesirable (adverse) outcome•Bad credit risks are the ones who most actively seek out a loan and are thus most likely to be selected. This is potentially problematic with Islamic profit-sharing financial contracts.

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DEFINITION OF MORAL HAZARD

•Moral hazard is the consequence of asymmetric information after the transaction occurs.•The lender runs the risk that the borrower will engage in activities that are undesirable from the lender’s point of view because they make it less likely that the borrower will repay the loan.

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Classification of Riba

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Definition of Riba or Interest

▣The word “Riba” means excess, increase or addition, which correctly interpreted according to Shariah terminology, implies Any excess compensation without due consideration (consideration does not include time value of money).

▣This definition of Riba is derived from the Quran and is accepted by all Islamic scholars.

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(a) Riba-un-Nasiyah or Riba-al-

Jahiliya

(b) Riba-al-Fadl or Riba-al-Bai

Classification of Riba

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Riba-un-Nasiyah or Riba-al-Jahiliya

“that kind of loan where specified

repayment period and an amount in

excess of capital is predetermined”. (

Imam Abu Bakr Jassas Razi)

Classification of Riba

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Riba-un-Nasiyah or Riba-al-Jahiliya

Real and primary form of riba.Premium paid to the lender in return for his waiting/giving or taking of every excess amount in exchange of a loan at an agreed rate irrespective of whether it is low or high.

Classification of Riba

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Riba-al-Fadl

▪Excess taken in exchange of

specific commodities which

are homogeneous.

▪Legal definition differs in

every fiqh.

Classification of Riba

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Hadith prohibiting Riba-al-Fadl▪ ‘sell gold in exchange of equivalent gold▪ sell silver in exchange of equivalent silver▪ sell dates in exchange of equivalent dates▪ sell wheat in exchange of equivalent wheat▪ sell salt in exchange of equivalent salt ▪ sell barley in exchange of equivalent barley

Classification of Riba

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Hadith prohibiting Riba-al-Fadl▪Sell barley in exchange of

equivalent barley but if a person transacts in excess, it will be riba.

▪However sell gold for silver anyway you please on the condition it is hand-to-hand(spot sales) and sell barley for date anyway you please on the condition it is hand-to-hand(spot sales)

(Kanz ul Amaal)

Classification of Riba

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Imam Abu Hanifa on Riba-al-Fadl▪ Commodities must have two

common characteristics ▪Weight▪Volume

▪ Includes all commodities having

weight or volume and are being

exchanged

Classification of Riba

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Imam Shafi on Riba-al-Fadl▪Commodities must have two

common characteristics ▪be a medium of exchange▪be edible

▪Includes all commodities that

are edible or can be used as a

medium of exchange(currency).

Classification of Riba

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Imam Maalik on Riba-al-Fadl▪commodities must have two

common characteristics ▪can be preserved▪be edible

▪ includes all commodities

that are edible and can be

preserved

Classification of Riba

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Imam Ahmad Bin Hanbal on Riba-al-Fadl

▪First citation conforms to the opinion of Imam Abu Hanifa

▪Second citation conforms to the opinion of Imam Shafi

▪Third citation includes three characteristics at the same time i.e. edible, weight and volume

Classification of Riba

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Present day Islamic scholars on Riba-al-Fadl

▪If two characteristics i.e. weight and use as medium of exchange is present then the following transactions are not allowed▪a deferred sale of goods having weight and homogeneous nature

▪a sale of unequal goods having weight and homogeneous nature

Classification of Riba

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First law

▪Exchange of any of the six

commodities with itself but

differing in quality, is

allowed only under certain

conditions

The Laws of Riba Al Fadl

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First Law CONDITIONS OF EXCHANGE

• Any difference in value/quality should be ignored

• The commodities should be exchanged in equal amounts (equal weight and volume).

• No direct exchange of commodities of the same kind

• A person should sell his commodity against cash at the market value and buy someone else’s commodity in exchange of cash proceeds at the market value.

The Laws of Riba Al Fadl

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Second law

▪Exchange of a product with

its raw material is allowed

under certain conditions

The Laws of Riba Al Fadl

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Second LawCONDITIONS OF

EXCHANGE▪ If the characteristics of the product

has been totally changed by the industry, then different amounts can be exchanged.

▪ If little difference has been made ▪ either the exchange should be in

equal weights ▪ or one of the commodities should be

sold in the market and the cash proceeds used to buy the then one.

The Laws of Riba Al Fadl

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Third Law

▪ Exchange of any of the six commodities with one another is allowed in unequal amounts but the payment should not be deferred

▪Provided that the general

conditions of a sale contract are

fulfilled

The Laws of Riba Al Fadl

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□Tijarti Sood(Commercial interest)▪ interest paid on loan taken for

productive and profitable purpose

□Sarfi Sood (Usury)▪ interest paid on loan taken for

personal need and expenses

Types of Riba

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Regarding validity of Commercial Interest there are two schools of thought on this issue.

A detailed analysis of their arguments is discussed as follows:

Riba-Present Day Arguments

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Argument 1: “Riba as practiced during the days of the Prophet (SAW) was only Usury”.

▣ Islam when prohibiting something does not only prohibit the prevalent form, but all forms that might erupt in future. The changed state does not change the ruling. E.g. Liquor, Pork, Corruption/Immorality: Today’s modern and sophisticated forms does not change their rulings.

▣ The same applies to interest and gambling.

The Laws of Riba Al Fadl

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First School

Argument 2: “Commercial interest did not exist in the days of Prophet (SAW).”

This claim is wrong as both forms of interest existed in Islamic

and pre Islamic history. Some examples: ▣ The tribe of Umr bin Aamir used to take interest from

the tribe of Mughairah. (Dar ul Mansoor by Ibn Jareeh)▣ The tribe of Thaqeef advanced cash as well as

commodities on interest to the natives of Taif, the tribe of Mughairah and the business community of Makkah. (Encyclopedia of Islam)

▣ H.Abbas and H. Khalid bin Waleed (RA) formed a company with joint capital whose prime business was cash advancement on interest. (Jamai ul Bayan)

▣ Hazrat Usman (RA) (pre-Islamic times) lent money on interest. (Tareekh e Tabree)

Riba-Present Day Arguments

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Second School :

3) Argument 1: The present day banking since no-one is exploited or faces injustice, therefore it cannot be called Riba.” ▣Islam has not only prohibited that one

party faces a loss and the other gets profit but also prohibits one party getting confirmed profit and the other party unconfirmed profit from the same investment.

Riba-Present Day Arguments

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Second School:

4) Argument 2: There is a Qura’nic verse “O believers do not devour one another’s possession wrongfully; rather than that, let there be trading by mutual consent” (Al Nisa verse 29). “Wrongful devouring” only arise if the consent of one of the parties is absent but in commercial interest the mutual consent is present of both parties, so its not Riba.

▣ Mutual consent is not the criteria to render anything halal which is haram.

Riba-Present Day Arguments

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□Riba al Nasiah is also classified as:

▪Sood-e-Mufrad( Simple

Interest)▪interest calculated only on the initial investment

▪Sood-e-

Murakkab(Compound

Interest)▪reinvestment of each interest payment on money invested to earn more interest

Riba-Present Day Arguments

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▣During the pre-Islamic era, when a borrower used to fail to pay back the principal and interest charged on him, then the lender used to extend the loan on the condition that the interest will also become part of the loan (essentially Compound Interest).

Quran

Page 57: Islamic banking and finance presentation

Quran▣ “Seized in this state they say: ‘Buying and

selling is but a kind of interest’, even though Allah has made buying and selling lawful, and interest unlawful.” Al Baqarah 2:275

ضبطت في هذه الحالة يقولون : " بيع وشراء ما هو ▣إال نوع من االهتمام ، على الرغم من أن الله قد جعل بيع وشراء مشروعة ، و مصلحة غير مشروعة "

2سورة البقرة :

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QURAN▣“O believers, take not doubled

and redoubled interest, and fear God so that you may prosper. (Surah Al ‘Imran, verses 130-1)

يا أيها الذين آمنوا ، ال تتخذوا تضاعفت و ▣مضاعفة الفائدة، و اتقوا الله لذلك لعلكم ,Surah Al ‘Imran) . تفلحونverses 130-1)

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The following hadith also proves that both simple and compound interest are forbidden:

▣“Listen! all Riba liable to you in the pre-Islamic days have been completely eliminated. You have to pay back the principal amount only. Neither hurt someone nor get hurt by someone. And the first riba to be completely eliminated is Abbas bin Mutalib’s. (Ibn e Khatir)

Hadith

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Hadith▣From Anas ibn Malik : The

Prophet, , said: "If a man extends a loan to someone he should not accept a gift." (Mishkat, on the authority of Bukhara's Tarikh and Ibn Taymiyyah's al-Muntaqa)

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Asymmetric risk▣Risk an investor faces when

the gain realized from the move of an underlying asset in one direction is significantly different from the loss incurred from its move in the opposite direction.

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ORIGINS OF ASYMMETRIC RISK WITHIN ISLAMIC BANKING

▣The principle of PLS stipulates that the partners are free to determine the extent of their profit-sharing ratio regardless of their capital contributions

▣ Collateral cannot be provided with PLS activities in the event that the project fails due to business risk. So in the event of the project failing the Islamic bank is exposed to financial loss.

▣The result is that Islamic banks are subject to asymmetric risk.

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ORIGINS OF ASYMMETRIC RISK WITHIN ISLAMIC BANKING

▣To ensure timely payment of the repayment obligations plus the institution’s share of the profits (if any), the bank could impose a fine on those borrowers who do not pay on time.

▣As per principles of the Sharia’a these fines must be deposited with a charity

▣So if the borrower defaults there is no explicit protection for the Islamic bank. Again this is asymmetric risk

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ASYMMETRIC RISK▣Since PLS emphasises on

risk sharing▣financer should worry

about the profitability of the proposed project for which the loan is requested rather than the credit-worthiness of the firm

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ASYMMETRIC RISK▣The Islamic, interest-

free system, imposes the burden on depositors of gathering information about the safety, soundness, riskiness and profitability of the bank. Again asymmetric risk is a problem

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FIVE REASONS FOR THE PROHIBITION OF RIBA

• it is unjust; • it corrupts society; • it implies improper appropriation of other people’s property;• it results in negative economic growth; • it demeans and diminishes human personality.

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Thank you