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Basic concepts of Islamic Banking

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ISLAMIC BANKING : Basic Concepts and PhilosophyBy

National Institute of banking and Finance, State Bank of Pakistan, Karachi

Muhammad Ayub

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PrePre-requisite for Isl. Banking Convincing clarity of the concepts All stakeholders Bankers, in particular Shariah scholars Regulators Product developers Implementers Those sitting at the front office2

Myths Any Return on deposits is Riba; Any prefixed return Riba Islamic banking: cost-less money costavailable Approach of Businesses Repayment of loans not a serious issue be waived of Trade profit similar to interest on loans / debts3

Myths (Contd) Credit and cash market prices of a commodity must be same Profit margin on credit sale by banks resembles Riba. Sharing vs. Non Sharing instruments: Permissibility & Priority two different aspects Money can be rented like other assets4

Loans in Islamic Financeother by way of virtue - same or similar amount of that thing would be paid back on demand or at the settled time. Dayn (Debt) : Incurred by way of rent or tradetradeought to be returned at the settled time without any profit.

Qard (Loan) : to give anything in ownership of

riyya: To give any commodity to other for usewithout taking any return for its use-Ghazwa useHunain; Camels and iron chest plates .

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Welfare Economy Framework Socio-economic & Distributive Justice Socio Ethics and value system Functioning of the Market & Role of the State: Right of ownership, freedom of enterprise, Competitive price mechanism Transparency and disclosures Over seeing role of the State; Creating additional value and sharing gains Closer linkage between real economy & finance6

Riba Prohibition Unanimity on Riba Prohibition; Prohibition; Problem then? Interpretation Consensus (Holy Quran gives principle defining Riba in Verse II-279). II-279)

O you who believe. Fear Allah, and give up the Riba that remains outstanding if you are (in truth) believer. (11:278).7

Riba - Unanimity (Contd)

If you do not do so, then be sure of being at war with Allah and his Messenger. Messenger. But, if you repent, then you have your principal. (11:279) principal. 11:279)

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And if you repent, then you have your principal. Wrong not, and you shall not be wronged . {without inflicting or receiving injustice}

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Foundation

Those who protested and argued that lending on interest was like an act of trade, were admonished through revelation that while trade was permitted, Riba was forbidden and in loan transactions they were entitled to their principal sums only.

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They used to say that it is all equal whether we increase the price in the beginning of the sale, or we increase it at the time of maturity. maturity. It is this objection which has been referred to in the verse by saying They say that the sale is very similar to Riba. (Ibn-Abi-Hatim) Riba. (Ibn-Abi11

Types of Riba Riba Al-Fadl - sale transactions, Al Quality premium in exchange of low quality with better quality goods of same kind; kind; prohibited e.g. dates for dates, wheat for wheat etc. etc. Riba Al-Nasia - loan transactions. Altransactions. Riba Al-Nasia (Riba Al-Ouran) involved in AlAlcredit/delay; credit/delay; modern banking transactions falls under Riba Al-Nasia, Al12

Overall Consensus Council of Islamic Ideology (CII): Preliminary Work CII Report on Elimination of Interest from the Economy (June, 1980) Unanimously Endorsed Representation of all Muslim sects in Pakistan Justice Dr. Tanzil-ur-Rahman (J Afzal Cheema) Tanzil-ur Mawlana Zafar Ahmad Ansari Mufti Sayyahuddin Kakakhel Khawaja Qamruddin Siyalvi Mawlana Muhammad Taqi Usmani Mawlana Muhammad Hanif Nadvi Allama Syed Muhammad Razi Mr. Khalid M Ishaq13

Prohibitions Earning returns from a loan or debt contract (Riba/Interest) Compensation-based restructuring of debts Compensation Excessive uncertainty in contracts in respect of the subject matter or the price. (Gharar) Gambling and chance-based games (Qimar) chance Selling debt contracts at discount Delayed exchange of foreign exchange14

Encouragements Benevolence Transparency and disclosures Purification of income Comprehensive and universal ethical approach Documentation15

Business Vs. Benevolence Banking or Benevolence ? Sharing of profit and loss on post facto basis arising from: i. (Deferred) Trading profit margin for Trading the seller ii. Rentals on leased assets iii. PLS iv. Combination of contracts Return free (loans)16

Businesses Modes Trading, Muzaraah, Musaqat (Gardening with Shirkah), Services (Ujrah and Ijarah) The Main businesses; Barter and the Money based transactions; Individual Businesses, with self capital or arranged on Riba; Loans, Debts (Credit /Forward contracts Salam/Salf Partnership

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Impact of contracts Bay: Definite transfer of ownership of goods against payment of price-spot, delayed and forward; price Hibah: Permanent transfer of ownership of assets free of any payment; Riba (al Nasia): Temporary transfer of ownership of goods/assets against payment; Qard Hassan / Tabarrue: Temporary transfer of ownership of goods/assets free of any payment; Ariyah: Temporary transfer of usufruct of goods along with or without assets free of any payments Ijarah: Transfer of usufruct of goods against payment of rent.18

Principles of Islamic Finance Lending a virtuous act Not a business. business. Prohibition of Riba and Gharar; permission of Gharar; trading. trading. All gains to principal not prohibited. prohibited. Deciding Factor: nature of transaction. Factor: transaction. Entitlement of profit: liability of risk of loss with the profit: capital itself; (Al Kharaj bil Daman) itself; Profit to be earned by sharing risk and reward of ownership through pricing of goods, services or benefits. benefits. Time has value that can be discounted only through price; not in the form of interest, price; sometimes negative value as well. well.19

Profit linked with Liability Ownership cannot be separated from the risk of its loss Al Kharaju Bil daman The above implies that entitlement to return from an asset is intrinsically linked to the liability of loss of that asset What that implies for the attitude towards risk? What that implies for time value of money?

in loans in deferred sales20

Principles of Islamic Finance(Contd) Ability to cause value addition. addition. Differentiating: Trading, loaning and leasing Differentiating: Ownership Transfer in: Sale of assets, Loans and Leasing; Any thing which cannot be used without consuming its corpus, or whose corpus changes its form in the process of its use, cannot be leased out like money, edibles, fuel, etc. Taking rent on leasing of asset permissible while rent on loan is prohibited. Repayment of loan- Must. loan- Must. Husan al qada: Repaying a loan in excess of the qada: principal. principal. Debt contracts cannot be sold at discount. discount.21

Prepayments Jews of Bani al Nadhir expelled from Madina, Daawoo wa Taajjaloo Another Hadith: Miqdad bin Aswad, 90 for 100 Drahim of Aswad, Loan; Holy Prophet termed it as Riba; Holy Prophet asked Kaab bin Malik to waive half of the debt payable by Abdullah bin Abi Hadrad; Jurists : remitted amount in case of Bani al Nadhir related to amount of Riba accrued to Jews Imam Malik: no difference of opinion about illegality of remitting a part of Dayn; Duyoon Haalah and Dyun Muajjalah; Remission in due loans allowed as delay is not right of the debtor: Shah Waliullah also of this view.

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Exchange Rules Different for different contracts and types of wealth: Goods, Durable assets, Shares representing pool of assets - Market based pricing Gold silver or any monetary units (Athman) Rules of Bai al Sarf Usufruct and services (Leasing/ Services) Loans/Debts Repayment or Assignment of the same amount. Well-Known Injunction on exchange of six Wellcommodities: Gold, Silver, Wheat, Barley, Dates and Salt. 23

Exchange Rules (Nawawi) Illah (Effective Cause of prohibition): Unit of value prohibition): and Edibility When underlying illah is different, short fall/excess and delay both are permissible, e.g. sale of gold for wheat. wheat. When commodities of exchange are similar, excess and delay both are prohibited, e.g. gold for gold or wheat for wheat, Rupee for Rupee, etc. etc. When commodities of exchange are heterogeneous but the illah is same, as in the case of gold for silver (medium of exchange) or wheat for rice (edibility), then excess/deficiency is allowed, but delay in exchange is not allowed. allowed. 24

Exchange of Currencies

Contd)

Special rules for exchange of monetary values. values. Forward Currency Contracts : Some scholars forbid them while others distinguish between the two cases: cases: First, where one currency is delivered on spot and the other is delayed - forbidden. forbidden. Second, permitted, involves the future exchange of both currencies at the previously agreed rate. rate. 25

Alternative Financing Principles Participation and sharing principle Deferred trading principle Interest free loans Combination of contracts26

Main Financial ContractsA. Debt creating Modes (Low Risk Category) 1. Qard Al-Hasan (interest-free loan) Al(interest2. Bai Muajjal (Price deferred sale) 3. Murabaha and Musawama 4. Salam (Commodity sale) 5. Istisnaa ((Order to Manufacture) Istisna B. Semi-debt Modes Semi1. Ijara C. Sharing or Non-debt Modes (Full Risk NonCategory) 1. Musharaka (Close to Venture Capital) 2. Specific Purpose Mudaraba 3. General Purpose Mudaraba

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Shirkah Rules Commingling by two or more persons, their money or work or obligations to earn a profit or a yield or appreciation in value