t2_basic prohibitions and ethics

8/2/2019 T2_Basic Prohibitions and Ethics

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Foundation of Islamic Finance ISF 1101

TOPIC 2.BASIC PROHIBITIONS AND

BUSINESS ETHICS IN

ECONOMICS AND FINANCE


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TOPIC CONTENT

1.The Basic Prohibitions

2.Islamic Business Ethics andNorms


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1.

The Basic Prohibitions


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Three Basic Prohibitions

Islam does not recognize transactions that have provenillegitimate factors

Three factors/elements identified

interest - riba

excessive ambiguity - Gharar

gambling - Maysir

Lead to contracts to be void/invalid/nullified


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1. Prohibition ofRiba

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


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Evidence for Prohibition ofRiba

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: 275-281. 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 HisApostle

Various sunnah on prohibition ofriba, 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


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Rationale for Prohibition ofRiba (1)

Rationale/reasons for prohibition ofriba so as to better appreciate wisdom behind

injunction:

1. Element of injustice in financing productive activities

Contract with unequal countervalues

Injustice to debtor obligated to pay interest even if business ventureresults 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

2. 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


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3. Inconsistent with Islams 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 mans inherent greed to spend beyond their means

Result in negative repercussions

The outcome is the proliferation of a credit society


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4. 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 abdand 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


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5. 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


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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


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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


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Types ofRiba

1. Riba al-Qard (Riba al-Dayn- debt)

As being highlighted in Quran, thus also known as riba al-

Quran

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 specifiedtime period

2. Penalty imposed on delinquent debt repayment or default: Jahilliansdoubled the amount of debt outstanding if payment is overdue = riba al-jahiliyyiah


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Types ofRiba

2. Riba al-Bay (sale) Also known as riba al-Sunnah

The Arabs used certain commodities like wheat, barley, dates and salt

(termed as ribawiitems) as medium of exchange to purchase other things,

and as such they were like money

Applies to sale transactions in commodities


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Riba al bay (sale)(1)

Basis for prohibition ofriba 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 saltlike for like, equal for equal, and hand-to-hand (spot); if thecommodities 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-nasiah- 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


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Riba al bay(2)

Summary of rules

Exchange Condition(Amount & Time)

Money1 + Money1 Equality

Hand-to-hand (spot)

Food1 + Food1 Equality

Hand-to-hand (spot)

Money1 + Money2 Hand-to-hand

Food1 + Food2 Hand-to-hand

Money + Food

No conditions

free tradingMoney + Others No conditions free trading

Food + Others No conditions free trading

Others + Others No conditions free trading


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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 forsilver), 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


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Misconceptions about Riba

Several misconceptions about riba and its prohibition,resulting in confusion in its applications

1. Interest-based commercial transactions were invented by modern

day business, thus not covered by riba referred to in the Quran

2. Bank interest is not riba because it is not excessive (usurious)3. Riba should be allowed under dharurah

4. Riba is only relevant to consumption loans, not commercial loans

5. Interest should be allowed because of inflation


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M1a: Modern day interest is not riba

Misconception

Prohibition ofriba was revealed in the last daysof Prophets life

Did notelaborate on interpretation and definition ofriba

Ambiguity in meaning ofriba (area ofmutashabihaat): its prohibition

cannot be extended to modern day banking

Addressing Misconception

Including prohibition ofriba 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 ofriba Prohibition ofriba 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


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M1b: Modern day interest is not riba

Addressing this Misconception

Mutashabihaat: verses ofQuran 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 ofShariah 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 thecorrect nature is not known to anybody


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M2: If it is not excessive, it is not riba

Misconception Al-Imran (3:130) - O those who believe, do not eat up ribadoubled and

redoubled

If rate of interest is not excessive (e.g. doubled), then it does not constitute riba,

therefore not prohibited


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

Quran 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


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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 ones life from dying of hunger


Is the necessity real or exaggerated?

Can the necessity be met with by any other permissible means?

At the individual (debtor) level

Is purpose ofriba-based loan to protect an absolute necessity? Have all other permissible

alternatives been exhausted?

At the institutional (creditor) level

Removal ofriba from economy does not imply that financial institutions will have togive charitable (interest-free) loans


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M4a: Ribaallowed for commercial loans

Misconception1. 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

2. 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

3. Basic cause of prohibition ofriba, zulm (injustice), is absent


1. 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 ofriba-based commercial loans As early as 2000 B.C. in Babylon, 500 B.C. in Greece, in time of Byzantine emperor Justinian

(527-565 A.D.)

Nature ofQuranic prohibition - includes all forms ofriba regardless of whether or

not prevalent at time of its revelation


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M4b: Ribaallowed for commercial loans

Addressing this Misconception (Continued)

2. 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


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M4c: Ribaallowed for commercial loans

Addressing this Misconception (Continued)

3. Need to differentiate/understand illatand hikmat Illat Basic feature of the transaction vs Hikmat Wisdom or rationale

behind the prohibition

Application of law depends on illatand not hikmat

Illatof a law is always determinable by hard and fast definition that leaveslittle room for dispute

Zulm (injustice) is relative, ambiguous and subject to manipulation

Rationale for making application of law based on illatand 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


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M5: Inflation justifies interest

Misconception Interest represents compensation for erosion ofvalue 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


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2. PROHIBITION OF GHARAR

Literally: Deceit, fraud, uncertainty, danger, peril, or hazard that mightlead 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 ofghararsale

Sale of fish still in the sea

Sale of birds in the air

Sale of unborn animals


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Prohibition ofgharar

All jurists agree that ghararshould be avoided in commercial

exchange contracts

Contemporary scholars differentiate between minor and

major gharar

Types ofgharar

1. Gharar yasir (minor or slight)

Can be tolerated and will not invalidate a contract

If exist, contract still valid

2. Gharar fahish (major or excessive)

Not tolerated and may result in contract voidability

If exist, contract is nullify


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Prohibition ofgharar(2)

Rationale for prohibition ofgharar

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

Ghararin commercial contracts may lead to injustice,

exploitation and/or enmity among contracting parties

ff k ( h ) d h


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Differences: Risk (Ghurm) and Gharar

Ghurm

(Risk)

Gharar

(Uncertainty)

Permissibilityin Islam

Allowed in Islam, as per Islamiclegal maxim Al ghurmu bilghunmi(no risk no gain)

Prohibited (e.g. selling fish inthe sea, birds in the sky)

Characteristic Inherent in productive economicactivities

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 spiritand productivity

Exploitation for self interest,can lead to harm and injustice


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3. Prohibition ofmaysir/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)


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Prohibition ofmaysir/qimar

Injustice elements in gambling:

Winner:

-Does not lawfully earn what he has won

-Consume/enjoy others 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 andprohibit injustices


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Concept ofiwad

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

Shariah requires all legitimate exchange to contain iwad Every increase, which is without iwad or equal countervalue, is riba

[ Ibn al-Arabi ]

Components of iwad

1. Risk (ghurm): Market risk - price risk, holding costs, obsolescence2. Work and effort (ikhtiyar): Services or activities that value-add

3. Liability (daman): Product liability borne by seller, in event of defects


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Examples of valid counter-value (iwad)

1. Risk (ghurm) of trade or ownership (daman milkiyyah) TV manufacturer undertakes risk that he might produce TVs 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

2. 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

3. 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


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Is there iwadin conventional banking?

1. 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


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2. 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

Banks 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


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3. 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
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2.

Islamic Business Ethics and

Norms
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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 ofnajash (bidding up price without intention to takedelivery

Prohibition ofkhalabah (misleading marketing): over-projectingquality of commodity

Disclosure, transparency and facilitating inspection: role ofinformation
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IBs are required to adopt transparency, disclosure and

documentation

Lack of transparency may render the transaction to benon-shariah compliant

The Quran requires to write down and take witness inall business transactions

The nature of IBs require full documentation andtransparency between the bank and the clients

Hence, the possibility of IBs to engage in illegalactivities such as money laundering is lesser than CBs

TRANSPARENCY AND DOCUMENTATION
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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 ofthe 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
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3. Mutual Cooperation and Removal of Hardship

Mutual help, solidarity, and joint-indemnification of lossesand harm

No cut throat competition, unethical practices like fraud andforgery

Mentioned in the Quran 5: 2

This forms the basis oftakaful

-Concept ofaqilah (kin or persons of relationship) were validated by theProphet

-Principle of reciprocal compensation and joint responsibility-To enable burden and losses being shared and distributed
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4. Free Marketing and Fair Pricing

Exchange is permitted only when undertaken in permissiblecommodities and according to shariah rules and principles

Islam envisages a free market where fair prices are determinedby 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 andproduction 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 freecompetition
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5. Freedom from Dharar(Detriment)

Definition: Harm, injury, damage

Saving others from any harm due to a contractbetween 2 parties

Enforcement of rights with a provision that theinformationally disadvantaged party to reverseits position

Regulators are to ensure:

Fair play and justice for all

To take paternal approach to protect traders fromunhealthy practices of any market players

Provide the general public with necessaryinformation about the nature of business activities
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Concluding article

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References

1. Ayub (2008), pp. 43-70

2. Haron and Azmi (2003), pp.

3. Iqbal and Mirakhor (2007)
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t2_basic prohibitions and ethics

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