Part Two: AN INTRODUCTION TO ISLAMIC FINANCE

Author: Ismail Nizam

Shari'ah Concepts in Islamic Finance

(1) Wadi'ah (safekeeping): In some countries deposit products are designed based on wadi'ah contract. Customers deposit funds with the bank and the bank quarantees refund of any part or the whole when requested by the depositor. The Bank can also use the pool of deposits for making profits for the bank. The bank is not obliged to pay any part of profit to depositors. But banks can give a hibah - which is discretionary. The bank can also charge a fee for the custodianship.

(2) Mudharabah (profit sharing): This is a form of investment in which one party provides capital and another party carries out a profitable venture or investment. Profits from the venture or investment is shared between the parties according to a pre-agreed ratio. Parties cannot quarantee a fixed amount of profit or a percentage of capital as profit. However, whatever profit that is earned is shared based on pre-determined ratio. Losses are borne by the capital provider.

(3) Musharakah (Profit and Loss Sharing): This is a form of investment where two or more parties pool capital to carry out a partnership venure or investment. Profits from the venture is shared based on an agreed ratio. Losses are shared according to the ratio of capital contribution. One or more parties can be incharge of management of the partnership or venture. Parties can also employ a third party for running the partnership on the basis of wakalah or ijarah. If one or more of the partners are managing the business, they may be paid management fee out of the profit before it is distributed among the partners.

(4) Murabahah (Mark-up sale): This is form of trading arrangement where a party buys an asset and sells to another party for a price which consists of the cost plus a margin of profit. Murabahah can be of two kinds - cash murabahah and credit murabahah. Cash Murabahah is buying an asset and selling it for a marked up price for cash. Credit Murabahah is a type of trading arrangement where an asset is bought by one party and sold to another party for a deferred price. The price includes cost plus a margin. The deferred price can be settled by installements or by lump sum after a specific time. This kind of arrangement is called Bay' Bi-thaman Al-Ajil.

(5) Bay'u al-salaam (Advance Sale): Bay' Salaam is a special type of sale where the price for a specific type of defined quantity is paid in advance for goods to be delivered in a future date. This type was traditionally used in agriculture where certain quantity of agricultural products would be sold in the beginning of a season for advance cash payment and goods to be delivered after a specified time. For example; 'Ali pays to Qadir Mrf2000 for 400 kg of watermelon today and the delivery of 400 kg of watermelon is agreed to be 6 months from today.

(6) Bay'u al-Istisna (Contract Manufacturing): This is also a special kind of sale which is applied in the manufacturing sector. In the case of Istisna, a buyer places an order for a particular product with well defined specifications, then the seller (producer) accepts the order and produces the product for specification. The price will be settled once the product is delivered to the buyer. Special arrangement for price settlement could be arranged such that installment payments are made as production completes stage by stage. For example, the price for construction of a house on Istisna basis could be made as follows;
(a) 10% when foundation is completed
(b) 15% when concrete framework is completed
(c) 10% when walls are completed
(d) 10 when walls are painted with doors and windows in place, and so on.

(7) Qard al-hassan (benevolent loan): This is an interest free loan intended to remove the sufferings of the needy people. An amount is lent to be repaid in a future date, but without any extra charge for the delay in repayment.

(8) Ijarah (Leasing): Under Ijarah arrangement, one party buys an asset and rent it to another party for rental payments. For example, an Islamic Bank can purchase a house and rent it to a customer for monthly rental. Contemporary Islamic banks have developed very creative products based on ijarah principles. AITAB (Al-Ijarah Thumma Al-Bay'u) is an example. Under this contract, an Islamic bank buys, say a car, from a manufacturer and rents it to a customer for a defined period of time. At the end of the lease period, say 15 years, the bank customer will buy the asset from the bank for a nominal price or the bank can give the car as a gift or hibah. The lease period and the rental will be determined such that at the end of the lease period the bank makes revenue over the break-even.

(9) Bay'u al-'Inah (back-to-back sale): Although shar'iah scholars have disputed on the permissibility of bay'u al-'inah, this contract is used in some countries. Bay'u al-'inah is popular in Malayisa, but the popularity is declining gradually. Bay'u al-'inah is considered shari'ah non-compliant in GCC countries, because majority of scholars such as hanafi, hanbali and maliki say bay'u al-'inah is illegal. Under bay'u al-'inah, a seller sells an asset to a buyer for deferred price and immediately buys it back from the buyer for cash, which much lower price than the deferred price. There are three types of bay'u al-'inah;
(a) The seller sells to the buyer at a higher price to be paid later. After delivery to the buyer, the seller buys in cash at a much lower price.
(b) The seller sells a product for deferred delivery for, say RM800. After delivery to the buyer, he sells it to a third party for a lower price, say RM400. The third party then sells it to the first party for, say RM400. This is called al-tawarruq.
(c) A man who wants to borrow, say RM800. The creditor refuses to lend using qard contract. He sells an asset to the borrower for deferred price of RM1000, the market price will be RM800. The lender makes RM200 profit from this transaction. He will be paid RM1000 for a good that cost RM800 by the borrower later.

(to be continued...)

Part One: AN INTRODUCTION TO ISLAMIC FINANCE

Author: Ismail Nizam

An Overview

Islamic Finance industry is a fast growing industry worldwide. An industry which had a very humble beginning is now growing at an average rate of 15% per year, perhaps 20% in some parts of the world. There are about 550 Islamic Financial Institutions in over 75 countries (Ayub, 2007, p. 15). Islamic Finance industry is not only growing in Islamic countries but also in non-Muslim countries where Muslims are a miniority of the population. Countries such as the USA, UK and other European countries have a well developed Islamic Financial Industry with well functioning Islamic capital Market.

What is Islamic Finance?

Islamic Finance is the provision of a shari'ah based financial services. Islamic Finance is governed by a branch of fiqh known as figh mu'amalat. This is an industry which is heavily regulated by the principles of Islamic shari'ah, and hence run consistently with the doctrines of Islamic fiqh. Transactions involved in Islamic Financial Market are interest free. It also prohibits transactions that invlove dealing in prohibited products, and processes. One of the key elements of shariah based financing is the imposition of moral values which covers fairness and justice to parties involved in a transaction. Potecting the public interest of the whole economy is central to the functioning of the whole financial system. Islamic Financing is based on profit and loss sharing, which is also known as participative financing or risk sharing investments.

Regulating Islamic Finance Industry

As I have said earlier, Islamic Finance industry is a highly regulated industry. In fact, any financial system is expected to have more regulations than any other industry because all other industries heavily depend on financial industry. Any shake in financial industry would shake all other industry severer than the financial industry.

Stringent and proper monitoring and supervision of Islamic Finance sector is essential for protecting the welfare of the public. This industry is regulated by the principles of fiqh mua'malat whose rulings are derived from both primary and secondary sources of Islamic Shari'ah. Primary sources of Islamic shari'ah consists of Al-Qur'an and the Sunnah, while the seondary sources are consensus of scholars, lexicons, and ijthihad.

Constitutionally, financial institutions operating in different countries are required to have a shari'ah advisory committee to advise on shari'ah issues relating to the products and services offered by them. These shari'ah advisory committees of the industry players do not have ultimate authority to approve products and services in some countries. For example, in Malaysia, all banks and other financial institutions such as takahful operators are required by law to appoint a shari'ah advisory committee, but the final approval of products to be offered in the market must be authorised by the Shari'ah Advisory Council of the Central Bank (Bank Negara Malaysia).

(To be continued...)

PART-2: EXPLAINING RIBA - MISCONCEPTIONS

Author: Ismail Nizam

The prohibition of Riba is clear-cut in Shari'ah. Riba is very clearly explained and prohibited in the Qur'an and Sunnah. Muslims unanimously accept that Riba is haram.

The issue is whether bank interest is Riba or not. Shari'ah scholars (except view modern scholars) agree that bank interest and Riba are same and prohibited. However, many Muslims do not think that bank interest is similar to Riba and it is prohibited. This attitude towards interest can be seen in almost all societies. The main reason for this is the lack of proper knowledge and understanding of interest and Riba.

Following are some of the misconceptions about Riba and interest;

(1) Bank interest is not prohibited because it is not excessive (usurious).

(2) Riba should be allowed under dharurah (necessity).

(3) Riba accrues only in consumption loans, not in production or commercial loans.

(4) Riba should be prohibited only when there is injustice.

(5) Interest should be allowed because of inflation.

(6) Interest is justified on the grounds of default risk.

(7) Banks are justified charging interest as they expend effort in providing financial intermediation services.

The above mentioned 7 are some of the reason used by the critics of Interest-Riba Equivalence teaching of Islam. It is worth evaluating them to see how far they hold logical and applicable. Let me address each misconception one by one;

Bank interest is not prohibited because it is not excessive (usurious)

People who raises this argument base their reason on a Qur'anic verse (Al-'Imran 130) which states "O you who believe! Do not eat Riba doubled and redoubled."Based on this verse they say that if the interest is not excessive, it is not Riba.

The very first remark I would like put forward is that they are in error. They are using a wrong methodology in understanding and practising the Qur'anic teachings. A thorough analysis of the verses of the Qur'an would very clearly show that 3:130 is not the last verse of Qur'an on Riba. Rather, it is a verse in the third stage of prohibition of Riba according to Scholars. Riba, like wine, is prohibited in stages. The verses revealed later on Riba gives a clear ruling that anything above the principal amount of a loan is Riba. (to be continued...)

PART-1: EXPLAINING RIBA

Author: Ismail Nizam

The literal meaning of the Arabic word riba is increase, addition or growth, though it is usually translated as 'usury'. As the following discussion shows, usury is not to be regarded solely as the practice of taking interest on a loan.

There are many classifications of riba. The two commonly defined classification of riba are riba al-fadl and riba an-nasiah, and two kinds of transaction into which these elements may be incorporated are riba al-buyu and riba al-qard.

Riba al-fadl involves a hand-to-hand exchange of unequal qualities or quantities of the same class of commodities, and could be described as the usury of surplus. Riba an-nasiah - the usury of waiting - involves the deferred exchange of equal qualities and quantities of the same commodity and does not therefore involve a surplus but only a difference in the timing of exchange. Some writers employ the term riba an-nasa to define such an exchange.

An exchange in which person-A gives 10 kg of rice now in return for 10 kg of rice to be received from person-B tomorrow can be described as riba an-nasiah. An exchange in which person-A gives 10 kg of rice now in return for 15 kg of rice to be received from person-B now can be described as riba al-fadl.

It is argued that modern day interest bearing loan is a combination of both riba an-nasiah and riba al-fadl as there is both a delay and a surplus involved in such transactions. It is one of the widespread forms of riba. The debt may arise from either lending money or from the purchase of an item on credit. In either case, the debtor enters into a contract to repay the lender a pre-agreed amount of wealth in addition to the original debt in return for a delay in the timing of repayment.

Riba al-buyu - the usury of trade - is a second major form in which the elements of riba al-fadl and riba al-nasiah may appear. In order to avoid riba al-buyu, both the quality and quantity of the exchanged items must match and the exchange must be simultaneous. Hence, if dates are to be exchanged for dates, the quality and quantity of the dates must be the same and the exchange must be made on the spot.