The Basis of Islamic Banking and Finance PDF

The Basis of Islamic Banking and Finance 1. Introduction 1 Islamic finance has been growing steadily at a compo...

The Basis of Islamic Banking and Finance 1. Introduction 1 Islamic finance has been growing steadily at a compound annual growth rate of 10.8% per year since 2006. As of 2020, worldwide Shariah compliant assets stood at US$1.7 trillion1. As such, it has become an increasingly attractive sector within the financial industry. To be able to understand Islamic finance, it is necessary to understand the underlying principles (outlined in this chapter) and recognise that Shariah governs all aspects of life. The term ‘conventional bank’ is used throughout this workbook, reflecting the fact that, within the Islamic financial industry, a conventional bank is understood to be a bank that is not based on Islamic principles. It is important to bear in mind that the workbook does not advocate any particular stream of the Islamic jurisprudence. The views on Islamic instruments presented throughout this workbook represent a generally accepted view of the financial instruments in the marketplace. 2. Islamic Banking and Finance: Conceptual Framework Learning Objective 1.1.1 Understand the ethical underpinning of Islamic finance: Islamic moral guidance governing property and wealth given through the Quran and Sunnah; to make charitable distributions: Zakat (obligatory) and Sadaqah (voluntary); the role of trade and investment in wealth creation; prohibition of Riba, gambling and Gharar Islamic commercial and financial ethics stem from the principles and rules of the Islamic faith and Shariah. Therefore, Islamic finance has a strong ethical underpinning as it is imbued with the concepts of efficiency (avoiding waste and resource misallocation), fairness (equitable distribution and non- monopolisation) and Ihsan (pursuing perfection and giving more than is due) which is clearly stated in some verses of the Quran: Allah commands justice (fairness), and (the pursuit of) virtue. (Surat Al Nahl, 16:90) 2.1 Islamic Commercial Ethics Islamic commercial and financial ethics are based on five main principles: 1. The Principle of Stewardship of Humanity on Earth The Quran designates human beings as Allah’s stewards in the created world. I will create a steward on earth. (Surat Al Baqara, 2:30) 1 https://www.thebanker.com/Markets/Top-Islamic-Financial-Institutions-2020 3 This verse affirms that man is responsible for developing the earth and the implementation of Allah’s (SWT) directives. SWT stands for Subhanahu wa Ta’ala, which has the meaning of ‘Blessed be His name’. It is placed after the name of Allah as a sign of reverence. Although private ownership is permitted, any personal wealth or property should be regarded by the individual as entrusted property from Allah (SWT). Ownership of assets is a means to provide a decent life for the owner, his family and society as a whole and not an end in itself. Fairness, justice and transparency in economic transactions are important characteristics and, in addition, the public and environmental good should be considered equally when using wealth or property in order to achieve fairness and perfection relating to society and nature. 2. Integrity Integrity is valued highly and should govern all acts. 3. Sincerity A person must always act with sincerity and should be fair and just. 4. Piety Piety implies that people have to be devout both in private and in public and that the values, norms and rules of Shariah will be implemented in all circumstances. 5. Righteousness and Perfection at Work A person must have the ability to perform his duties, but should not just confine himself to performing his occupational and professional duties. All people should strive to reach righteousness and perfection in all their religious, social and economic obligations. 2.2 Charitable Distribution Zakat, one of the five pillars of Islam, is mandatory almsgiving and is levied on anyone who has in excess of a minimum level of wealth (Nisab). For the calculation of Zakat, see chapter 4. The Quran also encourages Muslims to make voluntary charitable donations (Sadaqaat), the amount of which is dependent on the goodwill of the donor. Individuals are encouraged to prioritise the distribution of their charity as follows: They ask you about what they should spend (in charity), say, ‘whatever you spend on good (let it be first) on your parents, and (then) your close relatives, the orphans, the poor and the traveller and, whatever good you do, surely Allah knows’. (Surat Al Baqara, Verse 215) 2.3 Wealth Creation One of the major objectives of Shariah is the preservation of wealth. Preservation of wealth requires avoiding waste or improper use, but also entails the creation of wealth via appropriate means. Wealth creation is, therefore, in principle, an objective of Islamic economics, provided that it is directly linked to economic activity and production (see chapter 3). Making money purely from money (ie, lending on interest), gambling and deceptive uncertainty are prohibited for Shariah-compliant investors. This does not mean, however, that wealth creation as such 4  The Basis of Islamic Banking and Finance is prohibited. On the contrary, investments in trade and enterprises with a view to making a fair and 1 acceptable level of profit are encouraged. The challenge in Islamic finance is how to apply the basic principles of Shariah in such a way that individuals and organisations are able to finance their needs without violating the underlying principles. 2.4 Enterprise and Asset Bias As a result of the adherence to Shariah principles and its associated precepts, the modes of financing that can be applied differ from conventional banks. Conventional banking is largely based on lending and borrowing against interest, a practice that is prohibited in Islamic finance due to the prohibition of Riba (see chapter 3). In addition, within Shariah, deceptive uncertainty (Gharar – see chapter 3) is prohibited, which results in a situation where many derivative-type transactions that are common in conventional finance cannot be applied. The Islamic ban on interest does not mean that capital is costless in the Islamic system. Islam recognises capital as a factor of production. However, Islam regards finance as a means to undertake business activities: trade and production. The value of time is acknowledged in relation to economic value and wealth creation. Wealth and returns cannot be generated by pure lending and can only be created by means of real economic transactions. Legitimate transactions either involve ownership of goods and services, or represent an ownership stake in an enterprise. Both Riba and Gharar are forbidden as they decouple financial activities from the underlying real transactions, thus potentially creating an imbalance in the economy resulting in instabilities and crises. 3. Islamic Fundamentals Learning Objective 1.1.2 Understand the role and purposes of Shariah 3.1 Shariah and its Role Shariah is a comprehensive system of values, norms and rules governing all aspects of life. In Arabic, the word Shariah refers to a path, or to a water spring in which water is abundant and easily accessible. In early Islamic literature, Shariah refers to guidance and instructions concerning all Islamic teachings. In late Islamic literature, however, the meaning changed and mostly referred to rulings related to practical matters excluding matters of belief (Aqidah). Fiqh literally means ‘deep understanding’ and is often defined as jurisprudence. It represents the interpretations of Shariah scholars. Fiqh al Muamalat, ie, Fiqh related to worldly transactions, has developed over time from the Quran and the Sunnah, as well as the secondary sources (see section 3.2). 5 3.1.1 Morality of Shariah Although Shariah is often referred to as Islamic law, scholars clearly stipulate that it is a code of both moral and civil behaviour, simultaneously governing matters relating to this life and the hereafter.2 The relationship between the ethical and legal dimensions of Shariah is clear as Shariah rulings are categorised into two classes: 1. Religious verdicts (ahkam al-diyanah) – rulings on matters between a person and Allah (SWT). 2. Judicial verdicts (ahkam al-qadha) – rulings concerning actions before a judge or human court. However, despite the best efforts of a human judge, a court ruling cannot overrule a divine ruling. It is acknowledged that the world we live in is imperfect and that a human judge may not be in full possession of all relevant information. The moral dimension makes up for these imperfections which distinguishes Shariah from worldly legal systems. Example Although the Quran clearly forbids Israf (extravagant spending), a sale contract through which extravagant spending is conducted is legally valid. The contract is, however, not Shariah compliant. The sale of grapes for the purpose of making wine, or the sale of weapons for the purpose of killing innocents, is prohibited. The underlying sale contract is legally valid since the use of the asset is not stated in the contract. The contract is, however, not Shariah compliant. In either of these cases, a court is unlikely to invalidate the sale contract. It is the moral obligation of the seller not to conduct the sale if he has reason to believe the goods are intended to be used in a non- compliant manner. 3.1.2 Individual versus Collective Responsibility Shariah balances the responsibilities of the individual versus those of society. In this respect, the following two categories of obligation are identified: 1. Individual obligations (Fardh ‘ayn): to be fulfilled by each individual irrespective of other members of the society. The paying of Zakat is an example of an individual obligation. 2. Collective obligations (Fardh Kifayah): to be fulfilled individually or collectively. In the event they are not fulfilled, this will be the responsibility of every individual. For example, saving a drowning person is an obligation on all those nearby, but once some individuals start to rescue the person, there is no longer any obligation on the others unless called for by the rescuers. However, if no one volunteers to rescue the drowning person, each of them becomes accountable, both legally and morally. The same applies to, for example, taking care of orphans, the elderly and other philanthropic non-profit activities. Collective obligations also include building institutions vital for society, such as schools, hospitals, various markets and industries. Usually, governments are responsible for such institutions, but if the government fails to perform these responsibilities, every member of society becomes accountable until those institutions are established. 2 Al Zarqa, M Al Madkhal Al Fiqhi, Vol. 1, pp. 67-69, 277-280 6  The Basis of Islamic Banking and Finance 3.2 The Sources of Shariah 1 Learning Objective 1.1.3 Know the sources of Shariah: primary sources (Quran and Sunnah) and secondary sources (Ijma’ Qiyas, Ijtihad) There are a number of sources of Shariah, which can be roughly divided into primary and secondary, each of which is described further in this section. 3.2.1 Primary Sources There are two primary sources of Shariah: the Quran and the Sunnah. The Quran (Book of Allah (SWT)) The Quran contains the word of Allah (SWT) as it was dictated to the Prophet Muhammad (PBUH) by the angel Gabriel and communicated by him to others. In respect of the Quran, the Prophet Muhammad (PBUH) is an intermediary communicating the word of Allah (SWT) to man. The Quran is the primary reference for all Muslims and should be consulted before any of the other sources. The Sunnah (Words, Acts and (Tacit) Approvals of the Prophet) During the life of the Prophet Muhammad (PBUH), the Muslims sought his clarification and guidance on various parts of the Quran and observed his behaviour so they could follow what Allah (SWT) had described to him to be the model of a proper Islamic life. Each of the sayings, words, acts and (tacit) approvals of the Prophet Muhammad (PBUH) is represented by a Hadith which together form the Sunnah. The sayings of the Prophet Muhammad (PBUH) were used to outline the laws and provide moral guidance. For example, the principle of Al-Kharaju bi-dhaman states that the right to the revenue of an operation is linked to the responsibility to take on the possible loss of the same operation. The acts of the Prophet Muhammad (PBUH) refer to actions of the Prophet Muhammad (PBUH) that are used as a reference and followed. For example, the way of praying or the manner of performing the pilgrimage (Hajj). Tacit approval is the absence of a reaction of the Prophet Muhammad (PBUH) to an action carried out by one of his companions in his presence or to an action he was aware of. The lack of reaction is considered to be an approval, since the Prophet Muhammad (PBUH) was under an obligation to correct any undesirable action. 7 3.2.2 Secondary Sources Secondary sources are those that are referred to in the event that the Quran and Sunnah do not provide a direct answer to the issue at hand. There are three secondary sources: Ijma’ (consensus), Qiyas (analogy) and Ijtihad (interpretation), which are applied in this order. Collective Interpretation Ijma’ (Consensus) Ijma’ literally means ‘agreement on a matter’ or consensus, and is the consensus of the Mujtahidin (independent jurists) from the Ummah (the Muslim community) of the Prophet Muhammad (PBUH), concerning a specific issue. Ijma’ is of the utmost importance as the rulings adopted are integrated within Shariah and are considered to be a third source of Islamic law. The process of Ijma’ allows for contemporary issues to be addressed in light of the principles, values and rules of the Quran and the Sunnah. Example Jurists have reached a consensus (Ijma’) on the prohibition of forward sales, whereby the good sold is a debt obligation on the seller and the price is a debt obligation on the purchaser, each of which is to be delivered at a certain point of time in the future.3 Example Jurists have reached a consensus (Ijma’) that philanthropic activities, other than Zakat, are collective obligation of the society (Fardh Kifayah).4 Qiyas (Analogy) Qiyas (analogy) is one of the main interpretation techniques used by Islamic scholars and refers to the assignment of an existing legal rule to a new scenario. Qiyas is applied when there is no legal rule found in the Quran or Sunnah but there is a previous ruling for a similar case. Literally, Qiyas means measuring or estimating one situation in relation to another. It is technically defined as ‘the application of the legal rule of an existing case found in the texts of the Quran, the Sunnah, or Ijma’ to a new case whose legal rule is not found in these sources’. This transposition is made on the basis of the similarity of the attribute called the ‘illah’ (underlying rationale) of both legal rules. Example The prohibition of Khamr (grape wine) is laid down in the Quran. The Arabic word ‘Khamr’ means cover or veil. From this, it has been deduced by jurists that the underlying rationale (illah) for the prohibition of wine is intoxication, as this is against the objective of Shariah to preserve the intellect. Accordingly, scholars would look at other substances that intoxicate and extend the prohibition to include these. 3 Bidayah al-Mujtahid, Ibn Rushd, Vol. i, p. 480. 4 Al Istithkar, Ibn Abdul-Barr, Vol. 15, p. 358. 8  The Basis of Islamic Banking and Finance Ijtihad (Scholarly Interpretation) 1 Following the death of the Prophet Muhammad (PBUH), and with the expansion of Islam, religious leaders at the time were confronted with requests for guidance on new issues. Their recourse was first to the Quran to determine a course of action. If they were unable to find a solution to their problem in the Quran, they would turn to the Sunnah. Once it is established that an issue is not dealt with within the Quran, Sunnah or Ijma’, scholars come to their own judgement on the basis of an exhaustive examination of textual evidence (Ijtihad). There are two kinds of Ijtihad: individual Ijtihad interpretations performed by individual scholars and collective Ijtihad. Individual Interpretation Islamic scholars may refer to other Shariah sources to resolve an issue. In doing so, they might take into consideration public welfare (Istislah), common plight (Umoom Balwa) and/or the traditions (Urf) of the geographical location. They may also base their decision upon consideration of Shariah objectives and ultimate wisdom (Istihsan). Collective Interpretation Collective interpretation occurs when a group of scholars interpret a specific issue together. 3.2.3 Schools of Jurisprudence The scholars involved in Ijtihad follow the methodology of one of the five Islamic schools of jurisprudence. There are four Sunni schools of jurisprudence (Hanbali, Maliki, Shafi’i and Hanafi) and one Shi’a (Ja’afari). All schools use the Quran and the Sunnah as the primary sources of their legal opinions (Fatwa/plural Fatawa) but differ in their interpretation of the texts. The Sunni schools can be classified along a continuum, with the Hanbali school mainly promoting a literal reading of the sacred texts on the one hand and the Hanafi school primarily supporting logical reasoning on the other side of the spectrum. In between lie the Maliki school, which gives particular importance to the tradition of Medina, and the Shafi’i school, which is an important influence as its founder ordered the practice of Ijtihad. Hanbali – the Hanbali school originates from Damascus and is currently largely associated with Saudi Arabia. The Hanbali school is particularly influential in the Arabian Gulf region. Maliki – the Maliki school originates from Medina. This school ruled heavily in favour of the practice (Sunnah) of the local community of Medina because the town was the territory of the Prophet (PBUH) and, as such, the traditions of the town are directly in line with the Quranic message. Shafi’i – the founder of the school, Al Shafi’i, was the first to standardise the activity of Ijtihad. In a book defining Usul al-Fiqh (Principles of Islamic Jurisprudence), he advocates the use of the sources of Islamic law in the following hierarchical order: the Quran, the Sunnah, Ijma’ (consensus) and Qiyas (analogy). Al Shafi’i also mentioned the possible use of Istihsan (juristic preference). Its approach to Islamic jurisprudence has become a standard reference and is used by all the schools. Hanafi – the Hanafi school was created in Kufa in Iraq. It is distinctively renowned for using Ra’y, which is the logical deduction of scholars (using primary and secondary sources), comparatively more than the other schools. The Hanafi school has a strong influence on many modern practices in Islamic finance. Ja’afari – the Ja’afari school also originated in Iraq and, although it is a Shi’a school, it has many similarities with the Hanafi school. 9 3.2.4 Bodies of Interpretation Learning Objective 1.1.4 Know the authorities that are able to interpret the Quran and Sunnah and their role: the scholars within the schools of jurisprudence; the Islamic Fiqh Academy; the Shariah supervisory boards of regulatory or industry institutions The examination (Ijtihad) of the text of the Quran and the Sunnah can be performed by individual scholars of requisite competence, Islamic financial institutions, Shariah supervisory boards (SSBs) of regulatory bodies and the Islamic Fiqh Academy. Shariah Supervisory Board (SSB) Islamic Financial Institutions use the services of their SSB to ensure their practices are in line with Shariah. Part of the task of the SSB is to issue informed legal opinions allowing institutions to provide financial services in a Shariah-compliant way. The SSB, which often generally includes three or more Shariah scholars, adheres to the following process when determining whether a financial instrument is Shariah compliant or not: reviewing the product concept description created by the product development team reviewing the market conditions identified by the product development team reviewing the product development team’s views on the Islamic principles on which the transactions will be based reviewing the product development team’s proposals and issuing the proper legal opinions (Fatawa). The resulting opinion of the scholars is then reviewed by the product development team and can be followed by a discussion between the scholars and the product development team to finalise the product. The need for a constant dialogue between the product development team and the scholars throughout this process should be stressed. In the majority of countries where Shariah-compliant financial services are offered, each institution has its own SSB making individual decisions for the institution. In some countries, however, such as Malaysia and Sudan, Shariah compliance is centralised in the central bank. Centralised Shariah Supervisory Boards Originally pioneered by the Malaysian Central Bank (Bank Negara Malaysia), other central banks, such as those in Dubai, Oman, Nigeria and Pakistan, have more recently established a centralised SSB within the central bank or financial regulator. The central SSB is responsible for the approval of all Shariah- compliant financial transaction types in the country. The responsibility of the SSB of the individual financial institutions is to ensure the transactions undertaken by the institution are compliant with these rules. Any amendments requested by individual institutions must be presented to the central SSB for ratification. 10  The Basis of Islamic Banking and Finance In addition to a centralised SSB, Bank Negara Malaysia also maintains a register of approved scholars. 1 Scholars cannot be a member of more than one board per type of financial institution. As a result, a scholar could, for example, be a member of the SSB of a retail and an investment bank, but not of two retail banks. The Islamic Fiqh Academy The Islamic Fiqh Academy was created in Jeddah, Saudi Arabia, following a decision of the Organisation for Islamic Cooperation, founded in 1981. The Academy includes members from most Islamic countries which are represented by scholars and knowledgeable people in many scientific, economic and social domains. The Academy meets periodically to debate contemporary matters relating to Islam and issues resolutions (jurisprudence) which originate from the Islamic tradition and Islamic thinking. Note 1 Chapter Notes Note 1: This explanation is based on the translation of the Arabic website of the Islamic Fiqh Academy (www.fiqhacademy.org.sa). 11