Islamic Finance Qualification Ed10 PDF

Level 3 Certificate in Islamic Finance Islamic Finance Qualification (IFQ) Edition 10, February 2022 This learning manual relates to syllabus version 10.0 and will cover examinations from 1 June 2022 to 30 June 2025 Welcome to the Chartered Institute for Securities & Investment’s Islamic Finance Qualification study material. This workbook has been written to prepare you for the Chartered Institute for Securities & Investment’s Islamic Finance Qualification examination. Published by: Chartered Institute for Securities & Investment © Chartered Institute for Securities & Investment 2022 20 Fenchurch Street London EC3M 3BY Tel: +44 20 7645 0600 Fax: +44 20 7645 0601 Email: [email protected] www.cisi.org/qualifications ESA Business School 289 Clemenceau Street PO Box 113-7318 Beirut Lebanon Tel: +961 (0)1 373 373 Fax: +961 (0)1 373 374 Email: [email protected] www.esa.edu.lb Supported by: This is an educational manual only and the Chartered Institute for Securities & Investment and École Supérieure des Affaires accept no responsibility for persons undertaking trading or investments in whatever form. While every effort has been made to ensure its accuracy, no responsibility for loss occasioned to any person acting or refraining from action as a result of any material in this publication can be accepted by the publisher or authors. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise without the prior permission of the copyright owner. Warning: any unauthorised act in relation to all or any part of the material in this publication may result in both a civil claim for damages and criminal prosecution. Candidates should be aware that the laws mentioned in this workbook may not always apply to Scotland. A learning map, which contains the full syllabus, appears at the end of this manual. The syllabus can also be viewed on cisi.org and is also available by contacting the Customer Support Centre on +44 20 7645 0777. Please note that the examination is based upon the syllabus. The questions contained in this manual are designed as an aid to revision of different areas of the syllabus and to help you consolidate your learning chapter by chapter. They should not be seen as a mock examination or necessarily indicative of the level of the questions in the corresponding examination. Please note that, as part of exam security, hand-held calculators are not allowed in CISI exam venues. Candidates must use the onscreen calculator for all CISI CBT exams in all languages in the UK and internationally. Learning manual version: 10.4 (September 2023) Important – Keep Informed on Changes to this Workbook and Examination Dates Changes in industry practice, economic conditions, legislation/regulations, technology and various other factors mean that practitioners must ensure that their knowledge is up to date. At the time of publication, the content of this workbook is approved as suitable for examinations taken during the period specified. However, changes affecting the industry may either prompt or postpone the publication of an updated version. It should be noted that the current version of a workbook will always supersede the content of those issued previously. Keep informed on the publication of new workbooks and any changes to examination dates by regularly checking the CISI’s website: cisi.org/candidateupdate Foreword by Shariah Scholar Mufti Muhammad Nurullah Shikder Islamic finance continues to grow at a high rate, with an increasing number of people interested in this area of innovative finance. Some people see this as an excellent opportunity to diversify their business into this area of finance, whereas others are looking to do business in accordance with Islamic law because of their religious convictions. Whatever the motive may be, the fundamental rules and principles relating to Islamic finance apply to all. As such, all market participants, particularly the new entrants, need to have solid and accurate knowledge of Islamic financial products and services, and of the Shariah principles that govern them. In this regard, this latest edition of the Islamic Finance Qualification manual provides an excellent platform at an introductory level, which should allow the reader to grasp the fundamentals of Islamic banking and finance. This manual will provide a stepping stone for those who are interested in Islamic finance to familiarise themselves with the basic concepts and structures that are generally used by Islamic banks and financial institutions, and to enhance their understanding. (Mufti) Muhammad Nurullah Shikder Managing Director Alhuda Shariah Advisory Services Limited Foreword The IFQ represents a positive step towards the global recognition of Islamic finance and the role it has to play in global finance, and the Chartered Institute for Securities & Investment (CISI) would like to thank all of the contributors to the workbook and to the IFQ examination. The IFQ continues to underpin the development of the Islamic finance profession and the content of this edition is fully Shariah-compliant, having been reviewed by Mufti Muhammad Nurullah Shikder. The IFQ official workbook ensures that candidates gain a comprehensive understanding of examination content, as well as being a valuable reference for practitioners. Chartered Institute for Securities & Investment Workbook Contributors: Dr Abdel-Maoula Chaar Raed H Charafeddine Firas Hamdan Dr Natalie Schoon Mansoor Shakil Mufti Muhammad Nurullah Shikder Dr Anwar Misbah Soubra Dr Sami Suwailem Editor: Dr Natalie Schoon Advisory Council for Islamic Finance (ACIF) Members: Raed H Charafeddine (Chairman April 2009) Dr Abdul Sattar Abu Ghuddah Firas Hamdan Jean-Marc Riegel Samir Salameh Dr Natalie Schoon Mansoor Shakil Dr Sami Suwailem (March 2009) UK Technical Group for the Islamic Finance Qualification: Sultan Choudhury Mahmood Faruqui Usman Hayat David Kemp Mansur Mannan Waheed Qaiser Mufti Muhammad Nurullah Shikder The Basis of Islamic Banking and Finance.................... 1 1 An Introduction to Islamic Banking and Finance................ 13 2 Islamic Principles of Exchange........................... 31 3 Basic Contracts and their Treatment....................... 57 4 Financial Contracts and Techniques Applied by Islamic Banks....... 89 5 Islamic Asset Management............................. 135 6 Sukuk Market...................................... 151 7 Islamic Insurance – Takaful............................. 175 8 Islamic Corporate Governance........................... 195 9 Glossary......................................... 217 List of Arabic Terms.................................. 225 Multiple Choice Questions.............................. 229 References and Websites.............................. 261 Syllabus Learning Map................................ 267 It is estimated that this manual will require approximately 130 hours of study time 1 Chapter One The Basis of Islamic Banking and Finance 1. Introduction 3 2. Islamic Banking and Finance: Conceptual Framework 3 3. Islamic Fundamentals 5 This syllabus area will provide approximately 2 of the 100 examination questions 2 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 End of Chapter Questions 1. Name the five main principles of Islamic and commercial ethics. Answer reference: Section 2.1 2. In relation to the creation of wealth, what is one of the challenges within Islamic finance? Answer reference: Section 2.3 3. What is the relationship between Shariah and Fiqh? Answer reference: Section 3.1 4. What are the two classes of Shariah rulings? Answer reference: Section 3.1.1 5. What are the primary reference sources of Shariah used by all Muslims? Answer reference: Section 3.2.1 6. What is the definition of Sunnah? Answer reference: Section 3.2.1 7. What are the three secondary sources of Shariah? Answer reference: Section 3.2.2 8. What are the two forms of Ijtihad and how do they differ? Answer reference: Section 3.2.2 9. How would a jurist apply Qiyas? Answer reference: Section 3.2.2 10. Name the three bodies engaged in the interpretation of Shariah. Answer reference: Section 3.2.4 12 Chapter Two 2 An Introduction to Islamic Banking and Finance 1. The History of Islamic Finance 15 2. The Structure and Scope of the Islamic Finance Industry 20 This syllabus area will provide approximately 3 of the 100 examination questions 14 An Introduction to Islamic Banking and Finance 1. The History of Islamic Finance Learning Objective 2 2.1.1 Know the development of Islamic finance and banking: the beginnings of Islamic banking; Islamic banking in the Gulf Cooperation Council (GCC), Africa and the Middle East countries; Islamic banking in Southeast and South Asia and Australasia; Islamic banking in Europe and the Americas The history of Islamic finance is long and varied and its current development is subject to constant and rapid change. It is important for candidates to understand historic and current developments, so that they have a better idea of the background. 1.1 The Early History of Islamic Finance Islamic finance dates back to the 7th century CE and the beginning of Islam, when the Prophet Muhammad (PBUH) approved the usage of one of the main contracts of Islamic finance – the Mudaraba, a participation type contract (covered in chapter 5) – and his companions continued its practice after he departed. From the 7th century onwards, Islamic merchants traded over long distances and the means of financing their trades and investments in line with Shariah were introduced. By the 11th century, many of the commercial practices used by Islamic merchants had been adopted across Southern Europe, Asia and the Middle East. The concepts and practices of Islamic finance were revived in the 1960s. 1.2 The Contemporary History of Islamic Finance The contemporary history of Islamic finance can be divided into three stages: a founding period, that took place during the 1960s; a formative period, which began with the creation of the Islamic Development Bank (IsDB) in 1975 and ended in 1990; and a development period, which began in 1990. The timeline can be depicted as follows: Founding Period Formative Period Development Period 1963–1975 1975–1990 1990–Now 1963 Mit Ghamr, Egypt, Formation of IsDB and Regulation and based on profit sharing commercial banks standardisation and concepts of mutual First attempts to turn Islamic windows credit union conventional finance into Increasing sophistication an Islamic format, some new product development 15 1.2.1 The Founding Period (1963–75) Contemporary Islamic finance emerged in the 1960s with the creation in Egypt of the Mit Ghamr Saving Project in 1963. Set up by Dr Ahmad el Najjar, its aim was to assist the people of the region of Mit Ghamr with the financing of the development of their land in line with Islamic finance principles. All finance was free of Riba and based on profit sharing. Around the same time, the Muslim Pilgrims’ Saving Corporation in Malaysia offered to manage Muslim pilgrims’ savings according to Islamic rules. This programme was specifically developed to assist people in their efforts to save money so as to be able to fulfil one of the important elements of Islam – to go on pilgrimage (Hajj). 1.2.2 The Formative Period (1975–90) The second landmark in the history of Islamic finance was the inauguration of the IsDB in 1975. The IsDB is a multilateral bank with the objective of fostering the economic development and social progress of member countries and Muslim communities, using techniques that respect the principles of Shariah. This event was particularly important because it gave institutional recognition to the developing Islamic finance industry. A few months after the inauguration of the IsDB, the Dubai Islamic Bank, the first modern Islamic commercial bank, opened its doors, followed by the Kuwait Finance House, the Faisal Islamic Bank of Sudan and the Faisal Islamic Bank of Egypt. The Jordan Islamic Bank was incorporated in 1978 and, a year later, was followed by the Bahrain Islamic Bank. As it was only regarded of being of interest to a minority of customers, the development of Islamic finance during this period was still slow. Initially, the focus of the banks was on providing an alternative to conventional commercial banking functions in a Shariah-compliant manner, and services were predominantly retail and trade finance- oriented. Since the 1980s, Islamic banks have expanded into countries with a Muslim minority. Simultaneously, Iran, Sudan and Pakistan sought to impose Islamic banking solutions, while Malaysia made significant progress in establishing a dual-banking system. 1.2.3 The Development Period (1990 onwards) The development period began in 1990 with the incorporation of the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI). The establishment of AAOIFI was a clear statement that Islamic finance was becoming an integral part of the finance industry and this was reinforced further with the incorporation of the Islamic Financial Services Board (IFSB) in 2003. Both AAOIFI and the IFSB are detailed further in section 2. The result of the establishment of these two institutions was that Islamic finance started to offer a credible alternative to conventional finance. In addition to the regulatory frameworks provided by AAOIFI and the IFSB, Citibank, one of the largest full service conventional banks in the world, launched its Islamic finance operations under the name Citi- Islamic in Bahrain in 1996 and was the first conventional financial institution to offer Islamic financial services. More recently, some Western countries, such as the UK, have amended their regulation to facilitate the offering of Islamic financial services within the framework of their financial regulations. Since the 1990s, Islamic finance has become increasingly sophisticated and Islamic financial products have developed to match almost every demand from capital markets, consumer banking and wealth management. During this period, the number of Islamic banks has expanded significantly around the world. 16 An Introduction to Islamic Banking and Finance 1.3 The Geographical Development of Islamic Finance The Islamic financial industry has grown, irrespective of any government support. Initially mainly limited to Middle Eastern countries, it expanded into Asia in the 1980s and into Europe from around 2002. Bahrain, Malaysia and the UK have played important roles in their respective regional Islamic 2 finance markets and the developments in each of these jurisdictions have been beneficial to the global development of the industry. 1.3.1 The Countries of the Gulf Cooperation Council (GCC), Middle East and Africa Bahrain was the first country of the Gulf Cooperation Council (GCC) to develop a comprehensive approach to Islamic banking and finance and is considered as one of the key players in the field. It was among the first countries to recognise the importance of the industry and contribute to its growth. AAOIFI is based in Bahrain and the Central Bank of Bahrain (CBB) is playing an active role in the development of the Islamic financial industry. The CBB has established the necessary supervisory and regulatory framework to promote the growth of the sector. The CBB has, for example, implemented the IFSB standards for regulations, requires Islamic financial institutions under its supervision to adhere to AAOIFI standards and has designed an Islamic paper (Sukuk) issuance programme to provide a liquidity instrument for the Islamic financial institutions in Bahrain. The Kingdom of Saudi Arabia started a process to formalise a robust regulatory structure for Islamic banking and finance in 2000 and this has encouraged the rapid adoption of Islamic banking and insurance in the Kingdom. As the largest market in the GCC, robust growth is projected for institutions based in Saudi Arabia. All GCC countries now formally support Islamic banking and investment. More recently, Dubai formed the Dubai International Financial Centre (DIFC), Qatar formed the Qatar Financial Centre (QFC) and Kuwait has begun to examine how it may offer more robust financial services in the region. Although these centres aim to service their domestic economies, they are well positioned to service Iraq, Iran, the Indian subcontinent, and East Africa. All the GCC countries are applying a dual-banking system in which Islamic and conventional financial institutions are operating side by side. In Lebanon, Islamic banks and financial institutions have been authorised by the Central Bank (Banque du Liban) since February 2004 and are governed under the same legal and regulatory provisions as non-Islamic banks. An additional provision is included in the law which requires the banks to appoint a consultative body, consisting of three experts in Islamic law and banking and financial operations. This body is appointed for a renewable three-year period. Jordan has made it mandatory for Islamic banks in its jurisdiction to follow AAOIFI standards for accounting and reporting. Islamic banks have been incorporated in Sudan for many years and also, more recently, in Syria, where banking supervisors have made AAOIFI standards mandatory. Throughout the African countries, and currently in South Africa particularly, Islamic finance is gaining traction. In other countries, Islamic financial services are slowly being introduced. 17 1.3.2 South and Southeast Asia and Australasia Bank Islam Malaysia Berhad (BIMB) was incorporated in Malaysia in 1983 as part of a national strategy to establish a dual-banking system. The primary driver for this strategy was that Muslims were disproportionately not using the formal financial system and required a viable alternative. Currently, Malaysia has one of the most developed Shariah-compliant financial systems in the world and is committed to the international development of Islamic finance. The IFSB is based in Malaysia and is considered to be one of the main hubs of Islamic finance. The Malaysian Islamic banking sector is regulated by the Malaysian Central Bank and Bank Negara Malaysia under a dual-supervision regime. Pakistan originally had limited success in converting its financial infrastructure to be Shariah compliant and introduced a dual-banking system in 2004. Since the introduction of dual regulation, the Pakistani Islamic banking sector has rapidly expanded. Singapore, Hong Kong, Indonesia and Australia are all making progress on the introduction of Islamic finance. Australia mainly focuses on managing funds containing Asian-based investments and Indonesia issued its first government Sukuk in 2009. In each of these countries, the Islamic banking and finance industry is regulated using the same framework as that in place for conventional banks. 1.3.3 Europe and the Americas The US and the UK have been exploring the way to regulate domestic and cross-border Islamic financial services since the mid-1990s. In 2002, the Financial Services Authority (FSA) (the UK regulator at the time) and the Bank of England (BoE) adopted a series of measures to encourage the development of Islamic finance. Since then, several Islamic banks have been licensed to operate in the UK under the supervision of the UK regulator and, in 2014, the UK was the first country outside the Muslim world to issue a government Sukuk. The importance of London as an international financial hub is likely to lead to more institutions seeking authorisation and other European countries are exploring the possibilities of the Islamic financial industry. In the US, the Office of the Comptroller of the Currency (OCC) has issued a series of public and private interpretive letters on the subject, and the Federal Deposit Insurance Corporation (FDIC) and various other agencies at state level have created a flexible framework to allow limited Islamic banking activities to take place onshore (notably in New York, Michigan and Illinois). In addition, US banks are allowed to engage in Islamic financial services activities offshore (for example, Citibank operates an Islamic subsidiary in Bahrain). The Federal Reserve Bank has initiated a study group to research the opportunities associated with Islamic finance and its implementation in the US, and the Securities and Exchange Commission (SEC) is regulating a growing number of Islamic mutual funds aimed at US domestic investors. In addition, Freddie Mac and Fannie Mae, the US government-sponsored mortgage securitisation companies, have supported the development of Islamic alternatives to conventional mortgages since 2002. 18 An Introduction to Islamic Banking and Finance 1.4 The Future of the Islamic Finance Industry Learning Objective 2 2.1.2 Know the constraints and challenges on the development of the Islamic banking and finance industry 1.4.1 The Interaction of Shariah with Local Law and Regulation In some countries, local regulations do not permit the use of financial instruments that conform perfectly to each requirement of Shariah. Therefore, some concessions may have to be made in order to meet local regulatory requirements, for example, capital protection for retail customers. Shariah scholars approve financial instruments containing concessions in the event there is no other choice, since these products enable the Islamic finance industry to develop and may be used to advocate gradual change in local regulations in order to accommodate Shariah requirements. After all, something less than perfect is better than nothing at all. In addition, once the instrument is accepted, efforts can be made to improve them. In Muslim countries, these differences are less likely to be encountered. 1.4.2 The Constraints of Islamic Banking Even though some of its instruments have been applied for centuries, the contemporary Islamic financial services industry is relatively young and is still developing new Shariah-compliant ways to provide a balanced, full offering of financial products and services. The ways in which Shariah-compliant products are structured vary by region, within regions, and by school of jurisprudence. This workbook attempts to follow the mainstream view on the various structures based primarily on the Fiqh Academy of the Organisation of Islamic Cooperation, the international body officially representing Muslim nations worldwide, as well as the Shariah Council of AAOIFI. It needs to be taken into consideration that this generally might be more conservative than what is advocated by some regional Shariah bodies. This workbook does not make a judgement on the various schools of jurisprudence, or attempt to include different views, as this would be outside its scope. 19 2. The Structure and Scope of the Islamic Finance Industry 2.1 The Functions of Islamic Banks Learning Objective 2.1.3 Know the main functions of Islamic banks From an economic perspective, the functions of an Islamic bank are similar to those of the conventional financial industry and include the following: Investment and investment management – Islamic banks invest funds that have been placed or deposited with them (ie, their own capital funds and funds in their customers’ investment accounts) through investment mechanisms that are consistent with Shariah. Generic banking services – Islamic banks offer a variety of financial services similar to conventional banks, including current accounts, fund transfers, credit cards, consumer goods finance, home finance and small- to medium-sized business facilities, through Shariah-compliant arrangements. It is important to note that not all of these are offered uniformly by all institutions. In addition to these generic functions, Islamic banks carry out direct social services since they have an explicit responsibility for the development of their staff and their local communities. They also carry out indirect social services via the charities to which they have donated Zakat or other gifts. Besides commercial banks, the Islamic finance industry also encompasses investment banks, investment funds, Takaful (insurance) companies and multilateral and development banks, such as the IsDB. 2.2 The Operating Structures of Islamic Banks Learning Objective 2.1.4 Know the operating structures and organisational forms adopted by the Islamic financial services industry: the window model; branches; subsidiaries; fully-fledged banks Islamic financial services are offered via different structures, depending on whether or not the institution also offers conventional financial services. Institutions that provide conventional, as well as Islamic financial services, have three main organisational structures available to them. Although in some countries, such as Iran and Sudan, the financial system is fully Shariah compliant, in the majority of countries, Shariah-compliant and conventional banks exist side by side. In some countries such as Qatar, Kuwait and Lebanon, for example, it is not allowed for conventional banks to offer both Islamic and conventional financial services. In these countries, Islamic financial services can only be offered by fully fledged Islamic banks. In most countries, however, conventional 20 An Introduction to Islamic Banking and Finance banks are also allowed to offer Islamic financial services, but segregation of these services from the conventional financial services offering must be in place in order to ensure Shariah compliance. Contrary to some other countries, Malaysia has made the choice to be an early introducer of new 2 products and services and to enhance their Shariah compliance over time or replace them with new, more favourable options as they develop. Although not all schools of jurisprudence agree with some of the instruments available in Malaysia (namely, Bai al ‘inah), they are considered to be Shariah compliant by Shariah scholars in Malaysia who, in principle, follow the Shafi’i school of jurisprudence, which is predominant in Malaysia. The approach has made it possible for the Malaysian market to display significant growth and become one of the largest markets in the Islamic financial industry. It must be noted, however, that Bank Negara Malaysia, the central bank of Malaysia, issued a circular in December 2012 that strongly restricted Bai al ‘inah transactions, aligning them closer to the principles of Shariah as considered by the majority of schools of jurisprudence. There are four main organisational forms in which Islamic financial services can be offered and these are outlined below. Islamic Financial Services Offerings by Conventional Banks When conventional banks offer Islamic financial services, this is typically done using one of the following organisational models: The Windows Model – in this model, a conventional bank offers Islamic financial services via the same delivery channels it uses for its conventional financial services. For example, Lloyds in the UK offers Islamic financial products via the same branch network it uses to offer other financial services. Branches – contrary to the windows model, the Islamic financial services offered by a conventional bank are not distributed via the same channel, but instead via dedicated branches. For example, Standard Chartered Bank provides Islamic financial services in Pakistan via a dedicated branch network under the name Standard Chartered Saadiq. Similarly, HSBC offers Islamic financial services via the Amanah branch network in Malaysia. Subsidiaries – a subsidiary is a separate legal entity owned by a conventional bank or some other financial institution (a parent), which is set up specifically to provide Islamic financial services. The subsidiary can either have its own dedicated service delivery channels or utilise the parent’s service delivery channels which also offer conventional financial services. Being a separate legal entity, the subsidiary usually formulates and manages its own policies on Islamic financial services, but within the parent’s overall business strategies, eg, Citi-Islamic (a subsidiary of Citi) and Badr al-Islami (a subsidiary of Mashreqbank). It is important to bear in mind that, in each of these structures, the operations and accounting of the Islamic financial services offering are segregated from the conventional part of the bank, and although the services are offered by a conventional bank, the offering is generally managed separately. Disregarding the operating model, Islamic financial services are subject to the review and controls of a SSB. BNP Paribas, for example, which operates a windows model, has an Islamic banking unit which manages its Islamic financial services offering. 21 Fully-Fledged Islamic Banks Unlike any of the above, fully-fledged Islamic banks are stand-alone institutions and do not form part of conventional financial institutions. These banks are set up solely to provide Islamic financial services offered through their own service delivery channels. As they have fully independent management and operating structures, they draw up their own business strategies and policies. Most Islamic banks fall into this category. The following are among the largest Islamic banks (by total assets): Al Rajhi Bank Kuwait Finance House Dubai Islamic Bank Abu Dhabi Islamic Bank Qatar Islamic Bank Maybank Islamic. 2.3 The Regulators Learning Objective 2.1.5 Know the bodies overseeing and/or supporting Islamic banking and finance: the regulators (central banks or other authorities); the standard-setters (AAOIFI and IFSB); other institutions supporting the development of Islamic finance and banking (IIFM, CIBAFI, IIRA, IILM, and IsDB Group) AAOIFI REGULATORS IFSB IIFM Islamic Finance IRTI Institutions IIRA CIBAFI REGULATORS Figure 1: Islamic banking infrastructure Islamic financial institutions are, like other financial institutions, authorised and supervised by the regulatory authority in their country of incorporation. In addition, two standard-setting bodies have been established: the AAOIFI and the IFSB. Their main aim is to ensure the integrity and stability of the Islamic financial industry within the global financial system and to protect the interests of the stakeholders (especially the customers) of financial institutions. These and other supporting institutions are detailed in the remainder of this chapter. 22 An Introduction to Islamic Banking and Finance 2.3.1 The Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) AAOIFI, whose headquarters are in Bahrain, is an autonomous body established in 1990 by Islamic banks, and is responsible for the formulation and issuance of accounting, auditing, ethics, governance 2 and Shariah standards for the international Islamic banking and finance industry. The standards have been developed to encourage the harmonisation of Islamic banking and finance practices, and to ensure transparency and uniformity of financial reporting by Islamic banks and financial institutions. AAOIFI’s role is similar to that of the International Accounting Standards Board (IASB) of which it is a member. AAOIFI’s accounting standards build heavily on the International Financial Reporting Standards (IFRS) and are designed to provide best practice on how to handle financial reporting issues specific to Islamic institutions. Although the standards are international, they are not mandatory in every country. The standards are mandatory for Islamic financial institutions in countries such as Bahrain, Jordan, Syria and Sudan but are only used as guidance in, for example, Saudi Arabia. AAOIFI has issued standards for the following: Shariah Standards – these standards identify contractual issues with different instruments, such as trading in currencies, how to deal with a default in payment by a debtor, guarantees, Murabaha to the purchase orderer and any of the other instruments detailed in chapter 5. AAOIFI Shariah Standard No. 11, for example, deals with the requirements of Istisn’a (project finance) and Parallel Istisn’a. Accounting Standards – the accounting standards use the IFRS as a basis and provide additional standards that cater for the specific accounting requirements associated with Islamic financial instruments. Financial Accounting Standard (FAS) No. 9, for example, sets out the accounting rules for the treatments related to the determination of the Zakat base, and how it needs to be accounted for in the financial statements of the Islamic financial institution. Auditing Standards – these standards outline guidance on the objectives and general principles governing the audit of financial statements of Islamic financial institutions. Auditing Standard for Islamic Financial Institutions No. 2, for example, provides an overview of the elements that need to be contained in the auditor’s report. Governance Standards – these standards outline the additional governance required for Islamic financial institutions. Governance Standard for Islamic Financial Institutions No. 2, for example, outlines the requirements for Shariah review. Ethics Standards – the ethics standards defined by AAOIFI are applicable to internal accountants and internal auditors of Islamic financial institutions and deal with, for example, integrity, sincerity, trustworthiness and objectivity. 2.3.2 The Islamic Financial Services Board (IFSB) The IFSB, headquartered in Malaysia, is an international standard-setting organisation founded by central banks of member countries in 2003. IFSB aims to promote and enhance the soundness and stability of the Islamic financial services industry by issuing global prudential standards and guiding principles for the industry, broadly defined to include banking, capital markets and insurance sectors. 23 The IFSB also conducts research and coordinates initiatives on industry-related issues, as well as organising roundtables, seminars and conferences for regulators and industry stakeholders. The IFSB standards are based mainly on the identification, management and disclosure of risks relevant to Islamic products and operations. The role of the IFSB is comparable with that of the Bank for International Settlements (BIS) with whom it cooperates closely. Members of the IFSB include the Organisation of the Islamic Cooperation (OIC), member state central banks, multilateral banking regulators and a diverse group of central banks from non-OIC countries, including China and Singapore. IFSB standards are currently optional. However, there is an expectation that, as the Islamic financial industry becomes more mainstream, IFSB standards will be adopted by member countries and other jurisdictions to provide a stable and regulated environment. The IFSB has, for example, issued the following standards: IFSB-7 – Capital Adequacy Requirements for Sukuk, Securitisations and Real Estate Investment IFSB-8 – Guiding Principles on Governance for Takaful (Islamic Insurance) Undertakings. In addition, the IFSB issues technical notes, such as: TN-1 – technical note on issues in strengthening liquidity management of institutions offering Islamic financial services: the development of Islamic money markets and other documents such as the IFSB-IRTI-IsDB Islamic Finance and Global Stability Report. 2.3.3 Supporting Institutions The international Islamic banking and finance industry is also supported by several other institutions. International Islamic Financial Market (IIFM) The IIFM is the global standard-setting body for the Islamic capital and money market segment of the Islamic financial services industry. Its primary focus is the standardisation of Islamic products, documentation and related processes. The IIFM has issued a master agreement for treasury placement, which provides a standard for interbank Commodity Murabaha and has issued a standard for hedging under the name ISDA/IIFM Tahawutt Master Agreement, which includes a master agreement to use for profit rate swaps. The IIFM works closely together with the International Swaps and Derivatives Association (ISDA). ISDA is a global trade association and develops and maintains industry-standard conventional documentation and the IIFM’s role is comparable to that of ISDA. Islamic International Rating Agency (IIRA) The IIRA is an Islamic rating agency, playing a role similar to Moody’s, S&P and Fitch Ratings. The difference with the conventional rating agencies is that the IIRA focuses specifically on the Islamic financial services industry. The IIRA issues ratings based on an independent assessment and opinion on the likelihood of timely payment of financial obligations by sovereigns, corporates, banks and financial institutions; and securities issued by governments, corporates, banks and financial institutions. The assessment process includes an independent opinion on the level of compliance with Shariah principles. 24 An Introduction to Islamic Banking and Finance Other Supporting Institutions In addition to the above, there are other institutions supporting the Islamic financial services industry which include: 2 The General Council for Islamic Banks and Financial Institutions (CIBAFI), whose mission is to promote Islamic financial institutions and disseminate rules and concepts related to Islamic finance. The CIBAFI, an industry group, is also responsible for providing information relating to Islamic finance institutions and strengthening cooperation among Islamic finance players. The CIBAFI is comparable to the British Bankers Association (BBA) in the UK. The International Islamic Liquidity Management Corporation (IILM) is an international institution established by central banks, monetary authorities and multilateral organisations. Its objective is to create and issue short-term Shariah-compliant financial instruments to facilitate effective cross- border Islamic liquidity management. The Islamic Development Bank (IsDB) is a multilateral bank with the objective of fostering the economic development and social progress of member countries and Muslim communities using techniques that respect the principles of Shariah. One of the important members of the IsDB Group is the Islamic Research and Training Institute (IRTI), a specialised entity with a mission to promote Islamic research and training in Islamic finance and economics. IRTI has a comparable role to, for example, the World Bank Institute (WBI). 2.3.4 Conventional Institutions The following table shows the institutions described in the above sections and their conventional counterparts: Islamic Financial Industry Body Conventional Financial Industry Body AAOIFI IASB Accounting and Auditing Organisation for Islamic International Accounting Standards Board Financial Institutions IFSB BIS Islamic Financial Services Board Bank for International Settlements IIFM ISDA International Islamic Financial Market International Swaps and Derivatives Association IIRA Credit rating agencies such as Moody’s, S&P Islamic International Rating Agency and Fitch Ratings CIBAFI BBA General Council for Islamic Banks and Financial British Bankers Association (UK) and other Institutions comparable bodies IRTI WBI Islamic Research and Training Institute World Bank Institute 25 2.4 Other Components of the Islamic Finance Industry Learning Objective 2.1.6 Know other components of the Islamic finance industry: the Shariah-compliant equity markets; the market for Sukuk (Islamic capital market instrument); Islamic investment funds; Islamic insurance companies – Takaful; the Waqf properties (Islamic charitable trust); Zakat funds (funds constituted of charitable obligatory tax); Islamic microfinance; purification of non-permissible income (Haram) 2.4.1 The Equity and Capital Markets Islamic equity markets allow individual and institutional investors to buy and sell shares in Shariah- compliant companies. As with the conventional equity market, the Islamic equity market encompasses both listed and private equity. Like any other instruments, equity investments have to be Shariah compliant, which means that the activities and financial ratios of the company, as well as the inherent structure and documentation in connection with the equity investment, need to be compliant with Shariah. The establishment of a modern limited liability company and the buying and selling of its shares was accepted as permissible in Resolution No. 63/1/7, 7th Session of the Islamic Fiqh Academy, in Jeddah, in May 1992. During the same session, a resolution to permit Shariah-compliant investment funds was also accepted. Islamic capital markets have a similar function to conventional capital markets and provide short-term and long-term liquidity on an interbank basis. Contrary to conventional capital markets, Islamic capital markets solely use Shariah-compliant instruments, such as Sukuk (covered in detail in chapter 7). 2.4.2 Islamic Investment Funds The market for Islamic asset management (see chapter 6) has grown significantly over the years and there are currently close to 700 funds listed in the major databases, with estimated funds under management of around US$70 billion. The type of funds offered are varied and include fixed-income funds, lease funds, commodity funds, real estate funds, private and public equity funds, equity tracker funds, exchange-traded funds and hedge funds. The operations of these funds are fairly similar to those of a conventional fund, save for the fact that the fund structure, the underlying documentation, and all investments made by the fund, need to be Shariah compliant. 2.4.3 Takaful Takaful (covered in detail in chapter 8) is Shariah-compliant insurance and works on a mutual or cooperative basis. In Takaful, the participants jointly contribute funds (known as Tabarru) to a pool for the purpose of providing mutual indemnity and protection to the participants exposed to defined risk(s) under the Takaful policy. The pool is typically managed by an independent third party, the Takaful operator, on 26 An Introduction to Islamic Banking and Finance behalf of all participants against unexpected loss or damages which are covered under the terms of the insurance within the agreed period and terms of the policy. 2.4.4 Waqf and Zakat 2 Waqf and Zakat are both associated with benevolent giving but have different forms and imperatives: Zakat is obligatory whereas Waqf is recommended. Waqf represents charitable giving in a form comparable with a charitable trust. Waqf properties are those preserved for certain philanthropic purposes which cannot be overridden. They make up a considerable proportion of the societal wealth in all Muslim populations. Islamic institutions and financial markets are becoming increasingly sophisticated about the management of Waqf funds. Zakat is a mandatory religious duty paid by Muslims according to Shariah that can be donated to any one of the nominated recipients at the discretion of the donor. As detailed in chapter 4, Islamic financial institutions can pay this on behalf of their shareholders or leave the responsibility for the payment of Zakat to the shareholders. In the event that the Zakat payment is delegated to the shareholders, the institution remains responsible for informing them of the amount of Zakat per share. 2.4.5 Islamic Microfinance By its nature, Islamic finance is very suitable for microfinancing-type projects. The investments are typically in a tangible business venue and have a high level of social responsibility attached to them. There are a wide range of structures in Islamic finance that lend themselves to microfinance initiatives, with joint venture contracts, such as Musharaka and Mudaraba, potentially the most suitable. Microfinanciers tend to have a very close relationship with their clients, which makes a joint venture ultimately viable. The microfinance institution (MFI) will not only supply money, but also expertise related to the setting up and successful running of a company. It is highly likely that the client will initially only put in expertise, while the MFI contributes in cash and will take its profit share as agreed in Mudaraba. However, from experience with conventional microfinance, it appears that the entrepreneurs are likely to want to obtain full ownership over their business, which could become a feature of the contract. Looking at a $100 investment using a Mudaraba agreement, a suggested structure could be as follows: The bank invests $100 and receives 40% of the profit for their input of both capital and expertise. 20% of the profit is held by the bank in a reserve account, which can be used as a buffer for unforeseen circumstances or for the client to purchase units in the partnership from the bank with its share of the profit. 40% of the profit is paid directly to the entrepreneur. The advantage of this is that it provides a form of security to the entrepreneur and encourages savings to be built up. The entrepreneur should, however, be free to use other funds (eg, excess profits) to repurchase units. In the Middle East and Asia, entrepreneurial funding on this scale is often granted on an informal basis by small groups of friends, neighbours and family. The intensive nature of microfinance, in combination 27 with the fact that clients typically are not deemed creditworthy and the subsequent additional capital charge, does not necessarily make microfinance a viable business proposition to large banks. On the other hand, it should be recognised that the peer pressure on financiers, as well as their motivation, is extremely high, and the default rates are negligible, which makes it an attractive proposition, despite small ticket sizes. 2.4.6 Crowd Funding and Peer-to-Peer Lending Crowdfunding is a way in which individuals, charities and businesses (including start-ups) can raise money from the public to support a project, campaign or person. It usually takes place via websites that allow businesses or individuals to raise money, and investors to provide that money. The business or individual often explains their project in a pitch to attract loans or investment from as many people as possible1. Similarly, peer-to-peer lending provides alternative investment opportunities for individuals to lend directly to other people or businesses without using a bank. It operates on a ‘many to many’ lending model through internet-based lending platforms who arrange and manage the loans2. Although originally started with interest-bearing loans, there are a growing number of Shariah compliant crowdfunding and peer-to-peer financing platforms available. 2.4.7 Purification of Non-permissible (Haram) Income Globalisation and the interrelationship between Islamic and conventional financial institutions means that, for a number of reasons, a Shariah-compliant investor or financial institution may receive non-permissible (Haram) (prohibited) income, eg, when investing in large multinational companies, when the financial institution levies penalty interest charges or when a transaction that was deemed compliant has been processed incorrectly. Any transaction subject to non-permissible income is not automatically null and void. Instead, the financial institution will need to assess the amount of income attributable to the non-permissible activity and purify this income by donating it to charity. The charity and the size of the donation is usually approved by the SSB. 2.4.8 The Impact of Technology in Islamic Finance Learning Objective 2.1.7 Know the impact of fintech in Islamic finance Islamic finance institutions, as with conventional counterparts, are highly reliant on technology, and embracing change is critical to the survival of most of the Institutions. The introduction of fintech, particularly disruptive technologies and processes in the finance sector by the use of blockchain, artificial intelligence and cryptocurrencies, presents Islamic finance with new challenges but also new opportunities within the sector. 1 https://www.fca.org.uk/consumers/crowdfunding 2 https://www.gov.uk/guidance/peer-to-peer-lending 28 An Introduction to Islamic Banking and Finance With the rapid growth and uptake of emerging technologies in the global financial sector, Islamic finance is embracing some of these new technologies. Governments are even encouraging hubs to be set up around the main global Islamic finance centres in order to focus on developing fintech specialising in Islamic finance. 2 The scholars, in principle, have no real issue with most of the new developments, but they do have concerns as to how emerging technologies are being applied or used, ie, ensuring that new technology is applied and used in a Shariah-compliant manner. Some areas of technology are relatively clear (for example, the use of blockchain in smart contracts) and relatively straightforward to understand and implement, but scholars have differing views as to their usage and their level of Shariah compliance with other technologies, such as cryptocurrencies (eg, bitcoin). In the coming years, the use of these emerging technologies within the financial sector will become the norm and the Islamic finance sector will have implemented and embedded a number of these technologies within the operations of its institutions and products (depending on the jurisdiction of implementation and its own scholars’ interpretation). The use of these new technologies will vary, but it is inevitable that technological change will have an impact on Islamic finance, in areas ranging from operations, payments, transactions and customer communication to the introduction of new products. 29 End of Chapter Questions 1. Outside of the Muslim world, what was the first country to issue a Government Sukuk and when did this occur? Answer reference: Section 1.3.3 2. Name the four methods by which Islamic financial services can be offered. Answer reference: Section 2.2 3. When conventional banks offer Islamic financial services, what is the key difference between the windows model and branches? Answer reference: Section 2.2 4. What is the main aim of the two bodies engaged in regulating the Islamic finance industry? Answer reference: Section 2.3 5. Which body issues Shariah standards? Answer reference: Section 2.3.1 6. What is the primary focus of the IIFM? Answer reference: Section 2.3.3 7. How do Islamic capital markets differ from conventional capital markets? Answer reference: Section 2.4.1 8. What is the role of the Takaful operator? Answer reference: Section 2.4.3 9. How do Waqf and Zakat differ? Answer reference: Section 2.4.4 10. How is non-permissible income purified? Answer reference: Section 2.4.7 30 Chapter Three Islamic Principles of 3 Exchange 1. Introduction 33 2. Islamic Teachings Relating to Business 33 3. Principles of Islamic Contracting 35 4. Major Prohibitions: Riba 38 5. Major Prohibitions: Gharar 43 6. Rules of Exchange 46 7. Concluding Remarks 54 This syllabus area will provide approximately 13 of the 100 examination questions 32 Islamic Principles of Exchange 1. Introduction The Islamic principles of exchange are crucial to an understanding of Islamic finance, as they form the basis of all Islamic finance transactions. Fiqh al Muamalat is a comprehensive body of principles and rules, designed to promote harmonious relations between contracting parties and the avoidance of the kinds of problems in contracting that can result in a falling-out of the contracting parties, leading 3 to costly litigation and other misfortunes. Transactions in Islamic finance which do not comply with these principles and rules of contracting are not Shariah compliant and, apart from the fact that they transgress moral principles, may have negative consequences, such as non-enforceability of contracts or non-recognition of any resultant income. Section 2 of this chapter introduces Islamic teachings relating to business and, in particular, certain prohibitions which, if not observed, impair the legitimacy as well as the enforceability of contracts. Section 3 provides an introduction to the major principles of Islamic contracting and sections 4 and 5 cover the major prohibitions in Islamic finance, namely Riba and Gharar. Section 6 is concerned with detailed rules of exchange and section 7 contains some concluding remarks. 2. Islamic Teachings Relating to Business Learning Objective 3.1.1 Know the ethical precepts relating to Islamic business 2.1 Values to be Observed by Market Participants Chapter 1 introduced the five main principles on which Islamic commercial and financial ethics are based. The Islamic ethical principles consist of a set of rules that should be respected by every Muslim and every institution claiming to be Shariah compliant. Hence, the objectives of Islamic financial services must be in line with the teachings of the Quran and Sunnah. The Prophet Muhammad (PBUH) emphasises the importance of ethical behaviour in commercial and financial dealing by identifying some ethical guidelines that a Muslim must follow: Do not lie to sell your products (principles of honesty and sincerity). Honour your pledges and trustee obligations. Do not deceive or defraud others. Do not offer or solicit bribes. Do not boast about your products. Do not sell products that have a negative influence on the society (principle of stewardship). Uphold justice in all your dealings and transactions with both friends and enemies. This implies that all customers must be treated fairly, for example, when imposing charges and fixing profit-sharing ratios (principle of sincerity). Do not value your trade higher than your Lord (SWT) or allow it to distract you from the call to prayer. The above mentioned ethical behaviours apply to individuals as well as to institutions, commercial or otherwise. 33 2.2 Islamic Teachings Relating to Business Learning Objective 3.1.2 Know the Islamic teachings relating to business Based on the principles and foundation laid down by Shariah, the Islamic teachings relating to business are primarily structured by ten rules: 1. Avoidance of Riba – Riba is often translated by the term ‘interest’, but its literal meaning is ‘excess’. In Shariah, it is defined as ‘any excess compensation without due consideration’ and is banned. Any business agreement which includes an element of Riba is invalid from the Shariah point of view, even if the parties agree on the terms of the contract. To be lawful, any profit or benefit should be linked to the performance of a real asset and to its associated risk. The concept is explained in detail later in this section. 2. Avoidance of Gharar – the prohibition of Gharar is also a major tenet of Shariah. The term ‘Gharar’ means danger or hazard; it is related to the concept of harmful uncertainty or ambiguity. In a commercial transaction, Gharar normally relates to deceptive uncertainty, ignorance and lack of transparency that inadvertently lead to deceit, as well as outright fraud. An agreement that includes a significant element of Gharar is invalid from the Shariah point of view, irrespective of whether the parties agree upon such a contract or not. Gharar is explained in detail later in this section. 3. Honesty and Fair Trade – trade manipulation and malpractices (hoarding, using illegal markets, profiteering, cheating, taking advantage of a person in distress, manipulating numbers) are prohibited. The Quran stresses the importance of fairness in business: ‘And, O my people, give full measure and weight justly, and defraud not people of their things, and act not corruptly in the land making mischief. What remains with Allah (SWT) is better for you, if you are believers’ (Surat Hud, 11:85). 4. Disclosure and Transparency – it is the duty of the seller to disclose all known faults in his goods to the buyer. The Prophet (PBUH) states: ‘It is illegitimate for a Muslim to sell to his brother something with a defect without disclosing it to him.’ He also states: ‘The parties of a sale have the right to cancel unless they depart each other; so if they tell the truth and disclose, their trade will be blessed. If they lie and conceal, the blessing of their deal will be lost.’ 5. Avoid Misrepresentation – a Muslim businessman should not make false declarations concerning his goods. 6. Do Not Sell Over and Above the Sale of Another Person (Bai Alal Bai) – a person cannot interfere in a transaction that has been concluded. When person X has sold goods to another (Y), a third party (Z) cannot interfere and try to reverse the trade by offering his own goods at a better price or by undermining the goods already sold by X. Bargaining is permitted in Islam, but all offers should be made before the deal is closed. The Prophet (PBUH) said: ‘A person should not enter into a transaction when his brother is already concluding the transaction.’ 7. Non-permissible (Haram) Items – a Muslim can only trade goods and services which have been declared permissible (Halal) (lawful). Non-permissible (unlawful) items, such as wine and pork, are banned from any transaction. See chapter 6 for more detail on non-permissible items. 8. Hoarding – the Quran condemns hoarding and excessive affection for material wealth, particularly where it is not applied to helping the poor and supporting the needy. ‘And those who hoard gold and silver and do not spend it for the cause of Allah (SWT) give them tidings of a painful punishment’ (Surat Taubah, 9:34). 34 Islamic Principles of Exchange 9. Sale of Goods and Services in the Open Market – goods and services should be sold in the open market and parties – buyer and seller – must be aware of the state of the market before any transaction is concluded. Buyer and seller should not take advantage of each other’s ignorance of the conditions and prices prevailing in the market. The Prophet (PBUH) said: ‘Do not go out to meet the merchant in the way and enter into business transaction with him, and whoever meets him and buys from him when the owner of (merchandise) comes into the market he has the option (to cancel the transaction null and void if he finds that he has been paid less than the market price).’ 3 10. Avoid Taking Advantage of a Seller’s Helplessness (Bai’ al-Mudtar): Islam judges that it is unacceptable to take advantage of the hardship of an individual who is forced, under duress or false pretences, to sell an item. Instead of purchasing this item and taking undue advantage of the seller’s helplessness, the buyer should offer to help him. The above rules prove that Islam links business and wealth creation to social values. The prohibition of interest (Riba), speculation (Gharar), non-permissible (Haram) items and hoarding can be related to the principle of stewardship, while honesty and fair trade, full disclosure, misrepresentation, Bai Alal Bai and the sale of goods and assets in the open market are based on the principles of integrity and sincerity. As for Bai Al-Mudtar, it is indirectly linked to the Islamic obligation to distribute obligatory charity and encourage voluntary charitable giving. 3. Principles of Islamic Contracting Learning Objective 3.1.3 Understand the general principles governing contracts in Islamic law There are a large number of principles governing contracts in Islamic finance. The most important ones are detailed in this section.1 3.1 Freedom of Contracting In accordance with the principle of permissibility, all economic activities are permissible unless otherwise stated by Shariah. This results in the situation that the set of acceptable activities in daily and economic life (‘aadat) is unlimited, although there are a limited number of prohibited activities. It is, therefore, unnecessary to obtain proof that a particular transaction is acceptable; instead, special proof is required to establish that a transaction is not permissible. In the event two parties have contradicting opinions (one asserts a transaction is permissible and the other asserts it is not), the burden of proof is on the party asserting impermissibility, since permissibility is the default state. 1 Further detail on the most important principles governing contracting are available in Al Madkhal Al Fiqhi, by Sh. Mustafa Zarqa. A list of the most important 100 maxims of Shariah of the Majalla can be found at: www.iium.edu. my/deed/lawbase/al_majalle 35 3.1.1 Permissible Transaction Types The principle of permissibility means that permissible transactions are not limited to those that are stated in classical texts of Fiqh, thus leaving room to create, innovate or design new instruments and arrangements as needed, as long as they avoid the incorporation of any prohibited elements. Although there are no special rituals associated with contracts, a fundamental component of all transactions is that they need to be undertaken by mutual consent, ie, all parties need to be in agreement. Consent is derived from the intention of the contract and can be expressed through words, deeds or any other means. This is emphasised in the Quran and Sunnah: O you who believe, do not usurp your wealth among yourselves unjustly but as trade by your mutual consent. (Surat Al Nissa, 4: 29) 3.2 Actions are Judged by Objectives All actions are judged by the objectives of the parties involved, not just their words. For example, if a person says, ‘this item is yours for 10 dinars’, and the other accepts, this is considered to be a sales contract, despite the fact that the word ‘sale’ is not specifically mentioned. Equally, if a person was to say, ‘this is a gift to you for 10 dinars’, the objective is to sell something for 10 dinars, even though the word ‘gift’ is included. In both cases, the substance of the transaction is that of a sale. Example A creditor asks a debtor to provide a guarantor (Kafeel). The debtor agrees on the condition that the creditor shall no longer pursue him for the debt, but the guarantor. The substance of this condition is a transfer of debt (Hawala) instead of a guarantee (Kafala) since, effectively, the debt has been transferred from the debtor to the guarantor despite the lack of the word ‘transfer’ in the arrangement. In a Mudaraba transaction, the investor (Rab al Mal), as the principal, provides capital to the manager (Mudarib) as his agent to undertake a specific business activity. The two parties share the profits in accordance with a pre-agreed profit ratio and losses are born by the investor as the capital provider. The business manager is not responsible for any losses unless he is guilty of negligence. In the event that the investor stipulates that the agent needs to guarantee the capital, he will have to repay the capital under any circumstance and the transaction will need to be classified as a loan instead of a Mudaraba. In an agency agreement (Wakala), the principal appoints another person as his agent (Wakil) to undertake a particular activity on his behalf. If, for example, the Wakil is appointed to purchase a specific asset and he buys the asset with the intention to keep it for himself, the Wakil, and not the principal, is the owner of the asset. If the asset is subsequently damaged or stolen, it is the agent’s responsibility. However, if the agent intended to buy the asset for the principal, and it is subsequently damaged or stolen without negligence or malpractice on the side of the agent, the agent is not responsible for the damage. To avoid disputes, the agent has to indicate at the time of purchase (by any means) whether the good is purchased for the principal or for himself. 3.3 Do No Harm As a general rule, causing harm to people, property, and the environment in general is prohibited. 36 Islamic Principles of Exchange 3.4 Flexibility in the Case of Hardship Although it is prohibited to use Islam as an excuse to dishonour contracts or to reject or deny obligations, Shariah provides the flexibility to avoid hardship. Allah wants ease for you rather than hardship. (Surat Al Baqara, 2:185) This principle can be applied to Islamic financial services in several ways. When converting a conventional 3 (ie, interest-based) bank into an Islamic bank, a gradual approach could be taken since interest-based assets and liabilities cannot be repaid or called in immediately without incurring significant penalty charges. Instead, the transactions will be converted at maturity. The interest collected during the period can be used for non-profit activities or charitable donations. Equally, when a debtor is in hardship and has difficulties paying, the creditor should assist the debtor in any way he can, and charging additional penalties is not permitted. A solvent debtor, however, has the obligation to pay. 3.5 Incorporation of Custom and Convention Custom (‘urf) plays an important role in the execution of a contract or transaction. Any accepted custom is implicitly included in the transaction, even if it is not specifically mentioned. Example An item on the shelf in a shop in Malaysia has a price tag of 10. This is understood to mean 10 Malaysian Ringgit since that is the commonly accepted currency. A price tag of 10 in Afghanistan, on the contrary, cannot be assumed to be Afghani since, in Afghanistan, it is customary to pay either in Afghani or in US Dollars. If it is commonly expected that the delivery of a purchased good is the responsibility of the seller, the buyer has the right to claim for compensation if the seller refuses to do so, even if this was not explicitly stated at the time of purchase. If it is common practice for borrowers to regularly pay an additional amount of money to a lender in addition to the principal, this is equivalent to an explicit stipulation of interest and thus becomes Riba. In other words, custom or common practice is considered to be equivalent to explicit stipulation of a term. 3.6 Liability Justifies Return The benefit, yield, or return on an asset is rightfully owned by those who bear the physical risk of damage and loss. This principle imposes a certain degree of symmetry and balance between rights and obligations. Liability cannot be separated from benefits or, in other words, risk cannot be separated from return. One cannot (or should not) bear the risk associated with an asset without being entitled to its benefits. Separating the two, therefore, is not acceptable. 37 4. Major Prohibitions: Riba Learning Objective 3.2.1 Know the nature of Riba 3.2.2 Know the rationale for the prohibition of Riba 3.2.3 Understand the different types of Riba As highlighted in section 3 of this chapter, the Principle of Permissibility implies that economic activities are acceptable unless otherwise stated by Shariah. This section focuses on the major prohibitions. 4.1 Nature of Riba One of the most important rules of Islamic finance is the prohibition of Riba which is absolute and unqualified. The lexical meaning of the word Riba is excess, and is most commonly interpreted to mean interest in which case any addition over and above the loan amount is Riba. The prohibition of Riba is not unique to Islam but is common across Judaism and Christianity as well. Other faiths, such as B

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