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This topic reviews some basic concepts of Islamic banking and finance. It deals with riba and commercial contracts. This topic helps us to understand/justify the need for IBF. Coverage include:
Riba: Definition, Evidence, Types Issues on Riba: Misconceptions & Rationales Financial contracts in Islam
Riba - Definition
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Literally excess, increase, expansion, growth Technically every excess in return of which no reward or equivalent counter-value is paid a predetermined excess or surplus over and above the loan received by the creditor conditionally in relation to a specified time period A forced increase in value in the amount being loaned out Premium that must be paid by borrower to lender along with the principal amount as a condition for the loan or for an extension in its maturity
Riba - Definition
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Modern jahiliyyah:
Lending out money to another on a condition that after a certain time it would charge a fixed amount in addition to the principal Addition with no additional labor but due to time for which the principal has been borrowed
3 elements of riba:
Excess/surplus over and above the loaned capital Determination of the surplus according to time Bargain to be conditional on the payment of the pre-determined surplus
Al-Quran on prohibiting riba: al-Rum verse 39, al-Nisa: 161, al-Imran: 130, al-Baqarah: 275-281. For example:
(2:275) they say, trade is like riba, but Allah has permitted trade and prohibited riba beware of the war on the part of Allah and His Apostle
Various sunnah on prohibition of riba, severity of its sin and its form. An example:
The Prophet of Allah s.a.w. cursed the receiver and the payer of riba, the one who records it and the two witnesses to the transaction and said: they are alike (in guilt)
All jurists agree that riba is prohibited (haram) Prohibition of riba comes in stages:
Stage 1: Stress the fact that riba does not increase individual/national health, but on the other hand it decreases wealth (al-Quran, 30:39) Stage 2: Warning if not obeying the injunction (al-Quran, 4:161) Stage 3: Muslims are told not to take compound interest if they want real success in life (al-Quran, 3:130) Stage 4: Distinguish between trade and riba. Believers should refrain from interest or they will suffer both in this world and in the hereafter (al-Quran: 2;275-276) Stage 5: Clear prohibition of interest and declared it as unlawful in muslim society (al-Quran, 2:278-281)
Types of Riba
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Riba al-Qard
1. Loan with interest or other benefits
-when there is a predetermined excess/surplus over the loan received by the creditor conditionally in relation to a specified time period
Various incidences of riba al-Qard (i.e. riba that arises from loan):
repayment or default
-Jahillians increased the amount of debt outstanding if payment is overdue = riba al-jahiliyyiah
The Arabs used certain commodities like wheat, barley, dates and salt (termed as ribawi items) as medium of exchange to purchase other things, and as such they were like money The basis for prohibition of riba in exchange of commodities is based on hadith of the Prophet on six commodities (i.e. ribawi items): Gold for gold, silver for silver, wheat for wheat, barley for barley, dates for dates, salt for salt like for like, equal for equal, and hand-to-hand (spot); if the commodities differ, then you may sell as you wish, provided that the exchange is hand-to-hand or a spot transaction. [Muslim]
Riba al-Bay
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Food1 + Food2
Money + Food Money + Others
Food + Others
Others + Others
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Riba al-Bay
Interpretation
In trading commodities of same group (gold for gold), both commodities must be exactly equivalent and prompt delivery In trading commodities of same group but different kind (gold for silver), promptness of delivery a condition with some exception in food and food exchange (eg. Rice with wheat).
In trading commodities of different groups and kind (gold for wheat), no condition imposed, free trading can exist.
Islam encourages earning of profits from trade but forbids charging of interest
Riba al-Bay
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Implications
Certain restrictions imposed upon trading of ribawi commodities One presumable rationale for such an injunction is to curb price speculation on essential items Some jurists have relied on this Hadith to render modern-day currency derivatives impermissible
Several misconceptions about riba and its prohibition, resulting in confusion in its applications
Interest-based commercial transactions were invented by modern day business; thus, not covered by the riba referred to in the Quran Bank interest is not riba because it is not excessive (usurious) Riba should be allowed under dharurah Riba is only relevant to consumption loans, not commercial loans
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Argument
Prohibition of riba was revealed in the last days of the Prophets life Did not elaborate on the interpretation and definition of riba Ambiguity in the meaning of riba (area of Mutashabihaat): its prohibition cannot be extended to modern day banking
Addressing Misconception
Fact that Prophet included prohibition of riba in his last sermon does not mean that the prohibition was only introduced at that time Emphasizing importance, given the last sermon was attended by most of his followers, reiterate prohibition of riba Other prohibitions were also not given elaborate definitions E.g. prohibition of pork, liquor, gambling, adultery, etc. These were well known to its immediate audience
However, riba has substantial affects on wellbeing - relates to prevalent economic and social practice It is not imaginable that Allah the All-Merciful would wage war against a practice, which correct nature is not known to anybody
Argument
Al-Imran (3:130) - O those who believe do not eat up riba doubled and redoubled If rate of interest is not excessive (e.g. doubled) then it does not constitute riba and therefore not prohibited
Argument
Doctrine of Necessity under dharurah circumstances, the haram is permissible E.g. It is permissible to consume pork to save ones life from dying of hunger
Argument
-The common practice of riba during the time of its prohibition was the charging of interest on consumption loans taken by poor people to finance their basic needs -This form of exploitation is not present in production loans whereby in many cases, the debtor is economically well-off
Loans taken by rich businessmen are used to generate profit Basic cause of prohibition of riba, zulm (injustice), is absent
Quest for economic development clouds good moral judgment and Islamic value system
Greed leads to unethical business practices eg. greed in pay packages Degradation of natural environment (to reduce cost) Less emphasis on institution of family leads to social ills Essentially, Muslims forget their roles as abd and khilafah Members of society should help each other in times of need Riba entails taking advantage of another people Breeds hatred, jealousy, ill-will towards the rich
FINANCIAL CONTRACTS-i
Islamic financial products and services that are in accordance with the shariah (shariah-compliant) Emphasizes on ethical, social and dimensions of financial transactions which enhance equity and fairness for general benefit of the society Financial transactions which are free from riba, gharar and maysir Important role of financial contracts
Contract in Islam
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Islam prefers a market system where there is a need for exchange of goods and services. This exchange needs to be taken according to rules and regulations as defined by the shariah Contract in Islam is known as aqd
Contracting parties: individual/group/organization/state Medium/channel of communication: verbally/letter/telephone/sign/electronically Subject matter: physical goods/products/services Primary objective: al-bay (exchange and benefits of counter-value) or hibah (gift). Secondary objective (motive) must not conflict with primary objective
1. Trading-based arrangements
Murabahah Bai-bithaman ajil
2. Leasing-based arrangements
Operating lease Financial lease
3. Equity-based arrangements
Mudharabah Musyarakah
Trading-Based Arrangements
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Re-sale above the cost price (cost-plus) Shariah condition: Goods be clearly specified; quantity, kind/type, attributes Price to be paid including the profit must be agreed upon Complete/total posession must be given to buyer Transaction must be free from riba, gharar and maysir There must be two separate contract between the bank and supplier, and between the bank and customer
BBA
Deferred payment sale A type of murabahah where the murabahah payment is being deferred to a future date
Trading-Based Arrangements
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Murabahah
i) Used for short-term (less than one year) financing i)
BBA
Used for medium and long term financing
the
Trading-Based Arrangements
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Conventional
1. There is dichotomy between financing and the use of funds
2. Claims of Bank/obligations of bank Client are adjustable
Leasing-Based Arrangements
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Asset remains the property of the lessor Period of contract be specified Rental and its payment schedule be precisely stated Asset remains in working condition during the period of
the contract (lessors responsibility)
Leasing-Based Arrangements
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Leasing-Based Arrangements
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There are primarily two kinds of leasing: financial or capital leasing and operating leasing Operating leasing
Bank can adopt the course of operating lease with its client The obligation to arrange the asset can also be delegated to the client through wakalah (contract of agency)
Also called al-Ijara wa al-Iqtina Leasing ends with ownership transfer of asset to lessee Differences of opinions among Muslim scholars regarding validity of this type of leasing, majority goes in favor
Equity-Based Arrangements
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Equity-Based Arrangements
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Some of critical points and conditions about Mudarabah and Musharakah from the shariah perspectives:
1.
2.
Nature and scope of partnership must be defined Nature of role of mudarib/entrepreneurs must be explicitly stated Profit-sharing ratio of fruits of economic activity need not be proportion to equity-stakes of the partners (e.g. when capital ratio is 50:50, profit sharing ratio can vary, such as 70:30). Ratios must be precise and set before the contract goes into effect.
3.
4.
leasing products, especially Murabahah, BBA and financial leasing, service charges on loans, credits Some Muslim scholars believe that these products operate on the basis of time value of money, which is basically tantamount to Riba Issue on well-defined standards for Islamic banking products
Prohibition of gharar
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Literally: Deceit, fraud, uncertainty, danger, peril, or hazard that might lead to destruction or loss Technically: uncertainty caused by lack of clarity regarding the subject matter or price in a contract of exchange All jurists agree that gharar should be avoided in commercial exchange contracts A sale of a thing which is not present at hand or whose consequences is not known
Prohibition of gharar
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Contemporary scholars differentiate between minor and major gharar Types of gharar 1. Gharar yasir (minor or slight)
Tolerated and will not invalidate a contract
2.
Rationale for prohibition of gharar To ensure full consent and satisfaction of the parties in a contract
Without full consent, a contract may not be valid Can only be achieved through certainty, full knowledge, full disclosure and transparency
Gharar in commercial contracts may lead to injustice, exploitation and/or enmity among contracting parties
Prohibition of maysir
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Definition: easily available wealth; acquisition of wealth by chance A form of gambling Many direct references in the Quran prohibiting gambling, for example: Satan intends to excite enmity and hatred among you with intoxicants and gambling, and hinder you from remembrance of Allah, and from prayer (5:90) They ask thee concerning wine and gambling. Say: In them is great sin and some benefits for people; but the sin is greater than the benefits (4:219)
Concept of iwad
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Components of iwad
1. 2. 3. Risk (ghurm): Market risk price risk, holding costs, obsolescence Work and effort (ikhtiyar): Services or activities that value-add Liability (daman): Product liability borne by seller, in the event of defects
CONCLUSION
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To be safe: Follow mainstream view on riba and interest IBF is not only about interest-free banking Debt-based is never totally impermissible even though equitybased instruments have more economic merits. Ingredients of a successful project is