FUNDAMENTALS OF ISLAMIC BANKING: PRODUCTS

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FUNDAMENTALS OF ISLAMIC BANKINGPRODUCTS
INTRUMENTSDR. AZNAN BIN HASANAHMAD IBRAHIM
KULLIYYAH OF LAWS,INTERNATIONAL ISLAMIC
UNIVERSITY MALAYSIAhaznan_at_iiu.edu.my
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Outlines

• Framework of Islamic Finance
• Shariah, Fiqh Muamalat
• Necessary Requirements of Islamic Finance
• Essential Contracts in Islamic Finance
• Products and Instruments
• Standardisation and harmonisation in Islamic
  Finance

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Framework of Islamic Finance

• In general, the framework of Islamic finance is
  the same framework used by the conventional
  finance practices.
• These frameworks are, inter alia legal and
  regulatory framework, taxation framework,
  accounting and auditing standards, etc.
• Might have different or additional framework,
  such as accounting and auditing standard, etc,
  due to its peculiarity.
• In certain jurisdiction, Islamic banking and
  finance might be regulated by different sets of
  regulations, either separate or additional, e.g.
  IBA 1983

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Contd

• However, Islamic Finance, as the name suggests,
  has another framework, which is considered the
  major element that differentiates IBF from the
  conventional banking and finance.
• Any violation of this framework will definitely
  effect the validity of Islamic finance itself.
• Shariah Compliance Framework

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The Shariah Framework of Islamic Banking and
Finance

• Three main interrelated terminologies Shariah,
  Fiqh Muamalat
• Shariah, when viewed from legal perspective is
  the fixed elements of Islamic law, i.e. what has
  been clearly stipulated and mentioned in the
  text. E.g. five time prayers, prohibition of
  riba, etc.
• As such, it is revealed in nature

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Shariah Fiqh

• Shariah, in this sense, is wide and encompassing
  various branches of Islam
• Normally, it comes in its generality and it
  emphasizes only on the principles and not the
  detailed rules (not all the time)
• It is the duty of the judge (qadi), mufti and
  jurisconsult (ulama) to exert their intellectual
  efforts in deriving and applying these principles
  on certain given scenarios.
• The result of human reasoning and understanding
  to the shariah is known as fiqh
• Fixed v. Flexible
• Agreements v. Differences

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Fiqh Muamalat (Islamic Commercial Law)

• However, in its general usage, it is called
  al-syariat al-Islamiyyah (Islamic law).
• Islamic commercial law is one of the components
  of Islamic law
• Other components of Islamic law include
• Islamic law of purification and worship
• Islamic family law
• Islamic criminal law
• Islamic law of evidence and procedure
• Islamic law of inheritance, etc
• The main subjects of Islamic commercial law are
  commercial contracts and the rules governing them

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Islamic Finance Paradigm

• Original rule of permissibility
• - Initial legal ruling in commercial contract
  is permissibility
• - Contrary to acts of devotion (Ibadat)
• - No legal injunction is needed in
  sanctioning new contract
• - Every contract is considered lawful and
  acceptable if no principle of shariah is
  violated
• - Open a very wide door for further
  innovations
• Real Economic Activities
• Transactions-oriented not loan-based.

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What to do and what to avoid

• Conclusion of contract by mutual consent
• The avoidance of riba
• The avoidance of gharar
• The avoidance of transactions involving maysir
  (gambling)
• The avoidance of transactions involving
  prohibited commodities

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Mutual Consent

• al-Quran (429) O you who believe, devour
  not your property among yourselves by unlawful
  means except that it be trading by your mutual
  consent. verse al-Nisa (429)
• Manifested through expression of the parties
• No certain formalities in concluding contract
• In general, mutual consent is achieved if it is
  made freely by a competent person (puberty and
  prudence)

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The avoidance of riba

• Literally excess, expand, increase, growth
• Any unjustified excess above and over the
  capital, whether in loans (between creditor and
  debtor) or in trade (with similar commodities)

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DIVISION OF RIBA
Type of Riba
Riba al-buyu (Riba in exchange contracts )
Riba al-Duyun (RIba in Loan Contract)
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Riba al-duyun

• The debtor borrowed money to be paid in certain
  time, and the amount is more that the amount
  borrowed
• A creditor gives a periodic loan and takes
  monthly interest. The capital sum lasts until the
  expiration of the period. Upon expiry, if the
  debtor cannot pay, the period to pay back the
  capital will be extended and interest will be
  charged
• Arising out of exchange contract, a buyer must
  pay a consideration. If he failed to settle on
  time, the period will be extended by increasing
  the amount (principle interest).

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Riba al-Buyu

• Mainly based on the saying of the Prophet Gold
  for gold, silver for silver, wheat for wheat,
  barley for barley, dates for dates, and salt for
  salt like for like, hand to hand, in equal
  amounts and any increase is riba.

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Contd

• These commodities can be classified under two
  main categories which make the illah (ratio
  decidendi) for their prohibition
• - i- medium of exchange (currency) Gold
  and Silver
• -ii- Staple foods Wheat, barley, dates
  and salt
• Any other items, even though not mentioned in the
  hadith but serve the same purpose will be
  considered as having the same illah by way of
  qiyas (analogy)

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RIBA IN MODERN FINANCIAL TRANSACTIONS

• Riba al-duyun in loans and certain
  controversial contracts (bay al-inah, bay
  al-dayn, etc)
• Riba al-buyu mainly in bay al-sarf
• (exchange of currencies)

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THE AVOIDANCE OF GHARAR

• Meaning of gharar
• - Literally risk, uncertainty, hazard
• - The sale of probable item whose
  existence or characteristics are not certain, due
  to the risky nature which makes the trade similar
  to gambling

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EXAMPLES OF THIS KIND OF SALEIN HADITH

• Sale of fish in the sea, birds in the sky
• Sale of unborn calf in its mothers womb
• Sale of runaway animal, slave
• ? Involve item which may or may not exist
• However, the Prophet did not lay down the
  principles (qawaid) for the prohibition of
  gharar.
• Examples given in the hadith were some of the
  manifestations of the doctrine, but not
  principles.
• This has led to the dispute among jurists on the
  area and coverage of gharar.

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Application of Gharar

• Broadly speaking, gharar will effect the validity
  of contract if it occurs in these areas
• - gharar in kind / type / attribute /
  quantity of the object
• - gharar due to delivery time
• - gharar due to the price/ mode of payment
• - doubt over the ability to deliver

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The Benchmark

• Gharar is excessive (gharar fahish)
• Occurs in exchange contracts (uqud al-muawadat)
• Effects the subject matter of the contract
  directly, not just the appendage
• No public need (al-hajah al-ammah) for the
  contract in discussion.

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Contd

• However, the subjectivity of this benchmark is
  very obvious
• Demarcation on excessive and trivial gharar
• Determining the public need? To what extend
• Inevitably, this demarcation will be influenced
  by differences in time, societies, individual
  taste and preference, technology and the way
  certain transaction is conducted as well as
  regulatory framework.

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Contd

• To prevent gharar, the parties to contract must
  have adequate knowledge and information on the
  subject matter
• i- Their existence and deliverability
• ii- Its quality, quantity and attributes are
  known
• iii- Time frame for payment and delivery

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Tolerable gharar

• However, gharar is tolerable if
• - i) it is trivial (gharar yasir)
• - ii) It occurs in other than exchange
  contracts,such as in gratuitous contracts.
• -iii) It happens to the ancillary
  object (appendages) only
• (not the principal and main subject matter of
  contract).
• - iv) the economic need for the
  contract embodying the risk is
  substantial

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The avoidance of transactions involving maysir
(gambling)

• Involves the creation of risk for the sake of
  risk
• A combative relationship between two contracting
  parties, each of whom undertakes the risk of loss
  and the loss of one means gain for the other
• Apply to all games of pure chance
• No economic activities are gained in the
  practice. The gambler will simply seek to amass
  wealth without efforts.
• Gambling is gharar in its worst scenario.
• Prohibited by al-Quran in Surah al-Maidah (590)

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TRANSACTION INVOLVING PROHIBITED COMMODITIES

• It is also not allowed to conclude contract on
  illegal commodities such as pork, liquor etc.
• Illegality of certain commodities has been spelt
  out clearly in the texts of al-Quran and Sunnah
  of the Prophet.
• E.g.
• - Surah al-Maidah (53)
• - Surah al-Maidah (5 90)

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Essential Contracts in Islamic Finance

• Underlying principles utilised in devising
  products of IBF is very important as they
  separate IBF from conventional products.
• Contrary to conventional finance, which is
  specification driven product, Islamic finance is
  more structure and principle based product
• Rules and regulations will differ from one
  product to another, depending on the structure
  employed
• In general, various underlying Shariah principles
  have been utilised in devising products of
  Islamic Banking and Finance.
• They can be summarised as below
• - Sale based products
• - Lease based products
• - Participatory products
• - Fee based products

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Examples of the products and underlying principles

• Banking products
• IIMM products
• Capital Market Products

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Islamic Banking
ISLAMIC BANKING
SOURCES OF FUND
APPLICATIONS OF FUND
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SOURCES OF FUND
Sources of Fund
Current/ Saving Account
General/ Special Investment
NIDC
SBBA
Bay al-Dayn
Bay al-Inah
Wadiah Yad al-Dhamanah
Mudarabah
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Applications of fund
DEBT FINANCING
EQUITY FINANCING
Lease Based Financing -Ijarah -AITAB
Fee Based Services Wakalah Kafalah
Mudharabah Musharakah
Sale based financing BBA / Murabahah Inah
/ dayn Salam Istisna
Comsumer Banking
Corporate Banking
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IIMM
IIMM
BNNN
NIDC
MII
GII
IAB
IPDS
Q. Hasan
al-Inah
Al-Inah
Bay al-Dayn
Bay al-Dayn Bay al-Inah Etc.
Mudh.
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ISLAMIC CAPITAL MARKET
ICM
Equity Market
Bond Market
Derivatives Market?
-Future Contract -Options -Swap
Musyarakah Mudarabah

• Debt Based
• ABS
• Equity Based

Mutual Fund / Islamic REITs Wakalah / mudarabah
/ musharakah
Islamic Hedge Fund
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Shariah Differences

• Not all of these products and instruments are
  accepted by all jurists.
• Some differences arise as to the acceptability or
  otherwise of these products and instruments
• But more convergence than divergence

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Examples of main divergence

• Utilisation of disputable contracts, e.g bay
  al-Inah Tawarruq
• Underlying Assets and its suitability in becoming
  SM, e.g. future asset, deferment of both price
  and SM, financial right and its tradaility), ect.
• Terms and conditions of contracts, e.g. cross
  default, liberty to stipulate terms and
  conditions
• Purpose of Financing, e.g. Valid transaction but
  to be used for unislamic purposes

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Reasons for divergence

• Differences of interpretation of the meaning of
  words or intent of any particular injunction in
  the primary text, either in the Quran or Sunnah
  Human Reasoning
• Different need base
• - Legal framework
• - Incentive mechanism
• - Cultural preference
• - Etc.

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How Islamic Law Views Divergence

• Back to basic Divergence is the nature of human
  being. Small or big, principles or branches,
  anything that involves human thinking,
  understanding and reasoning, the divergence is
  inevitable.
• Shariah vis-à-vis fiqh Fixed and flexible
• Pluralism has been part and parcel of Islamic
  law, since its very initial days.

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Contd

• Jurists considered it permissible as long as
• there is no clear-cut texts (nas qati) on the
  matter
• the opinion is arrived at by using acceptable
  methodology, such as, by way of analogy (qiyas).
  
• Good or bad Depends on how it is dealt with

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Should We Have Full Convergence

• Arguably, it is the most desirable one, but
• Be realistic
• In certain circumstances, divergence might have
  its advantages
• So, the more realistic approach ? standardisation
  harmonisation
• Differences in preference should not be
  standardise,
• - e.g. current and savings accounts
  (wadiah or mudarabah)
• - Takaful structures wakalah or
  mudarabah

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The Needs for Shariah Standard

• Universal trading.
• Issue of marketability
• Consistency stability to the product
• It will facilitate other enhancement process

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Methods for standardisation/ harmonisation
(Domestically / Internationally

• Regulations and Guidelines (IBA, Guidelines on
  the Issuance of Islamic Securities 2004, Islamic
  REITs etc.
• Circular Circular on Asset Pricing by SC
• Supervision Central Bank Act 1958 (sec 16B)
• Basic Guidelines for main contracts Guidelines
  for the issuance of Islamic Securities 2004
• International Standard AAOIFI Syariah Standard

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Case Study AAIOFI

• The effort to create the standards has started
  with the establishment of Accounting and Auditing
  Organization for Islamic Financial Institution
  (AAOIFI) in Bahrain.
• AAOIFI has produced a number of Shariah
  standards for Islamic financial institutions
  covering both products and services
• Enforceability of these Shariah standards
• Bahrain and Sudan
• Other jurisdictions

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Contd

• Members are representative from various
  continents ? can become a mechanism to bridge the
  disagreement.

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Round-up Discussion on harmonization /
standardization

• Disagreement is inevitable
• Approach to harmonise and standardise is more
  practical, rather than full convergence
• Administrative and regulatory approach
• Continuous interaction among Shariah Advisors
  will help to close gap and standardise
  understanding
• Shariah Advisors nurturing products which are
  globally accepted.
• International Shariah Advisory Council?

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Conclusion

• Besides various frameworks applied to banking
  practices (be it Islamic or conventional),
  Shariah framework is a framework which is
  peculiar to Islamic finance alone
• Yet, it forms the very substance of Islamic
  finance, without which Islamic finance will loss
  its Islamicity
• As such, in practicing Islamic finance, the dos
  and donts must be clearly observed
• Islamic commercial law, from the fact that it
  subjects to human interpretation and
  understanding admits differences of opinion, as
  long as these differences are grounded by valid
  evidence, produced by capable personnel, done
  according to the right methodology

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Contd

• Full convergence in all aspects might be too
  idealistic
• More practical is to have standardisation and
  harmonisation of opinions
• More efforts are needed in this aspect

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• THANK YOU
• WASSALAM

haznan_at_iiu.edu.my 03-61964201 012-2121536