PART III ISLAMIC FINANCE – PRODUCTS AND PROCEDURES 177 8 Overview of Financial Institutions and Products: Conventional and
M. Fahim Khan Division Chief
4.8 SUMMARY
We have discussed the central ingredients of Islamic finance and some relevant aspects that could be helpful in achieving Shar¯ı´ah compliance for Islamic banks’ transactions. The term
“Islamic finance” or “Islamic banking” simply refers to a state of affairs wherein the financial institutions and the clients have to fulfil the relevant principles of Islamic jurisprudence.
Some conditions have been put in place to ensure that contracts do not contain the elements of Riba, Gharar and Qim¯ar – the main prohibitions as discussed in Islamic law.
Some of the major characteristics of Islamic banking can be described as follows: Islamic Shar¯ı´ah does not prohibit all gains on capital. It is only the increase stipulated or sought over the principal of a loan or debt that is prohibited. Islamic principles simply require that the performance of capital should also be considered while rewarding the capital. The prohibition of a risk-free return and permission to trade, as enshrined in verse 2: 275 of the Holy Qur’¯an, makes the financial activities in an Islamic set-up real asset-backed with the ability to cause
“value addition”.
Profit has been recognized as “reward” for (use of) capital and Islam permits gainful deployment of surplus resources for enhancement of their value. However, along with the entitlement to profit, the liability of risk of loss on capital rests with the capital itself; no other factor/party can be made to bear the burden of the risk of loss. Therefore, financial transactions, in order to be permissible, should be associated with goods, services or benefits.
While at a micro level this feature of Islamic finance leads to the generation of real economic activity and stable growth, at a macro level it can be helpful in creating better discipline in the conduct of fiscal and monetary policies.
The Islamic banking system is based on risk-sharing, owning and handling of physical goods, involvement in the process of trading and leasing and construction contracts using various Islamic modes of business and finance. As such, Islamic banks deal with asset management for the purpose of income generation. They have to prudently handle the unique risks involved in the management of assets by adherence to the best practices of corporate
23Shariat Appellate Bench, 2000, p. 593.
governance. Once the banks have a stable stream of Halal income, depositors will also receive stable and Halal income.
Islamic banks reflect the movement towards eliminating the role of interest in human society, in keeping with the teachings of Islam and other major religions. They mobilize resources through Shar¯ı´ah-compatible ways. The most important of these are demand and investment deposits as well as shareholders’ equity. Demand deposits normally do not participate in profit or loss to the banks and their repayment is guaranteed. In contrast with this, investment deposits are mobilized on the basis of profit/loss sharing. This should motivate the depositors to monitor the affairs of their banks more carefully and to punish them by withdrawing their deposits if the banks’ performance is not up to their expectations.
Islamic banks are, therefore, under a constraint to manage their risks more effectively.
If the banks, with the money mobilized on the Shirkah principle, conduct business keeping in mind the Shar¯ı´ah principles of trade and lease, their business will be Islamic and the return earned and distributed among the savers/investors will be Halal. They have to avoid Riba – earning returns from a loan contract or selling debt contracts at a discount or premium – Gharar – absolute risk about the subject matter of the contracts or the price – gambling and chance-based games and general prohibitions and unethical practices.
The rules pertaining to currency exchange contracts (hand to hand and in equal quantity in case of homogeneous currency) have also been discussed. Violation of these rules will result in Riba Al-Fadl (where the quantity of hand-to-hand exchanged money is different) or Riba Al-Nasiah (where money is exchanged for money with deferment).
This chapter has also explained that money has the potential for growth when it joins hands with entrepreneurship. Therefore, money has time value, but this can be manifested in sale/leasing contracts only. Accordingly, a person can sell any commodity for one price on a cash-and-carry basis and for a higher price on a deferred payment basis. However, this is subject to certain conditions, the fulfilment of which is necessary to differentiate interest from legitimate profit. What is prohibited is any addition to the price once mutually agreed because of any delay in its payment. This is because the commodity once sold, even on credit, belongs to the purchaser on a permanent basis and the seller has no right to re-price a commodity that he has sold and which no longer belongs to him. It further transpires that time valuation is possible only in business and trade of goods and not in exchange of monetary values and loans or debts. Loaning is considered in Shar¯ı´ah a virtuous act from which one cannot take any benefit. The discussion in the chapter leads to an important conclusion that valuation of the credit period based on the value of the goods or their usufruct is different from the conventional concepts of “opportunity cost” or “time value”.
Islamic economics has the genuine provision of converting money into assets, on the basis of which one can measure its utility. While it concedes the concept of time value of money to the extent of pricing in credit sales, it does not uphold generating rent to the capital as interest does in credits and advances, leading to a rentier class in society. Hence, economic agents in an Islamic economy will have positive time preference and there will be indicators available in the economy to approximate the rates of their time preferences, generally determined by the forces of demand and supply. There is no justification to assume a zero rate of time preference in real sector business in an Islamic economy.
Besides trading, Islam allows leasing of assets and getting rentals against the usufruct taken by the lessee. All such things/assets, the corpuses of which are not consumed with their use, can be leased out against fixed rentals. The ownership in leased assets remains with the lessor, who assumes the risks and gets the rewards of his ownership.
Other salient features of Islamic finance are:
• Differentiating between trading (definite transfer of ownership of goods against payment of price), loaning (temporary transfer of ownership of goods/assets free of any payment) and leasing (transfer of usufruct of goods against payment of rent).
• All gains on principal are not prohibited and the deciding factor is the nature of the transaction.
• Lending is a virtuous act – not a business.
• Islamic banking is a business; lending will not be its regular business. Rather, banks will be facilitating production and trade just like any business ventures, charging profit from the business community and giving ex post returns to savers/investors, getting management fees/shares for their services.
• Entitlement to profit is linked with the liability of risk of loss that comes with the capital itself. Profit is earned by sharing the risk and reward of ownership through the pricing of goods, services or benefits.
The discussion in this chapter has aimed at removing the myths about Islamic banking.
Major findings in this regard are:
• A fixed return in the pricing of goods and their usufruct, subject to fulfilment of the relevant Shar¯ı´ah essentials, is permissible.
• Islamic banking is also a business to be conducted by the funds mobilized primarily from the middle class of the economy. This does not mean the availability of cost-free money.
Islamic banks earn through trade, lease and services and the income is distributed among the suppliers of funds on the basis of defined principles.
• It is absolutely normal that in trade, the cash and credit prices of a commodity are different, provided one price is settled before finalization of the contract and there is no change in the liability thus created.
• While trade profit is permissible, any excess payment sought on loans or debts is prohibited due to being Riba. The profit margin that banks charge in their trade operations is permissible if the trading principles given by Islam are taken care of.
• It is true that the preferable modes for financing operations by banks are Shirkah- based modes (Musharakah and Mudarabah). But trading and lease-based modes are also permissible. Banks can use all of these modes, keeping in mind the risk profile of the savers/investors and cash flow and profitability of the fund users.