CHAPTER 3

Uncovering the Driving Principles of Islamic Finance

A Journey to Accumulate Wealth Responsibly

Saiful Azhar Rosly and Noripah Kamso

O ye who believe! Squander not your wealth among yourselves in vanity, except it be a trade by mutual consent.

(An Nisa: 29)4

And O my people, give full measure and weight in justice and do not deprive the people of their due and do not commit abuse on the earth, spreading corruption.

(Hud: 85)4

INTRODUCTION

On March 4, 2009, it was reported that the Vatican said banks should look at the rules of Islamic finance to restore confidence amongst their clients at a time of global economic crisis. The Vatican’s official newspaper, Osservatore Romano, said, “The ethical principles on which Islamic finance is based may bring banks closer to their clients and to the true spirit which should mark every financial service.”1 The Osservatore’s editor, Giovanni Maria Vian, said, “The great religions have always had a common attention to the human dimension of the economy.”2

Islam postulates a unique nexus of contracts among the Creator, people, and society on the basis of the Divine law that directly affects the working of the various social, political, economic, and financial systems. Therefore, to understand the way in which economic affairs and capital market players are to be organized in an Islamic system, it is first necessary to comprehend the nature of this relationship.

What differentiates Islamic finance from other systems of thought is its unitary perspective, which refuses to distinguish between sacred and profane and which insists that all of its elements must constitute an organized whole. Consequently, one cannot study a particular aspect or part of an Islamic system—say its economic system—without knowledge of the conceptual framework which gives rise to that part or aspect any more than one can study a part of a circle without conceptualizing circles in general.

In modern capital markets, interest payment plays a very important role. In fact, in the Western world people cannot think of any investment strategy without payment of interest. In the last three decades, a completely new way of investing evolved, through the applied Shariah Islamic investment. It offers a new paradigm and proves that investment still can be valuable and profitable without the interest element itself. Islamic investment interpretation has its roots in Islamic Divine Law (Shariah), which explicitly forbids any kind of investment or business activities that involve unfair and usurious elements. It means Islamic investments are based on acceptable driving principles that distinguish it from modern, conventional investment. This Islamic Divine Law is derived from one common source, which is the Holy Qur’an and Sunnah.

It is important to remember that Islamic Divine Law, or Shariah, was revealed for one basic universal purpose: to make the best interests of all humankind on earth, with the primary users being the state, the management, and the people. The integral part of the moral philosophy of Islam is its goal of social economic justice and equitable distribution of income and wealth. Human interests on Earth are realized through different means, of which a dominant activity is involvement in business activities and investment. To better understand underlying principles on which Shariah-compliant investment is based, it is important to understand the objectives of Shariah themselves. Objectives of Shariah should be in line with benefits (masalih) of Shariah as well, since the basic purpose is to protect interests of humankind.

Accordingly, goals, benefits, and objectives of Shariah (Maqasid al Shariah) are explained as follows:

• Preservation of Shariah through Divine source, which is Qur’an and Sunnah
• Protection of necessities, which include: life, religion, property, intellect and protection
• Preservation of complementarities, which include matter that people need in order to remove restriction and difficulties in applying the above necessities
• Preservation of embellishments intended to render human affairs or condition more inclined towards the highest standard of moral conduct3

THE FIVE BASIC PRINCIPLES OF ISLAMIC FINANCE

To apply these Shariah compliance functions, it is necessary to further elaborate on the concept of public interest (maslahah al-ammah). Public interest constitutes protection of everything that is useful for whole or most of the community, and doesn’t concern only individuals but considers those individuals as member of the whole. One example is the safeguarding of everything that possesses economic value from natural or human-induced destruction. It is clear that all Shariah-compliant investments need to be in line with Shariah objectives and public interest. Therefore, all contemporary guidelines for Shariah investment must be developed bearing in mind the underlying Shariah concepts as just mentioned. Consequently, the five basic driving principles of Islamic activities that influence Islamic investment are:

Prohibition of Interest Payment (Riba)

Riba literally means “to increase” or “to grow” in Arabic language. It is a predetermined and contractual increase that the borrower must pay on a loan given by the lending party in regard to financial transactions. Firstly, interest is derived from lending and borrowing. Loans are given via contracts of debt with repayment consisting of the principle loan plus a predetermined and contractual increase (i.e., interest). The second category of interest can arise from the exchange or sale of identical commodities that involve foodstuff and medium of exchange (currencies and debt instruments).

Interest is the excess money paid by the borrower to the lender over and above the principal for the use of the lender’s liquid money over a certain period of time. Financial products bearing the element of interest are deemed nonpermissible (haram). These include interest-bearing bank loans and deposits, government bonds, private debt securities, and money market instruments.

Money in Islam is not a commodity. It is a medium of exchange. But it stores wealth. The prohibition of interest arises from the fact that money is perceived only as a medium of exchange, a store of value, and unit of measurement. It possesses no intrinsic value.

Interest can arise when a commodity has been exchanged for an unequal amount of the same commodity or in cases when the amounts are equal but the delivery is deferred to future date. Another implication is that the Islamic ban on interest (riba) is not merely a monetary phenomenon. It is not a case reserved specially for banking and finance. Of equal importance is one involving the real sector.

Shariah serves to protect public interest, one of which is the protection of wealth; exchange of commodities involving basic necessities must be conducted in a win-win situation. This implies that exchange must take place in equal value. For any excess being interest, only one party gains while the other will not.

With financial interest, it is believed that some society members are becoming richer, while providing no equal counter value. It also creates opportunity for fraudulent activities. Interest prohibition corresponds to Islam’s goal of eliminating exploitation, not only in intrinsic terms, but also exploitation present in all forms of inequitable and unjust exchange in financial transactions.

With the presence of interest (riba), there is a restriction in wealth circulation among the affluent, since they wouldn’t provide loans to those whom they believe wouldn’t be able to repay them, thus not everyone would have equal opportunity. This contradicts to Qur’anic indication of wealth distribution between rich and poor.

Behavior toward Risk and Uncertainty

If we want to create a bond, like Sukuk, the cash flows extracted from the underlying assets should be characterized by a fair degree of periodic stability. However, this feature doesn’t necessary make the Sukuk risk-free instruments. Indeed, risk taking is valued in Islam; Islamic investment theory validates the distinction between risk (random quantity subject to probabilistic measure) and uncertainty (radical randomness out of the scope of probable distribution). Such a nuance is at the heart of Shariah principles, which rejects uncertainty and ambiguity.

As it can be noticed through previous discussions, much emphasis is asserted on risk in Islam. Risk is the exposure to uncertainty. People generally believe that the future is uncertain and worry that exposure to uncertainties will lead to loss and personal injury. Since uncertainties are often associated with potential harm, risk is also defined as a potential loss. However, uncertainties concerning future events can also imply a positive thing when the outcome is a windfall. Hence, taking risks can lead to profits, as well as losses. Since only God knows what lies ahead, while humans can only make predictions, all efforts to confront risk should be pursued without inflicting harm and injury to the society. Islam’s behavior toward risks has many dimensions based on risk avoidance or risk taking:

• Risk avoidance. Individuals who wish to see their money intact and preserved can do so by putting them in safekeeping. In this way, people who want to avoid potential losses on their assets should know the unwarranted cost of doing so. Avoiding risk in Islam is allowed with a condition that no contractual income is given away on the investment.
• Risk taking. In general, Islam’s attitude towards risk-taking behavior is a positive one. When an individual plans to invest his money and expects to earn returns from the investment, he is not allowed to avoid potential losses from uncertainties of future cash flows of the investment. This means that he can neither expect to receive capital protection nor fixed returns from the investment. He must allow the capital to depreciate or appreciate along with the market movements and is prohibited from passing the risk to someone else.

Prohibition of Uncertainty (Gharar)

Investment outcomes are unknown. Although people can predict the future, nobody knows what the exact future is like. For example, you expected to make 15 percent profit, but the actual profit is only 10 percent. While we can take the risk in business, however, business outcomes are uncertain. Usually, the riskiness deals with the variation of outcome (i.e., probabilities of profits and losses) and not the terms and conditions of contract.

Gharar literally means “uncertainty.” Technically, gharar refers to uncertainty in contractual terms that might lead to unknown results. Any vagueness in rights and liabilities might lead to exploitation in order to deceive people, which could lead to disputes exposing to violation and manipulation of contract. Islamic commercial law requires absolute certainty about the business partners and the terms of contractual obligations, such as the amount of capital invested, nature of project, termination, security, commitment, supervision, profit-loss sharing ratio, settlement of disputes, and so on. If there exists uncertainty in the terms and conditions of the contract, the contract is deemed null and void.

Prohibition of Gambling (Maysir)

Maysir literally means a way of obtaining something too easily and deriving unearned profit—hence, gambling. In an act of gambling, winning and losing are driven by pure chance alone. The outcome of gambling is neither influenced by knowledge nor value-adding elements of the betting parties. In this sense, taking part in gambling exposes gamblers to huge potential losses. People who gamble embrace risk in the most excessive way. They are willing to lose their bets in exchange for a disproportionately huge prize that is impossible to win. As a game of chance, gambling often makes people behave irrationally since their decision is predominantly driven by false illusions of winning big.

This extreme behavior of risk-taking is prohibited in Islam in view of the outcome (i.e., pure chance and loss of money if participants do not get the prize) rather than based on knowledge and value-additions. Islam, however, allows extreme risk-taking behavior when the outcome is based on insightful market research and sound business planning. For example, investment in the venture capital sector is extremely risky. It is common knowledge that out of every ten venture projects, only one is in the money. Failures in venture capital are often caused by market volatilities and lack of monitoring on the investee company. This extreme risk taking is calculated risk and thus not deemed excessive or left to chance.

Prohibition of Dealing with Nonpermissible Activities

Commodities including alcoholic beverages and pork are not permissible, based on many verses of the Qur’an. One important fact is that in these commodities, the harm is greater than the benefits. Since one of the intents of the Shariah is the protection of life (nafs), the consumption of, say, wine is believed to cause long-run adverse impacts on the body, such as alcoholic addiction, that can create further problems like broken marriages and road accidents.

Recent innovations in Islamic investment have led Shariah scholars to resort to independent thinking or ijtihad to deliver legal opinions on complex financial transactions. Examples are:

• Bundles/packages financing: Applying the majority rule. The simple form of a bundle is common stocks. They represent a group of assets, tangible and intangible, including cash and receivables. Yet, they can be traded at a market price that may be different from the face value because of the rule of majority. Consequently, the recognized ruling of Shariah is that common stocks may not be traded at a market price if the majority of the companies’ assets are in receivables and cash.
• Hedging through options versus trading of options. Finally, hedging existing positions may be differentiated from trading options. Although buying options for the purpose of price speculation may be argued as fictitious and profiteering without owning a real asset that may have an independent demand and supply for its own intrinsic utility/productivity, covering an existing position through buying or selling an asset to replicate the economic benefit of an option may be looked at as a means to reduce potential variations in prices and thus tame price speculation. Accordingly, this perspective would find hedging through options useful and permissible, a matter that can also be used in Islamic financial innovation.

Several measures have been suggested to reduce unwanted speculation and to eliminate the elements of gambling. These measures include design of a tax structure linked to the holding period of investment, introduction of transparency, regulation of institutional investors who influence the market, and imposition of restrictions of price changes so that no dealer is allowed to push prices upward or downward.

The practice of short-selling of stock is not compatible with the principles of Shariah. According to Shariah principles, an exchange contract is void unless the intention of the buyer is to buy and of the seller, is to sell, and that no one sells what he does not have. This raises the question of trading a borrowed financial claim, which does not appear to be compatible with Shariah. By eliminating the short-selling facility, markets will discourage speculative behavior, but will also eliminate the arbitrage opportunities that might hamper price discovery of a security.

There are now financial intermediaries serving as Islamic prime brokers like Newedge, which was formed in 2008 by Société Générale and Crédit Agricole CIB as a 50/50 joint venture, who provide brokerage services to the backroom support for Islamic hedge funds.

Application of Trade and Commerce (Al-Bay’) and Obligation of Risk Sharing

Islam is a complete code of life that offers its own social, political, and economic systems to guide human behavior in all spheres of life. Additionally, Islam is a flexible religion, meaning that when Islam imposes a prohibition on something due to its harmful effect on human society, it also provides an alternative for it that is beneficial to mankind. Hence, since Islam imposes strict restriction on interest, it also provides an alternative to it—namely, Islamic trade and commerce. It is therefore important to understand the virtues of trade and commerce.

Since Shariah prohibits injustice in the pursuit of profit and wealth, it encourages trade and commerce as an alternative. The Shariah principles stipulate that trade and commerce is a contract of sale, which includes exchange of one property for another for a consideration or compensation. Shariah determines that this is a legitimate way to make money. It means that people cannot expect to make a profit without assuming loss or risk in their business undertakings.

Under the principle of permissibility, the legal maxim states that all business trade and commerce transactions are initially acceptable except those that are explicitly prohibited or have prohibited elements. The rationale behind this is that Qur’an and Sunnah (the practice of the Prophet, peace be upon him) focused only on prohibited transactions; therefore, jurists have come to the conclusion that any transactions not included are permissible. This is especially applicable in areas where new, creative, and innovative forms of business conduct are needed due to changing times and demands.

The principle that liability justifies the gain indicates that liability and risk taken are accompanied by gain. A person who undertakes the risk is also entitled to a profit.

Also important is the principle that what’s forbidden to take is also forbidden to give. The best example is interest (riba); it is forbidden to take and also to give.

The Shariah specifies nonpermissible professions, trade, and commerce activities that may lead to unlawfully acquired wealth. Wealth from trade and commerce must be earned through “good,” “productive,” and “beneficial” work.

Islam encourages people to utilize, to the fullest extent possible, all the resources that God has created and entrusted to us for our use. Nonutilization of these resources for our benefit and for that of society is tantamount to ungratefulness to God’s provision of those resources. Wealth is considered an important mean by which people can pave the way for the attainment of their ultimate objectives. Islam refers to wealth as good, an object of delight, pleasure, and support for the community.

Islam regards trade and commerce and the creation of wealth as the lifeblood of the community, which has to be constantly in circulation. Therefore, possession of wealth excludes the right of hoarding. The implication is that wealth is lawfully earned—for example, through trade and commerce—and must be lawfully invested within the community to improve its economic well-being.

Investing wealth in Islamic investment funds is not only measured by the monetary gain associated with it but also by the benefits of Islamic investment funds that accrue to the society.

Obligation to Back Any Financial Transaction with Underlying Assets

The alternative to riba, namely trading (al-bay) as examined earlier in this chapter, has amplified the importance of risk-taking in business undertakings where capital is put at risk. While the contract of riba requires the protection of capital and fixed returns, the contract of al-bay as a business enterprise suggests that profits and loss from the trading positions are not known, thus the stipulation of capital and profit certainty in the contract of al-bay is absent. This serves to protect counterparties from making demands that may produce financial injuries on each other.

The contract of al-bay from the perspective of a business transaction, such as an asset-financing facility under a murabaha contract, can also be examined from the legal dimension involving the fulfillment of its respective pillars of contract. A contract is valid only when its pillars are free from the Shariah prohibitions such as riba, gharar, gambling, fraud and the exchange of prohibited commodities. These pillars are:

• Agents
• Subject matter
• Price
• Offer and acceptance

For example, the agents of the contracts must be rational (agil baligh) while the subject matter must be permissible (halal). Price must be stated on the spot, and offer and acceptance must be transparent. In an interest-bearing loan contract, the subject matter is money and it is exchanged for more or less money depending on the financial instruments utilized by the transaction, which is prohibited in Islam as riba. However, Islam allows the exchange of money for money, but only a par value, and the exchange usually falls under the contract of a benevolent loan (qardhu hasan). Thus one cannot profit from making a loan in Islam. However, to profit from a transaction or trading business, the subject matter should constitute a physical asset, coined an “underlying asset” by Islamic finance practitioners. It means that money is now exchanged with underlying assets rather than money itself as evident in interest-bearing loans.

For example, in trading (al-bay) money as capital, say $50,000 is utilized to purchase an asset that may be sold for $70,000 in the marketplace. But the outcome of the business is unknown, hence there is no guarantee that the asset can be disposed of at the intended price. In fact, the business may end up in losses if, say, an unexpected event (e.g., flooding) may cause it to force sell the asset below cost. If all is well, then the business should be able to make a $20,000 profit, which is a lawful one in Islam since it is created from an exchange of money with an underlying asset. However if capital of $50,000 is loaned out in exchange for $70,000 repayments, then this constitutes interest as riba, thus the $20,000 profit is deemed unlawful (haram).

Likewise, in a financial transaction—that is, one involving future obligations to pay, such as that in credit and equity financing—any profit gained from the transaction must be asset-backed, hence the obligation to support the financial transaction with an underlying asset, which, as mentioned earlier, represents the subject matter (mahallul ‘aqdi) of the contract. It means that Islamic financing is a real sector–driven phenemonon rather than one merely fueled by monetary and financial exchanges. As an example, in Sukuk issuance, capital is raised as a result of a true sale of the underlying assets between the originator and the investors.

CONCLUSION

Numerous benefits of Islam, including social justice, equality, preservation of property rights, sanctity of contracts, and the prohibition of interest (riba), can be discussed with relation to the economic behavior of individuals, society, and the state. The driving principles of this chapter, however, focus more on asset management framework, within the numerous tenets of Shariah. Islamic fund management frameworks are at a rather early stage of development. The concept of stock markets, for example, is in consonance with the Shariah principles of profit and loss sharing, but not every business listed on the stock market is fully compatible with the Shariah. These challenges do not hinder the developments of Islamic investment landscape. The screening process of these stocks endorsed by Shariah scholars provides the solution.

Incorporating those Shariah principles to find solutions for liquidity and investment management, efforts are made in two areas—namely, the development of debt-like securities, in the form of asset-backed securities and the development of Islamic investment funds, comprising portfolios of securities not limited to equities or commodities fund.

Clearly the driving principle of trading in monetary obligations (debt), currency, or equivalents of currency obligations demarcated in generic goods, which are not allowed. For example, Shariah rules that the stocks of a company are negotiable only if company owns some non-liquid assets. If all the assets of a company are in liquid form (i.e., in form of money), the stocks are non-permissible to be purchased or sold, except at par value, because it is argued that in this case, the stock represents money only and money cannot be traded except at par.

On the issue of uncertainty, it is comforting to note that recently scholars have distinguished between speculation and calculated risk-taking based on information available in the market.

Integrating the developments of fund management with Shariah principles is not an overnight task. The success of the conventional investment funds is the result of years of evolution. Therefore, challenges confronting the roadmap of a successful Islamic investment fund framework, like standardization of legal framework, disputes of resolution procedures for market practices, development of supporting institutions, financial engineering, and the multidisciplinary expertise of Shariah scholars, are seen as a learning avenue for a new market that cannot start from the experience of conventional market.

NOTES

1. “Tiberge” (blogger). “Vatican Paper Supports Islamic Finance. France Wants Its Share of Sharia Banking.” The Brussels Journal (March 12, 2009). www.brusselsjournal.com/node/3819

2. www.zoominfo.com/#!search/profile/person?personId=538224462&targetid=profile

3. Mashhad al-Allaf. “Islamic Divine Law (Shari’ah): The Objectives (Maqasid) of the Islamic Divine Law, or Maqasid Theory.” Islamic Philosophy Online. www.muslimphilosophy.com/ma/works/maqasid.pdf

4. The verses appreciate that people, regardless of their beliefs, can carry business and trade through reasonable acceptable means. They reflect the ways that realize equity and justice combined with the wellbeing of everyone on earth, removing the elements that are not allowed by Shariah, such as interest, gambling, high speculations, excessive risk taking, deception, misrepresentation, and uncertainty. These prohibited elements cause financial damage, injustice, and unfairness in the marketplace and society at large.

General Reading

Ad-arir, As-iddiq Muhammad Al-Amin, Gharar: Impact on Contracts in Islamic Fiqh. Al-Baraka Banking Group(ABG), 2012.

Ayub, Muhammad, Understanding Islamic Finance. New York: John Wiley & Sons, 2007.

Ibn Ashur, Muhammad al-Tahir, Ibn Ashur Treatise on Maqasid al-Shariah. IIIT, 2006.

Rosly, Saiful Azhar, Critical Issues on: Islamic Banking and Financial Markets—Islamic Economics, Banking & Finance, Investments, Takaful and Financial Planning. Author House, 2005.

Trakic, Adnan, and Hanifah Haydar Ali Tajuddin, “Islamic Banking and Finance: Principles, Instruments and Operations.” Current Law Journal (CLJ) Sdn. Bhd., 2012.