Islamic banking and finance presentation

CONTENTS
•Sources of Sharia' law: legal basis for
Islamic banking
•Islamic Law of Contracts
•Six key Islamic banking principles
•Definition of asymmetric information,
Adverse Selection, Moral hazard
•Origins of asymmetric risk within Islamic
banking
•RIBA, ITS PROHIBITION &
CLASSIFICATIONS
•Five reasons for the prohibition of Riba

SHARIA LAW
•Sharia’a: A Sharia’a compliant product must
meet all the requirements of Islamic law.To
facilitate this, a Sharia’a Supervisory Board is
usually appointed. This board or committee is
usually comprised of Islamic scholars
available to the organization, for guidance
and supervision, for the development of
Sharia’a-compliant products.
•The SSB guarantees, and certiﬁes, that the
banking activities are halal (permissible).

Sources Of Sharia Law
Fiqh is an expansion of Shariah or Islamic
law based on five sources which are
classified into primary and secondary:
Primary sources:
 The Quran
 Sunnah
Secondary sources:
 Ijma(Consensus of opinion)
 Qiyas
 Ijtihad

QURAN
Qur’an literally means reading or recitation. It
is a proof of the prophecy of Mohammed, the
most authoritative guide for Muslims, and the
primary source of the Sharia’a.
The main attributes are:
• it was revealed exclusively to the Prophet
Mohammed
• it was put into writing
•it is all mutawatir (universally accurately reported)
•it is the inimitable speech of God
•it is recited in salah (ritual prayer).

SUNNAH
•Sunnah is the actual embodiment of the will of Allah
shown in the actions of His Messenger(PBUH).
•The Holy Quran being the word of Allah treats,
major issues and often deals with subjects in brief
terms, leaving details to be explained by Holy
Prophet
•In the Quran we are commanded to pay zakat by all
Muslims. But the percentage and exact amount is
unspecified. All these details were learnt by the
Prophet’s deeds or words. The clarification of the
Quran was provided by the Holy Prophet(PBUH) who
himself participated in Shariah formation.

IJMA
•Ijma can be deﬁned as the consensus
of opinion of the Companions of the
Prophet (Sahaba) and the agreement
reached on the decisions taken by the
learned Muftis, or Jurists, on various
Islamic matters
• Ijma represent authority. Once an Ijma
is established it tends to become an
authority in its own right

QIYAS
• Qiyas means measuring or ascertaining the length,
weight or quality of something
• Qiyas is the legal principle introduced in order to
derive a logical conclusion of a certain law on a
certain issue that has to do with the welfare of
Muslims. In exercising this, however, it must be
based on the Qur’an, Sunnah and Ijma
•It is perfectly acceptable, in using Qiyas, to derive a
logical conclusion in Sharia’a law in as much as that
conclusion does not go against the injunctions of the
Qur’an or the Sunnah of the Prophet.

IJTIHAD
Ijtihad is the making of a decision in Islamic law by
personal effort, independantly of any school of
jurisprudence, following the decisions of religious
expert without necessarily examining the scriptural
basis or reasoning for that decision.
Qualification of Mujtahid:
A mujtahid is an Islamic scholar who is competent
enough to interpret shariah by ijtihad. He should
fulfill the following conditions to be a mujtihad,
• Upright character whose judgment people can trust.
• Knowledge of the Quran.
• Knowledge of Hadith.
• Knowledge of Arab linguistics
• Knowledge of Qiyas.

CONTRACTS
A voluntary, deliberate, and legally binding
agreement between two or more competent
parties. Contracts are usually written but may
be spoken or implied, and generally have to
do with employment, sale or lease, or
tenancy.
A contractual relationship is evidenced by
(1)an offer,
(2)acceptance of the offer
(3)A valid (legal and valuable) consideration.

Legal Definition Of A Contract
Under Islamic Law
Contract in Arabic is called Aqd. Literal
meaning of Aqd is to bind or to strengthen.
The word Aqd is also used in Arabic in the
sense of confirming an oath. As such, any
covenant, pact, agreement and treaty will
also be referred to as Aqd since all of them
demonstrate firm resolve for execution. Plural
of Aqd is Uqood.

PREREQUISITES
According to Sharia, a contract cannot be defined as
such unless it has the following four pre-requisites.
1)Existence of minimum two parties:
A contract cannot be formed with the presence of a
single party. Although a single intention may lead to
various obligations, such as remission of a debt or
declaration of donation, etc, these cannot be called
contract in Sharia.
2) Offer and acceptance:
It is necessary for a contract to have consent by both
parties over the purpose and content of the contract.
In Arabic it is called Ijab wa Qabool, meaning 'Offer'
(Ijab) and 'Acceptance' (Qabool).

PREREQUISITES
3) A condition that is against the contract and not in
market practice but is in favor of one of the
contractors or subject matter, the condition is void.
For example if ‘A’ sells a car with a condition that will
use it on a fixed date every month, this contract will
be void.
4) A condition, which is against the contract, not in
the market practice and not in favor of any
contractor, that is not a void condition. For example if
both A and B decide to give to charity, a certain
percentage of both subject matter and cosideration,
upon completion of sale.

Now a question arises what is the ruling of
void condition, whether it invalidates the
contract or not?
VOID CONDITIONS AND VOID CONTRACTS:
•The contracts of compensation (Uqood Muawadha)
like sale, purchase, lease agreements become void
by putting void condition.
•Non-compensatory (voluntary) agreements (Uqood
Ghair Muawadha) like contract of loan (Qard-e-
Hasanah), do not become void because of void
condition. The void condition, however, becomes
itself ineffective.

SIX KEY ISLAMIC
BANKING
PRINCIPLES

KEY PRINCIPLES
Six key principles drive the activities of Islamic
banks:
•Predetermined loan repayments as interest (riba) is
prohibited
•Proﬁt and loss sharing is at the heart of the islamic
system
•Making money out of money is unacceptable (all
financial transactions must be asset backed)
•Speculative behavior is prohibited
•Only sharia’a-approved contracts are acceptable
•Contracts are sacred.

Predetermined Payments are
Prohibited
Any predetermined payment over and above
the actual amount of principle is prohibiten.
Islam allows only one kind of load and that is
Qard-e-Hasanah(literally meaning good
loan), whereby the lender doesn’t charge any
interest or additional amount over the money
lent.

Profit And Loss Sharing
•The principle here is that the lender must share in
the profits or losses arising out of the enterprise for
which the money was lent.
•Islam encourages Muslims to invest their money
and to become partners in order to share profits and
risks in a business instead of becoming creditors.
•Islamic finance is based on the belief that the
provider of capital and the user of capital should
equally share the risk of business ventures, whether
those are industries, services companies or simple
trade deals.
•Translated into banking terms, the depositor, the
bank and the borrower should all share the risks and
the rewards of financing business ventures.

Risk Sharing
•One of the most important features of Islamic
banking is that it promotes risk sharing between the
providers of funds (investors) and the users of funds
(entrepreneurs). By contrast, under conventional
banking, the investor is assured of a predetermined
rate of interest.
•In conventional banking, all the risk is borne by the
entrepreneur. Whether the project succeeds and
produces a proﬁt or fails and produces a loss, the
owner of capital is still rewarded with a
predetermined return. In Islam, this kind of unjust
distribution of risk is not allowed.

Making Money Out of Money is Not
Acceptable
•Making money from money is not Islamically
acceptable. Money, in Islam, is only a medium of
exchange, a way of deﬁning the value of a thing. It
has no value in itself, and therefore should not be
allowed to generate more money, via ﬁxed interest
payments, simply by being deposited in a bank or
lent to someone else.
•Muslims are encouraged to spend and/or invest in
productive investments and are discouraged from
keeping money idle. Hoarding money is regarded as
being Islamically unacceptable. In Islam, money
represents purchasing power, which is considered to
be the only proper use of money

Uncertainty is Prohibited
•Gharar (uncertainty, risk or speculation) is also
prohibited, and so any transaction entered into
should be free from these elements
•Contracting parties should have perfect knowledge
of the counter-values intended to be exchanged as a
result of their transactions
• Also parties cannot predetermine a guaranteed
profit.
•The rationale behind the prohibition of gharar is the
wish to protect the weak from exploitation. Therefore,
options and futures, considered to be very risky, are
deemed to be forbidden as are forward foreign
exchange transactions, given that forward exchange
rates are determined by interest rate differentials

Only Sharia’a-Approved Contracts
are Acceptable
Conventional banking is secular in its
orientation. In contrast, in the Islamic system,
all economic agents have to work within the
ethical system of Islam. Islamic banks are no
exception. As such they cannot finance any
project that conflicts with the Islamic moral
value system. For example Islamic banks are
not allowed to finance a wine factory, a
casino, a night club or any other activity
prohibited by Islam or known to be harmful to
society

SANCTITY OF CONTRACT
The basic principles of the law are laid down
in the four root transactions of
•sales (bay): transfer of the ownership or
corpus of property for a consideration
•hire (Ijara): transfer of the usufruct (right to
use) of property for a consideration
•gift (hiba): gratuitous transfer of the corpus
of property
•loan (ariyah): gratuitous transfer of the
usufruct of property

CONTINUED
•These basic principles are then applied to
the various speciﬁc transactions of, for
example, deposit, guarantee, agency,
assignment, land tenancy, waqf foundations
(religious or charitable bodies) and
partnerships.
•Islam upholds contractual obligations and
the disclosure of information as a sacred
duty. This feature is intended to reduce the
risk of asymmetric information and moral
hazard, deﬁned in the next section, which are
potentially major problems for Islamic banks.

DEFINITION OF ASYMMETRIC
INFORMATION
•Asymmetric information can be defined as information that is
known to one party in a transaction but not to the other. The
classical argument is that some sellers with inside information
about the quality of an asset will be unwilling to accept the terms
offered by a less informed buyer. This may cause the market to
break down, or at least force the sale of an asset at a price lower
than it would command if all buyers and sellers had full
information
•Lack of sufficient information creates problems before and after
the transaction is entered into, which is potentially a major
problem with Islamic profit-sharing financial contracts. The
presence of asymmetric information normally leads to adverse
selection and moral hazard problems

DEFINITION OF ADVERSE
SELECTION
•The term refers to the problem created by
asymmetric information before the transaction
occurs.
•It occurs when the potential borrowers are the
ones most likely to produce an undesirable
(adverse) outcome
•Bad credit risks are the ones who most actively
seek out a loan and are thus most likely to be
selected. This is potentially problematic with
Islamic proﬁt-sharing ﬁnancial contracts.

DEFINITION OF MORAL
HAZARD
•Moral hazard is the consequence of
asymmetric information after the transaction
occurs.
•The lender runs the risk that the borrower
will engage in activities that are undesirable
from the lender’s point of view because they
make it less likely that the borrower will repay
the loan.

Definition of Riba or Interest
▣The word “Riba” means excess,
increase or addition, which correctly
interpreted according to Shariah
terminology, implies Any excess
compensation without due
consideration (consideration does not
include time value of money).
▣This definition of Riba is derived from
the Quran and is accepted by all
Islamic scholars.

(a) Riba-un-Nasiyah or Riba-al-Jahiliya
(b) Riba-al-Fadl or Riba-al-Bai
Classification of Riba

Riba-un-Nasiyah or Riba-al-
Jahiliya
“that kind of loan where specified repayment
period and an amount in excess of capital is
predetermined”. ( Imam Abu Bakr Jassas Razi)

Riba-un-Nasiyah or Riba-al-Jahiliya
Real and primary form of riba.Premium paid
to the lender in return for his waiting/giving
or taking of every excess amount in
exchange of a loan at an agreed rate
irrespective of whether it is low or high.

Riba-al-Fadl
▪Excess taken in exchange of specific
commodities which are homogeneous.
▪Legal definition differs in every fiqh.

Hadith prohibiting Riba-al-Fadl
▪‘sell gold in exchange of equivalent gold
▪ sell silver in exchange of equivalent silver
▪ sell dates in exchange of equivalent dates
▪ sell wheat in exchange of equivalent wheat
▪ sell salt in exchange of equivalent salt
▪sell barley in exchange of equivalent barley

Hadith prohibiting Riba-al-Fadl
▪Sell barley in exchange of equivalent barley but if a
person transacts in excess, it will be riba.
▪However sell gold for silver anyway you please on the
condition it is hand-to-hand(spot sales) and sell barley
for date anyway you please on the condition it is hand-
to-hand(spot sales)
(Kanz ul Amaal)

Imam Abu Hanifa on Riba-al-Fadl
▪Commodities must have two common characteristics
▪Weight
▪Volume
▪Includes all commodities having weight or volume and
are being exchanged

Imam Shafi on Riba-al-Fadl
▪Commodities must have two common
characteristics
▪be a medium of exchange
▪be edible
▪Includes all commodities that are edible or can be
used as a medium of exchange(currency).

Imam Maalik on Riba-al-Fadl
▪commodities must have two common
characteristics
▪can be preserved
▪be edible
▪includes all commodities that are edible and
can be preserved

Imam Ahmad Bin Hanbal on Riba-al-Fadl
▪First citation conforms to the opinion of Imam
Abu Hanifa
▪Second citation conforms to the opinion of Imam
Shafi
▪Third citation includes three characteristics at the
same time i.e. edible, weight and volume

Present day Islamic scholars on Riba-al-Fadl
▪If two characteristics i.e. weight and use as
medium of exchange is present then the following
transactions are not allowed
▪a deferred sale of goods having weight and
homogeneous nature
▪a sale of unequal goods having weight and
homogeneous nature

First law
▪Exchange of any of the six commodities with
itself but differing in quality, is allowed only
under certain conditions
The Laws of Riba Al Fadl

First Law
CONDITIONS OF EXCHANGE
•Any difference in value/quality should be ignored
•The commodities should be exchanged in equal
amounts (equal weight and volume).
•No direct exchange of commodities of the same kind
•A person should sell his commodity against cash at
the market value and buy someone else’s commodity
in exchange of cash proceeds at the market value.

Second law
▪Exchange of a product with its raw
material is allowed under certain
conditions

Second Law
CONDITIONS OF EXCHANGE
▪If the characteristics of the product has been
totally changed by the industry, then different
amounts can be exchanged.
▪If little difference has been made
▪either the exchange should be in equal weights
▪or one of the commodities should be sold in the
market and the cash proceeds used to buy the
then one.

Third Law
▪Exchange of any of the six commodities with one
another is allowed in unequal amounts but the payment
should not be deferred
▪Provided that the general conditions of a sale contract
are fulfilled

□Tijarti Sood(Commercial interest)
▪interest paid on loan taken for productive and
profitable purpose
□Sarfi Sood (Usury)
▪interest paid on loan taken for personal need and
expenses
Types of Riba

Regarding validity of Commercial Interest
there are two schools of thought on this issue.
A detailed analysis of their arguments is
discussed as follows:
Riba-Present Day Arguments

Argument 1: “Riba as practiced during the days of the
Prophet (SAW) was only Usury”.
▣ Islam when prohibiting something does not only
prohibit the prevalent form, but all forms that might
erupt in future. The changed state does not change
the ruling.
E.g. Liquor, Pork, Corruption/Immorality: Today’s
modern and sophisticated forms does not change
their rulings.
▣ The same applies to interest and gambling.

First School
Argument 2: “Commercial interest did not exist in the days of Prophet
(SAW).”
This claim is wrong as both forms of interest existed in Islamic
and pre Islamic history. Some examples:
▣ The tribe of Umr bin Aamir used to take interest from the tribe of
Mughairah. (Dar ul Mansoor by Ibn Jareeh)
▣ The tribe of Thaqeef advanced cash as well as commodities on interest to
the natives of Taif, the tribe of Mughairah and the business community of
Makkah. (Encyclopedia of Islam)
▣ H.Abbas and H. Khalid bin Waleed (RA) formed a company with joint
capital whose prime business was cash advancement on interest. (Jamai ul
Bayan)
▣ Hazrat Usman (RA) (pre-Islamic times) lent money on interest. (Tareekh
e Tabree)

Second School :
3) Argument 1: The present day banking since no-one
is exploited or faces injustice, therefore it cannot be
called Riba.”
▣Islam has not only prohibited that one party faces a
loss and the other gets profit but also prohibits one
party getting confirmed profit and the other party
unconfirmed profit from the same investment.

Second School:
4) Argument 2: There is a Qura’nic verse “O believers do not
devour one another’s possession wrongfully; rather than
that, let there be trading by mutual consent” (Al Nisa verse
29). “Wrongful devouring” only arise if the consent of one
of the parties is absent but in commercial interest the
mutual consent is present of both parties, so its not Riba.
▣ Mutual consent is not the criteria to render anything halal
which is haram.

□Riba al Nasiah is also classified as:
▪Sood-e-Mufrad( Simple Interest)
▪interest calculated only on the initial
investment
▪Sood-e-Murakkab(Compound Interest)
▪reinvestment of each interest payment on
money invested to earn more interest

▣During the pre-Islamic era, when a
borrower used to fail to pay back the
principal and interest charged on him,
then the lender used to extend the loan
on the condition that the interest will also
become part of the loan (essentially
Compound Interest).
Quran

Quran
▣“Seized in this state they say: ‘Buying and selling
is but a kind of interest’, even though Allah has
made buying and selling lawful, and interest
unlawful.” Al Baqarah 2:275
▣ ‫يقولون‬ ‫الحالة‬ ‫هذه‬ ‫في‬ ‫ضبطت‬" :‫من‬ ‫نوع‬ ‫إال‬ ‫هو‬ ‫ما‬ ‫وشراء‬ ‫بيع‬
‫و‬ ، ‫مشروعة‬ ‫وشراء‬ ‫بيع‬ ‫جعل‬ ‫قد‬ ‫هللا‬ ‫أن‬ ‫من‬ ‫الرغم‬ ‫على‬ ، ‫االهتمام‬
‫مشروعة‬ ‫غير‬ ‫مصلحة‬"‫البقرة‬ ‫سورة‬2 :

QURAN
▣“O believers, take not doubled and
redoubled interest, and fear God so
that you may prosper. (Surah Al ‘Imran,
verses 130-1)
▣ ‫مضاعفة‬ ‫و‬ ‫تضاعفت‬ ‫تتخذوا‬ ‫ال‬ ، ‫آمنوا‬ ‫الذين‬ ‫أيها‬ ‫يا‬
‫تفلحون‬ ‫لعلكم‬ ‫لذلك‬ ‫هللا‬ ‫اتقوا‬ ‫و‬ ،‫الفائدة‬. (Surah Al
‘Imran, verses 130-1)

The following hadith also proves that
both simple and compound interest are
forbidden:
▣“Listen! all Riba liable to you in the pre-Islamic
days have been completely eliminated. You have
to pay back the principal amount only. Neither
hurt someone nor get hurt by someone. And the
first riba to be completely eliminated is Abbas
bin Mutalib’s. (Ibn e Khatir)
Hadith

Hadith
▣From Anas ibn Malik : The
Prophet, , said: "If a man extends
a loan to someone he should not
accept a gift." (Mishkat, on the
authority of Bukhara's Tarikh and
Ibn Taymiyyah's al-Muntaqa)

Asymmetric risk
▣Risk an investor faces when the
gain realized from the move of an
underlying asset in one direction is
significantly different from the loss
incurred from its move in the
opposite direction.

ORIGINS OF ASYMMETRIC RISK
WITHIN ISLAMIC BANKING
▣The principle of PLS stipulates that the
partners are free to determine the extent of
their proﬁt-sharing ratio regardless of their
capital contributions
▣ Collateral cannot be provided with PLS
activities in the event that the project fails
due to business risk. So in the event of the
project failing the Islamic bank is exposed
to ﬁnancial loss.
▣The result is that Islamic banks are
subject to asymmetric risk.

ORIGINS OF ASYMMETRIC RISK
WITHIN ISLAMIC BANKING
▣To ensure timely payment of the
repayment obligations plus the
institution’s share of the profits (if any), the
bank could impose a fine on those
borrowers who do not pay on time.
▣As per principles of the Sharia’a these
fines must be deposited with a charity
▣So if the borrower defaults there is no
explicit protection for the Islamic bank.
Again this is asymmetric risk

ASYMMETRIC RISK
▣Since PLS emphasises on risk
sharing
▣financer should worry about
the proﬁtability of the proposed
project for which the loan is
requested rather than the credit-
worthiness of the ﬁrm

ASYMMETRIC RISK
▣The Islamic, interest-free
system, imposes the burden on
depositors of gathering
information about the safety,
soundness, riskiness and
proﬁtability of the bank. Again
asymmetric risk is a problem

FIVE REASONS FOR THE
PROHIBITION OF RIBA
• it is unjust;
• it corrupts society;
• it implies improper appropriation of other
people’s property;
• it results in negative economic growth;
• it demeans and diminishes human
personality.

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