cima cert if 1

Islamic Commercial Law

Certificate in Islamic FinanceA global product for a diverse world

Certificate in Islamic Finance and Banking Book one2

Chartered Institute of Management Accountants (CIMA)26 Chapter Street, London SW1P 4NP, UKT. +44 (0)20 8849 2287F. +44 (0)20 8849 2450E. [email protected] edition 2008

Published by SPG Media Limited

CIMA Certificate in Islamic Finance, set: ISBN 978-1-85971-585-7Islamic Commercial Law, Study Guide One: ISBN 978-1-85971-581-9

Copyright ©2008 CIMA

All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, photocopying or otherwise, without prior permission of the copyright owner.

No responsibility is assumed by the copyright holder for any injury and / or damage to persons or property as a result of products liability, negligence or otherwise, or from any use or operation of any methods, products, instructions or ideas contained in the material herein.

Whilst every effort has been made to ensure the accuracy of the information in this publication, neither CIMA nor SPG Media Limited accept responsibility for errors or omissions.

Printed by The MANSON Group Ltd

Contents

Certificate in Islamic Finance and Banking Book one 3

ContentsIslamic Commercial Law How to use this guide 4

What is finance? 8

Introduction 14

Chapter one An introduction to Islamic finance 18

Chapter two Shari’ah compliance 38

Chapter three Sources of Islamic commercial law 54

Chapter four Methodology of interpretation 76 of Islamic commercial law

Chapter five Formation of contracts 90

Chapter six Classification of contracts 104

Chapter seven Comparison of classifications 124 of contract

Chapter eight Traditional Islamic contracts 140 and Islamic finance

Chapter nine Overview of Islamic banking, 152 Takaful and capital market products

Chapter ten Application of Islamic 166 contracts in Islamic finance

Chapter eleven Implementation of Shari’ah standards, 182 policies and rulings in Islamic finance

Sample Examination 198

Glossary 204

Index 216

Certificate in Islamic Finance and Banking Book one

How to use this guide

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Realising your potential with this study guide as a learning companionWe at CIMA want you to succeed in your studies and to use this success both to your own advantage and to that of your current or future employers. Regardless of how interested you are in the subject, distance learning materials are challenging at the best of times. For many of you the subject will be new and hence out of your usual comfort zone. The following pages include useful information and tips that will assist you in using the guide as a learning companion on the journey to expanding your learning horizon.

We at CIMA, with a group of respected authors and industry experts in the field, have pioneered and with substantial effort developed four study guides that cover the major areas of Islamic finance, which provide a strong foundation in the field of Islamic finance. To enable you to have a complete learning experience we have provided you with all the material you need to pass the required assessments. You or your employers have invested a considerable amount of money in purchasing the study materials for the CIMA Certificate in Islamic Finance (CIMA CIF). We wish you every success in your learning experience and subsequent career in this exciting and fast growing field of the finance industry.

The Certificate in Islamic Finance comprises four study guides:

Study guide one: Islamic Commercial Law

Study guide two: Islamic Banking and Takaful (Products and Services)

Study guide three: Islamic Capital Markets and Instruments

Study guide four: Accounting and Analysis of Islamic Financial Institutions.

You may choose to study the above modules in any order but we strongly suggest that you begin with study guide one. Study guide one includes an introduction to the subject of conventional finance and explains why Islamic finance has become increasingly important in recent years and why it continues to grow. Study guide one includes a glossary of the key terms and contracts used throughout each subsequent guide. For easy reference, this introduction and glossary can be found on the CIMA website at (www.cimaglobal.com/islamicfinance). It is vital that you read this introduction and that you refer to it regularly as you work through each of the study guides.

It is also important that you appreciate the relevance of several key aspects of the study guides. Each of these aspects is explained below and tips are offered, where appropriate, as to how you can get the most from your studies.




LanguageAll four guides are written in English; however Islamic finance relies to a great extent on a large number of Arabic terms and phrases as well as a few in Latin. Islamic finance is built on a foundation of historic contracts, which have been used for centuries in Islamic commerce. These contracts, while straightforward in terms of content, are known by their Arabic names. These names, many of which are challenging to pronounce, will probably be new to you. The subtle differences between the meanings of some of them need to be understood, as that understanding is the key to you pursuing a successful career in Islamic finance. In addition to the actual contract names there are many other Arabic terms used in the industry. You will in essence be learning to use words from the Arabic language, which will be new to most of you. You cannot avoid this and need to be comfortable with these terms and phrases as they are integral to the construction and delivery of the various contract types that underpin the whole of Islamic finance. By referring back to the terms and phrases identified in the glossary you will soon be comfortable with such terms as Qard, Wakalah, Musharakah and Murabahah, to name but a few.

Without any doubt, the most challenging aspect of the study of Islamic finance will be your understanding of these terms and phrases, but, as with any new language, the sense of achievement you will feel once you become fluent in their use will make it worthwhile. You will also be able to impress your family, friends and business associates with your new found language skills. After dinner conversations and presentations during meetings will never be the same again.

Self study - the guidesWorking on your own, particularly when the subject matter is new to you, is never an easy task. In writing these study guides the authors have constantly put themselves in your position and attempted to create materials that will hold your interest. They have also tried to ensure that they are easy to follow and act as a complete learning experience. We believe that the guide you are about to read will give you a thorough underpinning in the subject area. For a foundation course this is all that you need to pass the final examination and to follow a successful career in Islamic finance.

The text regularly requires you to stop, attempt exercises or Islamic challenges in order to get you to interact with what you are reading. It is crucial to your understanding of the subject that you attempt these exercises or challenges honestly. The answers for the questions and exercises are given at the end of the respective chapter to confirm your understanding. In addition, at the end of each chapter is a series of questions with which to test your new-found knowledge. Each set of questions at the end of the chapter includes a series of multiple choice questions, which are in a similar form to those that comprise the final assessments you will be expected to pass before achieving your Certificate in Islamic Finance. Again, solutions follow the questions at the end of the chapter.

Each guide concludes with a mock examination, which has the same number of questions as the relevant final assessment and is a good way of assessing whether you are ready or not to sit the final assessment.

Learning outcomesAt the start of each chapter we list the learning outcomes that you should have achieved by the time you have worked through the chapter. These learning outcomes relate to the questions you will be required to answer in the live electronic assessment, which you must pass to achieve a credit in this subject. It is therefore vital to your success that you feel confident at the end of each chapter that you have achieved these outcomes. A useful tip would be to return to the learning outcomes once you have come to the end of each chapter and make sure that you are familiar with each of them. The questions and answers at the end of each chapter have been created to test you in your achievement of these learning outcomes. Getting the right answer to these questions at the first attempt is a good sign that you are achieving the learning outcomes, where inability to answer them is a sure sign that you need to return to the detailed content of the chapter. The final examination will include questions relating to each chapter and the respective learning outcomes (see below for more details).

Key pointsThe authors have highlighted “key points,” which they feel you should remember. While the rest of the text is important to your understanding of the subject in question, these key points indicate the crucial element of the text which you need to remember.



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Quotes and examples from real lifeThroughout the study guide you will see quotes and examples from real life. The quotes presented refer to authoritative sources on the topic in question. While the study guide is not a religious text, some of these quotes come directly from the Qur’an and the Traditions of the Prophet Muhammad. This is both deliberate and unavoidable as the very reason that Islamic finance has developed is to offer an alternative to conventional finance based on compliance with requirements of Shari’ah principle and rules derived from the Qur’an and the Traditions of the Prophet Muhammad. Quotes from these sources, we believe, are essential to your understanding of the development of the subject matter.

Other quotes come from individuals or organisations at the forefront of the development of best practices in Islamic finance. These quotes are given in the context of the topic being discussed in order to emphasise or further explain a point being made.

Exercises with solutionsIncluded throughout the guide are exercises that require you to respond to the material you have just been reading. The answer to each exercise is given at the end of the relevant chapter, but to get the most from your studies you should refrain from simply reading the question and then going to the answer. You will learn little from this practice and remember even less. Read the question and give an answer, if you can. If the answer is not on the tip of your tongue, then go back through the preceding text and see if you can find it.

Islamic finance challengesIn addition to the exercises mentioned above, each chapter includes a series of ‘Islamic finance challenges’. These have been devised to develop and test your knowledge beyond that which is required for the final examination. In most cases these questions require you to apply the knowledge you have attained to a specific problem or issue. Merely repeating what you have just read will not be sufficient to achieve the correct answer. You will be required to think about what you have been reading and give a reasoned answer. By including such challenges we believe that you will be making best use of the guide, not just as a vehicle for passing the final examination. These are meant to assist you to apply the knowledge you have gained in a way that will provide insight on possible situations as well as practical applications of Islamic finance where relevant to the financial needs of business or individuals with a higher sense of fulfilment.

Chapter summariesAt the end of each chapter we have included a summary that lists the important points that you should have understood from your studies. These summary points help you to trace the important sub topics and the key points discussed in the guide.

Revision questions with answersEach chapter ends with a series of questions and answers. The first revision question will always involve a series of multiple choice (MCQ) sub-questions. It is very important that you attempt each of these as they are indicative of the MCQs that will be used in your final examination. In addition to MCQs, you will also find a variety of other question types where relevant. Although these additional question types do not appear in the final examination they have been devised to increase your understanding of the subject and, through better comprehension, will help you answer the MCQs.

Mock examinationFor a comprehensive pre-assessment of your learning experience, you will find a mock examination at the end of the study guide. In terms of the number and type of questions, this mock examination exactly replicates the examination you will need to do in your final ‘live’ on-line examination. While the live questions will be different to those tested here, the areas and weightings of topics covered will be the same. If you can answer these questions correctly you can be fairly confident that that you will be able to answer the ‘live’ questions correctly and thus pass the test. You need to score 65% in the examination to pass.

The questions asked have been created to test each of the learning outcomes, which were listed at the start of each chapter. The revision questions at the end of each chapter also represent the type of direct or analytical questions you will be asked in the ‘live’ examination. You should use both sets of questions to test your understanding of this challenging subject.



Examples from real lifeIslamic finance is an innovative and dynamic subject, which is a thriving financial activity around the world today. We have included, where possible, examples of real Islamic financial products to complement descriptions in the text. Many such examples are given in the form of extracts from advertising materials used by real financial institutions to market their products. It should be emphasised that these real life examples are given as exemplars only. Islamic finance is a dynamic and fast-changing industry and some of the products illustrated as examples in the text may already have been superseded by new or altered versions. To ensure that you have access to up to date versions of each product we recommend that you search the internet for similar products being offered at the time you are reading the text.

CIMA CIF websiteWhile the four guides that make up the Certificate in Islamic Finance are all you need to successfully complete your studies, we also know that you will feel more comfortable knowing there is somewhere out there you can go to for support. CIMA CIF website has been created to provide the assistance you need. It includes important information about the certificate, keeps track on your progress and is where you can register for the final examinations.

The website also has an area where we list frequently asked questions and the answers that were given. It also includes an area where we will post updates which we feel are relevant to your studies.We would hope that you will be a regular visitor to the website and thus feel that you are not alone in your studies. The website can be found at www.cimaglobal.com/islamicfinance.

Islamic Finance is constantly changing and CIMA will regularly update the study guides to reflect these changes. As changes to the hard copy guides can only take place during a reprint, we will keep you up to date by posting details on the website of changes which have occurred between print runs. Where necessary we will also supply references to additional support material, including suggested further reading.

Most changes to material which we highlight on the website will be for information purposes only and will not affect the assessments you sit. Where changes that take place are deemed sufficiently important CIMA may change the assessments to reflect this.

Students will be emailed alerts about any new examinable material which appears only on the website. Where applicable, new material will be assessable three months from the date of the first alert and when it appears on the website.

The futureYou are embarking on a new journey, which for many of you will be a gateway to new knowledge and experience. Like all journeys, you need to be properly prepared in order to meet all eventualities. This guide, as part of the Certificate in Islamic Finance, is, we believe, a vital part of a successful career in this exciting new development in global finance.

The final examinationsIn order to achieve the CIMA Certificate in Islamic Finance you will need to take a final examination comprising of multiple choice questions in each of the four subjects. The cost of each examination is included in the price of the study guide. The examinations are computer based and you can take these only at CIMA-accredited examination centres.

You may do the final examinations in any order but CIMA strongly recommends that you do module one, Study Guide One: Islamic Commercial Law first as this provides the vital introduction to and underpinning for the other modules.

Each examination consists of 40 or 50 multiple choice questions. For each question there are four options, only one of which is correct. The answers to all the questions in the final test are contained within the study guide and reflect the learning outcomes shown at the beginning of each chapter. You will have had the opportunity to do numerous practice examples by the time you come to the end of this study guide. You have about an hour to complete each examination. In order to pass the examination you need to achieve a 65% pass mark. If you pass you will get your result immediately afterwards.

Each module is separately certificated. When you have completed all four modules and passed the final examinations, you will receive the CIMA Certificate in Islamic Finance.

We wish you every success.


What is finance?

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What is finance?The finance industry has evolved over hundreds of years and covers a wide range of subjects including banking, credit, investment and insurance. One of its key functions is the allocation of resources between those who have a surplus and wish to invest and those who need to borrow in order to finance a project or purchase transaction. Simply put it is a mechanism for reallocating funds between those who have and those who have not. Finance can also be viewed as an opportunity to arbitrage when there is disparity between price and value arising from a state of disequilibrium of value expectations. Every level of risk or uncertainty, assumed by the investor or financier, is met with an expected or required return. The finance industry also includes the insurance sector where individuals or those in business safeguard themselves or their assets against injury or loss by the transfer and pooling of risks.

Conventional or western finance has become a multi billion dollar industry, where individuals or businesses can invest or borrow funds through specialist markets around the world. With the exception of funds generated for illegal activities, the finance industry does not concern itself with the use to which funds are put or how the funds arise. There is almost no limit to the variety of financial products available for those with a need to invest or borrow. As an individual, you will no doubt have interacted in some way with the finance industry; most likely as a depositor, borrower or having taken out some form of insurance.

Two factors underpin conventional finance: (1) the use of interest as the form of return or benchmark for those investing funds and a cost to those borrowing them and (2) almost all areas of finance involve an element of uncertainty. Conventional finance has evolved into sophisticated products to meet the financing requirements of individuals and businesses with funds to invest, funding requirements to be met and insurance cover to be provided. Each of these products to some extent will involve an element of risk or uncertainty and in the banking products will incorporate interest charged as a form of remuneration or as a cost of borrowing or defaulting on an agreement. Traditionally in finance interest rates rise in order to compensate for increasing risk or uncertainty assumed by the lender. Alternatively, measures to mitigate or reduce the risk or uncertainty can anticipate a lower rate of interest.

What is finance?

What is finance?


What is Islamic finance?Islamic finance involves the revival of trade and investment principles and practices established centuries ago within the context of modern finance and the financial system. As a relative newcomer to the finance industry, it has arisen as a result of the fact that conventional finance does not meet the requirements of Shari’ah principles and rules and does not conform to the beliefs and precepts of the religion of Islam. Key to the evolution of Islamic finance is the belief held by Muslims that absolute ownership belongs to God and man as the servant and vicegerent act in trust in administering wealth in a just and equitable manner. Oppressive behaviour, such as usury, is prohibited and the charging and receiving of interest is unacceptable. Hence a moral code and social order is prescribed based on the Islamic belief system.

The Qur’an is the absolute source of divine guidance and Shari’ah law according to Islamic belief. It prescribes mankind to engage in activities that are lawful and good and prohibit those that cause harm and dispute in the society. Among its prohibitions are trading in pork or pork products as well as intoxicants and games of chance. The teachings of Islam based on the Qur’an and the Traditions of the Prophet Muhammad state that the entire value chain of activities relating to these prohibited activities is also equally prohibited. This includes all aspects of the production, storage, transportation, marketing and advertising of such products and activities.

In prescribing the form of economic activities under Islam, trade is encouraged, usury is prohibited and the acquisition of wealth should be achieved through lawful means that promote mutual consent and goodwill. In this respect interest as usury is replaced with profit from trade. Muslims believe that profit should involve decisions on risk preferences and choices and that finance should be mobilised for acceptable, personal and business purposes as prescribed by the Shari’ah principles and rules.

You will now realise that the conventional finance industry, as described at the start of this section, does not meet the requirements of the Shari’ah principles and rules as it is practised and motivated by interest rate, takes risk in favour of lenders and is not generally concerned about the use or application of funds. In the last 40 years various financial institutions have attempted to develop financial products that are consistent with the Shari’ah principles and rules. The cash surpluses generated from the extraction of oil in the Middle East and throughout South East Asia, both of which areas have substantial Muslim populations, focused attention on the need to develop a financial system that met the requirements of Muslims. Similarly, from the perspective of insurance, many individuals who follow the teachings of Islam also wanted to insure themselves or their property against loss or injury, through risk sharing and pooling arrangements that promote mutual goodwill and assistance in case of peril or hazard.

Simple economic theory explains what happened next. With an estimated 1.8 billion Muslims worldwide, increasing cash balances from oil extraction and the demand for acceptable investment and insurance products, an industry developed to meet these requirements. 25% of all Muslims live in countries with a Muslim majority, which means that the demand for acceptable products in these countries is backed by the political will to underpin the industry with relevant legislation and legal systems. To date, mainly as a result of substantial oil revenues, development in this sector has been focused in two key regions of the world, South East Asia and the Middle East. However, an ever increasing number of Muslims and non-Muslims worldwide are seeking out Islamic financial products. As a result of this increasing demand, financial institutions around the world have taken up the call for new products and almost all areas of the conventional financial industry have now been replicated or adapted in a way that is acceptable to Islamic beliefs and practices.

Shari’ah complianceA vital part of Islamic financial activities is the requirement to achieve Shari’ah-compliant status - to ensure that the financial activities of the institution meet the requirements of the Shari’ah principles and rules prescribed in the Qur’an and the Traditions of the Prophet Muhammad. To achieve this, there is a need to establish adequate systems and controls in the form of an Internal Shari’ah Control System (ISCS). The ISCS provides assurance that all financial activities are conducted in accordance with Shari’ah principles. An internal Shari’ah review is a prudent, if not a regulatory requirement to self assess the degree of compliance the financial institution adheres to in terms of all Shari’ah principles prescribed in the form of standards, guidelines and best practices by relevant governing bodies such as the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) and the Islamic Financial Services Board (IFSB).


What is finance?

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Shari’ah compliance is critical to an Islamic Financial Institution’s (IFI’s) operations and must permeate throughout the organisation, their products and activities. The implications of Shari’ah non-compliance and risks associated with the IFIs’ fiduciary responsibilities towards different fund providers would expose the IFI to fund providers’ withdrawals, loss of income or the voiding of contracts. This in turn would lead to a diminished reputation and/or the limitation of business opportunities.

Shari’ah advisory boardsShari’ah advisory boards are independent advisory panels, comprising scholars and jurists in Islamic commercial law and Islamic finance. The board explains and interprets the teachings of Islam as well as formulating policies and expressing opinions to guide Islamic financial practices based on Shari’ah principles and rules. These opinions, policies and guidelines have been developed to provide assurance and integrity to the systems of financial institutions by ensuring that the products, processes and instruments do not run contra to the principles set under the Shari’ah. They are perceived as the most essential organ of governance in the structure of Islamic banking and finance. The Shari’ah board or Shari’ah committee of an IFI should be able to express opinions on the financial institution and should be able to endorse the products or services of that institution.

Although all Shari’ah boards share the common goal of ensuring compliance, variations arise in terms of establishment and conduct of the board such as methods of appointment, composition of members, internal supervision and so on. International Shari’ah standard setting bodies such as AAOIFI have issued several standards on such matters as well as on aspects of governance of Shari’ah compliance. The recommended practices of many governing bodies such as AAOIFI and IFSB, as well as adopted practices by individual IFIs, are based on the decisions of the Shari’ah board and are binding on the IFIs and those institutions that adopt Islamic financing transactions.

The importance of contractsFulfilment of contractual rights and obligations is an integral element of social conduct within an Islamic society. These contracts should be lawful and proper and adhere to Shari’ah principles and rules. A variety of commercial contracts play a vital part in underpinning the products and services offered by IFIs as well as Islamic financial instruments. Such contracts ensure that those interacting within the Islamic financial system are seen to be benefiting from trading and real investment activities and not simply the transferring and holding of cash balances and receivables in the form of loans and advances. Those practising the Islamic belief do not accept that profits are earned simply from the use of money – interest earned from loans and advances. Muslims believe that profit should be earned by the recipient from productive investment or trading activity. As such, surplus funds held by an individual should only be invested in projects in which the investor has an active role in assuming trade or investment risk or both, if they are to benefit from the investment, for example, if they wish to see the surplus funds increase. Consequently individuals or businesses can obtain financing instead of loans by involving the financial institution in financing purchase, trade or investment transactions. The financial institution then profits from a true sale, real trade or investment transactions.

Under conventional finance X borrows from Y to obtain funds. Y charges X interest based on the amount of the loan, the perceived risk and duration of the loan. In the context of Islamic finance X and Y need to become trading parties or investment partners. The necessity for both the provider and user of funds to interact in a trading enterprise requires that agreements or contracts play an important role in the trading or investment process. The nature of these contracts is at the very heart of every aspect of Islamic finance.

To date the Islamic finance industry has replicated conventional interest-bearing and risk-bearing products by using a set of key trade and investment contracts types. An understanding of these contract types is crucial to understanding most of what follows in the area of Islamic finance. The glossary, which forms part of each guide, explains all of the major contract types. You need to understand each if you are to be articulate and involved in Islamic finance.

Islamic financial institutions: products and servicesThe nature of IFIs, which have evolved since the 1960s, has adapted to meet the various needs of the Muslim communities, society and the industry. From specialised financial institutions that promoted the welfare of Muslims during the earlier phase, these institutions have now become innovative and enterprising financial institutions within the global financial industry. The financial intermediation of

What is finance?


lending-based institutions is replaced with trading and profit-sharing institutions that, are directly involved in the financing of transactions as well as engaging in equity partnerships.

Loans and advances are replaced by new financing vehicles that are based around sales, lease and equity contracts. The financing of sales and purchases, as well as leasing, involves trade contracts. Equity-based financing involves Mudarabah and Musharakah financing or investments. These contracts vary in their application to suit the purpose of financing, such as term or working capital financing, as well as matching customer requirements, such as retail or corporate, as well as the financial institution’s funding objectives.

Fixed deposits are replaced with investment accounts where fixed determinable interest paid to depositors is replaced with profit sharing dividends. The latter involves a predetermined profit sharing ratio mutually agreed by both the financial institution and the investment account holder. For certain types of investments, the investment account holder can specify the area in which the funds are to be invested. In this respect the investment account holders share the profits with the financial institution for a given level of risk exposure. Other savings and current accounts are based on safe custody contracts or loan contracts that do not involve interest payments. The financial institution may however, at its discretion, declare dividends in the form of a gift (Hiba) to the account holders.

The Islamic Capital Market (ICM)Capital markets, along with financial institutions, perform the function of effectively mobilising funds in society. The capital markets help to mobilise surpluses from economic units with excess capital and transfer them to agents, who have managerial and entrepreneurial talents and investment opportunities. This method of fund mobilisation is known as direct financing because the funds are transferred from the public to companies directly, without the financial intermediation of financial institutions. The ICM refers to a market where capital market activities are carried out in ways that comply with relevant Shari’ah principles and rules. Over the years, the ICM has evolved to provide a wide array of products and services to meet the needs of both companies and investors who are seeking products and instruments that are not only commercially feasible and attractive but also, more importantly, Shari’ah compliant. Generally speaking, the ICM provides three markets similar to the conventional capital markets described above: the Islamic equity markets, the Islamic fixed-income instruments or Sukuk market and Islamic derivatives or Islamic-structured products market.

The Islamic equity market

The Islamic equity market refers to the market place where Shari’ah-permissible stocks or shares are transacted. A share is known in Arabic as Sahm or Asham (in plural). There is no distinction with regards to the features of a share in Islamic finance vis-à-vis a conventional share. As described above, they are capital-raising instruments, a means of sharing risk, a means of securing ownership and are transferable, negotiable and liquid. The main concern of Islamic equity does not relate to the structure of an ordinary share, but on the activities of the company that issues the share to the public. In other words, investors, particularly Muslim investors who are sensitive to Islamic investment guidelines, must examine whether the company undertakes its activities according to Shari’ah principles and rules. As shares represent an ownership right in the company, Muslim shareholders ought not to invest their capital to support activities that are non compliant. As a result, they should not invest in companies that offer interest-based financial products, conventional insurance, gambling activities, pornography and entertainment activities. It should be noted that the Islamic equity component of the ICM also includes other sub-divisions such as Islamic unit trusts or mutual funds, Islamic private equity funds, Islamic real estate investment trusts, Islamic exchange-traded funds and to a lesser extent specialised funds such as leasing funds and Mudarabah commodity funds. Each of these will be fully explained in the respective study guide.

The Islamic fixed-income instruments or Sukuk market

A Sukuk refers to the process of aggregating tangible assets or usufruct or an interest in a project into divisible units or securities that reflect the proportionate ownership of that asset or usufruct or project, as the case may be. A Sukuk does not deal with receivables or financial assets. Sukuk holders each hold an undivided beneficial ownership interest in the underlying assets. Consequently, Sukuk holders are entitled to share in the revenues generated by the Sukuk assets. In short, Sukuks are monetary-denominated participation certificates of equal unit value issued to investors. These Sukuks represent their proportionate share in the ownership of the underlying assets and a pro-rated share in the income generated by those assets. Sukuks do not represent any indebtedness by issuer to the investor.


What is finance?

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The return to the investors in Sukuks is not fixed or guaranteed but is subject to the performance of these underlying assets. A Sukuk, which is performance based, does not promise any fixed income.

The Islamic derivatives or Islamic structured products market

Islamic-structured products or Islamic derivatives are meant to hedge the financial risk associated with an underlying asset. This asset could be commodity, share, bond, Sukuk, currency, profit rate and so on. Several Shari’ah contracts can be used to achieve the desired objectives of derivatives. Typically a Salam contract in Islamic commercial law is a hedging investment tool where both the buyer and seller have locked in the future price to be paid by one to the other. Chronologically speaking, the first derivative investment in conventional finance was probably the forward contract. Not surprisingly, forwards were also the simplest type of derivatives. The next step in the evolutionary chain was the development of futures contracts, which were designed to manage risk more effectively and efficiently. Another derivative instrument is the option, which is a right (but not the obligation), to buy or to sell, which is given to an option holder. It provides flexibility to execute a purchase or sale obligation at a predetermined price in the future. A swap is another useful product in this respect. All these products and instruments have some Shari’ah justification to make them compliant and able to manage risk in Islamic finance.

Accounting and analysis of Islamic financial transactionsWithin Islamic finance, the purpose of financial reporting is re-examined in the light of ensuring that it addresses user information needs, and ensuring that all financial activities of IFIs are not only commercially viable but also Shari’ah compliant.

The nature of accounting, reporting and analysis of the financial operations of IFIs significantly evolved with the establishment of AAOIFI financial accounting, reporting, auditing and governance standards. The contractual rights and obligations of Islamic financial activities needs to be disclosed as does the fact that neither unlawful income nor unlawful expenditure has been earned or incurred. In addition, the profit-sharing mechanism between shareholders and investment account holders needs to demonstrate equitable distribution policy and practices. Hence the financial reality, presented in the financial statements, reflects both financial and religious accountability in terms of meeting international financial reporting standards as well as Shari’ah principles and rules.

Certificate in Islamic finance - contentIntroduction

The growth in the Islamic finance industry has outpaced the development of education in this area. This study system has been devised to meet the shortage in teaching materials and will introduce you to key areas of the Islamic finance industry as identified above. Through the four study guides you will be introduced to Islamic commercial law, banking and insurance (Takaful), Islamic capital markets and instruments and the accounting and analysis of IFIs. Each of these guides has been developed to give you an in-depth understanding of the principles that underpin the Islamic finance industry, the key factors that drive growth in the industry and the challenges that face the industry today. The guides have been written in such a way as to allow you to understand the practical applications of the knowledge you are gaining.

Terminology

Many of the technical terms used in Islamic finance are derived from Arabic. You will already have noticed the use of such words as Takaful, Shari’ah, Mudarabah, Musharakah, Hiba, Sukuk and Salam, above, which are all Arabic terms. For those of you with no experience in Arabic, these words and terms may prove challenging, but it is essential, if you are to succeed in understanding much that underpins Islamic products and services that you master these concepts and terms. We have created a glossary of terms for you to refer to and we have included a detailed explanation of the nature of the contracts, the key to all of the Islamic financial products and services. It is left to you to make the most of the glossary and contract explanations to maximise the benefit you gain from these guides.

Benefits and objectives

The Certificate in Islamic Finance programme is designed to meet the needs of those who work in the Islamic financial industry. It provides an important platform for professionals to gain new knowledge, develop new skills equip them to address emerging issues within the Islamic financial industry.

What is finance?


Certificate in Islamic Finance - overview of study guides Study guide one: Islamic Commercial Law

This study guide will introduce you to Islamic law and Islamic commercial jurisprudence as it relates to Islamic finance, including the sources, principles, concepts, methodology, standards and applications of Islamic law in relation to the financial system, industry and environment. In addition to the theoretical aspects this guide will explain the importance of contracts in relation to Islamic finance and will outline practical applications of Islamic contracts to contemporary Islamic financial products and services.

Study guide two: Islamic Banking and Takaful (Products and Services)

In this study guide you will be introduced to the financial systems, products and services offered by IFIs in the Islamic banking and Takaful industries. The guide also provides an overview of the types of financial institutions operating within the system. It explains the various financial products and services provided by both banking and Takaful institutions in terms of product features and mechanisms. Finally, it highlights pertinent risk management issues relevant to the financial institutions involved in Islamic financial activities.

Study guide three: Islamic Capital Markets and Instruments

In this study guide you will be introduced to the nature and development of Islamic capital markets, relevant international agencies, Islamic bonds and Sukuk, Islamic mutual funds, Islamic stock screening processes and Islamic structured products. The study guide explains the importance and need for Islamic capital markets, the distinct features of Islamic capital market system and instruments such as Islamic bonds, Sukuks and Islamic asset-backed securities and identifies the challenges in adopting relevant contracts and structures in Islamic structured finance.

Study guide four: Accounting and Analysis of Islamic Financial Institutions

In this study guide you will be introduced to the reporting framework and reporting standards of IFIs as well as analysing and classifying Islamic funding and financing transactions. The various funding facilities are analysed in terms of reporting requirements as well implications on the profit sharing distribution mechanisms. In addition it explains how the financing transactions adopting different contracts of financing are reported in the financial statements. Reasonable assurance in terms of financial accountability and Shari’ah compliance of the financial institutions is also covered in this study guide. It will also assist you in understanding and analysing the financial information of IFIs.

Study plan for Certificate in Islamic Finance

All candidates are encouraged to be familiar with study guide one prior to reading the other study guides. Study guide one enables a learner to be familiar with the foundations of Islamic commercial law, which are constantly referred to in the other study guides.

You may then decide to continue with either study guide two or three depending on your familiarity with the banking, Takaful and Islamic capital market areas. Study guide four assumes that the learner is familiar with Islamic commercial law as well as the financial industry prior to acquiring understanding of accounting, reporting, auditing and governance requirements of IFIs and transactions.

To facilitate learning, each study guide is designed with expected learning outcomes, exercises, Islamic challenges, key point notes as well as revision questions to provide feedback and reassurance in relation to the learning experience. In addition, relevant examples and quotes from financial industry and the environment are cited to allow students to be familiar with the context of material discussed in the Islamic financial services industry. Islamic challenges are included to stimulate discussion beyond the scope of each topic discussed in the chapter. This allows the more advanced learner to articulate a more in-depth and stimulating learning experience.

A mock exam paper is included at the end of each study guide. This should allow you to prepare yourself for the computer-based assessment examinations that you need to pass to achieve the Certificate in Islamic Finance.

We wish you every success in your studies.

For further information and advice please visit the website

www.cimaglobal.com/islamicfinance.



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The CIMA Certificate in Islamic Finance IntroductionThe Islamic Financial Services Industry (IFSI) has emerged as a significant sub sector of the global finance industry. While certain areas of the industry have developed at a faster rate than others there are no areas of conventional finance that cannot be transformed or replicated in a Shari’ah-compliant way. The CIMA Certificate in Islamic Finance covers all aspects of the discipline of Islamic finance as they exist today. Such is the speed of change in the industry that Islamic finance practices are expected to expand and develop exponentially over the forthcoming years.

The certificate, through its four study guides, will introduce you to the major areas of current development. Study Guide One, Islamic Commercial Law, introduces you to the differences between conventional and Islamic finance, the terms applied, the contracts used and the legislative underpinnings that exist worldwide to support the industry. Study Guide Two, Banking and Takaful, introduces two of the major areas of Islamic finance, banking and insurance (Takaful). Study Guide Three, Islamic Capital Markets and Instruments, reviews the current developments in the Islamic Capital Markets (ICMs) and the products being created to meet demand in this area. Study Guide Four, Accounting and Analysis of Islamic Financial Institutions, examines the Framework of Financial Reporting which currently exists for Islamic Financial Institutions. In addition it introduces the standards set by such groups as the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI), the differences in reporting required and the roles of the external auditors, Shari’ah boards as well as audit and governance committees.

This guide introduces you to Islamic commercial law and its application to transactions within Islamic finance. It highlights the sources of the Islamic commercial law including the Qur’an and the Traditions of the Prophet Muhammad. It explains the methodologies used by modern scholars to solve modern problems in Islamic finance. It also introduces the historic contracts involved in Islamic commercial law, explaining how they are classified and why particular contracts are chosen to meet particular financial requirements. An understanding of these contracts and their behaviour will help you understand the structures and application of Islamic financial products. Finally, the guide explains what is meant by ‘Shari’ah compliance’, its significance in Islamic finance and how it is applied in modern financial activities. Shari’ah compliance is a key issue in Islamic finance and the guide briefly explains the nature and importance of the Shari’ah standards that have been developed in this area.

Introduction



Terms and contracts

A key requirement for the successful completion of all four guides, which comprise the Certificate in Islamic Finance, is your understanding of the Arabic technical terms and historic contacts used in creating Shari’ah-compliant products. Each study guide includes a detailed glossary of these terms and contracts. You are strongly recommended to refresh your memory in this area. A copy of the introduction can be found at our website www.cimaglobal.com/islamicfinance.

Study Guide OneContents

Chapter one looks at the roots of Islamic finance. It highlights the unique features in Islamic finance that were actually established more than 1,400 years ago. This chapter also describes the main differences between Islamic finance and conventional finance. Finally the chapter will also introduce you to how useful Shari’ah-compliant products are created.

Chapter two highlights the key issue in Islamic finance which is Shari’ah compliance. It defines Shari’ah compliance and how it is applied in modern financial activities. This chapter also introduces the methods used to ensure compliance, which is essential at both the financial structuring and operations stages.

Chapter three explains how Islamic commercial law varies from the conventional modern law, as it is derived from sources that were revealed by God Almighty. This chapter will introduce the sources from which Islamic law developed including both the primary and secondary sources of law. It highlights the practice of reasoning (Ijtihad) and the principles which underlie this process. Ijtihad is one of the methodologies used by the modern scholars to solve modern issues and problems using their reasoning and interpretative skills which give great impact to the development of Islamic finance.

Chapter four looks at how Ijtihad can solve practical modern financial issues from an Islamic perspective. It introduces the basis and idea of Ijtihad or interpretation as practised within Islamic commercial law. It covers the many types and variations of Ijtihad that enable jurists to solve modern and day-to-day problems.

Chapter five builds on the importance of the contract which is the core foundation of an Islamic finance product. It explains that the creation of financial products results from the ability to use one or more traditional contracts to meet the requirements of the customer. This chapter also looks at the meaning of contract as used in Islamic commercial law including the explanation of what makes a valid and enforceable contract. Finally this chapter considers the significance of understanding the components needed for a valid contract in Islamic finance.

Chapter six highlights how various contracts in Islamic commercial law are classified. The variety of contract classifications is essential to meet the diversity of relevant commercial purposes. Only with a full understanding of each classification are Islamic financial institutions able to structure products that meet the ultimate aim of clients and customers in a Shari’ah-compliant way.

Chapter seven explains how to compare and contrast a variety of classifications of contract in Islamic finance. This chapter also highlights the application of a particular contract to meet a specific financial purpose.

Chapter eight introduces the process by which Islamic IFIs select the appropriate contracts to meet the needs of their clients. The chapter will also introduce the process of transforming particular traditional contracts into financial products. This process is known as financial engineering. As a result, simple contracts have been used to create products that effectively satisfy modern financial needs. This chapter attempts to guide you through this interesting and challenging task.

Chapter nine highlights some of the leading Islamic financial products and services, not only in the banking industry but also in the Takaful and capital market. It also introduces you to relevant contracts that form and create these products and, to some extent, to the reason why a particular contract is able to meet a certain financial aim and objective. This chapter gives an overview of the products that are currently available in the market and attempts to link these products with the original contracts that dictate the behaviour of these financial products.

Chapter ten introduces the reasons why a particular contract or group of contracts is chosen to meet a particular financial need. It explains in practical terms the development of Islamic financial products, which are comparable with conventional financial products. This chapter also reinforces the previous discussion on contracts, classifications of contracts and transformation of contracts into financial products.



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Chapter eleven explains the objective of Shari’ah standards. It also highlights the attempts being made by Shari’ah scholars to ensure harmonisation of standards across the industry and some of the solutions proposed.

Learning outcomesOn completing this study guide you should be able to achieve the following learning outcomes according to the following chapters:

Chapter one: An Introduction to Islamic finance

• Define Islamic finance whether in the form of banking, insurance or capital market segments.

• Describe the salient features of Islamic finance comprising of interest-free transactions, uncertainty-free transactions, profit and loss sharing and the economic and monetary functions of money.

• Illustrate how these features require the provision of different financial products to those supplied through conventional finance.

• Explain how Islamic finance can satisfy financial needs without violating religious prohibitions.

Chapter two: Shari’ah compliance

• Define the meaning of Shari’ah compliance.

• Appreciate the importance of Shari’ah compliance in all financial activities of an IFI.

• Identify the key stakeholder interested in Shari’ah compliance.

Chapter three: Sources of Islamic commercial law

• Define the meaning of source of law from an Islamic perspective.

• State the importance of source of law in Islamic law.

• Distinguish between the primary and secondary sources of Islamic law.

• Distinguish between Shari’ah (Divine sources of law) and Fiqh (Islamic substantive law or positive law).

• Identify the most workable technique of law in developing contemporary Islamic commercial law.

Chapter four: Methodology of interpretation of Islamic commercial law

• State the basis of interpretation in Islam.

• Define the meaning of Ijtihad or interpretation.

• Distinguish various forms of Ijtihad inclusive of both textual-based and human-based reasoning.

• Identify the need of Ijtihad in modern times.

• Demonstrate the practicality of Ijtihad in solving modern issues and problems.

Chapter five: Formation of contracts

• Explain the meaning of contract (‘Aqd) in Islamic commercial law.

• Explain the requirements of a valid and enforceable contract.

Chapter six: Classification of contracts

• Describe the basis of classifications of contracts.

Chapter seven: Comparison of classifications of contract

• Compare and contrast various classifications of contracts.

• Apply respective contracts to a specific case for a specific purpose.

Chapter eight: Traditional Islamic contracts and Islamic finance

• Illustrate the flexibility of Islamic commercial law to meet financial need without resorting to lending for an interest.

• Describe the relationship between traditional contracts and Islamic finance products and services.



Chapter nine: Overview of Islamic banking, Takaful and capital market products

• Understand and explain Islamic banking products.

• Understand and explain Takaful products.

• Understand and explain Islamic capital market products.

Chapter ten: Application of Islamic contracts in Islamic finance

• Explain the reason(s) why some contracts are preferable over other contracts in Islamic finance.

• Discuss briefly product development in Islamic financing using the traditional contracts.

Chapter eleven: Implementation of Shari’ah standards, policies and rulings in Islamic finance

• Describe the objectives of Shari’ah standards.

• Explain how to deal with different rulings arising from different interpretations of the sources and techniques of law.

• Identify solutions to enhance Shari’ah compliance.


An introduction to Islamic finance

On completion of this chapter, you should be able to:

define Islamic finance whether in the form of banking, insurance or capital market segments

describe the salient features of Islamic finance comprising of interest-free transactions, uncertainty-free transactions, profit and loss sharing and the economic and monetary functions of money

illustrate how these features require the provision of different financial products to those supplied through conventional finance

explain how Islamic finance can satisfy financial needs without violating religious prohibitions.

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Learning outcomes

Chapter one



1.0 IntroductionIslamic finance has its roots in the past as well as the present. Its links to the past relate to the fact that it is based on principles and features that were established more than 1,400 years ago. Its links to the present relate to the fact that these ancient features are now being presented to contemporary society in a form that is both modern and innovative. Islamic finance is distinct from conventional finance in many respects but has a common goal in achieving the same economic benefit as conventional finance offers to society. In this chapter you will be introduced to the main differences between conventional and Islamic finance, including the need to exclude interest and uncertainty. You will also be shown how the features of finance that are acceptable can be used on their own, or in combination with Shari’ah principles to create useful Shari’ah-compliant products. Islamic finance is essentially driven by principles and contracts that are structured in a manner that is not only compliant to Islamic teachings but is also capable of offering products and services comparable to and compatible with those of conventional finance.

1.1 Islamic traditionThe essence of Islam is that it derives its principles and values from the Qur’an and Traditions of the Prophet Muhammad. The history of Islamic law begins with the revelation of the Qur’an that contains legal principles and injunctions dealing with subjects such as ritual, marriage, divorce, succession, commercial transactions and penal laws. In contrast, the Traditions of the Prophet Muhammad record the sayings, actions and tacit approvals of the prophet Muhammad. The literature of the Traditions of the Prophet Muhammad covers a much wider range of topics than the legal verses in the Qur’an.

Unlike other legal systems, Muslims believe that Islam starts from a given or self-evident premise, namely the revelation. It was with the aim of directing and guiding humanity to the realisation of its moral potential and worldly worth that Islam undertook to create a system known as the Shari’ah. Muslims believe that Shari’ah refers to commands, prohibitions, guidance, and principles under Islam and is the clear path for the believer to follow in order to obtain guidance in this world and deliverance in the next.

Indicative syllabus content

Introduction to Islamic finance.

Salient features of Islamic finance.

Conventional versus Islamic finance.

Compliance with religious beliefs.

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The essence of Islam is that it derives its principles and values from the Qur’an and Traditions of the Prophet Muhammad.

Muslims believe that Shari’ah refers to commands, prohibitions, guidance and principles under Islam and is the clear path for the believer to follow in order to obtain guidance in this world and deliverance in the next.

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Key points



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Shari’ah provides guidance in terms of belief, moral conduct and practical rulings or laws. The focus in this study guide will be confined to the practical rulings or substantive law governing Islamic finance. This does not negate the importance of moral values in Islamic finance. Essentially, a complete system of life is based on both legal prescriptions and moral and good conduct. Moral values have been incorporated as legal requirements in some specific contracts such as Amanah (honesty) in Murabahah (mark-up) financing. Other principles of moral values pertaining to commercial transactions include:

(a) timeliness in the payment of debt or delivery of an asset; the failure to observe this aspect might involve legal consequences

(b) tolerance in terms of bargaining, where the parties are encouraged to be considerate of each other’s requirements and circumstances

(c) mutual revocation of a contract on request by one party if he finds himself uncomfortable with the outcome of the transaction

(d) honesty or Amanah in all statements, representations and warranties.

These principles are not meant to be exhaustive but rather to highlight areas where morality is relevant in commercial dealings.

1.2 The meaning of Islamic financeIslamic finance is a term that reflects financial business that is not contradictory to the principles of Shari’ah. Conventional finance, particularly conventional banking business, relies on taking deposits from, and providing loans to, the public. Therefore, the banker-customer relationship is always a debtor-creditor relationship. A key aspect of conventional banking is the giving or receiving of interest, which is specifically prohibited by Shari’ah. For example a conventional bank’s fixed deposit product is based on a promise by the borrower, that is the bank, to repay the loan plus fixed interest to the lender, that is the depositor. Essentially, money deposited will result in more money, that is the basic structure of an interest based system.

In other non-banking businesses, conventional products and services such as insurance and capital markets could be based on elements that are not approved by Shari’ah principles such as uncertainty (Gharar) in insurance and interest arising in conventional bonds or securities. In the case of insurance, the protection provided by the insurer in exchange for a premium is always uncertain as to its amount as well as its actual time of happening. A conventional bond normally pays the holder of the bond the principal and interest.

Conventional practices could also involve selling or buying goods and services that are not lawful from a Shari’ah perspective. These might be non-Halal foods such as pork, non-slaughtered animals or animals not slaughtered according to Islamic principles, alcohol or services related to gambling, pornography and entertainment. In short, conventional business practices could be non-compliant from a contractual structure perspective (if they are based on interest and uncertainty) and/or from a transactional perspective when they are involved in producing, selling or distributing goods and services that are not lawful according to the Shari’ah.

Exercise 1.1Which of the following best defines Islamic finance?

(A) Financial products and services that are offered to Muslims only.

(B) Financial products and services that are offered by Islamic banks.

(C) Financial products and services that are conducted according to Islamic teachings.

(D) Financial products and services that were offered during the time of Prophet Muhammad.

Islamic finance is a term that reflects all aspects of financial business that are not contradictory to the principles of Shari’ah.

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Key point



1.2.1 Banking and interest (Riba)

Islamic banking is the branch of Islamic finance that has seen the most growth to date. It is also the branch of finance that needs to be viewed from a different perspective as it cannot replicate conventional banking. This is because the most important underlying principle of conventional banking is that money creates money or that money has a premium, known as interest or usury. This practice (known in Arabic as Riba) is the antithesis of Islamic finance because Islamic law, from the beginning, has categorically denounced it. Money has never been perceived as a commodity for which there is a price for its use. Instead, Islamic law consistently views money as a medium of exchange, a store of value and a unit of measurement.

As money cannot earn money, a link has to be introduced between money and profit as an alternative to interest. It is against this backdrop that Islamic banking has been primarily involved in trading, leasing and fee-based as well as investment activities. Those involved in Islamic banking are not in a position to either borrow or lend money for interest. Subsequently, the nature of the Islamic banker-customer relationship varies according to the different contracts that Islamic banks and their customers enter into.

1.2.2 Islamic banking – the relationship between the user and the supplier of funds

The relationship of the Islamic bank with the suppliers of funds can be of agent and principal, custodian and depositor, entrepreneur and investor as well as between fellow partners in a joint investment project. Similarly, the relationship of the bank with the users of funds can comprise of vendor and purchaser, investor and entrepreneur, principal and agent, lessor and lessee, transferor and transferee, and between partners in a business venture. This is in sharp contrast to that of conventional banking, which is simply a lender-borrower relationship.

Conventional banks will accept a deposit from a depositor and promise to repay the money plus interest which is fixed, let us say, at 3%. As a financial intermediary, the bank will use this money deposited to lend to customers who need a loan. Here, the bank will charge the customers interest, let us say, at 4%. The spread or the difference between the interest rate paid and interest rate charged, namely 1%, is the bank’s profit. The notion of interest has made this model of financial intermediary work well.

Riba is defined as usury or interest.

In interest-based systems, money earns more money through lending.

The application of financial interest or Riba is prohibited in Islam.

Money in Islam is a medium of exchange, a store of value and a unit of measurement.

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Key points

Conventional Banking Islamic Banking

• Lender-borrower relationship • Depositor-custodian relationship

• Lender-borrower relationship (but free from interest)

• Investor-entrepreneur relationship

Table 1.1 Deposit/liability: contractual relationship conventional banks and Islamic banks

Financing/Asset: Contractual Relationship

Conventional Banking Islamic Banking

• Borrower-lender relationship • Purchaser-seller relationship

• Lessee-lessor relationship

• Principal-agent relationship

• Entrepreneur-investor relationship



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The above illustrates that Islamic banking has departed from the concept of loans to use other contracts that are compliant and free from the element of interest in both deposit taking and finance provision.

1.2.3 Basic principles of Takaful – Islamic insurance

With regards to Islamic insurance, better known as Takaful, the insurer, that is the insurance company, is prohibited from providing indemnity to the insured, that is the policyholders, as this is not acceptable to Shari’ah principles. This is because both the premium paid by policyholders and the indemnity paid by the insurer are uncertain and therefore not permissible as they contain the element of uncertainty or Gharar. A simple conventional insurance contact is based on buying protection.

David seeks to insure his life for 30 years. Let us say that the premium he has to pay is $100 per month for 30 years for the insured sum of $200,000. If David dies during the policy period, his nominee or beneficiaries will benefit from this insured sum irrespective of when David died during the thirty year period. He might have paid only $2,400. Alternatively, David could survive until maturity and in this case, he will receive no benefit at all. This leads to uncertain results that are not acceptable under Islamic beliefs.

Conventional life insurance companies are profit seeking entities and need to allow for things like average life expectancy and high risk customers when setting their premiums in order to ensure that it profits from offering life insurance to its customers.

Takaful introduces the contract of donation among the participants/policyholders as a substitute for the contract of sale of indemnity for a premium as practised in conventional insurance. This is to make uncertainty irrelevant because in Islamic terms uncertainty is only tolerable in gratuity or in a unilateral contract such as a donation. The presence of the element of uncertainty in a donation contract, which is unilateral in character, does not render it invalid. A donation contract can accept and tolerate any uncertainty because the purpose of any unilateral contract is not a commercial gain.

1.3 Other differences between conventional and Islamic financeIslamic capital markets that consist of both equity investments and fixed income instruments must avoid some conventional elements and principles from both contractual and transactional perspectives. In addition to interest and uncertainty, issues such as gambling, which is a zero-sum game, investments in unlawful activities and capital guarantee elements in equity-based products are to be avoided. In short, Islamic finance, unlike conventional finance, must be distinctive in its contractual and transactional features to render it different from conventional finance, although ultimately both may achieve the same economic benefits.

Exercise 1.2Briefly explain why:

(i) under Islamic commercial law, money cannot generate income by the mere act of lending it out to a borrower?

(ii) Islamic banking cannot rely on interest earned on a loan?

Takaful is a scheme that provides mutual contribution and mutual assistance to cover both life and general policies.

Takaful is based on donation contract and not a sale contract. Thus, uncertainty in Takaful is acceptable because the ultimate aim is merely to help one another and not to achieve any commercial gain.

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Key points

Takaful is an Arabic term derived from the root word kafala, meaning to guarantee. To be more precise, it is derived from the verb ‘Takafala’ meaning to mutually guarantee and protect one another. Therefore, literally, it means mutual help and assistance.



1.4 The salient features of Islamic financeAs mentioned above, Islamic finance, especially Islamic banking, enjoys certain features that you would not find in conventional banking. These features are as follows:

1.4.1 Interest free

Islamic banking is interest free, meaning that all banking business and activities must prima facie be free from any element of interest. In Islamic law, interest can arise when there is an exchange of two similar usurious items or assets such as money for money or main food for main food. In banking, the leading practice from which interest originates is the exchange of money for money, that is, money lending. Modern banking is based on the lending of money for a premium - interest. Islamic banks must eliminate interest in all its forms, be it in cash or kind. A fixed deposit account in a conventional bank is a good example of how the bank pays interest in cash. A good example of the avoidance of interest in kind is the prohibition of any advertisement of gifts for prospective saving and current account holders when these accounts are based on a Wadiah (safekeeping) or Qard / Hassan (loan) contract. This is deemed to be promising a form of interest in kind payable to savings and current account holders. Although a gift such as a pen or umbrella or savings box is not in monetary form, it is still deemed as an extra gain for the lender. The Qur’an states that interest, be it in cash or in kind, is not permissible.

Islamic finance challenge 1.1Z has a business idea that requires substantial capital funding from third parties. Z has heard from one of his friends that he could obtain this funding from an Islamic bank. Confused, Z has asked you to explain why he should approach an Islamic bank for funding and how borrowing from an Islamic bank would be different from borrowing from a conventional bank. Draft some notes for Z explaining the relationship between a borrower and an Islamic bank and explain what difference this will make to his loan.

Points to note:• under Islam, loans offered in return for interest earned are prohibited

• profit must be generated from other contracts such as trade, lease or investment by converting the money into a real asset prior to undertaking other contracts such as sale or lease

• money must be put into real business transactions to generate income; this might include the purchase of goods at ‘x’ and the sale of those goods to a customer at x + y on a deferred payment scheme

• the bank would arrange to supply the necessary capital equipment for Z on this basis

• suppose Z approaches a conventional bank to borrow a sum of €100,000 to purchase new equipment for his printing business and for this he is quoted 4% interest per annum on the proposed loan; in contrast, an Islamic bank can offer him credit sale financing whereby the Islamic bank will purchase the equipment from the vendor at €100,000 and sell it to Z at €100,000 plus a mark-up or profit, let us say of 4% per annum

• Z would not incur interest but the bank would earn a profit on the transaction.

‘Those who devour usury will not stand except as stands one whom the satan by his touch hath driven to madness. That is because they say: “Trade is like usury,” but God Almighty hath permitted trade and forbidden usury...’

Qur’an 2:275



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1.4.2 The need for underlying assets

Islamic finance requires that all banking business based on sale or lease must have an underlying asset. As the Islamic bank either acts as a seller or a service or usufruct vendor, or lessor, the asset or service is of paramount importance. The absence of an underlying asset will render the contract void ab initio. This is in contrast to conventional banking where the asset element is not a necessary requirement. Its importance lies only in terms of collateral security in the sense that the asset purchased using the loan money may be charged or assigned as security in favour of the bank. The asset was never part of the loan transaction.

1.4.3 The avoidance of uncertainty or gambling

All transactions made by Islamic financial institutions (IFIs) must be free from elements of uncertainty (Gharar) and gambling (Maisir). This is because Gharar might lead to disputes caused by an unjustified term in the contract arising from misrepresentation and fraud. Gambling is seen as an action that always enriches one party at the expense of the other - a zero-sum-game.

1.4.4 Profit and loss sharing

Profit and loss sharing is possible in some Islamic banking activities. The bank will share the profit made with its customers either on a proportionate basis or on an agreed profit-sharing ratio. In the case of a loss, the loss will be borne by the bank under a Mudarabah contract or by both parties proportionately in the case of a Musharakah contract. This concept is in direct contrast to fixed income-based products. Again, the concept of profit and loss sharing is peculiar to Islamic banking although, strictly speaking, Islamic banking is not an equity market, which is normally represented by the stock market.

1.4.5 Rights and liabilities of banks and customers

The rights and liabilities of both banks and their customers are well documented not only in conventional banking laws but also the legislation of many countries including contracts acts, the sale of goods acts, consumer protection acts and hire purchase acts. An important and significant feature of Islamic banking is the new perspective it gives to this relationship. This has pushed Islamic banking beyond normal and conventional ‘banking business’. An Islamic bank is neither a lender nor a borrower, but can instead become a bona-fide trader licensed under banking law. This aspect of the transaction has not been given proper attention until now, although certain amendments to various legal systems have been made.

Amendments to the stamp duty acts and the real property gains tax in jurisdictions such as Malaysia, the UK and Singapore illustrate this aspect. The buying and selling of property, for example, would otherwise attract a double stamp duty for the two transactions required to achieve the financing features of the product. The changes also preclude a gains tax arising from the sale of the property to the customer by the bank – the second of two sales transactions. The first transaction occurs when the financier purchases the asset from the vendor. The second transaction occurs when the financier sells the same asset at a mark-up to their customer. Without these necessary amendments, a gain would result from both transactions. In practice, this cost or extra tax would have to be borne by the customer making Islamic products more costly from a customer’s perspective.

1.4.6 Shari’ah compliance

The central focus of Islamic finance is Shari’ah compliance. To ensure compliance a distinctive feature of Islamic finance is the establishment of a Shari’ah advisory or supervisory board to advise IFIs, Islamic insurance companies, Islamic funds and any other providers which offer Islamic financial products. The establishment of a board, the opinions of which are binding on all IFIs, is required to guide the institutions towards Shari’ah compliance. An institution cannot claim to be doing Islamic financial business until and unless it sets up a Shari’ah board or committee consisting of qualified scholars who are of high reputation and who possesses the necessary skills.

1.4.7 Unlawful goods or services

Another equally important feature is that Islamic finance must not be involved in any activities pertaining to unlawful goods and services. These prohibited goods and services include, among others, non-halal foods such as pork, non-slaughtered animals or animals that were not slaughtered according to Islamic principles, intoxicating drinks, entertainment and pornography, tobacco-related

A Mudarabah contract is a profit sharing contract. Under a Mudarabah contract, the capital provider agrees to share the profits between themselves and the entrepreneur at an agreed ratio or percentage.

A Musharakah contract is a form of equity partnership investment. It is similar to equity investment in a conventional capital market but the investments made must be confined to stocks and financial securities or other assets that are consistent with the principles of Shari’ah.



products and weapons. Non-involvement is not only limited to buying or selling but also includes all chains of production and distribution, such as the packaging, transportation, warehousing and marketing of these prohibited goods and services.

1.4.8 Overriding principles of Islamic law

Islamic finance essentially refers to Shari’ah-compliant financial activities. In addition to observing the above-mentioned features, Islamic financial products and services must not contain any principles, terms and conditions that are contradictory to established legal maxims or legal principles. These legal maxims are the overriding principles and essential parameters of Islamic law, widely accepted by Muslim jurists. An example would be the principle that capital in equity-based financing or investment cannot be guaranteed by the manager or other partner. An equity contract must be free from capital guarantee to reflect the very essence of equity investment that is equity investors must bear the risk of loss of capital.

Exercise 1.3A bank has been set up to offer Islamic financial products and services. In order to attract new customers. This bank advertises in the media that the first 1,000 customers who open Islamic saving accounts based on the principle of Qard / Hassan (interest-free loan) will be given a gift worth $100 each. Does this product offering comply with Shari’ah principles?

Islamic banking comprises the following features:

• interest free • the need for underlying assets • the avoidance of uncertainty • profit and loss sharing • rights and liabilities of banks and customers arising from commercial contracts other than a loan contract • Shari’ah compliance • prohibition of unlawful goods or services • overriding principles of Islamic law.

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Key points

Islamic finance challenge 1.2John and Tom each intend to purchase a house. John intends to use an Islamic house financing facility while Tom intends to use a conventional bank loan. Each house is being sold by the developer at $100,000, but John will have to pay the bank $130,000 when he buys the house from them. Explain the stamp duty liabilities which will arise in:

(a) a country where stamp duty exists and no amendment has been made to the relevant act to take account of Islamic house financing transactions, and

(b) where the relevant stamp duty has been amended to allow for Islamic house financing transactions.

Solution(a) John will be required to pay 2% of $100,000 and 2% of $130,000 that is a total of

$4,600. Tom will only have to pay $2,000 that is 2% of $100,000 loan.

(b) In countries where relevant amendments have been made to the stamp duty act to facilitate Islamic financing schemes, John would only have to pay stamp duty on the first transaction only, that is 2% of $100,000 which is equivalent to $2,000 only. This will render stamp duty paid under both Islamic house financing and a conventional house loan to be the same amount.



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1.5 Riba and GhararAs a key to understanding Islamic finance it is important to further explain the meaning of two terms or concepts that must be avoided by Islamic finance in all circumstances: Riba and Gharar. The avoidance of these two elements is a basic requirement of all Islamic financial activities.

1.5.1 Riba

Riba is simply translated into English as usury or interest. Any premium charged on money borrowed is tantamount to Riba irrespective of the amount paid. Riba in its simplest term is an advantage to one party at the expense of another for no appropriate consideration. Islamic commercial law addresses the issue of this unjustified advantage from two possible transactions, namely in a loan or currency exchange contract as well as in a barter trading contract.

Muslim jurists have unanimously agreed that two separate classes of assets are susceptible to Riba, namely currency or money and a few commodities, mainly food items. The requirements of an exchange involving these two types of assets are the same.

It is explained in the tradition that the Prophet Muhammad was reported to have said: “Gold for gold, silver for silver, wheat for wheat, barley for barley, dates for dates, and salt for salt, like for like, equal for equal, hand-to-hand, if the commodities differ, then you may sell as you wish provided the exchange is hand-to-hand.”

These requirements are only applicable when there is an exchange of one currency for another currency whether it is the same currency or different currencies. The requirements also apply to the exchange of a food item for another food item, be it of the same food item or of different types and kinds.

A summary of the above tradition and its inherent requirements is depicted in the following table.

The above table clearly illustrates that Riba is confined to these categories of assets, provided they are exchanged within the same class, that is, currency for currency. An equal amount of the counter value is required in exchange of assets of the same class. Spot exchange, or the simultaneous delivery of counter values, is also required when one currency is exchanged for another currency or when a food item is exchanged for another food item, irrespective of whether these currencies or food items are the same or different types. Any delay in the delivery will render the exchange tantamount to Riba, known as Riba al-nasiah, that is, Riba by virtue of deferment in the exchange or delivery of these two counter values.

Currency for currency Food item for food item

Subject matter Shari’ah requirements Subject matter Shari’ah requirements

Same currency(GBP for GBP)

Spot transaction

Equal amount

Same food item(barley for barley)

Spot transaction

Equal amount

Different currencies(GBP for USD)

Spot transaction Different food items(barley for wheat)

Spot transaction

Table 1.2 Requirements for an exchange involving usurious items



From another perspective, the exchange of these two assets is also subject to the same amount or quantity of the two counter values if they are of the same type. The failure to observe this would lead to the practice of Riba called Riba al-fadl, namely Riba by an excess of one of the counter values. However, the requirement to have the same quantity is not applicable if they are of different types such as GBP for USD or wheat for barley.

This tradition is the foundation of the permissibility of currency exchange, done on the basis of the prevailing rate of exchange, for example to exchange £1,000 for $3,000, provided this is done on a spot basis. Any deferment of the exchange or delivery as in the case of a forward currency exchange is not in line with the requirements of the tradition, and is thus prohibited. The amount of exchange is not relevant when the exchange involves two different usurious items such as USD for GBP.

From the above, a loan in GBP provided by conventional banks and other institutions that imposes on the borrower the requirement to repay the principal amount borrowed plus a premium in the same currency would come under the purview of Riba (interest/usury). This practice of modern Riba in the banking sector relates to both Riba al-nasiah (Riba by deferment) and Riba al-fadl (Riba by excess) because the borrower is obligated to pay more than he borrowed and repayment will take

Exchange transation Time of delivery Remark

£1,000 to £100 Spot No Riba

£1,000 to £100 Deferred Riba

£1,000 to $3,000 Spot No Riba

£1,000 to $3,000 Deferred Riba

100 tons of wheat for 100 tons of wheat Spot No Riba

100 tons of wheat for 100 tons of wheat Deferred Riba

100 tons of wheat for 100 tons or barley Spot No Riba

100 tons of wheat for 100 tons of barley Deferred Riba

Table 1.3 Illustration of Riba by deferment (Riba al-nasiah)

Exchange Amount Remark

GBP to GBP Same/equal No Riba

GBP to GBP Not equal Riba

GBP to USD Same/equal No Riba

GBP to USD Not equal No Riba

Wheat to wheat Equal No Riba

Wheat to wheat Not equal Riba

Wheat to barley Equal No Riba

Wheat to barley Not equal No Riba

Table 1.4 Illustration of Riba by excess (Riba al Fadl)

The theory of Riba could therefore be summarised as follows:

RIBA(1) = exchange of two similar usurious item for different counter values and for deferred exchange, for example, £1,000 for £1,200 being exchanged of one another on deferred basis

RIBA(2) = exchange of two dissimilar usurious items for deferred exchange, for example, £1,000 being exchanged for $1,000 on deferred exchange.



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place in the future. This is the reason why conventional saving accounts and fixed deposit accounts, as well as all financing modes based on loan-for-interest are not compliant to Shari’ah principles. The theory of Riba also applies to currency exchange, which can only be done on a spot basis. Forward or future currency transactions are not allowed.

It is important to explain one exception to the above principles of exchange involving either currency or food items. Islamic commercial law does allow a loan contract, called Qard / Hassan but it must be free from Riba in the repayment of the loan. However, Islamic commercial law ‘tolerates’ the requirement of having to exchange two counter values on a spot basis as this is illogical to the concept and philosophy of a loan, which is essentially to allow the borrower to repay their loan obligation in the future. If they have to repay the loan almost immediately after borrowing, then the loan has no meaning. This exception is granted to allow the practice of lending of either money or fungible goods for no premium. What is more relevant is the prohibition of any excess in the repayment of the loan. The deferment in time can be tolerated if the loan is for the purpose of helping the borrower who seeks financial help in terms of money.

Exercise 1.4An Islamic bank has provided two loans. The first loan of $10,000 was made to a customer with the requirement that $11,000 be repaid after one year. The second loan of $10,000 made to another customer, had the requirement that $10,000 be repaid after one year.

Is either of these transactions Shari’ah compliant?

1.5.2 Gharar

Gharar is another element that is to be avoided in any transaction. Gharar simply refers to a lack of knowledge or uncertainty that could result in an outcome detrimental to one party. This lack of knowledge, as well as a lack of control of the outcome of any transaction, may stem from misrepresentation, mistake, fraud, duress, or terms beyond the knowledge and control of one of the parties to the contract.

There are many examples of Gharar-based transactions that are prohibited including the sale of the off-spring in the womb of a pregnant animal as the outcome is obviously beyond the control of the parties involved and therefore uncertain. In addition, the sale of fish in the water, birds in the sky or a runaway horse are also prohibited. The reason behind this is that the ability of the seller to deliver these items is uncertain.

Gharar in practice relates potentially to issues such as pricing, delivery, quantity and quality of assets that are transactional-based and would affect the degree or quality of consent of the parties to a contract. For example, one cannot buy an ‘option’ at a certain price to have the right to purchase its underlying shares, as an ‘option’ is not ascertainable and is thus uncertain. An option is just a right. It is not an asset whose specifications are clear and attainable. In conventional insurance, the premium paid by policyholders and the indemnity provided by the insurer upon a claim are equally uncertain, thus making conventional insurance non-compliant from an Islamic legal perspective.

Unlike Riba, which is determined by a fixed formula as previously explained, the determination of Gharar is based on many aspects. This is because the parameter of knowledge or consent and the risk tolerance by society is not fixed. Above all, Islamic commercial law has accepted the distinction between major uncertainty (Gharar Fahish), which is to be avoided at all times, and minor uncertainty (Gharar Yasir), which is tolerated by society. The practice of paying a certain amount of money for the use of a public toilet in some societies reflects the tolerance level in that society. The society accepts different levels of consumption of facilities that are uncertain for a standard payment which is fixed.

The theory of Riba could therefore be summarised as follows: ‘The stipulation of an excess for the lender in loan is prohibited, and it amounts to Riba, whether the excess is in terms of quality or quantity or whether the excess in a tangible thing or a benefit, and whether the excess is stipulated at the time of contract or while determining the period of delay for satisfaction or during the period of delay and, further, whether the stipulation is writing or is part of customary practice.’

Qur’an 2:275. AAOIFI Shari’ah Standard, No. (19), Qard (loan), 4.4/1



1.6 Profit and loss sharingIn addition to these two prohibited items, Islamic finance is also closely associated with the practice of profit and loss sharing. This is unique as IFIs will share the profit or loss, as the case may be, with depositors as well as fund users if the contracts entered into by the two parties are based on either Mudarabah or Musharakah. In terms of deposit, IFIs act as the manager while the depositors are the capital providers who deposit their capital on the basis of a Mudarabah contract either through their savings or investment account. The depositors will share the profit with the bank based on a particular ratio. The depositor will also bear the loss entirely under the Mudarabah contract while the banks will lose their time, work, effort and expected profit.

IFIs may finance their customers using either Mudarabah or Musharakah. Here, the IFIs act as the capital providers and share the profit with their customers upon its realisation in any business venture. Loss will be borne by the IFI under the Mudarabah contract, but the loss is to be shared between the IFI and the customer under the Musharakah contract. This makes Islamic finance distinctive from that of conventional finance.

Exercise 1.5(i) Is profit and loss sharing distinctive to Islamic banks?

(ii) What type of Riba is involved where there is an increase of one of two counter values in the exchange of two similar usurious items?

(iii) Is an exchange of £50,000 for $50,000 on a spot basis tantamount to Riba?

1.7 Islamic finance compared with conventional financeIslamic finance does not, and should not, deal with money directly as money cannot earn more money by itself. Money must be put into real business activities to earn extra money. This is the whole basis of trading. In other words, IFIs facilitate the financing needs of customers by becoming sellers, lessors or partners as the case may be. The function of money has been transformed from a commodity into an enabler to facilitate trading, leasing and investment as illustrated in the following diagram.

The pool of money, collected through various Islamic accounts and or shareholders’ funds, is channelled to finance trade, lease or investment activities. From a micro perspective, the money has been transferred into real economic stock in order to generate more income. Thus, the profit generated by IFIs is the outcome of dealing with a real asset rather than a monetary asset.

Gharar simply refers to a lack of knowledge or uncertainty that could result in an outcome. •

Key point

Figure 1.1 The function of money in Islamic finance

Shareholders fund

‘x’ money Islamic Financial

Institution

Islamic Deposit Accounts

Purchase of an asset at ‘x’ from

the vendor

Capital investment in

‘x’ project

Customer/partner

Lease the same asset to customer at x+y

Sell the same asset to customer at x + y

‘x’ money

y% profit sharing x% profit sharing



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A simple illustration of this could be where a bank has allocated £100,000 to finance a customer to purchase a house from a vendor at the cost of £100,000. This initial £100,000 will be used by the bank to purchase the identified house from the vendor. By doing so, a monetary asset has been transformed into a real asset i.e. a house. Subsequently, the bank will sell the same house to the customer. The selling price, based on a Murabahah contract, is £120,000 which is payable over ten years. The whole process is a total departure from the conventional practice of lending and borrowing. The bank in Murabahah financing has to purchase the house before it can be sold to the customer. There are real sale and purchase transactions underlying this facility and in some jurisdictions, this would trigger a double stamp duty on the two sets of documents. In those jurisdictions, relevant amendments have been made to the relevant stamp duty acts to avoid double stamp duty for these two transactions.

1.8 Shari’ah compliance and the equity marketThe distinction between Islamic finance and conventional finance is more obvious in banking and insurance products as well as in fixed income instruments than it is in the equity market. Conventional banking and fixed income instruments are essentially based on interest, while the conventional insurance contract is based on the sale of an indemnity for a premium that contains a considerable degree of uncertainty. The distinction between the Islamic and conventional equity markets is however less clear because the prohibited elements are contained not in the structure of the respective contracts but in transaction-based activities.

There is no Shari’ah issue on the contract of investment in the equity market as it is essentially based on the principle of profit and loss sharing. In other words, buying a share in any stock exchange is permissible as this purchase reflects a contract of Musharakah among the shareholders. This contract per se is compliant. However, Shari’ah objections are mainly concerned with the activities of the companies in which the capital, through subscription to the shares, is put. These activities may include the sale or purchase of assets and services that are not approved under Shari’ah principles such as the sale or purchase of non-Halal food and drink. Non-approved activities also include activities related to the balance sheet of the company such as the borrowing or raising of more capital through interest-based transactions such as overdrafts and conventional bonds.

In the realm of investment where money has to be injected into real economic activities, Islamic commercial law is also relevant to the transactional activities of the companies. This shows that compliance at both contractual and transactional levels is important in Islamic finance, making it distinctive from conventional finance.

House Financing

Conventional Islamic

• £100,000 of loan

• £120,000 [Loan + Interest]

• £100,000 of purchase price payable to vendor by the bank

• £120,000 of selling price payable to the bank/seller by the customer

Islamic finance challenge 1.3Islamic finance does not view money as a commodity. Here, money has no intrinsic value of its own, but having money allows for the purchase of goods and services. Money can potentially grow by putting it into real economic activities such as trading and investment activities. How, on the other hand, does conventional finance perceive money in terms of both theory and practice?

Points to noteThere is more than one answer to this question. Many conventional textbooks on finance, define money as a medium of exchange, a unit of measurement and a store of value. In medieval times, money was viewed by many as a ‘commodity’ in as far as the owner of money could claim a premium if the money was loaned to another party. This is the origin and basis of modern interest. This view tends to be prevalent in the contemporary conventional financial market.



Exercise 1.6(i) A bank has extended a Murabahah facility to a customer whereby the bank purchases from

the vendor an asset at ‘x’ amount i.e. €200,000. The bank subsequently sells the asset to a customer at ‘x+y’ amount e.g. €250,000 payable within five years. Why is this additional payment permissible in Murabahah but not permissible in a loan contract?

(ii) A new Islamic bank has been established in your area. The bank accepts deposits on Islamic principles. It has received an application for financing except from a customer who intends to purchase a factory that produces alcoholic liquor. This customer has put in an application for Murabahah financing, which has been declined. The customer has asked you to explain why the application has not been accepted. How would you explain this to the customer?

1.9 ConclusionThis chapter introduced you to many of the key components that make up the subject of Islamic finance. Specifically, the chapter outlined the history and development of Islamic finance. It also introduced the differences between conventional and Islamic finance. Having studied this chapter you should now appreciate why such key aspects as the avoidance of interest and uncertainty in Islamic transactions, the need to ensure Shari’ah compliance and the concept of profit sharing underpin the need for the development of Islamic finance. The chapter also briefly introduced you to Islamic insurance or Takaful, concluding with an explanation of the critical matters relating to Shari’ah compliance and the equity market. All of these components will be discussed again in more detail throughout this and the other guides which comprise the Certificate in Islamic Finance.

The following chapter will examine the sources of Islamic Commercial law that underpin many of the Shari’ah principles governing commercial transactions.

1.10 SummaryHaving read this chapter the main points that you should understand are as follows:

1. the essence of Islam is that it derives its principles and values from the Qur’an and the Traditions of the Prophet Muhammad

2. the principles of Islam as enshrined in both the Qur’an and the Traditions of the Prophet Muhammad are known as Shari’ah

3. Islamic finance is a term that reflects financial business that is not contradictory to the principles of Shari’ah

4. the giving or receiving of interest (Riba) is specifically prohibited by Shari’ah, as is the existence of uncertainty (Gharar)

5. unlike conventional banking, where the relationship is simply lender-borrower, the relationship in Islamic banking can be of agent and principal, depositor and custodian and investor and entrepreneur, on the liability side of the bank; as for the asset side, the relationship could be of seller and purchaser, lessor and lessee, principal and agent, as well as between fellow partners in a joint investment project

6. in order to remove the element of uncertainty from Islamic insurance (Takaful), the contract of donation is introduced among the participants/policyholders in place of the contract of sale of indemnity for a premium as practiced in conventional insurance

7. all banking business based on sale or lease must have an underlying asset

8. profit and loss sharing is possible in some Islamic banking activities

9. Islamic finance must not be involved in any activities pertaining to unlawful goods and services

10. Islamic finance does not, and should not, deal with money directly; this is because money cannot earn more money by itself, money must be put into real business activities to earn extra money

11. the distinction between the Islamic and conventional equity markets mainly concerns the activities of the companies in which the capital through subscription of the shares are put; these activities may include activities such as the sale or purchase of assets and services which are disapproved by Shari’ah principles.



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Chapter 1 AnswersExercise 1.1(C) Any types of financial products or services, compliant to the requirements of Islam, fall within the scope of Islamic finance. They can be offered to anyone and by anyone without any restriction because Islamic finance is inclusive in character. The only restriction is with regard to the products and services themselves. These must be structured according to the teachings of Islam. For example, the payment or charging of interest is not allowed in Islam. Thus, products of Islamic finance must be free of any element of interest.

Exercise 1.2(i) Under Islamic commercial law, money must be put into a real business transaction to

generate income. This might include the purchase of goods at ‘x’ and the sale of those goods to a customer at x + y on a deferred payment scheme or credit sale.

(ii) Under Islam, loans offered in return for interest earned are prohibited. Profit must be generated from other contracts such as trade, lease or investment by converting the money into a real asset prior to undertaking other contracts such as sale or lease.

Exercise 1.3The bank’s product offering is not compliant because Islamic finance must be free from interest either in cash or in kind. Giving a gift, which is advertised prior to the opening an account, is deemed as interest in kind. This is because the bank will borrow the money from the depositor under this contract and therefore, any extra payment intended to be paid by the borrower to the depositor/lender in the form of gift is tantamount to Riba.

Exercise 1.4The first transaction is not compliant. However, the second is compliant. Although Shari’ah principles require the repayment of loans to be on a spot basis i.e. not deferred, Shari’ah principles tolerate non spot transactions if the loan is meant to help the borrower and not to provide any commercial advantage to the bank from its lending activities.

Exercise 1.5(i) Yes. No such arrangement of profit and loss sharing is being practised in an interest-based

banking system.

(ii) The type of Riba is called Riba al-fadl or Riba by excess because of the premium in one of the counter values in the exchange involving two similar usurious items, for example, £1,000 for £1,200.

(iii) No. There is no Riba involved as the requirement of equal amounts does not apply to an exchange involving two dissimilar usurious items, that is, GBP for USD. The rate of exchange is to be agreed by both parties with spot delivery. In practice, the exchange rate agreed will be the same as prevailing conventional exchange rate (though in theory they could adopt a different exchange rate).

Exercise 1.6(i) Murabahah financing to purchase an asset is permissible because it does not deal with

money directly. The financier is selling the asset to a customer at a mark-up. The financier did not advance a loan and charge a premium on the loan.

(ii) Financing to purchase a factory that produces alcohol is not acceptable as alcohol is not compliant. The factory therefore would be used for the production of prohibited goods. Both the contract and subject matter (or the use to which it might be put) must be compliant. If the factory was to be used in the production of a Shari’ah-acceptable product then the finance could proceed.

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Revision Questions

Question 1 Multiple choice1.1 As well as being interest free, Islamic finance must also be free from:

(A) Gharar

(B) profit

(C) loss sharing

(D) equity.

1.2 In Islamic finance, how can profit be realised?

(A) By lending money out to the borrower.

(B) By leaving the money idle.

(C) By trading or leasing.

(D) By creating a charge on money for a loan.

1.3 Which of the following is a non-lawful asset from a Shari’ah perspective?

(A) A car.

(B) A house.

(C) Printing equipment.

(D) Non-slaughtered animals.

1.4 Fixed deposits, as practised by conventional banks, are not permissible because they include:

(A) Gharar (uncertainty)

(B) Riba al-fadl (Riba by excess)

(C) Riba al-nasiah (Riba by deferment)

(D) both Riba al-fadl and Riba al-nasiah.

1.5 Which of the following is not a correct description of the profit sharing concept in a Mudarabah investment account?

(A) Investors bear the loss of capital.

(B) Manager shares the loss of capital with the investors.

(C) Profit is to be shared between the investors and managers.

(D) Profit must be shared according to an agreed ratio.

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Question 2

Identify which of the following descriptions reflects Riba (Tick ), and which are free from Riba (tick )

1. A $1,000 is being loaned out to a person with a condition the repayment must be made in the future for $1,000.

2. An importer purchases 1,000 tons of wheat from an exporter at £10,000 to be paid in the future.

3. A and B enter into a forward currency contract to deliver to each other a certain currency, i.e. USD, for Saudi Riyal at the exchange rate of 1:4. The delivery date will be six months later.

Question 3Match the following subject headings to the descriptions.

Subject Matter Descriptions

1. Islamic finance Both parties must share the profit and loss.

2. Riba Lack of knowledge that could render one of the parties in a

disadvantageous position.

3. Shari’ah board Financial activities which conform to Shari’ah principles

4. Gharar A board consisting of qualified scholars to advise on Shari’ah

compliance.

5. Musharakah A premium or deferment in the exchange of two usurious items.


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Answers

Question 1 Multiple choice1.1 (A) Gharar, as well as Riba, must be avoided as they may put one or other party in a


1.2 (C) Money can grow if the owner of the money is willing to take risks. Among others risks, he can use his money to purchase goods at a cost of ‘x’ and sell them to another party at ‘x+y’. In short, profit gained through a sale transaction is allowed by the Shari’ah.

1.3 (D) Non-slaughtered animals are deemed to be not pure or clean from a Shari’ah perspective.

1.4 (D) Both Riba al-fadl and Riba al-nasiah.

1.5 (B) The manager will not share the loss of capital under Mudarabah because he does not essentially provide any capital. The investors will bear all of the loss of capital.

Question 2

1. A $1,000 is being loaned out to a person with a condition that the repayment must be made in the future for $1,000.

(The deferment of time of repayment does not lead to Riba provided there is no extra repayment amount).

2. An importer purchases 1,000 tons of wheat from an exporter at £10,000 to be paid in the future.

(Any sale contract for a future payment involving money for a commodity is not Riba because Riba could only occur when there is an exchange of similar commodities or money for money.

3. A and B enter into a forward currency contract to deliver to each other a particular currency, i.e. USD, for Saudi Riyal at the exchange rate of 1:4. The delivery date will be six months later.

(Forward Forex is not compliant as the exchange of the two currencies is not spot. Currencies must be exchanged on a spot basis).


Question 3

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1. Islamic finance Financial activities which conform to Shari’ah principles.

2. Riba A premium or deferment in the exchange of two usurious items.

3. Shari’ah board A board consisting of qualified scholars to advise on Shari’ah

compliance.

4. Gharar Lack of knowledge that could render one of the parties in a


5. Musharakah Both parties must share the profit and loss.


Shari’ah compliance


define the meaning of Shari’ah compliance

appreciate the importance of Shari’ah compliance in all financial activities of an Islamic financial institution (IFI)

identify the key stakeholder interested in Shari’ah compliance.

•

•

•

Learning outcomes

Chapter two



2.0 IntroductionShari’ah compliance is the key issue of Islamic finance. In this chapter you will be introduced to the term ‘Shari’ah compliance’, the requirement for Islamic financial products to comply with Shari’ah principles and the stakeholders interested in Shari’ah compliance. You will also be introduced to methods used to ensure compliance, which is essential at both the structuring and operational stages.

2.1 Meaning of Shari’ah compliance2.1.1 The general meaning of compliance

The need for compliant behaviour for every society is based on established norms and values that are adopted as the basis for particular laws, regulations, guidelines or principles. Compliance or conformance is necessary to ensure the preservation of a social order which will facilitate the achievement of societal objectives. In this respect compliant behaviour is universal and in Islam it relates to Shari’ah principles and rules.

The policies and practices of financial institutions and behaviour of market participants in the Islamic financial services industry are required to comply with Shari’ah principles and rules expressed in the form of regulatory requirements, guidelines and standards. The scope for such compliant behaviour includes all activities where reasonable assurance should be provided to the investing public and society that such activities do not confound or violate Shari’ah principles and rules. Any form of non-compliance will impair such assurance and affect investor confidence in the Islamic financial system.

Exercise 2.1Before proceeding, in your own words what do you understand by the term compliance?

Compliance essentially refers to the status of conforming to a certain standard, which subsequently dictates the status of being compliant or otherwise. Compliance imposes on a person or corporation the requirement to adhere to all those requirements that are prescribed by a certain point of reference. This guides the process of compliance and sets a standard which those seeking compliance are expected to achieve. Compliance with a standard can only be expected if the relevant standard has been made known to all parties concerned.

Standards are usually set by experts in the field and are determined after lengthy debate over what should be included. Most standards are not legally binding but are expected to be followed by virtue of the fact that they are supported by leading experts. It is normally left to the conscience of the individual as to whether they adopt a standard. Not following a standard would be going against that which was generally accepted as best practice and would need to be supported by evidence that the standard did not apply in the given circumstances.

2.1.2 Compliance with Shari’ah standards

In the context of Islamic finance, a standard is embodied in Shari’ah principles and thus, Shari’ah compliance means adherence to all Shari’ah principles. Products and services coming under the


The meaning of Shari’ah compliance

Salient features of Shari’ah compliance

Stakeholders in Shari’ah compliance

Regulation and Shari’ah compliance

•

•

•

•



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banner of Islamic finance must adhere strictly to the requirements of the Shari’ah principles in all aspects pertaining to a financial product or service. This means that compliance is not only limited to the design and structure of the product or service, but also the terms and conditions, the legal documentation, the accounting treatment, the standard operating procedures, IT aspects, through to the marketing brochures relating to the product or service. To be Shari’ah-compliant requires that each of these must conform to the requirements of Shari’ah principles.

Products that are in conflict with, or depart from, Shari’ah principles are deemed to be non-compliant. Normally, any areas of non-compliance will be addressed and, if applicable, relevant action will be taken to bring the products into compliance. In some jurisdictions, such as in Malaysia as per the Islamic Banking Act 1983 (Section 4), non-compliant activities may lead to the revocation of a license granted to an IFI. Although this is not specifically mentioned in other jurisdictions, this is a logical consequence for any licensing process because IFIs must adhere to their articles of association that normally mention their duty to comply with Shari’ah principles. Mention should also be made that, with the exception of Malaysia, other jurisdictions have no separate legislation or act covering Islamic banking.

Compliance is a Shari’ah requirement of conducting Islamic finance activities. The availability of Shari’ah standards is an important aid to facilitate Shari’ah compliance and to make Shari’ah compliance measurable and comparable across jurisdictions.

2.2 Salient features of Shari’ah complianceThere are three salient features of Shari’ah compliance:

(a) the fulfilment of all mandatory requirements of a particular contract

(b) the avoidance of any prohibited practices, terms and conditions

(c) the maintenance of compliance throughout the life of the product.

This diagram shows that full-fledged compliance should meet these requirements at all times, otherwise there will be a breach of Shari’ah compliance. A possible breach may take place in one of these areas or, in a worst-case scenario, in all three areas. However, the most likely breach is

Shari’ah compliance means total adherence to all Shari’ah principles.

Products and services coming under the banner of Islamic finance must adhere strictly to the requirements of the Shari’ah principles.

The availability of Shari’ah standards is an important aid to facilitate Shari’ah compliance and to make Shari’ah compliance measurable and comparable across jurisdictions.

•

•

•

Key points

Figure 2.1 Salient features of Shari’ah compliance


Fulfilment of all the necessary requirements

Avoidance of all prohibitions

Continuous compliance



normally a failure to sustain continuous compliance. A product such as house financing may be endorsed as compliant because it fulfils all conditions and is free from all prohibited terms. However, if a customer were to default, an IFI may wish to impose on the customer some additional payment that would not be compliant.

Shari’ah compliance must be represented in both the process and the outcome. It should start from the product design and go through to product implementation and, as stated above, relate to all supporting services such as accounting, IT, marketing and advertisement, legal documentation, risk management, application forms and all other documentation.

As shown in the above diagram, Shari’ah compliance transcends the scope of product design and structure to cover other relevant considerations. For example, a product may be compliant and lawful in its product offering but it may contain a risk management tool that is not compliant, such as an interest rate swap to hedge any asset liability mis-match of the bank. In this case, the Shari’ah compliance requirements would demand the risk management tool to be equally compliant, such as having a compliant profit rate swap instead of an interest rate swap. The concept of a profit rate swap will be discussed in Study Guide Three.

Exercise 2.2Explain how information technology might impact on an IFI’s ability to achieve Shari’ah compliance?

Figure 2.2 Coverage of Shari’ah compliance

Risk management

Recovery and restructuring

IT solutions

Accounting treatment

Legal documentation


Product design and structure

Islamic finance challenge 2.1The DEF Company is an airport operator. They have issued a Sukuk Ijarah amounting to €500 million. The Sukuk is based on the following structure. The DEF Company has sold the airport to investors through an SPV/Issuer at €500 million and leased back the airport from the investors at €700 million payable within five years. The prospectus of the Sukuk issuance mentioned that the proceeds of the Sukuk will be issued to finance the construction of a new terminal and an airport hotel.

Given this information, what are the key areas that the Shari’ah advisors of this Sukuk must supervise to ensure strict compliance to Shari’ah principles?

SolutionOne of the key areas would be the actual utilisation of the Sukuk proceeds. The proceeds must be used to finance the projects as mentioned. Special attention must be given to the development of a hotel as it may involve some services which are not compliant to Shari’ah principles.

Sukuk – certificates of investment



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2.3 Stakeholders in Shari’ah complianceCompliance with Shari’ah principles is key to the operation of Islamic financial activities. There are many parties concerned with Shari’ah compliance including regulators, shareholders, a bank’s management, customers and the public at large. These stakeholders have a direct and indirect interest in the achievement of Shari’ah compliance in any given IFI.

2.4 Regulators – central governmentRegulators are concerned with compliance issues relating to a licensed financial institution as the licence will have been granted subject to compliance with Shari’ah principles. It is common for a company, which intends to be licensed as an Islamic bank, to incorporate in its memorandum and articles of association that the primary business of the company is banking under Shari’ah principles. Some countries, such as Malaysia, also state in their statutes that the award of an Islamic banking license depends primarily on the establishment of a Shari’ah board for the company. The Malaysian Islamic Banking Act 1983, Section 3(5) (sub-section b) provides that, “the central bank shall recommend the grant of a license and the Minister shall not grant a license, unless the central bank or the Minister, as the case may be, is satisfied:

Although similar direct provision cannot be found elsewhere, it can be envisaged that the approving authority may not award a license if certain prerequisites are not met.

2.5 Regulators – Shari’ah advisory and supervisory boardsA prudent regulatory policy to be imposed on an Islamic bank is the requirement to set up its own Shari’ah board prior to its licensing. A Shari’ah board can take the form of either a Shari’ah advisory board or a Shari’ah Supervisory Board (SSB). The two boards differ as follows:

a. A Shari’ah advisory board is mainly entrusted to issue Fatwas/religious opinions on particular products or issues, whereas the Shari’ah supervisory board is expected not only to issue an endorsement where applicable, but also to supervise the day-to-day activities of the bank. In other words, the supervisory role is wider than the advisory role and from the perspective of Shari’ah compliance, the supervisory function of the Shari’ah board is more appropriate. Having said this, what determines the supervisory or advisory role is not the title and the nomenclature, but the actual terms of reference of the Shari’ah board. If the terms of reference in the appointment of a Shari’ah advisory board include a supervisory and review function, then

Stakeholders of Shari’ah compliance

Bank’s

shareholders

Bank’s

management

Customer and public

Regulators

Figure 2.3 Stakeholders in Shari’ah compliance

‘That there is, in the articles of association of the bank concerned provisions for the establishment of a Shari’ah advisory body to advise the bank on operations of its banking business in order to ensure that they do not involve any element which is not approved by the religion of Islam.’



its position is as good as a supervisory board. Likewise, the title of a Shari’ah supervisory board does not necessarily reflect the power of supervision and review unless this power is clearly mandated in the terms of reference of the establishment of the Shari’ah board.

b. The Shari’ah supervisory board is used to reflect the comprehensiveness of Shari’ah advice and reviews all the activities of an institution, whereas the Shari’ah advisory board is used in some contexts and jurisdictions to reflect the limited power and coverage that this Shari’ah board has. If the institution being supervised is a full-fledged IFI, Islamic insurance (Takaful) or Islamic asset management company, then the term ‘Shari’ah supervisory board’ is more appropriate. The board members, consisting of qualified scholars, must ensure that all activities of the institution, as explained in section 2.1.2, conform with Shari’ah principles. In the case of an Islamic window operating from within a conventional bank, that is a conventional financial institution offering selected Islamic financial products, Islamic insurance or Islamic funds, the term ‘Shari’ah advisory board’ would be deemed to be more appropriate. The function of the scholars who are on this board is mainly to ensure that a particular product, scheme or fund being offered by this Islamic window or conventional entity is in line with Shari’ah principles. The design, structure and legal documentation of these products must be Shari’ah compliant. Other dimensions of a full-fledged IFI such as IT solutions, accounting treatment and risk management methodologies should support Shari’ah compliant products and systems. The Shari’ah board is not entrusted to endorse except on product design, structure and the main activities, as well as on respective legal documents or prospectus, as the case may be.

The Shari’ah supervisory services to be provided by a Shari’ah board are expected to guide the Islamic bank in carrying out all of its activities according to Shari’ah principles. From a regulator’s perspective this would probably be the best method to achieve compliance as the bank’s management may not be able, academically and intellectually, to achieve this statutory requirement without the assistance of a Shari’ah board. An Islamic bank’s licence may be revoked if the bank fails to establish this Shari’ah board or fails to observe Shari’ah principles. Such a provision is included in the Malaysian Islamic Banking Act 1983 section 4 (3), which states:

Definition of SSB

‘A Shari’ah supervisory board is an independent body of specialised jurists in Fiqh al-Muamalah (Islamic commercial law). However, the Shari’ah supervisory board may include a member other than those specialized in Fiqh al-Muamalah, but who should be an expert in the field of Islamic financial institutions and with knowledge of Fiqh al-Muamalah. The Shari’ah supervisory board is entrusted with the duty of directing, reviewing and supervising the activities of the Islamic financial institution in order to ensure that they are in compliance with Islamic Shari’ah rules and principles. The Fatwas, and rulings of the Shari’ah supervisory board shall be binding on the Islamic financial institution.’Governance Standard for Islamic Financial Institutions No.1. Accounting, Auditing and Governance Standards for Islamic Financial Institutions 2004-2005, Shari’ah Supervisory Board: Appointment, Composition and Report p.5

Shari’ah advisory board Shari’ah supervisory board

Limited in issuing Fatwa on products. Entrusted to issue Fatwa and review the whole activities pursuant to Fatwa.

Appropriate and relevant to Islamic window or conventional financial institutions offering Islamic financial products.

Appropriate and relevant to fully-fledged Islamic Financial Institutions (IFIs).

Table 2.1 Advisory versus supervisory boards

‘where a licence is subject to conditions, the Islamic bank shall comply with those conditions.’



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2.5.1 Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI)

The Accounting and Auditing Organisation for Islamic Financial Institutions’ (AAOIFI’s) governance standard on the appointment of the Shari’ah board is equally important as the standard is directed to the appointing authorities and that may include the central bank and other agencies. Article 7 of the standard provides:

This is followed by Article 8, which notes:

2.5.2 Independence of boards

The establishment of the Shari’ah board, either as the Shari’ah advisory board or the Shari’ah supervisory board acts as an external organ to the Islamic bank. The Shari’ah advisers appointed to the board are neither shareholders nor employed as salaried staff of the bank. Independence from the bank gives this board the power and authority to guide it towards Shari’ah compliance. It is common practice to allow shareholders in their Annual General Meeting (AGM) to appoint Shari’ah advisers or endorse a proposed list of these Shari’ah advisers as suggested by the bank’s management. AAOIFI’s governance standards, Shari’ah Supervisory Board: Appointment, Composition and Report, specifically allows for this. Article 3 states that:

The requirement of establishing a Shari’ah board implies that the compliance to Shari’ah principles should be maintained by the bank and not by the regulators. The main aim is to have an independent Shari’ah board whose role is to guide the Islamic bank and also, possibly more importantly, to objectively review and audit the Shari’ah compliance of the bank at both the process and outcome level.

Exercise 2.3An Islamic financial institution has established a committee of three scholars to advise on its operations. The main task is to issue the Fatwa and to review its operations for the purposes of issuing a Shari’ah certification of compliance, to be included in the annual financial report. Does this reflect the work of a Shari’ah advisory or Shari’ah supervisory board?

‘The Shari’ah supervisory board shall consist of at least three members. The Shari’ah supervisory board may seek the service of consultants who have expertise in business, economics, law, accounting and/or others. The Shari’ah supervisory board should not include directors of significant shareholders of the Islamic financial institution.’

‘The dismissal of a member of the Shari’ah supervisory board shall require a recommendation by the board of directors and be subject to the approval of the shareholders in several meetings.’

‘Every Islamic financial institution shall have a Shari’ah supervisory board to be appointed by the shareholders in their annual general meeting upon the recommendation of the board directors taking into consideration the local legislation and regulations.’

Islamic finance challenge 2.2What are the advantages and disadvantages of having a central Shariah Board at the Central Bank?

Solution

Advantages Disadvantages

Harmonisation of Fatwas in one given

jurisdiction.

Turn around time might be long /not efficient

Imposition of common standards Could lead to lack of innovation



2.6 Regulators – central bank Shari’ah boardThe matter of Shari’ah compliance for the regulators has been made clear by recent developments that allow central banks or monetary agencies to appoint a Shari’ah board. The Central Bank Act of Malaysia 1958 (revised 1994), for example, incorporated this power to the central bank to establish a Shari’ah board. In addition, the central bank has issued guidelines for the establishment of Shari’ah committees at each individual Islamic bank and Islamic Takaful company in Malaysia. In other relevant guidelines, such as the Guidelines on the Offering of Islamic Securities, issued by the Securities Commission of Malaysia (2004), a standard or criteria has been placed on those who are qualified to act as Shari’ah advisers to advise on the issuance of Islamic securities, such as Islamic Sukuk. These criteria are as follows:

“An independent Shari’ah adviser who has been approved by the Securities Commission and who meets the following criteria:

i. is not an un-discharged bankrupt

ii. has not been convicted for any offence arising out of a criminal proceeding

iii. is of good repute and character

iv. possesses the necessary qualifications and expertise, particularly in Fiqh al-muamalah and Islamic jurisprudence, and has a minimum of three years’ experience or exposure in Islamic finance.”

These specific requirements are not provided in other jurisdictions. The requirement of good character of the Shari’ah advisors is normally documented in the letter of appointment of the Shari’ah advisors by the IFIs.

These requirements, both statutory and non-statutory, are necessary to safeguard the very essence of Islamic finance that is the attainment of Shari’ah compliance. The power invested in Shari’ah boards gives them the authority to enforce compliance be it Shari’ah or otherwise and ensure the soundness and stability of the entire financial and monetary system in a given country.

2.7 ShareholdersMuslim shareholders of IFIs, who contribute their capital to support banking and financial business activities, are equally likely to be concerned with the degree of Shari’ah compliance that their bank adheres to. They would expect that all the activities of the bank would conform with that stated in its articles of association, whether it is a private limited company or a public listed company. However, the expectation may be higher if this bank is a public listed company. The investors buying into the shares of this company may have made their decision on the basis of statements made in the company prospectus to only undertake Shari’ah-compliant business.

As previously mentioned, the role and function of the shareholders, among others, is to endorse the appointment of the members to the Shari’ah board of the company. This is seen as an important role as the selection of qualified and high-calibre Shari’ah advisers will not only ensure Shari’ah compliance but will also work with management to produce new and innovative Shari’ah-compliant products, hence adding value to the shareholders.

In addition, AAOIFI governance standards prescribe that the annual Shari’ah report, which is likely to include the Shari’ah review report, should be submitted to the AGM for endorsement. This provides a platform for all shareholders to assess the performance of their institution as far as Shari’ah compliance is concerned. Active participation by shareholders could potentially enhance the Shari’ah-compliance process and environment in the institution.

Related to this issue is a new phenomenon where some conventional banks, with the consent and approval of their shareholders and relevant regulatory authority, have decided to convert their total operation into an Islamic bank. Here it is essential that shareholders are regularly updated on the whole process of conversion. In some cases, the consent of the shareholders is required to write-off some assets in the balance sheet of the (existing) bank where these assets cannot be converted into Islamic assets for one reason or another. Examples of such assets include, for example, credit card receivables and housing loan receivables. These are existing receivables that originate from interest-based contracts, thus not a lawful income to the new entity seeking to comply with the Shari’ah principles. The write-off of these receivables may be necessary because they cannot be easily converted into Islamic assets. The consent to write-off reflects the concern of shareholders to be compliant and their commitment to the future business of the new entity, which should be free from Riba and Gharar. These assets may be disposed of or sold to a third party prior to the decision of the

Fiqh al-muamalah – Islamic commercial law



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conversion policy. Otherwise after a decision has been made by the shareholders to convert the bank, any proceeds from the disposal of non-approved assets to a third party must be given to charity.

The management of the bank has to fulfil the mandate, expectations and resolutions passed by the AGM of the shareholders and, in this context, undertake all financial activities in tandem with Shari’ah principles. Most of the management team of existing IFIs are not well-versed in Shari’ah principles. Therefore, it is difficult, if not impossible, for them to ensure strict compliance to Shari’ah principles in terms of product design as well as implementation of the products. Hence the need for a Shari’ah board or committee. The Shari’ah board, although not part of the management, is useful to guide the management to attain Shari’ah compliance in all aspects of the activities. The presence of the Shari’ah board not only meets the expectation of the central bank and the shareholders, but also assists management in avoiding any non-compliance.

2.8 Shari’ah compliance officersNew and recent developments in Islamic finance have seen the management of many IFIs appointing dedicated staff with Shari’ah backgrounds as full-time officers entrusted to assist with Shari’ah compliance. The duties of these Shari’ah compliance officers are, among others:

(a) to follow-up on the implementation of Fatwa and resolutions issued by the Shari’ah board by the management in all aspects (as the Fatwa and resolutions of the Shari’ah board are binding on IFIs)

(b) to vet all relevant documents pertaining to a product, such as legal contracts and documents, relevant forms and marketing brochures

(c) to liaise with the Shari’ah board on any issues and matters relevant to Shari’ah compliance

(d) to assist in carrying out an annual Shari’ah review under the guidance of the Shari’ah board

(e) to inculcate and maintain the environment of Shari’ah compliance in all aspects of the business by conducting training for other staff, assisting in replying to staff queries on Islamic finance, advising the management on the direction of Islamic finance, etc.

Exercise 2.4 A Shari’ah compliance officer functions like a legal compliance officer in most financial institutions. In what sense, does the role and function of the Shari’ah compliance officer differ from a Shari’ah supervisory board.

2.9 Customers and public at large The customers and public at large are also privy and party to the requirements of Shari’ah compliance. Relatively speaking, their interest in Shari’ah compliance is more sensitive compared with other stakeholders as the customers are the direct consumers and users of Islamic financial products. The reason why they have opted to open an account with an Islamic bank or to obtain an Islamic house financing scheme, for example, is because they are reliant on the endorsement by the respective banks that their financial products are compliant with Shari’ah principles. Any element of non-compliance will be a misrepresentation on the part of the bank, which should uphold the interests of the customers at all times.

There have been cases where IFIs have decided to write-off an amount owed to them when it discovered there were some non-compliant issues pertaining to the debts. It could happen that in a house financing under Murabahah, the bank, upon the request of the customer who faces financial

‘While the SSB is responsible for forming and expressing an opinion on the extent of an IFI’s compliance with the Shari’ah, the responsibility for compliance therewith rests with the management of an IFI. (Consideration should be given to the definition of management in relevant national legislation and regulation). To enable management to carry out this responsibility effectively, the SSB of the IFI shall assist by providing guidance, advice and training relating to compliance with the Shari’ah. The Shari’ah review of an IFI does not relieve management of their responsibility to undertake all transactions in accordance with the Shari’ah. It is the management’s responsibility to provide to the SSB all information relating to the IFI’s compliance with the Shari’ah.’

Governance Standard for Islamic Financial Institutions No.2. Shari’ah Review, Accounting, Auditing and Governance Standards for Islamic Financial Institutions 2004-2005, p5



difficulty, agrees to reschedule the tenor of the payment period and, subsequently, the amount of monthly payment to a lower amount, but the total payable under this rescheduling exercise will be increased from the original selling price. Although the rescheduling is acceptable, the additional price due to rescheduling is not compliant as this is deemed to be of Riba transaction. Therefore, any extra income generated from this rescheduling exercise, if any, has to be written off. This is the highest manifestation of adherence to Shari’ah principles as income generated from these non-compliant activities cannot be recorded as legitimate income.

In some cases, the bank may commit a mistake that triggers the breach of Shari’ah compliance. In this scenario, the customer cannot be burdened in their obligation and thus, their obligation will be distinguished to ensure that they are not oppressed by a mistake committed by the bank. For example a bank agreed a selling price and calculated the monthly payment incorrectly that is lower than was agreed. If and when the bank notices this shortfall after a period of time, then it cannot revoke the contract due to its own mistake. Also, the bank is not entitled to ask the customer to make good of the past under-payment as this will incur an extra burden to the customer. Obviously, the bank may charge the correct amount of payment from the date the error was spotted, but cannot back-date the payment.

From the above it is obvious that Shari’ah compliance is integral to all stakeholders of Islamic finance. This is a phenomenon that is totally absent in the conventional banking system. The non-adherence to this requirement will defeat the very meaning of Islamic finance in both its law and the spirit of the law.

2.10 ConclusionShari’ah compliance lies at the heart of all aspects of Islamic finance. This chapter explained why Islamic financial products must comply with Shari’ah principles and outlined the reasons why stakeholders need to be confident that compliance has been achieved. Systems need to be put in place to achieve stakeholder confidence. This chapter also introduced you to the methods which have been developed to ensure compliance, both at the structuring and operational stages.

The following chapter will look at the legal sources that underpin the development of Islamic finance. It will also consider the various schools of thought that exist and explain how Shari’ah standards, policies and rulings are implemented in the framework of Islamic finance.

There are many parties that are concerned with Shari’ah compliance. These include regulators, shareholders, a bank’s management, customers and the public at large.

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Key point

Islamic finance challenge 2.3Shari’ah compliance is only effective if the Shari’ah board members are provided with full information on the operations of the IFIs. They should also be given access to relevant documents and IT systems. What remedies do the Shari’ah boards have where these are not made available?

SolutionThere are many remedies available to the Shari’ah board, including:

(a) report to the Central Bank or relevant authority

(b) make a special report to the annual general meeting of the shareholders

(c) if necessary, undertake public awareness in the society.



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1. compliance essentially means conforming to a certain standard that subsequently dictates the status of being complaint or otherwise

2. compliance imposes on a person or corporation the requirement to adhere to all prescribed requirements

3. standards are usually set by experts in the field and are determined after lengthy debate over what should be included

4. products that are in conflict with, or depart from, Shari’ah principles are deemed to be non-compliant

5. Shari’ah compliance must be represented in both the process and the outcome.

6. parties concerned with Shari’ah compliance include regulators, shareholders, a bank’s management, customers and the public at large

7. regulators are concerned with compliance issues relating to a licensed financial institution, as the licence will have been granted subject to compliance with Shari’ah principles

8. Muslim shareholders expect all the activities of the company to be Shari’ah-compliant, as investors buying into the shares of this company may have made their decision on the basis of the prospectus of the company to undertake Shari’ah-compliant business

9. the interest of customers and the public at large lies with the fact that they are the direct consumers and users of Islamic financial products; they probably articulate with the bank because the bank has stated that its financial products are compliant with Shari’ah principles.



Chapter 2 AnswersExercise 2.1The key aspect to include in your answer is that compliance means doing something that conforms to an agreed standard, rule or piece of legislation. In not contravening a standard, rule or piece of legislation, an individual is said to be complying. Compliance normally means acting in a way that is consistent with both the spirit as well as the letter of the standard, rule or piece of legislation.

Exercise 2.2The IT function is to record all transactions using information technology. The method of recording this data and how that would generate overall data processing might breach some Shari’ah principles. Any gap in the IT must be fulfilled as the IT system reflects the actual recording of transactions. For example, if the IT system does not follow the proper sequence of a contract, then the recording of the transaction will not be in accordance with Shari’ah principles. In the case of a Tawarruq deposit product, the IT system must record that the IFI purchases an asset from the customer/depositor after the customer/depositor has purchased that asset from a commodity broker through the IFI. Also, the IT system may be set up to impose a penalty interest on any overdue payment which is not compliant.

Exercise 2.3This reflects the function of a Shari’ah supervisory board as it includes the review exercise.

Exercise 2.4While the Shari’ah board is external to the financial institution, the Shari’ah compliance officer is internal and is employed as a full time member of staff. Thus, he has more time and resources to check all relevant activities and documents to ensure Shari’ah compliance and to report any non-compliance matters to the SSB.

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Revision Questions

Question 1 Multiple choice1.1 What is Shari’ah compliance?

(A) Adherence to the Fatwa of the Shari’ah board.

(B) Adherence to regulations issued by regulators.

(C) Adherence to all Shari’ah principles required in a given contract.

(D) Adherence to all Shari’ah principles governing a contract and all supporting materials and processes.

1.2 Which of the following is not integral to the Shari’ah compliance process?

(A) The avoidance of all prohibitions in a certain financial product.

(B) Continuous compliance throughout the life of a product.

(C) Annual reporting to regulators.

(D) The fulfilment of required principles, terms and conditions.

1.3 Which of the following is not a stakeholder of Shari’ah compliance?

(A) Regulators.

(B) The AAOIFI.

(C) Customers.

(D) A bank’s shareholders.

1.4 Who has the authority to dismiss a member of a Shari’ah board?

(A) The regulators.

(B) The shareholders.

(C) Other members of the Shari’ah board.

(D) The board of directors.

1.5 Which of the following best describes a Shari’ah compliance officer?

(A) A Shari’ah audit officer appointed by the regulator to oversee the day-to-day Shari’ah compliance requirements.

(B) A full-time Shari’ah officer appointed by the IFI to ensure the compliance of the IFI to Shari’ah principles.

(C) A representative of the board of directors who is well versed in Shari’ah principles.

(D) Member of the audit committee of the bank who holds a Shari’ah degree.

Revision questionsShari’ah compliance

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Question 2Match the following roles and functions to the appropriate column, depending on whether they are performed by the Shari’ah advisory board or the Shari’ah supervisory board

(A) Issuance of Fatwa.

(B) Issuance of Fatwa and its supervision.

(C) Supervisory role of Shari’ah board.

(D) Advisory role of Shari’ah board.

Question 3Why do IFIs need to write off non-approved assets?

Question 4According to AAOIFI’S Governance Standard on Shari’ah Supervisory Board (article 3), which party is normally acknowledged as the best authority to appoint the Shari’ah board members?



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Answers

Question 1 Multiple choice1.1 (D) Shari’ah compliance presupposes adherence to all Shari’ah principles relevant to a particular

contract. These might include other supporting materials and processes. It is wider than adherence to the fatwa of the Shari’ah board and any guidelines issued by respective regulators.

1.2 (C) The duty of annual reporting to respective regulators is not relevant to Shari’ah compliant processes though it may be relevant from a regulatory framework perspective.

1.3 (B) The AAOIFI is a standard-setting body that is not linked to the financial institution and its products.

1.4 (B) According to the AAOIFI Governance Standard, the dismissal of any member of the Shari’ah Board can only be decided by the shareholders. This serves to reinforce the notion that the Shari’ah board is an independent body that is separate from the management of the bank.

1.5 (B) A Shari’ah officer is an employee of the financial institution who is responsible for ensuring the compliance of all activities of the institution. The Shari’ah officer is also required to report any non compliant issues to the Shari’ah board.

Question 2

Question 3These non-approved assets, which may occur accidentally or through negligence, cannot lawfully be distributed to shareholders or depositors to the IFIs.

Question 4The best authority to appoint Shari’ah board members, according to AAOIFI’S Governance Standard on Shari’ah Supervisory Board (article 3), is the shareholders in their annual general meeting. This ensures that the board is independent from the management of the IFI. In this way, the Shari’ah board is responsible to shareholders instead of the board of directors.


(A) Issuance of Fatwa. (B) Issuance of Fatwa and its supervision.

(D) Advisory role of Shari’ah board. (C) Supervisory role of Shari’ah board.


Revision questionsShari’ah compliance

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Sources of Islamic commercial law


define the meaning of source of law from an Islamic perspective

state the importance of source of law in Islamic law

distinguish between the primary and secondary sources of Islamic law

distinguish between Shari’ah (divine sources of law) and Fiqh (Islamic substantive law or positive law)

identify the most workable technique of law in developing contemporary Islamic commercial law

describe the early development of Islamic (Sunni) schools of law.

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Learning outcomes

Chapter three



3.0 IntroductionIslamic commercial law, as distinct from conventional modern law, is derived from sources which, according to Muslim belief, were revealed by God Almighty. According to Islam, the requirements as stated in these sources must be adhered to when establishing a point of law. Basically, a source is a place from which something is derived or extracted. In this chapter you will be introduced to the sources from which Islamic law developed including both the primary and secondary sources of law. You will also be introduced to the practice of reasoning (Ijtihad) and to the principles that underlie this process. Ijtihad allows modern scholars to solve modern issues and problems using their reasoning and interpretative skills and this has resulted in the development of several Islamic schools of law.

3.1 The meaning of source of law in Islam3.1.1 The meaning of Shari’ah

Literally, Shari’ah means the path to the watering place. Muslims believe that Shari’ah is the clear path for believers to follow in order to obtain guidance in this world and deliverance in the next. In its common usage, Shari’ah refers to the commands, prohibitions, guidance and principles that Muslims believe God Almighty has prescribed to mankind.

3.1.2 The sources of law

The essence of Islam is that it derives its principles and values from a given source. In a legal sense, the term source has more than one meaning. Source can denote the originating fount of a system. For Islam and Islamic law this source is the Qur’an and is held to be divine in character. Source can also refer to the main body of the law such as in the case of judicial precedent in English common law. When used in the plural, it generally refers to the totality of rules and authorities arranged in a structural hierarchy. Essentially, the source of the law is not the law itself. Rather it is the place from which a law can be derived and extended. To put it simply, the source indicates where a rule or legal argument is taken from.

However, in some cases, the divine source also contains laws that are substantive in character. Both of these are known as the sources; one provides the proof and the other the law from which a principle of law can be extracted. This phenomenon can be compared with the way European civil law and English common law work. European civil law relies heavily on enacted laws and statutes while English common law relies on case law. Both statutory and case law are the sources of law for European civil law and English common law respectively.


The meaning and source of Islamic law.

The importance of source.

Primary and secondary sources of law.

Shari’ah law and Fiqh law.

Schools of law.

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3.1.3 Combined sources of law

Islam has combined these two elements in two divine sources of law namely the Qur’an and the Traditions of the Prophet Muhammad. The Qur’an on its own contains principles of law as well as substantive law. For example, the Qur’an prescribes that an obligation is to be fulfilled (chapter 5: verse 1). This is a leading principle in Islamic commercial contract without which the sanctity of the contract cannot be upheld. On the other hand, the Qur’an also prescribes a specific law for a specific case such as the prohibition of interest (Riba), (chapter 2: verse 275) and the permissibility of providing a collateral or a pledge to secure a loan or financing (chapter 2: verse 283).

The source of law in Islam provides the overriding and general principles for general application as well as detailed specific law for a specific case. The source of law in Islam is seen as divine as it was revealed by God Almighty to the Prophet Muhammad. It is from this source that the whole Islamic legal system evolves and develops.

Islam is a religion based on a system of principles and rules designed to achieve the betterment of humankind.

According to Islam, Shari’ah refers to the commands, prohibitions, guidance, and principles that God Almighty has prescribed to mankind.

Islam has combined these two elements in two divine sources of law namely the Qur’an and the Traditions of the Prophet Muhammad.

A source of law may establish a general principle as well as prescribe a specific law for a specific case.

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Key points

Islamic finance challenge 3.1Using the internet or your local library look up the case of Donoghue v. Stevenson [1932] All ER Rep 1; [1932] AC 562; House of Lords and explain how case law can be a source of law in English common law.

Points to noteA case decided by a court must have been based on a reason, known as ratio decidendi, or simply the legal basis on which a law is established (in Islamic law, this is known as ‘Illah). In the case of Donoghue v. Stevenson, the primary test or principle used in determining the existence of a duty of care is known as the neighbour principle. In this case, the defendant, a ginger beer manufacturer sold ginger beer drinks to a retailer. The ginger beer bottles were opaque. ‘A’ bought a bottle and entertained a friend, the plaintiff who drank the ginger beer. When ‘A’ refilled the glass, the remains of a snail came out of the bottle. The plaintiff suffered shock and was severely ill as a consequence. The plaintiff sued the manufacturer and claimed that the manufacturer had a duty in the course of his business, to prevent snails from entering into his ginger beer bottles and further that he had a duty to ensure that all empty bottles were carefully inspected before they were filled with ginger beer. The issue in this case was whether the defendant owed such a duty to the plaintiff. The House of Lords held that the test to determine the existence or otherwise, of such a duty, was whether the plaintiff was the neighbour of the defendant. This decision in this case can be used to decide on future case because the neighbour principle is an objective test in the sense that the court will ask the hypothetical question: would a reasonable man, who is in the same circumstances as the defendant, foresee that his conduct will adversely affect the plaintiff? If the answer is ‘yes’, this means that the plaintiff is a neighbour of the defendant and the latter owes the former a duty of care. The ‘neighbour principle’ is the basis of law to which future cases must refer.



Exercise 3.1Briefly explain:

(i) What is the origin of the sources of law in Islam?

(ii) Why the sources of law are different from substantive law?

(iii) What the sources of law in Islam are?

3.2 The importance of the source of law in Islam3.2.1 The Qur’an

The source of law is important in any legal system. The history of Islamic law begins with the revelation of the Qur’an, which contains legal principles and injunctions dealing with subjects such as ritual, marriage, divorce, succession, commercial transactions and penal laws.

3.2.2 The Traditions of the Prophet Muhammad

Another divine source of Islam is the Traditions of the Prophet Muhammad, which is a record of all the sayings, actions and tacit approvals of the Prophet Muhammad. The literature of the Traditions of the Prophet Muhammad is extensive and covers a much wider range of topics than the legal verses in the Qur’an. This is not a difficult matter to appreciate as the Prophet Muhammad was often approached by his companions and the community for his decisions on a particular case or problem. The Prophet Muhammad answered and addressed these cases either through the Qur’an or through his Traditions, which is seen as equally divine in character. The Prophetic Traditions, generally speaking, like English case law, concern a particular fact or situation by recording an answer given to a specific question or a remedy provided for a specific grievance. Among other examples, he was asked by his community on the permissibility of Salam sales, that is forward sales or a sale of deferred delivery against a cash payment in advance. To this he replied that a sale is valid provided the asset to be delivered in the future is certain in its specifications and its weight or its measure. The time of delivery must also be certain.

3.2.3 The importance of the two divine sources

These two divine sources are important as they provide not only the parameters of what is approved and what is not but also some specific injunctions for specific cases in life. Once these are prescribed, they become binding on Muslims who are expected to strictly follow these guidelines and injunctions. Muslim jurists may extend these guidelines and injunctions to other cases where relevant but they are not authorised to change the fundamental principles and injunctions as contained in the Qur’an and the prophetic traditions.

Islamic law developed historically through the divine-text approach in the sense that Muslim jurists are guided not by intuition but by textual evidence. This textual evidence constitutes the source of law from which the law is derived, and is later extended by jurists through other legal techniques of application and extension. For example, the source of law in the prohibition of liquor is the verse that clearly prohibits the consumption of liquor (chapter 5: verse 60). This verse has been the basis from which the same prohibition was extended to other items that are intoxicating in nature such as drugs. The method of extension will be illustrated later under the technique of analogy (section 3.3.6).

Exercise 3.2 According to Islam, the “source” denotes a place from which one may find what one is looking for. Explain the importance of “source” in the context of Islamic law.

The Qur’an contains legal principles and injunctions on dealing with subjects such as ritual, marriage, divorce, succession, commercial transactions and penal laws.

The Traditions of the Prophet Muhammad are a record of all the sayings, actions and tacit approvals of the Prophet Muhammad.

These two divine sources are important as they provide not only the parameters of what is approved and what is not but also provide specific injunctions for specific cases in life.

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3.3 Primary and secondary sources of Islamic lawIn Islamic law, sources of law may be classified into two broad categories, namely primary and secondary depending on their origin. While primary sources are based on revelation, secondary sources are based on human interpretation and reasoning, which, in practice, are, or should be, traced back to primary sources. Islamic law has combined both revelation and human reasoning. Although Islamic law is sacred, it is by no means irrational to the effect that determining the law is a matter of speculation or ad hoc finding. There is always interplay and synergy between revelation and human reasoning, or primary and secondary sources, in order to provide legal answers and solutions to a given case.

3.3.1 General principles and maxims of the Qur’an

Although the Qur’an contains specific rulings on matters such as marriage, divorce, inheritance and criminal offences and punishments, the larger part of Quranic legislation consists of broad and general principles and maxims. It has been observed that the Qur’an provides general principles through the following two means:

(a) Constitutional principles

The first is by embodying in a specific verse a principle of law, which is meant for general application in all places and in all ages. For example, the sanctity of life; the obligation to fulfil an obligation; the duty towards one’s parents; the prohibition of illegal means of enrichment; the provision of financial protection for the poor and needy; the duty to obey authority; the equality of man and woman, and many other principles of law are thus directly or indirectly laid down in the Qur’an. The ability to identify all relevant ‘constitutional’ principles of the Qur’an depends on one’s ability to deal with the Qur’an from a methodological perspective to derive as many principles as possible. Many of these principles are also common in the constitutions of most modern states such as the sanctity of life, the rule of law, equality of sexes, etc.

(b) Empirical reading of the verses

The second approach is found through an empirical reading of the verses of the Qur’an. The Qur’an is full of verses that have common themes, so much so that a scholar can extract a principle of law that is common to all of those verses. What is of relevance and importance here is the main message of the principle of law underlying these verses, irrespective of the form in which these verses are presented in the Qur’an. A principle of law could be inspired through a direct legalistic form, a narration or an implied prescription. Muslim jurists have undertaken such an empirical study of the Qur’an and concluded that there are five objectives that Islam was essentially revealed to protect.

Islamic finance challenge 3.2Explain how the case of a Salam sale can be used as a principle of law for future cases?

Solution Salam sales, although specific, allude to many principles of law that are of general application. These include, amongst others, the following:

(a) forward sales are only permissible if the payment is made in advance

(b) the underlying asset of a Salam sale is something which is either weighable or measurable

(c) a Salam sale allows both parties to ‘lock in’ the price at the time of contract against future fluctuation of the price; this is useful for financial risk management, particularly against market risk.

Primary sources of law in Islam are based on revelation.

Secondary sources of law are based on human interpretation and reasoning.

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These are the protection of:

• religion

• life

• intellect

• lineage

• property.

This is because the Qur’an has constantly and empirically endorsed these aspects of protection and promotion, which makes it clear under Islamic belief that these five aspects are fundamental to the survival and very existence of humankind.

The same approach to looking at verses of the Qur’an could add other objectives to these five identified objectives of Islamic law. The Qur’an also discusses the importance of education, freedom, justice and fairness as well as other themes that are empirically founded and endorsed. These could also be promulgated as the Quranic fundamental requirements for the benefit of mankind. Being a source, the Qur’an should be general enough to transcend the limits of time and place and, therefore, the effort to understand and interpret the Qur’an is equally everlasting.

3.3.2 The Traditions of the Prophet Muhammad

The other revealed source of Islam is the Traditions of the Prophet Muhammad. This simply refers to the sayings, deeds and tacit approvals of the Prophet Muhammad in so far as they relate to legal rulings. Legal rulings in Islamic law have five categories, namely:

• the obligatory

• the recommended

• the forbidden

• the reprehensible

• the permissible.

The Prophetic Traditions are the manifestation of rulings that originated from the Prophet Muhammad and can best be described as the case law of Islam. Unlike the Qur’an, the cases that were referred to the Prophet Muhammad were normally based on particular facts to which the Prophet Muhammad gave his judgment either in the form of sayings, deeds or tacit approval.

The Traditions of the Prophet Muhammad are full of precedents, which Muslim jurists throughout the ages have referred to as a guide in arriving at a particular legal ruling by way of analogy and other techniques of legal interpretation. What is important in the Prophetic Traditions is not the case per se but the facts of the case and the ‘ratio’ or legal basis on which the Prophet’s pronouncement was made. It is this basis that is relevant and extendable to modern and current application of law. Each new case requiring a legal solution must share the same legal basis of the precedent or original case as prescribed in the Qur’an, Prophetic Traditions or both.

3.3.3 General principles of financial law as laid out in the Traditions of the Prophet Muhammad

In terms of general principles, the Traditions of the Prophet Muhammad provide, inter alia, the maxim that the benefit is in proportion to the liability or detriment (Al-kharaj bi al-Daman). This tradition simply establishes a maxim that in order for someone to earn a benefit or profit from their commercial transaction, they must take a corresponding risk. This tradition precludes activities which would bring benefit without taking any risk such as the enjoyment of interest in a fixed-deposit account, as offered by conventional banks.

Like English common law cases, the Traditions of the Prophet Muhammad deal with particular facts of various situations by recording an answer given to a specific question or a remedy provided for a specific grievance. Someone, with a question, problem, grievance or dispute, would have gone to the Prophet Muhammad who gave an answer or ruling for such a remedy. The Traditions of the Prophet Muhammad therefore, to some extent, represent the case law of Islam.

One example of such a case involved the Prophet Muhammad’s two companions who wanted to mutually exchange palm dates. The exchange would have involved two different quantities and amounts of dates. The Prophet Muhammad instructed that the transaction be stopped because it would be



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tantamount to Riba (interest/usury). Instead, the Prophet Muhammad instructed the owner of the lower-grade dates to sell his dates in the market first for cash and only after that could he buy the better dates from another party through the payment of money. Riba was avoided as the dates were exchanged for money and not for dates of different quality and quantities, as initially proposed.

Exercise 3.3Explain the ‘ratio’ or the legal basis for the prohibition of the exchanging of two different amounts of dates.

The above case indicates that barter trading is discouraged as it may lead to fraud and injustice. In addition, the case highlights the principle of Riba, particularly Riba al-fadl, that is Riba by an excess that arises when two similar usurious items, which have different values, are exchanged (refer to section 1.5.1).

Exercise 3.4 The Qur’an provides general principles of law and the Traditions of the Prophet Muhammad, to a large extent, provide explanations to these principles. Provide one example to illustrate this relationship.

3.3.4 Ijtihad or legal reasoning

The law-making methodology based on the Qur’an and the Traditions of the Prophet Muhammad is generally known as Ijtihad, legal reasoning.

Jurists and scholars use this legal reasoning or Ijtihad to arrive at what is thought, on a best effort basis, to be the law as intended by the law giver, God Almighty. All subsidiary sources come under the purview of Ijtihad.

Ijtihad in most cases relies on the faculty of mind, namely Ra’y (a considered opinion). Ra’y has a flexible and dynamic nature. It decides the cases in light of the spirit, wisdom and fairness of Islam. It is the well-considered and balanced opinion of a person who aspires to reach a correct decision. These subsidiary sources include Qiyas (analogical reasoning), Istihsan (juristic preference), Maslahah Mursalah or Istislah (unrestricted public interest), Sadd al-Dharai’ (blocking the means), ‘Urf (customary practice) and Istishab (presumption of continuity). All these terms are juristic in character and are cited in Arabic. An English translation and a brief illustration of each of these terms will be provided in the next section. Students are encouraged to refer to the glossaries to assist in understanding these terms.

The above subsidiary sources are all discussed in Islamic law as the bases of law finding for cases not specifically covered by the legal texts. Generally, all of these sources are aimed at arriving at a decision, as a result of thought, contemplation and a genuine search for the truth, in a case where indications are conflicting or lacking. In Islamic law, a considered opinion is binding within the sphere of law simply because it is arrived at by a competent scholar, as a result of diligent and conscientious reasoning (Ijtihad). In other words, a tentatively constructed rule has the full force of a bona fide rule of law if the interpretation or reasoning upon which it is based is diligent and conscientious. Therefore, it can be said that a considered opinion in Islam is binding in matters of law.

The sources of Shari’ah are of two types: revealed and non-revealed. These are only two revealed sources- first the Qur’an; second, the teachings and exemplary conduct (Sunna) of the Prophet Muhammad. The authority of the Sunna as a source of Shari’ah as next to the Qur’an is indicated in the Qur’an itself. The non-revealed sources of Shari’ah are generally founded in juristic reasoning and may take a variety of forms, including analogical reasoning (Qiyas), juristic preference (Istihsan), considerations of public interest (Istislah) and even general consensus (Ijma) of the learned.”

Mohd Hashim Kamali, “Law and Society - The Interplay of Revelation and Reason in the Shari’ah”, in the Oxford History of Islam, p.118

For Muslims, the Sunnah is the secondary source of Islamic law after the Qur’an. Some things not explained in detail in the Qur’an are clarified in the Sunnah as a result of religious actions instituted by the Prophet Muhammad.



3.3.5 Ijma’ – consensus of Muslim jurists

The first tool or technique of Ijtihad is Ijma’. This refers to the consensus of Muslim jurists on a particular legal issue at a particular point of time after the demise of the Prophet Muhammad. Once a consensus is achieved, it becomes a binding authority on Muslim communities. It must be upheld unless the basis of arriving at that consensus has changed due to a new discovery of principles or a new Ijtihad, which is more appealing. It is to be noted that a technical and valid Ijma’ or consensus is hard to achieve as it requires the unanimous consent and agreement of all qualified jurists at a particular time, on a particular legal issue that requires a common standpoint. In modern times, Ijma’ will arguably be the least effective means of Ijtihad, particularly in the area of Islamic commercial law as this aspect of law is very dynamic, hence consensus is often difficult to attain.

However, the decisions and resolutions on Islamic finance, issued by international Islamic bodies, such as the International Islamic Academy of Fiqh of the Organisation of Islamic Conference (OIC) and the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) could be persuasive if not binding because these decisions reflect the views of the majority of contemporary Muslim jurists on a particular legal point. The decisions of these two bodies, although not satisfying the strict requirements of a technical consensus, are well-respected and acknowledged by many regulators and stakeholders in contemporary Islamic finance.

Exercise 3.5Explain why the process of Ijma’, that is consensus or agreeing differences, is difficult to achieve in practice?

3.3.6 Qiyas – analogical reasoning

Of all the subsidiary sources, Qiyas or analogical reasoning is the most important and workable instrument. Qiyas, broadly speaking, is the legal method of extending the law beyond what is stated in the authoritative legal sources. It is an extension of a precedent and not the establishment of a fresh ruling by itself. To do this, it is necessary to draw a parallel or to find a similarity between what is mentioned in the legal texts and a new problem. This is known as ‘Illah or ratio decidendi, loosely translated as the ‘reason’. Once it is known that both the original and the assimilated cases share the same ‘reason’, the judgment (Hukm) of the original case is extended to the assimilated case. As a result, the new problem carries the same ruling as the original. In the case of wine prohibition, the basis is intoxication. In the case of strict requirements of exchanging certain food items, the legal basis relates to the nature of these items, namely main foods instead of specific items as mentioned in the relevant Tradition of Prophet Muhammad. In the case of Donoghue v. Stevenson, it was held that negligence has occurred if someone has a duty of care but has breached that duty which as a result has caused harm to another party.

Although Qiyas is based on reasoning and is speculative in character, it is the most accepted instrument and legal method. It is more systematic and less arbitrary than other forms of legal reasoning. This is due to its internal system and processes that free the application of Qiyas from relying merely on discretion or personal whim. Credit goes to the detailed procedure and methods used to establish the proper ‘Illah or “reason” applicable in the proper context.

Islamic finance challenge 3.3Explain the need for Ijtihad when two divine sources of law already exist.

SolutionThe written texts are limited in number but the incidents of daily life are unlimited and it is impossible for something infinite to be enclosed by something finite. Each case is therefore looked at on its facts and a decision is made. The sources of law are provided to ensure that the reasoning and interpretation are not devoid of Divinely guided principles. Therefore a Muslim jurist cannot decree that interest can be made lawful in certain circumstances because this reasoning (Ijtihad) would be null and void. Although Ijtihad is useful in solving modern problems, it cannot in any way contradict the principles of law which are prescribed by the sources of Islamic law.



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Qiyas assists the jurist not only to find and discover a correct ‘Illah, ratio decidendi or reason contained in textual evidence, but also to ensure the application of this ratio to a correct context and situation. This is to avoid the discovery of an improper reason or the discovery of the proper reason wrongly applied to an improper case. Clearly the finding of the correct reason does not necessarily guarantee the proper extension of the legal ruling to a new case. Therefore, the most crucial factor is to determine the element of similarity that justifies the transfer of the rule from one case to another, because it is this element that determines the validity of the conclusion.

3.3.7 ‘Illah – reason

The central theme of Qiyas is the ‘Illah, ratio decidendi or reason. Among other salient features of the ‘Illah are the following:

(i) the ‘Illah must be an evident attribute and hidden considerations such as intention, consent, and goodwill are not to be considered as ‘Illah since they are not ascertainable; in other words, the ‘Illah must be definite and perceptible; the ‘Illah for a valid contract, for example, is the offer and acceptance instead of the buyers’ and sellers’ actual consent, simply because consent is imperceptible

(ii) the ‘Illah must also be a constant and regular attribute that is applicable to all cases without being affected by differences of persons, times, places and circumstances, etc

(iii) the ‘Illah should also be co-extensive in a way that whenever it exists, the rule of law will also exist

(iv) the ‘Illah should also be co-exclusive, that is, if the ‘Illah does not exist, the rule of law will also not exist.

An accurate appreciation of these features would prevent Muslim jurists from making unnecessary and invalid legal conclusions.

3.3.8 Qiyas al-tard – case-to-case comparison

The most common logical argument used in Islamic legal theory is analogy or Qiyas al-tard. This is basically a case-to-case comparison. The basic course of reasoning is the extension of a legal rule from one case to another due to a similarity, deemed by the jurists to be a ‘material similarity’. The form of this argument is as follows:

A has the property X.

B has the property X.

A has the rule J.

X is a relevant property in inducing J.

Therefore, rule J must also apply to B.

Qiyas al-tard or analogy is relatively similar to a syllogistic argument.

The law making methodology based on the Qur’an and the Traditions of the Prophet Muhammad is generally known as Ijtihad – legal reasoning.

Ijtihad, in most cases relies on the faculty of mind, namely Ra’y - a considered opinion.

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A case in point is the Quranic prohibition of wine drinking. The jurist may argue that the reason for its prohibition is its intoxicating quality. They may therefore formulate their findings in the categorical proposition: “All intoxicating substances are forbidden.” Once they establish the major premise, they will be able to set forth a syllogism in which the minor premise is, for example: “Vodka is an intoxicating substance” and the conclusion is “vodka is forbidden”. Since wine drinking is prohibited because of its intoxicating properties, the prohibition, therefore, would apply to other intoxicating substances.



3.3.9 Istihsan – juristic preference

Another principle or technique of law is known as Istihsan or juristic preference. This principle in Islamic legal theory is discussed by Muslim jurists in connection with the principle of Qiyas. Literally, Istihsan comes from the root (in Arabic) Hasuna, meaning beautiful’, ‘comely’, ‘good’, ‘pleasing’ ‘appealing’ and other similar words. Broadly speaking, Istihsan takes place when a jurist makes a decision in a particular case that is different from a similar case that has already been decided. The case decided based on Istihsan is a departure from a precedent for a reason, which is stronger than the one found in similar cases. In other words, Istihsan’s application is to discard the application of Qiyas by virtue of another reason that is stronger and more ‘appealing’. The features and functions of Istihsan are very similar to equity in common law. The equity principle was developed to remove the rigidity and, occasionally, the harshness of the principles of law.

Istihsan can be loosely associated with the doctrine of ‘equity’ in English law. It normally applies where there is a conflict between law and equity where equity should prevail. In the case of Walsh v. Lonsdale [1882] 21 ChD 9, it was decided that equity should prevail over the established principles of law for the sake of justice and fairness. In this case a person who was let into possession of land under an invalid instrument was relieved by treating the instrument as an agreement for a lease.

3.3.10 Maslahah or public interest

The next technique of law is centred on the doctrine of Maslahah or public interest. Briefly, Maslahah in the eyes of jurists is an expression for the search for something useful or the removal of something harmful. Literally, Maslahah is an Arabic word that means ‘utility’, ‘what is good’ or ‘beneficial’, ‘an advantage’ and ‘something for the public good’. In a legal sense, it tends to underline the aims of legal rulings and the intended utility of the law. These aims are well-manifested in the preservation of Maqasid (objectives) of the law, which consist of five safeguards for human beings: faith, life, intellect, posterity and property. What assures the preservation of these five principles is Maslahah and whatever fails to preserve them is Mafsadah (evil and harm). Maslahah, as a principle of legal reasoning, is to argue that good is lawful and that lawful must be good.

3.3.11 Sadd al-dharai` or blocking the means

Another principle or technique of law, which is largely related to Maslahah, is Sadd al-dharai`, that is, blocking the means or ‘to consider the ultimate result of any action’. By virtue of blocking the means, any particular action that would bring harm to mankind would be deemed unlawful and illegitimate. Therefore, blocking the means must imply blocking the means to evil and not something good. A typical case for the application of this principle will normally arise when lawful means are expected to lead to unlawful results, or lawful means that normally lead to a lawful result are used to procure an unlawful end.

In this context, it is worth mentioning an example of the application of Istihsan in modern cases. Islamic law lays down rather precise prescriptions regarding the custody and maintenance of children. The presumption is that the welfare of the child is always in the custody of prescribed relatives. Among other prescriptions, the law says that a girl should remain with her mother until puberty, at which time she goes to the custody of her father. However, what if either parent is an unfit guardian? The recognition of a judge’s right to exercise Istihsan in custody cases requires the departure from this principle by allowing the welfare of the minor to prevail over the letter of the law. The guardian in this case could be either the mother or the father or indeed a party other than the parents if both parents are found to be unfit.

The following example illustrates the legal reasoning based on Maslahah. It relates to the case of creating a trust for the benefit of the investors in Islamic capital market products, for example, Sukuk al-ijarah. The creation of trust will transfer the legal ownership of the leased asset to the trustee and away from the issuer/lessee. In the case of the issuer/lessee going into liquidation, the leased asset will be removed from any bankruptcy action. Hence, the interest of the investors will be protected even though the issuer/lessee has been served with a liquidation order.

A good example is a ‘doubtful’ deposit received without checking the source. This might mean that monies from illegal activities are being accepted. Thus there is the need to avoid money laundering activities.



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3.3.12 ‘Urf or customary practice

In addition to other subsidiary sources, Islamic law also gives importance to ‘Urf or customary practice. Essentially, the prevailing practice or standard reflects a kind of public interest that has been accumulated and accepted in given society. This is valid as long as the practice or standard does not contradict the established principles of Islamic law, as no legal system would recognise a practice that runs counter to its fundamental principles. The recognition of custom is expected to initiate new laws, where other sources of law are silent or are to be applied to the standing law or be used as circumstantial evidence in cases of dispute. It is on the merit of this argument that many practices have been accepted in society without any dispute, as if they are an integral part of the law. This includes the obligation of delivery on the part of the seller in some merchandise contracts and a right of warranty in some products and goods. Islamic law has affirmed the position of ‘Urf or custom by having many legal maxims such as ‘custom is binding or authoritative’. ‘Urf or custom should conform to the following conditions in order to be recognised as valid in Islamic law:

(i) it should be commonly practised by the community or a community, the former being a phenomenon common to all sections of Muslim society and the latter common to a particular group or in a particular area

(ii) a practice should be current at the time of the contingency to which it relates and from which it is to be consulted; a previous ‘Urf is not admissible nor is ‘Urf that post-dates the contingency

(iii) ‘Urf should not contradict an explicit provision of the Qur’an or the Traditions of the Prophet Muhammad; consequently, wine drinking, adultery, usury and the like cannot be justified on grounds of common custom in the society

(iv) in cases of dispute, ‘Urf is to be considered only where there is no explicit stipulation between the parties concerned; if an explicit stipulation exists, that stipulation should be adopted and custom discounted.

3.3.13 Istishab or ‘presumption of permissibility’

The last technique of law is the principle of ‘presumption of permissibility’, that is, Istishab. This is based on an important maxim in Islamic law that dictates that the original ruling for every matter is permissible unless proven otherwise. This principle is useful in Islamic commercial law as it announces from the very beginning that all contracts and terms are deemed to be legitimate and lawful. If research fails to find any prohibition to these contracts and terms then they are upheld as compliant to Islamic law.

A fair value concept is a good example of how Islamic law accepted a new concept of valuation in addition to book value and market value.

Islamic finance challenge 3.4Outline the reasons for the introduction of equity in common law tradition and explain how this can be seen in Islamic law.

SolutionEquity is based on natural justice, good conscience and fairness. Common law was regarded as technical and rigid whereas equity was not. In the case of Walsh v. Lonsdale, there was a conflict between law and equity and it was decided that equity should prevail. In this case, a person who was granted possession of land under an invalid instrument was relieved by treating the instrument as an agreement for a lease. This is so as not to bring injustice to that person. The same line of argument took place in Islamic law. A person entered into an agricultural partnership or Muzaraah contract. The person cultivated the land that was provided by the other party. However, the cultivator died before the harvest was ready. According to the established principles of partnership, the partnership terminates with the death of one of the partners. Were this to be upheld, the deceased partner or his family would have been treated unfairly. The Istihsan principle comes in to ensure that the partnership is presumed to continue until the harvesting is gathered. In this way the family of the deceased cultivator are able to share the crop as agreed.



3.4 Comparison between Shari’ah (divine sources of law) and Fiqh (Islamic substantive law)3.4.1 Shari’ah

Muslims believe that God Almighty sees the Shari’ah as essential to human life. The Shari’ah, as the divinely-ordained blueprint for human conduct, is a self-contained system. It encompasses all aspects of human life, on the individual as well as at collective levels, in matters of faith, moral conduct, practical rulings and observance in all aspects of life, be it family, worship, financial transactions or justice administration. To this effect, the Shari’ah has been described by leading western scholar Joseph Schacht as “the epitome of Islamic thought, the most typical manifestation of the Islamic way of life, the core and kernel of Islam itself.”1.

3.4.2 Fiqh

Fiqh is an Arabic word that means a deep and thorough understanding and intelligence. Technically speaking, Fiqh refers to a set of practical rulings and laws that are the outcome of the legal interpretation (Ijtihad) as interpreted by Muslim jurists. This expression implies that Fiqh is about practical rulings and laws (excluding matters of faith and morals). It is also a product of human understanding and interpretation of the sources of law.

3.4.3 Differences between Shari’ah and Fiqh

The basic differences between Shari’ah and Fiqh can be summarised as follows:

(i) While Shari’ah is divine in character, Fiqh reflects the effort of humans, namely Muslim jurists, to understand the Shari’ah and to apply its principles and general guidance to specific cases, which are not provided for in sources of the Shari’ah or in a case where the texts of the Shari’ah are less clear and need some Ijtihad.

(ii) The methodology of the Shari’ah is to provide general principles and maxims, such as the requirement to fulfil an obligation. In addition, Shari’ah is not typically concerned with detailed explanations or illustrations. On the other hand, the function of Fiqh is to provide explanations and detailed prescriptions to meet the complexities of human life. For example, in the case of a breach of contract, Muslim jurists have to address the issue of compensation in detail, such as the basis of a valid and enforceable composition, the quantum of compensation and the method of payment. These detailed prescriptions are only documented in Islamic Fiqh literature and books and are not available in the texts of the Shari`ah. Thus, Fiqh is also known as ‘the substantive or positive law of Islam’.

(iii) The Shari’ah covers matters of faith, moral conduct and laws. Fiqh relates only to the last aspect of the Shari’ah, that is, the practical aspects of the Shari’ah, known in modern terms as ‘laws’ or ‘rules’. The practical aspect of observance and compliance includes almost all aspects of human affairs, such as personal worship, financial activities, family affairs, dispute resolution and justice administration and international law. Thus Islamic finance is a subset of Fiqh, an area of practical rulings known in Arabic as Fiqh al-Muamalah or simply Islamic commercial law. Islamic commercial law essentially covers a number of issues such as the formation of contracts, the sale of goods and services, investment activities, security and collateral. The overall relationship between Islam, Shari’ah, Fiqh, Islamic commercial law and its various applications is depicted in the following diagram.



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Exercise 3.6 A friend of yours is confused about the relationship between Shari’ah and Fiqh. So has asked you to explain how they relate to each other.

3.5 Ijtihad – the technique of developing contemporary Islamic commercial law3.5.1 Islamic legal theory

Islamic law, as seen in previous sections, is a very distinctive law. On one hand it relies heavily and primarily on divine texts that are represented by the Qur’an and the Traditions of the Prophet Muhammad. On the other hand it relies on the jurists to interpret these sources and apply their interpretations to new cases. Here lies the importance of Ijtihad as the technique in developing contemporary Islamic commercial law to relate revelation to reason and vice versa. The process and procedures of Ijtihad are compiled in a discipline called Usul al-Fiqh or Islamic legal theory, which assists and guides the jurists to interpret and deduce the law from both revelation and reason systematically. This is because, although legal constructions are humanly conceived, the validity of arguments in Islamic law, unlike in western and modern law, rest primarily upon the epistemological value of the revealed premises from which they are constructed. In other words, the legality of Ijtihad or interpretation in Islamic law is always subject to its confinement to a parameter, which is provided by Shari’ah principles. Reasoning cannot be void of Shari’ah guidance. All reasoning efforts must conform to general principles of the Shari’ah. Ijtihad, though it is a human reasoning, must be

Shari’ah

Figure 3.1 The overall relationship between Islam, Shari’ah, Fiqh, Islamic commercial law and its various applications

Faith

Morals

Worship

Family affairs

Financial activities

(Islamic commercial law/Fiqh al-Muamalah)

Justice

administration

Penal code

International

law

Contracts

Banking products

Insurance products

Capital market

products

Fiqh (Law and Rules)

Fiqh refers to a set of practical rulings and laws that are the outcome of the legal interpretation (Ijtihad) as interpreted by Muslim jurists.

Shari’ah is divine in character whereas Fiqh reflects the effort of humans to understand the Shari’ah and to apply its principles and general guidance to specific cases.

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properly governed to ensure it is undertaken and exercised according to particular standards and principles so as to avoid the whims and fancies of those involved.

It is clear that the search for new laws requires the process of legal reasoning to arrive at what is most likely to be the ruling of God Almighty in a given situation. Therefore, in Islamic legal theory, determining the law is not a matter of speculation or intuition. Rulings for individual cases have to be arrived at through a highly complex methodology known as Ijtihad. Above all, Islamic jurisprudence is not only concerned with the law proper (Fiqh) but also with questions of linguistics, logic, methodology, custom, epistemology, fairness and justice. In conclusion, Ijtihad seems to be an effective means of addressing the challenges facing contemporary issues in Islam particularly with regard to financial matters. A more detailed illustration of the function of Ijtihad will be given in the forthcoming chapters.

3.6 Early development of Islamic schools of law in Sunni IslamAs there are many ways and methods of understanding both the Qur’an and the Traditions of the Prophet Muhammad and their interpretations, disagreement is inevitable in Islamic law. These differences of opinion are well documented in the legacy of Islamic law, particularly in the writings of all major schools of Islamic law.

3.6.1 Madhhab – schools of Islamic legal thought

From the middle of the eighth century (AD), a number of juristic scholars emerged whose independent interpretations of the general principles and specific cases of both the Qur’an and the Traditions of the Prophet Muhammad stimulated the development of separate legal schools in Islam. Islamic jurisprudence became a highly technical process and disputes about methods and judicial opinions crystallised into various legal schools designated by the names of their founding scholars. The differences in legal thought were mostly due to the various ways in which the Qur’an and the Traditions of the Prophet Muhammad were interpreted in relation to local customary law and the quality of reasoning used in extending the principles to unprecedented cases. As a result, several legal systems or schools called Madhahib (plural of Madhhab) developed corresponding to different methods of conducting jurisprudence. These Madhahib usually differed with regard to the details of practical applications, but divergence of opinions with regard to general principles of Shari’ah has been negligible.

3.6.2 The ‘Hanafi’ school of law

The oldest legal school is the one that followed Iraqi tradition and is called the ‘Hanafi’ school of law. It is named after its founder Abu Hanifah, who died in 767AD. The Hanafi school of law is known for its endorsement of reasoning and logic as legitimate sources in the application of practical rules to the practical questions of life.

Abu Hanifah’s unusual ability to broaden juristic practice with the use of analogy and juristic preference allowed Hanafi jurists to carry out meticulous investigations of legal sources to formulate their juridical decisions. The Hanafi school of law has been the most flexible and workable school in the area of commercial transactions. In terms of the geographical distribution the school came to dominate most territories of what was the Ottoman Empire, particularly in the eastern Mediterranean, simply because it was the official school of law of the ruling government. The Hanafi school of law is also predominant in the Indian subcontinent and central Asia covering both Russia and China and could therefore be considered the largest school of law in the Muslim world.

3.6.3 The Maliki school of law

Chronologically, the next school is the Maliki, which originated in Medina and was named after the prominent legal scholar and traditionalist Malik bin Anas (d.795AD).

Those who adhered to the rulings of Malik bin Anas were known as the Malikis. In his legal formulations Malik relied heavily upon the well-established practices of the early companions of the Prophet Muhammad in Medina. Although he was bound by the practice of the Medinese in his legal doctrines, Malik also used analogical deduction in cases not treated in the Quranic verses or in the Traditions of the Prophet Muhammad to arrive at a rule. Maliki jurists regard ‘juristic preference’ and ‘public interest’ as valid sources of juridical decisions. The adherents of the Maliki school of law tend to be concentrated today in North and West Africa, although they are found in other parts of the Arab world, including the Hejaz in Saudi Arabia, and Kuwait.



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3.6.4 Shafi’i school of law

The third major surviving school is called the Shafi’i school of law. This school was named after Muhammad bin Idris al-Shafi’i (d.820AD).

The Shafi’i school of law was the result of a synthesis conducted by a single scholar who was thoroughly familiar and well versed with the doctrines of both the Maliki and Hanafi schools. From the Maliki school of law he reaffirmed the Traditions of the Prophet Muhammad as a source of law co-existing and co-equal with the Qur’an. He articulated the view, which subsequently found widespread acceptance, that the Traditions of the Prophet Muhammad explained the meaning of the Qur’an. From the Hanafi school of law he accepted the role of independent sound judgment and used that as a tool for analogical inference in his legal theory.

Al-Shafi’i’s contribution lies in his synthesis of legal theory in Islamic jurisprudence. It can be noted that the legal theory in Islamic jurisprudence developed by al-Shafi’i deals best with areas of law that are fixed. These include devotional matters and the like because al-Shafi’i and his school of law was never involved in areas of law that are flexible and worldly, as in the case of the Hanafi school of law. The distribution of the members of the Shafi’i school of law tends to correspond to the pattern of the major trade routes, with which Shafi’i communities mostly associated. One finds large numbers of the Shafi’is in East Africa, Yemen, Malaysia and Indonesia.

3.6.5 The Hanbali school of law

The last of the four schools of law is the Hanbali school of law. It was named after its founder Ahmad bin Hanbal (d.855AD) who compiled work on the Traditions of the Prophet Muhammad. This became the source for juridical decisions of the Hanbalis.

Generally speaking, the Hanbali school of law leaned more on tradition than the science of law and jurisprudence. The Hanbali school of law has dwindled in size so that its adherents are rarely found outside central Saudi Arabia. However, the widely-appreciated originality and intellectual distinction of some of its medieval jurists has allowed it to retain an influence entirely out of proportion to its number.

3.6.6 All schools are equal

Muslims attribute an equal value to all four surviving schools as the differences between them are in the detail. These differences are in the domain of the application of law (branches of law) and not in the principles of the law (roots of law). It is important to note that these four schools are in agreement on all points vital to Islam. They acknowledge the authority of the Qur’an and the Traditions of the Prophet Muhammad as the ultimate sources of law in Islam. They have a different emphasis of adherence to other subsidiary sources. These differences have led to different perspectives on many legal issues.


(i) Why various schools of law developed in Islam?

(ii) Whether these schools of law are contradictory to each other in their final conclusions and opinions?

3.7 ConclusionThis chapter introduced you to the sources from which Islamic law developed including both the primary source (revelation) and secondary source (human interpretation). It also introduced you to the crucial process of Ijtihad and to the principles which underlie this process. You will have seen that the use of Ijtihad has resulted in the development of several Islamic schools of law. You were introduced to the four major Islamic schools of law that are the Malikis, Hanbalis, Shafiis and Hanafis. As explained, these schools of law have a direct effect on the geographical development of

Madhhab is a school of Islamic legal thought.

All schools of law agreed on principles of law though they may differ in specific cases and legal formulations.

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Islamic finance. You will see in later chapters of this guide and throughout the other three guides that this effect on geographical development has led to fierce debate throughout the Muslim world as to what constitutes acceptable practice in Islamic finance.

The next chapter will explain Ijtihad in further detail and show how it can be applied as a solution in modern financial issues.


1. Islam is a religion based on a system of principles and rules

2. the essence of Islam is that it derives its principles and values from a given source; for Islam and for Islamic law, which is part of Islam, these sources are the Qur’an and the Traditions of the Prophet Muhammad

3. the two sources are important as they provide not only the parameters of what is approved and what is not permitted but also some specific injunctions for specific cases in life

4. secondary sources are those based on human interpretation and reasoning which in practice are, or should be, traced back to the primary sources in one way or another

5. Ijtihad is the legal reasoning used by jurists and scholars to arrive at what is thought, on a best-effort basis, to be the law as intended by the Qur’an and the Traditions of the Prophet Muhammad

6. Ijtihad is the most workable technique in developing contemporary Islamic finance. However, the exercise of Ijtihad must be properly governed to avoid resorting to the whims and fancies of an individual

7. Ijma’ refers to the consensus of Muslim jurists on a particular legal issue at a particular point in time; this then becomes a binding authority on Muslim communities

8. Qiyas is a form of analogical reasoning that extends the law beyond what is stated in the authoritative legal sources; it is an extension of a precedent and not the establishment of a fresh ruling by itself

9. Qiyas al-tard is the use of analogy, that is, the extension of a legal rule from one case based on a similarity, deemed by the jurists to be a ‘material similarity’

10. the ‘Illah or reason given in a Qiyas must be an evident attribute, as well as constant and regular; it should also be co-extensive and co-exclusive

11. Istihsan or juristic preference takes place when a jurist departs from a precedent and takes a decision in a case by virtue of another ‘reason’ that is stronger and more ‘appealing’

12. ‘Urf is the acceptance of customary practice where the prevailing practice or standard in society reflects a kind of public interest that has been accumulated and accepted; this is valid as long as the practice or standard does not contradict the established principles of Islamic law

13. Istishab suggests that in Islamic commercial law all contracts and terms are deemed to be legitimate and lawful until research determines whether there is any prohibition

14. while Shari’ah is divine and contains general principles, Fiqh is the understanding by Muslim jurists of the Shari’ah and also deals with detailed prescriptions of the law

15. there are at least four surviving Islamic schools of law in Sunni-Muslim society; although they may have many different perspectives on specific laws and legal matters, they have one common perspective on Shari’ah and the general principles of Islamic law.

Notes:

1. Schacht, Joseph, Origins of Muhammadan Jurisprudence, Oxford 1950, 124ff



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Chapter 3 AnswersExercise 3.1(i) The origin of the source of law in Islam is revelation as both the Qur’an and the Traditions

of Prophet Muhammad are regarded as being divinely revealed and inspired.

(ii) The source denotes a place from which a substantive law originates. Substantive law generally speaking is detailed and specific to a particular case in point.

(iii) The sources of law in Islam are the Qur’an and the Traditions of the Prophet Muhammad.

Exercise 3.2The source of law is important in Islam because it denotes a place from which the whole body of law will later develop. To ensure that Islam is always centred upon revelation, this source must be equally revealed and divine in character. The main function of the source is to provide a guideline or parameters for general application on matters such as an obligation to fulfil a contract. The source also provides general principles to be extended to other similar cases, such as the extension of the prohibition of liquor to other intoxicating items such as drugs. Islamic law has developed historically through the divine-text approach because all legal formulations and conclusions by the jurists had to be based on the divine texts of both the Qur’an and the Traditions of the Prophet Muhammad.

In conclusion, the source denotes a place from which a required solution can be arrived at. This source, as far as Islamic law is concerned, is based on revelation applied and extended through interpretation and extension. This reflects a significant synergy between the sources of law, which are divine and the process to benefit from these sources, which is human driven.

Exercise 3.3The legal basis is not related to a specific item such as dates or barley. Although dates are mentioned in one of the Traditions of the Prophet Muhammad (refer to section 1.5.1) the dates, as well as other items mentioned in that tradition, are not the real reason for this prohibition. Some jurists have extracted the basis of this prohibition as the “main foods” and therefore, any exchange of two main foods must be subject to the same requirements. Therefore, an exchange of corn for corn is equally governed by the same ruling and requirement (on the assumption that corn is a main food in some societies) that are of equal and spot exchange.

Exercise 3.4The Qur’an has categorically prohibited interest or Riba. However, the Qur’an never explained the forms and classifications of prohibited Riba. It is only the Traditions of the Prophet Muhammad that explain Riba in detail. A good example is the Prophet’s pronouncement on the exchange of two different qualities of dates as explained in section 3.3.3.

Exercise 3.5Ijma’ requires all living scholars to agree on a particular part on law. Any disagreement will result in an invalid ijma’. Getting all living scholars to agree to any one solution to a difference of opinion is unlikely to be easy. Indeed it may not be possible.

Exercise 3.6Shari’ah is a comprehensive system that governs many other components. One of the components is known as Fiqh, which relates to practical rulings on human conduct. Thus, Fiqh is part of the Shari’ah as the Shari’ah is wider in scope. Also, while Shari’ah is Divine, Fiqh is human in the sense that Fiqh is derived from interpretation by man.

Exercise 3.7(i) The emergence of various schools of law in Islam was the result of Ijtihad. Ijtihad is bound

to result in more than one opinion, thus the development of many schools of law.

(ii) Many of the legal conclusions and opinions of these schools of law could be contradictory. Differences of opinion occur, however on the detailed application of the law only and not on the principles.

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Revision Questions

Question 1 Multiple choice1.1 Which of the following is NOT a valid description of both the Qur’an and the Traditions of the

Prophet Muhammad?

(A) Both were revealed through Revelation.

(B) Both are primary sources of Islamic law.

(C) Both can be extended to other specific and new cases.

(D) Both primarily provide detailed rulings of Islam.

1.2 What does Qiyas or analogy refer to?

(A) Public interest that is good for the society and which does not contradict Shari’ah principles.

(B) The customary practice of the society, which is both beneficial and acceptable.

(C) An extension of a ruling prescribed in the Qur’an or the Traditions of the Prophet Muhammad to a new case which shares similar reasoning with the original ruling.

(D) The consensus of the Muslim jurists and scholars at one point in time, on a specific legal issue.

1.3 Which of the following defines Ijtihad?

(A) The consensus opinion of a number of leading Muslim jurists and scholars.

(B) Customary practice.

(C) A reliance on the texts of the Qur’an and the Traditions of the Prophet Muhammad.

(D) The process of legal reasoning by the jurists to arrive at a legal solution for new cases.

1.4 What is the function of ‘Urf (customary practice)?

(A) To provide an explanation as circumstantial evidence in cases of dispute.

(B) To extend the law to new cases.

(C) To block any means to consequences which are unfair or harmful.

(D) To presume that everything is permissible unless proven otherwise.

1.5 Which of the following statements is NOT correct with regard to the Islamic schools of law in Sunni Islam?

(A) The schools of law were named after their founders.

(B) The schools of law were distributed across the globe.

(C) The schools of law differed from each other in matters of specific rulings.

(D) Various schools of law developed in order to encourage a variety of opinions.

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Question 2Match the following descriptions to both Shari’ah and Fiqh respectively.

Descriptions

General principles.

Humanly interpreted.

Governs faith, moral and law.

Detailed rulings.

Revealed by God Almighty.

Relates to law only.

Question 3Fill in the blank(s) to correctly complete the following sentences.

1. Juristic preference (Istihsan) is to prefer one ruling over another ruling that is already prescribed as the precedent. This preference is due to a reason which is and .

2. All contracts and terms under the principle of presumption of permissibility are deemed unless proven otherwise.

3. Reason (‘Illah) is the effective cause or reason for a ruling in Islamic. Among the attributes of valid reason in Islamic law are that it must be evident, constant, and .

4. The distinctive features of Hanafi school of law are and .

5. Differences of opinion among the scholars did not relate to but they were always related to .

Shari’ah Fiqh


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Answers

Question 1 Multiple choice1.1 (D) Muslims refer to the Qur’an and also to the Traditions of the Prophet Muhammad as their

main reference for rulings. However, the Qur’an provides detailed rulings of Islam only in a few limited cases.

1.2 (C) Qiyas uses rulings in the Qur’an and the Traditions of the Prophet Muhammad as the basis for a decision in a new case. Qiyas is an extension of an original ruling to a new case.

1.3 (D) Ijtihad is a legal reasoning by the jurists to solve a new case that requires a legal solution. The solution required is either not clearly or directly provided in the text or not provided in the text at all.

1.4 (A) In most cases ‘Urf or customary practice provides a useful reference to settle disputes in a society, particularly in matters that are commonly upheld by the society.

1.5 (C) The difference between the schools of law in Sunni Islam is only on the details of practical applications.

Question 2

Question 31. Stronger and more appealing.

2. Lawful/permissible.

3. Co-extensive and co-exclusive.

4. Reasoning and logic.

5. Principles of law, branches of law.

Shari’ah Fiqh

General principles

Revealed by God Almighty

Governs faith, moral and law

Detailed rulings

Humanly interpreted

Relates to law only


Revision questionsSources of Islamic commercial law

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Methodology of interpretation of Islamic commercial law


define various forms of Ijtihad inclusive of both textual-based and human-based reasoning

identify the need for Ijtihad in modern times

understand the practicality of Ijtihad in solving modern issues and problems

describe approaches to Ijtihad.

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Learning outcomes

Chapter four



4.0 IntroductionIn this chapter you will learn more about the basis and idea of Ijtihad or interpretation as practised within Islamic commercial law. The introduction will cover the many forms of Ijtihad that enable the jurists to overcome modern and day-to-day problems. You will also learn how Ijtihad can solve practical modern financial issues from an Islamic perspective.

4.1 The basis of interpretation (Ijtihad) in IslamAlthough Islamic law starts from given or self-evident premises that constitute the sources of Islamic law, it also appeals to Ijtihad to enable it to answer all questions arising in a given society at any point in time. However, it should be made clear that Ijtihad is not applicable to matters of belief and theology. Theological issues are not subject to Ijtihad as all the principles and foundations of belief have been revealed without the need for further interpretation and reasoning. Ijtihad, in the context of religion of Islam, applies exclusively to matters of law.

This and other traditions reaffirm the basis of Ijtihad. On the other hand Ijtihad is an inevitable technique of law for the following reasons:

4.1.1 Life is complex

While the legal texts in the Qur’an and the Traditions of the Prophet Muhammad are limited, the potential issues in life are not. Thus, it is impossible for something infinite to be enclosed by something finite. In other words, in cases that require a decision, and authority from either the Qur’an or the Traditions of the Prophet Muhammad cannot be found, the accepted methodology is to undertake legal reasoning and interpretation to find an answer.

4.1.2 Understanding and application

Even in the case of the availability of a legal text it does not mean that Ijtihad is not needed as Ijtihad involves the whole process of understanding a text and the application of this understanding to the correct context and issue.

A case in point is the basis of Riba or interest involving the exchange of four items namely, wheat, barley, dates and salt. The Prophet Muhammad reportedly said: “Gold for gold, silver for silver, wheat for wheat, barley for barley, dates for dates, and salt for salt, like for like, equal for equal, hand-to-hand. If the commodities differ, then you may sell as you wish, provided that the basis of exchange is hand-to-hand.” This text has provided a basis as to why an exchange involving these six commodities shall be observed with extra diligence to ensure its compliance to Shari’ah requirements.


The basis of interpretation in Islam.

Ijtihad.

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The basis of interpretation can be traced to the time of the Prophet Muhammad. The most obvious basis is the record of the prophet’s conversation with his companion, Muadh bin Jabal, on the eve of the latter’s departure to Yemen as a judge and teacher. The Prophet Muhammad asked Muadh bin Jabal how he would solve a legal issue should a new case arise in Yemen. He replied that he would resort to the Qur’an if there was anything he could base his conclusion on, otherwise he would refer to the Traditions of the Prophet Muhammad to find an answer. The Prophet Muhammad probed further as to how he would solve a legal issue in a case where neither the Qur’an nor the Traditions of the Prophet Muhammad could help. Muadh bin Jabal replied that he would resort to applying Ijtihad and would not be negligent in his undertaking. The Prophet Muhammad endorsed this methodology and this tradition has become the most celebrated basis of Ijtihad.



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Muslim jurists have unanimously agreed that the legal basis (ratio decidendi) of the first two items, namely gold and silver, is their function as currency at that point in time. Therefore, using simple analogy, any form of currency will be equally subject to the same rule; they have to be of spot and simultaneous transfer (hand to hand) as well as of equal amounts if they are in exchange for the same currency. If the two currencies are of different denominations, then they can be exchanged for each other based on a negotiable rate, as long as the transfer of the two currencies is spot and simultaneous (refer to section 1.5.1).

An Ijtihad is required in determining the legal basis of the last four items as scholars have unanimously agreed that they were not meant to be specific or exhaustive. These four items need a common basis to render them extendable to other new items. Guided by the above text, scholars of different schools of law have attempted to give their respective interpretations. While the Shafi’is upheld the fact of edibility as the legal basis, the Hanafis have contended that the common basis of these four items is that they are measurable and weighable. The Maliki school of law argued that what these four items have in common is that they are main foods and can be preserved.

Clearly, there is more than one interpretation of the intended legal basis of these four usurious items and these could logically lead to various, if not conflicting, rules and decisions. Having said this, the fact remains that Ijtihad is a necessary tool in Islamic legal tradition in the issue of deciding the legal basis of Riba in these four food items.

4.1.3 Limitation of divine texts

It has also been advocated that Ijtihad is needed because Islamic law in totality was not given ready made. Many aspects, particularly detailed explanations and illustrations of legal principles, are not readily and instantly available in the divine texts. As previously mentioned, Islamic revelation was stopped by the demise of the Prophet Muhammad and Muslims are left with two divine sources or texts that are not in the form of detailed codes and specific rulings for all specific issues - current and in the future. This is the nature of Islamic revelation and, subsequently, the law-making process in Islamic legal tradition.

Guided by these two sources, Muslim jurists and scholars are expected to do their level best to understand, interpret and apply these texts to all issues and cases. From a legal perspective this process means that, among other things, Islamic law is open to innovation and legal reasoning. Ijtihad is to use one’s personal reasoning to interpret and reinterpret the texts and principles. The basis of Ijtihad is to encourage the culture of innovation and creative reasoning in attempting to solve a problem with a solution that requires comprehension and contemplation.

Exercise 4.1Indicate which of the following statements is true/false:

(A) Ijtihad is not valid where relevant text exists to provide a solution to an issue

(B) Ijtihad has only been valid since the demise of the Prophet Muhammad.

4.2 Meaning of Ijtihad or interpretationIjtihad, which is an Arabic word, is derived from the root word Jahada, meaning to strive to do something. It applies to any kind of work that requires some effort by the doer. Work that does not require any effort or any considerable effort cannot be deemed as Ijtihad.

4.2.1 Salient features and requirements of Ijtihad

In 4.1 above, a tradition of the Prophet Muhammad was cited as an example of how the Prophet Muhammad endorsed the approach to be taken by a would-be judge on the eve of the latter’s departure to Yemen. This piece of tradition indicated a few critical salient features and requirements of Ijtihad. Among other things, the tradition mentions the use of one’s personal opinion (Ra’y). This opinion should be considered and contemplated because the same tradition maintains that Ra’y cannot be exercised without due diligence and care. It is only a considered opinion when it is

When a decision or authority is not found in the Qur’an or the Traditions of the Prophet Muhammad, the accepted methodology is to undertake legal reasoning and interpretation (Ijtihad) to find an answer.

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exercised by a qualified jurist. It should be undertaken in good faith and with a high standard of scholarship.

Ijtihad, from a basic legal definition, is to make use of one’s best ability under the guidance of the broad principles of Shari’ah in the search for a legal status. From a more technical perspective, Ijtihad is seen as ‘the total expenditure of effort in the search for an opinion as to any legal rule in such a manner that the individual sense (within himself) has an inability to expand further effort’. It is clear that Ijtihad requires a high standard from both the Mujtahid, that is, the doer of Ijtihad, as well as the exercise of Ijtihad itself. This definition emphasises that the search must be total, involving the jurists’ utmost energies and skills. If the jurists fail to discover evidence that they were quite capable of discovering, then their reasoning will be void as they have been negligent in their research and contemplation.

Ijtihad is a process and means to arrive at a particular objective. It takes place at the beginning of the process, the outcome of which is called Fiqh (Islamic substantive law). In other words, Ijtihad interprets the texts and principles of law, as the case may be, and results in a concise legal formulation or answer for a specific issue.

4.2.2 The approach to Ijtihad

As mentioned in chapter one, Islamic law is distinct from both common law and civil law respectively. Law finding in Islamic law is always based on a text-oriented approach. In the history of Islamic law, the great bulk of positive or substantive law was the outcome of juristic interpretations. Roman law was also known for its heavy dependence on interpretation as the means to discover the law and for this reason Roman law is known as the ‘jurists’ law’.

Although jurists in Islamic law, as in the case of Roman law, had the function of discovering the law for the consumption of interested parties and authorities in the state, Muslim jurists were probably more restricted than their Roman counterparts. Roman jurists depended largely on their intuition in arriving at solutions to legal problems. They were guided as much by notions of equity as they were by substantive legal doctrine. This intuition is likely to have derived from the social and psychological forces of the age. In Roman eyes, a jurist was a man possessed of legal wisdom; it was his sound judgment and insight, more than any specific philological or hermeneutical skills that elicited the respect of his contemporaries and provided the basis for his authority. On the contrary, Muslim jurists were bound to more formal sources and texts. Their authority depended more upon the jurist’s skills than upon any inherent wisdom.

To some extent, this process of interpretation is also true with regard to common law. However, unlike Roman law and Islamic law, which place a significant role on the jurists, judges were primarily responsible for the development of common law. Common law is alternatively known as ‘judge-made-law’. It is noteworthy that in the UK, parliament provided judges with the general assistance of the Interpretation Act 1889, which provides rules for statutory interpretation. Even with the help of the interpretation act, judges are constantly faced with cases that depend on their interpretation of a word or phrase in a statute for which no adequate definition is provided by the legislature.

4.2.3 Methodologies of interpretation as developed in common law

The following are some established methodologies of interpretation as developed in common law:

1. The judge should apply the words according to their ‘ordinary, plain and natural meaning’. This is a known as the literal rule, the application of litera legis. One of the most striking examples of the use of this rule occurred in Race Relations Board vs Dockers Labour Club and Institute Ltd. (1976) where the House of Lords considered the phrase ‘to the public or a section of the public’, contained in the Race Relations Act 1968. The lords decided that membership of a private organisation did not come within the phrase and so racial discrimination in this context could be practised within the law.

Ijtihad requires a high standard both from the Mujtahid, that is, the practitioner of Ijtihad, as well as the exercise of Ijtihad itself.

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2. The literal application need not be applied if to do so would lead to absurdity or inconsistency within the statute itself. An outstanding example of this rule occurred in Re Sigsworth (1935), where a man was found to have murdered his mother. In the statute dealing with the distribution of the mother’s estate it was laid down that the estate was to be distributed among ‘the issue’. The son was her only child. The judge held that the common law rule that a murderer cannot take any benefit from the estate of a person he has murdered prevailed over the apparently clear words of the statute.

3. If the literal rule fails to assist a judge, they are entitled to consider the ‘mischief’ rule. This rule, which was first settled in Heydon’s Case (1584), allows the judge to consider (1) what was the common law, (2) what was the defect or mischief in the common law, and (3) what remedy parliament in the legislation has provided for the defect. Here a judge is entitled to examine existing legislation and case law before coming to their decision, with the intention that their ruling will ‘suppress the mischief and advance the remedy’. In Kruhlak vs Kruhlak (1958) the court held, in connection with affiliation proceedings, that a married woman with no husband to support her is ‘a single woman’ for the purposes of the legislation. The mischief that the statute in that case was aimed at was the situation of an illegitimate child with no means of support. This rule is sometimes referred to as interpretation ratio legis as distinct from interpretation litera legis.

4.2.4 Relevance of methodologies of interpretation to Islamic legal interpretation

These methodologies of interpretation, while relevant to the common law system, are also relevant in Islamic legal interpretation. Interpretation is inevitable in most legal systems as can be seen in both civil law and common law legal traditions.

The need for interpretation in Islamic law is more obvious, because Islamic law starts from self-given texts that are revealed in Arabic, thus interpretation is central and fundamental. This is what it is meant by the statement that Islamic law always has a text-oriented approach. Put simply, interpretation in Islamic law, which is always guided by the texts, is inherently of philological or linguistic implication. A Muslim jurist must determine what meanings the words of the text ‘have’ in the classical language and whether they are particular or probable meanings. In particular, he must be able to identify commandments and prohibitions and determine the precise nature of such commandments or prohibitions, that is, whether they allow, recommend, require, disapprove or forbid acts.

4.2.5 Language and interpretation of Islamic law

Familiarity with the Arabic language is a prerequisite to understanding the Qur’an and the Traditions of the Prophet Muhammad since both have come to Muslims in the language, grammar and morphology of Arabic. The following examples illustrate the importance of interpretation in Islamic law.

Although the text may seem easy to understand, the actual meaning of ‘marriageable age’ and ‘the attribute of prudence or sound judgment’ need some considered opinion to make their technical meaning clear to all interested parties.

In another case in the Qur’an, it was mentioned that a pledge might be a useful means to secure loan or financing for someone who is on a journey and away from his family and relatives.

This verse does not, however, restrict the act of pledge to the circumstances of being on a journey. In fact, the verse simply confirms the fact that a pledge would be a relatively easier instrument to convince potential lenders or creditors. A pledge is equally permissible in other circumstances.

Exercise 4.2Briefly explain what is meant by the term Ijtihad.

The Qur’an states: “Prove orphans till they reach the marriageable age and if you then find sound judgment in them, release their property to them.” (Chapter 4, verse 6)

The Qur’an reads: “If ye are on a journey and cannot find a scribe, a pledge with possession (may serve the purpose).” (Chapter 2, verse 283)



4.3 Various forms of Ijtihad ranging from textual-based reasoning to human-based reasoning based on equity and consideration of customIjtihad is a process of reasoning to find a solution for a case for which there is no direct textual solution. Occasionally, it involves some interpretative effort to understand the text. While many forms of Ijtihad are applicable, these are the two basic grounds that explain why Ijtihad is used.

The first logical form of Ijtihad is to use one’s ability to understand the meaning, in any given text, be it in the Qur’an or the Traditions of the Prophet Muhammad. While some of the meanings are clear and straightforward, some are probable in character as they are open to more than one interpretation. Where a text is open to interpretation, Muslim jurists, guided by broad principles of Islamic law, will require many skills of interpretation such as philological principles, contextual understanding and analogical reasoning to put forward their respective best understanding of the meaning of a particular text.

The Qur’an states that there must be a written document for a contract that creates future obligation.

4.3.1 The need for written contacts

The question arises as to whether this imperative really means an obligation to document all contracts in writing, particularly those of debt-based contracts. The verse seems to indicate such an obligation. However, Muslim jurists, after taking into consideration the whole structure and style of the verse, have concluded that the documentation of contracts is only ‘recommended’ or ‘encouraged’.

The verse implicitly indicates that the purpose of this documentation is to protect the interests of contracting parties. Documentation is not an integral element to the contract. Protection of the interest could be achieved through written documentation, as well as from attestation and pledge that are also mentioned in the Qur’an. This is the contextual interpretation of the verse that is upheld by the majority of scholars. Some scholars who are ‘literalists’ have, however, upheld the rule of obligation for a written documentation of a debt-based contract.

4.3.2 The definition of solvency

In one of the Prophetic Traditions, the Prophet Muhammad is reported to have stated:

The literal meaning of this tradition may be open to interpretation. In a legal discourse, standards must, however, be established for both procrastination and solvency, that is, how is one legally perceived as delaying a financial obligation and how is one described as solvent? For example, does difficulty in payment due to some temporary cash flow problem mean a state of insolvency?

The common prevailing meaning in the Islamic financial market is that a person is deemed to be financially solvent if he is not declared bankrupt, even though he may have some financial difficulties. Therefore, he is still expected to make scheduled payments as agreed and documented in the agreement between him and the creditor/financier. The onus of burden of proof of insolvency, or at least extreme financial difficulty, is upon him to prove, otherwise he is deemed to be financially capable of paying whatever he owes to the financier/creditor. The requirement of presumption of solvency was brought in to ensure that some equitable consideration is given to the debtor. This is obviously an Ijtihad based on fairness and the Maslahah principle, which is another form of Ijtihad other than interpretative form of Ijtihad on the texts.

4.3.3 Default of payment

The same tradition also speaks about the punishment for those who default on payment of their debt while they are solvent. Muslim jurists have suggested that imprisonment, penalty and compensation, foreclosure of their personal assets and physical punishment could all be considered

The Qur’an reads to the effect: “O ye who believe! When ye deal with each other, in transactions involving future obligations in a fixed period of time reduce them to writing, let a scribe write down faithfully as between the parties; let not the scribe refuse to write: as God Almighty has taught him, so let him write.” (Chapter 2, verse 282)

“The procrastination of a solvent debtor is unjust which justifies him to be punished and his reputation to be tarnished.”

Maslahah – what is good or beneficial



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in such cases, but the prevailing practice in the Islamic financial industry is to impose a financial penalty on the solvent defaulter. The proceeds of this financial penalty are to compensate only for the actual loss incurred by the creditor/financier, which does and should not include the cost of fund or opportunity loss. Any surplus penalty is to be given out to charitable bodies and organisations.

4.4 Qiyas or analogyAnother form of Ijtihad is to extend the ruling already prescribed in the texts to a new case that shares the same or similar ‘basis’ of law, called Qiyas or loosely translated into English as ‘analogy’. This is the most systematic and structured form of Ijtihad that requires rigorous procedures and processes. In Islamic commercial law, the practice of Qiyas or analogy is always relevant, as analogy is based on ‘ratiocination’, that is, to find the right basis of the legal ruling for the purposes of extending it to a new case. In section 1.3.7 of chapter one, an example of analogy involving intoxicating items was explained to show how a legal basis in wine was extended to other intoxicating items such as spirits and drugs. This is basically a case-to-case comparison.

4.4.1 Induction

Another form of analogical argument is induction. Unlike analogy, induction starts from the common rule for a number of cases, which will be similar or identical in relevant aspects. The form of argument is: A, B, C, D and so on are cases that have the common characteristic X and the rule J; all cases that have the characteristic X must have the rule J; S has the characteristic X; therefore S has (and must have) the rule J. A concrete example of induction from Islamic law is the case of interest (Riba). The Prophet Muhammad was said to have prohibited the exchange of gold for gold, silver for silver, dates for dates, wheat for wheat, salt for salt and barley for barley unless they were equal in quantity and delivered immediately.

The jurists, other than the Zahiris (literalists), have unanimously agreed that the above pronouncement is not due to their particular species but rather to a specific ‘reason’. Nevertheless, jurists are divided among themselves as to the intended reason for the above prohibition. In short, the Shafi‘is maintain that such a transaction (with reference to dates, barley, wheat and salt) is unlawful in the exchange because they are edible. The Hanafis believe the ‘reason’ for the prohibition is because of the goods’ capacity to be sold by weight or measure. According to the Malikis, the exchange is unlawful because these articles are food and can be preserved, which is the ‘reason’ for usury in barter trading.

It is obvious that the reason formulated in the respective schools of law is derived from the tradition through induction, that is, articles of wheat, salt, dates and barley are cases that have the common characteristic X (the ‘reason’) and therefore, subscribe to the rule J (the prohibition of exchange of two similar Ribawi items unless hand to hand and of equal amount). Subsequently, by way of extension, all cases that have the characteristics X must have the rule J.

This premise of argument is agreeable to all the schools of law even though they have considered different rationales (‘reason’) as the underlying cause of the judgement. In accordance, all goods possessing this reason must be subject to the above prohibition pronounced by the Prophet Muhammad. For instance, in the Hanafi school of law, goods that are saleable by weight and measure, for example raisins, must be subject to the same requirements of exchange, such as quantity and time of delivery otherwise Riba is applicable.

Islamic finance challenge 4.1Within an Islamic context, how would new problems in society be resolved if Ijtihad was not used?

Solution If Ijtihad were to be neglected or marginalised, the solutions to new problems would either have to be determined on an ad hoc basis or it might not be possible to find a solution.

Another form of Ijtihad is to extend the ruling already prescribed in the texts to a new case that shares the same or similar ‘basis’ of law, called Qiyas or loosely translated into English as ‘analogy’.

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Key point



4.5 Ijtihad - applied to new and unprecedented casesThe third and the last form of Ijtihad requires referral to some grounds or techniques of law to arrive at the required solutions. This is the widest scope of Ijtihad as it could be based, for example, on customs, public interest, blocking the means to evil and juristic preference. Unlike the first and second approaches, this approach is more flexible and dynamic. Most of the new and unprecedented cases are the outcome of this kind of Ijtihad. This approach depends more upon the skills of the jurist to put a systematic argument to their conclusions in tandem with general objectives of the Shari’ah.

Many examples can be presented to show this methodology of interpretation. Among other practical examples is the premature distribution of profit arising under Mudarabah contract as well as the contribution of assets as the capital in equity-based financing. These will now be explained.

4.5.1 Mudarabah

Mudarabah is a partnership contract wherein one party provides the capital and the other provides the work and management. Mudarabah is used as a contract in Islamic investment accounts in most Islamic Financial Institutions (IFIs). The depositors are the investors and the bank is the manager. Normally, a particular period of the investment account is agreed upfront between the two parties, for example, a 12-month period. The net realised profit, if any, will be distributed between the two parties based on an agreed ratio or percentage at the end of the investment period. However, the practice allows a premature distribution of profit, for example after six months. This is now easier as many IFIs have adopted a daily basis of profit calculation. The practice of allowing the premature distribution of profit is supported by the principle of public interest. Above all, the practice is void of any Shari’ah prohibited items and elements as profit can be distributed either at the end or prior to the end of the investment account period, but later subject to a process of rationalisation.

This reflects a sort of Ijtihad because the established principles on Mudarabah have stated that profit can only be realised and distributed after the expiry of the investment period. This might suit a typical project using Mudarabah as a source of financing. However, in the field of Islamic deposit or account, such a rule might not attract depositors to invest in IFIs. Therefore, flexibility, by allowing a premature distribution to Islamic depositors, would be in line with the principle of the public interest, thus representing a kind of Ijtihad.

4.5.2 Capital for equity-based finance

As with the capital in any equity-based financing and investment, the capital should ideally be in the form of monetary assets, for example, GBP or Japanese yen. However, there is also a possibility that assets such as machinery, equipment or land can be accepted as capital in a joint-venture business. There is no Shari’ah prohibition in taking these assets as capital because they, like money, help to generate more business opportunities and, hopefully, profit. Also, the presumption of law is always that every contract or term or clause is deemed approved unless proven otherwise. In order to avoid dispute, jurists have imposed that these assets must be subject to valuation first to translate these assets into capital that is worth a particular amount of money. This will help in terms of determining the profit or loss sharing due to the liquidation of the joint venture or company.

Exercise 4.3The principle of capital introduced as equity-based financing and investment is that it should be in the form of cash. Explain why capital introduced in the form of another ‘asset’ might also be acceptable as capital?

Induction is another form of analogical argument.

Unlike analogy, induction starts from the common rule for a number of cases, which will be similar or identical in relevant aspects.

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Key points

Mudarabah is a partnership contract wherein one party provides the capital and the other provides the work and management.

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Key point



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4.6 Need of Ijtihad in modern times Although Islam is based on revelation, this stopped with the demise of the Prophet Muhammad. New cases are inevitable and require a Shari’ah solution as and when they occur. Issues such as short sales, purchasing and trading of options, swap transactions and future commodity markets are contemporary financial issues. Also cases can originate from old contracts when they are implemented in a modern framework. Issues such as the redemption of Musharakah capital or the floating rate of rental payment based on certain benchmarks such as the London Inter-Bank Offer Rate (LIBOR) are real and bona-fide issues in contemporary Islamic financial markets.

Obviously, these issues need some Shari’ah perspective if not a solid solution. It is against this background that the need for Ijtihad arose. Without resorting to Ijtihad, two possible scenarios are likely to arise:

• Islam will be defective and unable to face the challenges of modernism and post-modernism in all aspects of life

• solutions proposed to solve these new problems may not be grounded on accurate Ijtihad because they are ad hoc exercises undertaken by non-qualified jurists to satisfy the requirements of society.

Ijtihad, however, offers creative reasoning supported by structured and systematic methodologies, which provides a sound basis for a new legal solution.

Ijtihad is the vehicle through which best-probable solutions can be provided in a manner that is systematic and transparent. A fact to be noted is that Ijtihad, unlike texts of the sources of law, will only produce rulings that are probable in character. The probability of the legal ruling is the parameter of Ijtihad. Also, for Ijtihad to achieve this status of probability, it must be fulfilled by qualified jurists and scholars. Modern Islamic societies have enhanced the function of Ijtihad to meet modern needs more satisfactorily. Among these measures are:

1. The scholarship of Mujtahid

The scholarship of the Mujtahid (the one who undertakes Ijtihad) should be well established and accepted by the community. This could be achieved through proper qualification or practice, or both.

2. Collective Ijtihad

Instead of relying on personal views and reasoning, a collective Ijtihad is adopted. Therefore, views, opinions and resolutions issued and pronounced by some international bodies, such as the International Islamic Academy of Fiqh of the OIC, the AAOIFI Shari’ah boards and other IFIs that have issued Fatwas are always worthy of adherence.

3. The publications of resolutions

The publication of resolutions means that the stakeholders of Islamic finance can have access to them. Some Ijtihads are well grounded and hence, well accepted across jurisdictions. The acceptance of these views by the general public across jurisdictions is the key evidence of their soundness and validity.

4.7 Practicality of Ijtihad in solving modern issues and problemsIjtihad should have a practical application in solving modern issues and problems not only in Islamic finance but also in other fields of law. Ijtihad sometimes interprets the meaning of a verse, qualifies its meaning and on other occasions reinterprets the meaning. One tradition accepted by the majority of the scholars is the prohibition of a person selling something that they do not own or possess. Some jurists have, however, contended that the meaning of this tradition does not refer to non-physical

Islamic finance challenge 4.2Ijtihad is a form of creative thinking used to solve a particular problem. Can anyone exercise Ijtihad to produce a valid solution to a problem or are specialist skills required?

Solution Although Ijtihad is a form of creative thinking, it must be performed only by someone who has the required knowledge and skills. It is only useful and valid if it is performed according to the correct methodologies and guidelines. A non-expert would therefore not be able to perform Ijtihad.



ownership or possession. It refers to the ability of the vendor to deliver the sold asset as and when requested by the buyer. In other words, according to this interpretation, a trader may sell something that he does not own provided he is in the capacity to deliver the said asset upon concluding a contract.

4.7.1 Qualifications and contextualisation of interpretations

In giving a proper interpretation a jurist may qualify or exempt some application from the general principles. This is also part of the interpretative effort. A jurist may also attempt to give a contextual interpretation of a text. As discussed some jurists have interpreted the pronouncement, “Do not sell what you do not own,” to mean that the trader can still sell something he does not own at the time of contract provided he is in a position to deliver the said asset to the purchaser. This interpretation refers to a contextual interpretation, that is, the context in which the prohibition was pronounced.

In another similar tradition the pronouncement, “Do not sell (something) until you have possessed (it)”, has been qualified by a leading scholar as a prohibition relating to food items only. As for other items and goods, no such requirement is needed. This is also an example of how a qualification or a contextual interpretation has been attempted. Other scholars would apply the prohibition in this tradition to all items and goods.

4.7.2 Dealing with new situations

On another dimension, Ijtihad could offer a fresh resolution that is not necessarily backed by previous views and opinions. Some issues were not deliberated on in the past as they were not relevant given the time and environment. However, new issues need modern solutions and contemporary scholars must provide the best probable answer. For example securitisation is a new idea that receives endorsement by most contemporary scholars. Basically, securitisation refers to a process of converting something into its cash equivalent in the form of papers that are tradable in the secondary market. It is through securitisation that an illiquid asset can be transformed into tradable securities.

The product of securitisation is known as Sukuk, that is, certificates of investment. Sukuk al-ijarah, for example, reflects the process of the division of the ownership of tangible assets, for example, the leased assets, into units that have equal value and the issuance of those units to investors. A Sukuk holder or investor is essentially a beneficial owner of this asset, which is divided proportionately among the investors. For this reason, Sukuk investors are entitled to receive the rental payments paid by the lessee. The development of Sukuk al-ijarah, certificate of investment in leased assets, is a new compliant solution to mirror the fixed-income instrument in the conventional bond market.

Exercises 4.4A company wishes to borrow $100 million to finance an extension project. The company balance sheet shows that it owns a factory worth in excess of $100 million. Compare and contrast how the company could raise this finance by issuing either bonds or a Sukuk.

Islamic finance challenge 4.3Explain why it is acceptable that Ijtihad, more often than not, tends to have created more than one opinion instead of achieving one common view.

Solution Ijtihad requires personal reasoning by jurists. Although jurists are governed by the general principles of the Shari’ah, this does not necessarily lead them to one opinion. Differences of opinion in Ijtihad are not abnormal. On the contrary, it contributes to the development of Islamic law. For example, the issue of whether someone can sell an asset without owning it is a subject of Ijtihad. While some scholars have not disapproved such a transaction, some have found it to be compliant provided the ability to deliver the asset on the part of the seller is certain. This gives room for product development in some cases where the ownership is not established at the time of contract.



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4.8 ConclusionLeading on from the preceding chapter, this chapter explained in more detail the crucial concept of Ijtihad or interpretation as practised within Islamic commercial law. The primary sources of Islamic commercial law were written hundreds of years ago. Life in the 21st century is complex and you were introduced to how Ijtihad may help to resolve current issues in Islamic finance, which were not relevant at the time the primary sources were written. You should now see that Ijtihad, in its various forms, is an efficient tool in product development in 21st century Islamic finance.

The following chapter turns to the formation of contracts, an essential topic in the study of Islamic finance.


1. the Qur’an and the Traditions of the Prophet Muhammad require interpretation (Ijtihad) when applied to much of the modern commercial world

2. Ijtihad, from a basic legal definition, is to make use of one’s best ability under the guidance of the broad principles of Shari’ah in the search for a legal status

3. the first logical form of Ijtihad is to use one’s ability to understand the meaning, of any given text, be it in the Qur’an or the Traditions of the Prophet Muhammad

4. Qiyas is another form of Ijtihad, which that extends a ruling already prescribed in the texts to a new case that shares the same or similar ‘reason’ of law, that is, through analogy

5. the third form of Ijtihad requires referral to some grounds or techniques of law to arrive at the required solutions, and depends more upon the skills of the jurist to put a systematic argument to their conclusions, in tandem with the general objectives of the Shari’ah

6. Ijtihad has a practical application in solving modern issues and problems not only in Islamic finance but also in other fields of law.



Chapter 4 AnswersExercise 4.1(A) False. Ijtihad is valid irrespective of the availability of relevant text as long as there is a need for

some form of interpretation. In other words, the text is probable in meaning and therefore needs or requires an interpretation to identify the most likely intended meaning.

(B) True. Ijtihad was not needed during the lifetime of the Prophet Muhammad because the ultimate

reference was the revelation.

Exercise 4.2 Ijtihad is the total effort required in terms of reasoning on the part of the Mujtahid/scholar to find a solution to an issue.

Exercise 4.3The whole purpose of having capital in the partnership is to enable the business venture to commence. Although cash is ideal for this purpose, cranes to be used for construction work or machines to be used for production work are also useful. Cash invested is often used ultimately to purchase assets such as cranes or machinery to support the business venture in addition to meeting the working capital needs.

Exercise 4.4Issue bonds - if the company decides to issue bonds it will have the bonds created and exchange these for the finance required. The bonds will acknowledge the borrowed amount and the obligation to repay this amount along with an agreed element of interest.

Issue a Sukuk - the company could issue a Sukuk that under the terms of which they agree to sell the factory to investors for the required $100 million. As the owners of the factory, the Sukuk holders would normally lease the factory back to the company. The relevant rental payment typically includes the principal amount and an element of profit. In this way the company gets the cash injection it needs. It also maintains the use of the factory until it ultimately regains ownership of the factory. The company would never resort to paying interest.

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Revision Questions

Question 1 Multiple choice1.1 Which of the following is true with regard to the Prophetic statement on Ijtihad?

(A) The Prophet Muhammad endorsed the practice of Ijtihad for use after scholars have considered both the Qur’an and the Traditions of the Prophet Muhammad.

(B) Ijtihad is an exercise that can be freely undertaken by anyone involved in Islamic finance.

(C) Ijtihad is valid even without prior reference to the Qur’an or the Traditions of the Prophet Muhammad.

(D) The Prophet Muhammad restricted Ijtihad only to his time.

1.2 Ijtihad practised on the four food items as mentioned in the Prophetic Tradition has resulted in three different views on the probable ‘reason’ for this prohibition. Which of the following is not a probable ‘reason’?

(A) Edibility.

(B) Medium of exchange.

(C) Measurability and weightability.

(D) Main and preservable foods.

1.3 Ijtihad is still relevant and useful in some cases where divine texts are provided because:

(A) the legal texts in the Qur’an and the Traditions of the Prophet Muhammad are unlimited but potential issues in life are limited

(B) Ijtihad is required in all text interpretations

(C) the text might be probable and therefore require interpretation

(D) Islamic law in totality has given detailed explanations and comprehensive illustrations of legal principles in the divine texts.

1.4 What does the term ‘ratiocination’ refer to?

(A) Extending an old law to a new case.

(B) Interpretation to render texts more clearly understood.

(C) Establishing new contracts types when they are needed by society.

(D) Discovering a legal basis for a given original ruling.

1.5 Which of the following is an appropriate measure to enhance Ijtihad?

(i) A high level of scholarship on the part of Mujtahid (the practitioner of Ijtihad).

(ii) Ijtihad is open to all to exercise.

(iii) Collective Ijtihad.

(iv) Making the bases of Ijtihad known to other scholars.

Mark all that apply:

(A) i and iv

(B) ii

(C) i, iii, iv

(D) all of the measures.

Question 2 (A) Why has Qiyas or analogy been deemed to be part of Ijtihad?

(B) Explain why capital, in the form of assets that are subject to valuation, can be accepted as valid capital in equity-based financing or investment.

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Answers

Question 1 Multiple choice1.1 (A) The Qur’an is the primary source of reference while the Traditions of the Prophet

Mohammad will be referred to if no relevant reference can be found in the Qur’an. Thus, Ijtihad must refer to these two primary sources before considering other techniques such as Qiyas, Istihsan and so on.

1.2 (B) Various schools of law mentioned edibility, the fact that the food is measurable and weighable and that the food belongs to the main food category and can be preserved are the probable reasons why the exchange of these four food items must be of equal amount and/or spot as the case may be in the exchange. The function of medium of exchange was never mentioned.

1.3 (C) Scholars rely on Ijtihad even in cases where the texts are provided because these texts could give more than one meaning and thus require some interpretation to identify the most likely interpretation or meaning intended by the lawgiver.

1.4 (D) ‘Ratiocination’ is a process to discover a ‘ratio’ or the basis of a legal ruling in a given original case such as the basis of intoxication in the prohibition of wine drinking.

1.5 (C) The quality of the practitioner of Ijtihad coupled with a concerted effort on the part of the scholars is believed to add value to decisions reached by Ijtihad. Furthermore disclosure of the basis of these decisions will ensure that Ijtihad-based decisions are accepted and upheld.

Question 2(A) Qiyas or analogy requires the jurists to understand the basis of law contained in the text and

later to extend this basis to a new case, provided the new case shares the same legal basis. This requires an effort to be undertaken by the jurists, thus it is an Ijtihad.

(B) Like cash, assets in the form of land or equipment for example, are useful when undertaking a new business venture. There is no prohibition on taking these assets as capital in a joint-venture business. Some, if not all, of the cash-based capital will be converted into assets to undertake the business venture.

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Formation of contracts


explain the meaning of contract (‘Aqd) in Islamic commercial law

explain the requirements of a valid and enforceable contract.

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Learning outcomes

Chapter five




5.0 IntroductionContracts are the foundation upon which Islamic financial products rest. The creation of financial products results from the ability to use one or more traditional contracts to meet the requirements of the customer. In this chapter you will be introduced to the meaning of contract as used in Islamic commercial law. This will include an explanation of what makes a valid and enforceable contract. An understanding of what constitutes a valid contract is essential to the creation of legitimate Islamic financial products and services which are based on such contracts.

5.1 Meaning of contract (‘Aqd) in Islamic commercial law

Islamic commercial law, known in Arabic as Fiqh al-Muamalah, constitutes an important branch of law dealing with issues of contract and the legal effect(s) arising from a contract. The effect of a contract is as important as the formation of a contract because a contract could be valid, invalid or voidable. The contract is central and fundamental to many aspects of life.

The whole idea of contract is to facilitate the rightful and legitimate needs of people towards each other. The contract could be political, social, commercial or even family-based such as those relating to marriage and divorce. The Mejelle highlighted above has, however, focused mainly on commercial contract as the Mejelle related to the civil code of the Ottomans.

Exercise 5.1Using an example from your own everyday life explain why contracts are a fundamental part of life.

5.2 The nature of contractThe contract is known in Arabic as ‘Aqd, which translated means ‘to tie’. Put simply, a contract ties both the offeror and offeree.

Contract plays a significant role in fulfilling the human need to deal with each other. A contract is a complex legal issue both in its jurisprudential foundation and its practical function. Intellectually, it is perhaps the most rewarding field of the law in action. Contracts have been an integral element of human life, in both primitive and modern times. Without contracts, dealings and interactions among people could not have been possible. Contracts express the intention of the parties and establish their rights and liabilities.

However, from a wider perspective, contracts can include a broad range of relationships, be it religious, political, social or economic. In other words, contracts apply to the ruler and the ruled,


The meaning of contract.

The requirements of a valid and enforceable contract.

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Majallah al-Ahkam al-Adliyyah [the Islamic Civil Code of the Ottoman Empire promulgated in 1876] or translated into English as the ‘Mejelle’ states that man is social by nature and that social life is essential to him. Therefore, “in view of the fact that a man is social by nature, he cannot live in solitude like other animals, but is in need of co-operation with his fellow men in order to promote an urban society. Every person, however, seeks the things which suit him and is vexed by any competition. As a result, it has been necessary to establish laws to maintain order and justice.”

Majallah al-Ahkam al-Adliyyah [the Islamic Civil Code of the Ottoman Empire promulgated in 1876]



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husband and wife, as well as to a financial contract such as sale, lease or partnership. This section concerns contracts that are financial in nature and create financial rights and liabilities.

5.2 Contracts and the Qur’an

As mentioned in chapter one, Islamic law, unlike other legal systems, starts from given premises in the form of the Qur’an and the Traditions of the Prophet Muhammad. The Qur’an, as the primary source of law, deals with the principle of contract in one way or another. The Traditions of the Prophet Muhammad explain and illustrate the meaning and implication of a contract from an Islamic legal perspective.

The Qur’an mentions many types of contracts including about 40 verses dealing with a dozen commercial contracts that are financial in character.

Central to these Quranic verses is verse 1 of chapter 5 of the Qur’an that enjoins believers to ‘fulfil their contracts’ which is also supported by other verses with the common theme of keeping a promise and fulfilling all obligations.

The Qur’an uses a technical word for a contract which is ‘Aqd in Arabic, meaning to tie or to knot. The verse above attaches an obligation to fulfil all contracts made. Obviously, obligation has a legal connotation that imposes some legal injunctions and implications on the parties to a contract.

As in other legal systems the contract in Islamic commercial law reflects the consent of both parties to a contract.

The Qur’an (chapter 4, verse 29) prescribes on Muslims ‘not to devour your assets among yourselves in vanity, except in trading by your mutual consent’.

The verse explains that the transfer and exchange of properties, assets and services will only be valid if they are based on the consent of the parties involved. Mutual consent is normally achieved through a contract that is based on an offer from one party (offeror) and an acceptance by another (offeree).

In addition to verses that establish the principle of the sanctity of a contract and its rationale, there are others that reveal a relatively advanced stage of commercial contracts, for example, sale, hire, forward sale, debt-based transactions, charges in Rem or personal guarantee as security and fiduciary contracts such as deposit taking. The mention of these contracts in the Qur’an gives the impression that contracts in their various manifestations were not uncommon during the time the Qur’an was revealed.

5.3 Contracts and the Prophet MuhammadThe Traditions of the Prophet Muhammad not only reaffirm the meaning and function of contract but also provide sufficient illustrations to explain what a valid contract is vis-à-vis an invalid one.

The Prophet Muhammad has been reported to have pronounced: ‘The property of a Muslim is not lawful for others to enjoy unless by the owner’s consent’.

This tradition reaffirms the need for a contract to transfer property from one to another without which the consumption of another’s property is unlawful. The Traditions of the Prophet Muhammad, as the ‘case law’ of Islam, has illustrated many forms of both lawful and unlawful contracts. For example, the sale of the foetus of an animal is prohibited as its delivery in the future, cannot be guaranteed, for example, the foetus could have died while in the womb. This case and many others reaffirm the function of a contract, which is to express the real consent of the parties involved. The presence or absence of any element that might affect the quality of the consent, as will be discussed later, will render the contract void or voidable.

‘O ye who believe! Eat not up your property among yourself in vanities; but let there be amongst you traffic and trade by mutual goodwill.’

Qur’an 4:29

Contract is known in Arabic as ‘Aqd.

A contract ties both the offeror and offeree.

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Key points



5.4 The technical definition of a contractGenerally speaking, contract has been defined in modern law as an agreement between two or more persons that creates an obligation to do or not to do a particular thing. Surprisingly under traditional Islamic commercial law there was no technical or precise definition of a contract. The nature of contract was essentially defined when considering sales (Al-bay’), as a sale is the most common medium under which a contract can be concluded. Issues such as offer and acceptance and how they relate to each other and how they lead to particular legal rights and liabilities were discussed with reference to a sale contract and not in a specific chapter on contract per se. The duty of contemporary scholars and legal practitioners is to extract from these extensive discussions principles to govern the general theory of contract in Islamic law. Thus, the discussion of the general theory of contract in Islamic commercial law is a recent phenomenon.

The Majallah al-Ahkam al-Adliyyah, or ‘Mejelle’ referred to earlier, was most likely the first attempt to give a precise technical definition of a contract or ‘Aqd. It defined a contract or concluding a contract as ‘the connection of an offer with an acceptance in a lawful manner which marks its effect on the subject of that connection’. As can be seen, this definition is similar to the definition of a contract in other legal systems. However, the Islamic definition is distinctive as it qualifies the manner and impact of concluding a valid contract with the instruction that it should comply to Shari’ah principles as expressed in the statement ‘in a lawful manner’. The proper and valid manner of concluding a contract will make the contract valid and its result enforceable. How to achieve a proper conclusion of a contract will be elaborated in the next section.

Exercise 5.2 Would a contract to form a partnership to produce alcohol for export to a non-Islamic export market be a good and valid contract from an Islamic perspective?

5.5 Requirements of a valid and enforceable contract For a valid and enforceable contract to take place under Islamic commercial law, certain conditions must be met. Islamic commercial law, generally speaking, has six elements that are integral to a valid and enforceable contract. Each of these elements is a requirement on its own merit to the effect that the non-compliance of each of them will render the contract invalid or voidable though the other remaining requirements may be in order. The six elements are illustrated in the following diagram:

A contract is defined in modern law as an agreement between two or more persons that creates an obligation to do or not to do a particular thing.

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Key point

Islamic finance challenge 5.1Islamic commercial law did not develop a theory of contract until recently through the codification of civil code of the Mejelle. Did this mean that Muslims in the past were not exposed to the importance of contract and its requirements?

Solution Structured discussions of the definition of contracts, its elements and various possible practices and implications was not documented in the past. This does not necessarily mean that the contract was ‘foreign’ to Islamic civilisations. The Qur’an itself specifically mentioned contracts and their sanctity. Muslim jurists have focussed discussion pertaining to contract on the sale contract, where an explanation is given as to the meaning of offer, acceptance, etc. The same is repeated in other discussions on other contracts such as lease, partnership and so on. In other words, the discussion was not systematic in one chapter but was made in all transactions such as sale, lease, partnership etc.



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These six elements are logical requirements from a common sense perspective as a contract, in most forms, is dependent on them to exist. Unlike other legal systems, Islamic commercial law adds another requirement as the basic foundation; that after satisfying all six elements, the contract must be compliant to Shari’ah principles.

The necessary elements of a contract are different in other legal systems. While offer and acceptance, consideration and an intention to create legal relations are fundamental elements in common law, the concept of consideration is not central in civil law.

5.5.1 An offerAn offer is a statement of intention expressed by one of the parties inviting the other party to accept their proposal. An offer could technically be initiated by any party to a contract be they a potential buyer or seller. The one who initiates a proposal is known as an offeror and the one to whom the proposal is addressed is called the offeree. The Mejelle (the civil code of the Ottoman caliphate) defines an offer as:

Compliance with Shari’ah principles

Off

er

Acc

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Off

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r

Off

eree

Obj

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erat

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Contract

Figure 5.1 Six elements integral to a valid and enforceable contract

The requirements for a valid contract in Islam are as follows: • offer • acceptance • offeror • offeree • object • consideration.

In addition, the purpose and the objective of the contract must be compliant with Shari’ah principles

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Key points

‘The statement made in the first place with a view to making a disposition of property and such disposition is proved thereby.’



An offer should be clear, absolute and communicated to the offeree. This basic requirement is similar to other legal systems. Some scholars have required that an offer must refer to a definite and specific party while others do not require such a condition. The view of the latter scholars is manifested in their writings in the following example.

However, this situation must be distinguished from ‘an invitation to treat’. Unlike a valid offer, an invitation to treat is simply an invitation to the public at large to give their offer for particular goods. Inviting the public through, for example, advertisements or the display of goods with a tagged price is not essentially an offer from the party who advertises or displays his goods. A member of public interested in the goods may approach the merchandiser to give his offer to purchase, but the acceptance should come from the party who advertises and displays the goods. As it is merely an invitation to treat, the consent of any of the public to purchase shall not be deemed as an acceptance because this invitation is not an offer from a Shari’ah perspective.

The same position is upheld under common law in the UK. One of the leading cases to uphold this position is Pharmaceutical Society of Great Britain vs Boots Cash Chemists [1953] 1 QB 401. The defendants, Boots Cash Chemists, were charged under the Pharmacy and Poisons Act 1933 (UK), which provided that it was unlawful to sell certain poisons unless such sale was supervised by a registered pharmacist. Boots was one of the first stores during that time operating a new system of sale. When a customer entered the store he was given a basket and could pick items off the selves as they wished and place them in the basket. The customer would then take it to the cash desk next to which a registered pharmacist would sit.

The plaintiff, the Pharmaceutical Society of Great Britain, argued that the display of goods was an offer to sell that was accepted by the customer upon placing the drugs in the basket, at which moment the contract of sale was formed. This was deemed to breach the sale of certain drugs without the supervision of a pharmacist. The court ruled that the display was only an invitation to treat. A proposal to buy was made when the customer placed the articles in the basket. Hence the contract of sale would only be made at the cashier’s desk. That being the principle, the shop owners had not made an unlawful sale. Similar decisions were upheld in many other cases relating to an ‘invitation to treat’ such as Fisher v Bell (1961), Grainger v Gough (1896) etc.

Islamic finance challenge 5.2Having read the details of the Boots Cash Chemist case above, explain what you would expect the Shari’ah perspective to be on this point of law.

SolutionIslamic commercial law also recognises the principle of ‘invitation to treat’ as distinct from a proper offer. One of the features of this principle is that this invitation is open to all without specifying a particular offeree. Also, Islamic law holds that the display of goods in a shop generally does not constitute a proposal to sell. The shop-owner merely holds himself prepared to consider proposals made to him at the suggested price, normally tagged to the items. The position is therefore the same for both conventional and Islamic businesses.

An offer is a statement of intention expressed by one of the parties inviting the other party to accept the proposal.

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Key point

If someone has presented his goods for sale and offered to sell them at a certain quoted price, the sale is concluded for the one who has paid such an amount because he has heard the offer or has been informed about it. The sale is binding on the offeror and he has no right to decline the sale of these goods, except where the buyer who came forward to purchase has not heard of the offer or has not been informed about it.



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5.5.2 Accepting an offer

An acceptance is an expression of approving the proposal by the offeror with regard to the same details as expressed in the offer. Any variation in the acceptance with regards to some or all the details in the offer would turn this acceptance into a counter offer or counter proposal. Therefore, it is important to ensure that the offeree accepts the offer as it was given without putting or deleting anything that was not originally included. Otherwise, this kind of acceptance will be deemed a new offer from the ‘offeree’ to the ‘offeror’, which gives the choice to the original offeror to accept or otherwise. This logic will continue until both parties have agreed on all the specifications and details mentioned in the offer. Only when this happens can it be said that the contract is legally concluded because the acceptance conforms to the offer, thus ‘the meeting of two minds’ or, to put it simply, mutual consent, has been reached.

If an offer is to be accepted, the unequivocal acceptance of that offer must be communicated to the person who has made the offer. It is important to note that the expression of both the offer and acceptance could be made verbally or in writing or even by the conduct of the relevant parties that indicates a particular proposal and acceptance by the other party. This also includes a written mode of expression that covers all modern means of communications such as the telephone, fax or email. The Shari’ah does not require or insist on any specific technique to reflect an offer and an acceptance. Equally important is that both the offer and acceptance must be communicated to each other. A mere expression, be it verbally or in writing, that is not communicated to the knowledge of the other party, be it the offeror or offeree, is not a valid offer or acceptance.

5.5.3 When acceptance takes place

The communication of an offer and its acceptance means that both parties are informed of the other’s intention. Communication methods will obviously differ depending on whether it is an inter praesentes contract or an inter absentes contract. If the two parties are physically present (inter praesentes), then communication should be direct and instant or simultaneous as they are physically close to one another. In an inter absentes contract, communication depends on the medium through which the offer or acceptance, or both, are being communicated to each other.

While it is clear that communication of an acceptance can take many forms, it is less clear when acceptance takes place. When an acceptance is made over the telephone, the acceptance is deemed to occur at the time and place that it is heard by the offeror. This rule should also apply to other instantaneous forms of communication, such as a direct offer and acceptance between two parties who are physically present in the same place. For non-instantaneous forms of communication, the acceptance is effective upon the receipt of the acceptance through letter, email, telex or facsimile.

Islamic commercial law, unlike other legal systems, requires that the acceptance to the offer be immediate so both the offer and acceptance are jointly connected in one single session without any gap in time. This is the requirement of the essential unity of time, technically known as the session of the contract, which should be continuous and not disrupted. Therefore, certain interruptions during the session of contract, such as stopping to eat or the discussion of other subjects or a change in position or attitudes, or even falling asleep are deemed to terminate the session of the contract, thus making the offer lapse in terms of time. This requirement is relatively easy within contracts inter praesentes but it is problematic with regard to contracts inter absentes. Here the Muslim jurists have to extend the doctrine to the time when the offeree receives a particular offer. As for the acceptance, the unity of time terminates or lapses if the offeree has failed to respond to the offer within the timeframe mentioned in the offer or when the offeror revokes his offer, or when the offeree makes a declaration of acceptance.

Exercise 5.3 Indicate which of the following statements are true/false.

(A) In inter-praesentes contract, both offer and acceptance may not be instantly linked to each other at the same time.

(B) Other than providing a general principle on the obligation to fulfil a contract, the Qur’an does not mention contracts in any other context.

(C) The ‘session of contract’ refers to the meeting of two minds within the same time period.



5.5.4 Parties to a contract

With regard to parties to a contract, there must always be two parties: the offeror and the offeree. The two parties could be individuals, a group of people or even a legal entity such as a company. For a contract to be concluded there must be more than one party otherwise the offer cannot be accepted and, therefore, there is no conclusion. However, it is important to note that Islamic law, unlike English law, considers unilateral contracts such as donations, gifts, wills and endowments as a normal contract, although the offeree will not have to accept the offer to make the contract valid. This kind of contract is valid and enforceable even though the offeree has no notice or knowledge of the proposal made by the offeror. In other words, the contract concludes once the offeror, normally the donor, declares their intention to write a will to someone irrespective of whether or not the offeree or recipient is aware of this declaration at the time of contract. This constitutes a one-party contract to the effect that the consent or acceptance by the offeree or rather the recipient is not required. The offeree has no obligation to pay any consideration or price for whatever he receives from the offeror. Under English law this kind of contract is known as a ‘contract under seal’ that must be registered at the court to be valid and enforceable.

Under Islamic commercial law some contracts are concluded through three parties, such as the assignment of debt (Hiwalah), which involves the transferor (principal debtor), the transferee and the beneficiary. Having said this, technically speaking, the consent of two parties, the transferee and beneficiary/claimant, is sufficient to effect a valid assignment or transfer of debt. The consent of the transferor is not really required as his consent is insignificant. The transferor merely transfers the right to claim an amount of money owing from him to another person so the beneficiary or claimant may claim that amount of money from another party, namely the transferee. All in all, this contract too has two dominant parties whereby the third party, although integral to the whole contract, is supplementary to the process.

The most relevant issue pertaining to parties to a contract is legal capacity or capability covering their rights and liabilities. Islamic commercial law has placed a significant focus on the issue of the capacity to conclude a contract.

Even the Qur’an has indirectly alluded to this requirement as seen in verse 6 of chapter 4, ‘prove orphans until they reach marriageable age and if you find in them sound judgment, deliver to them their properties’.

5.5.6 Physical and intellectual maturity

In Islamic commercial law, no person can validly conclude a legal transaction without first having attained physical and intellectual maturity, that being the equivalent of the majority age. To enjoy full capacity, a person, whether male or female, should attain physical puberty (Bulugh) and enjoy sound judgment also known as prudence (Rushd) in his or her judgment.

Having said this, most modern civil codes in Muslim countries have adopted a particular age as the majority age to make the law standard and applicable to all cases. Most countries give 18 as the age of maturity, thus the age when someone is capable of concluding a contract. This approach, particularly in modern times, is acceptable to provide certainty in law. If a particular law deems a certain age as having attained the age of majority, then it will be taken as such without the need to examine the actual attainment of that with reference to marriageable age and prudence status. The burden of proof will be shifted to any party who claims something contradictory to the provision of law.

5.5.7 Aspects of religion

Aspects of religion could also be relevant to contracting parties. Generally speaking, in most financial contracts and matters, there is no requirement that all the contracting parties should be Muslims. Thus, a Muslim party can conclude a contract with a Muslim and non-Muslim party alike. This applies to most Islamic commercial contracts such as sale, lease, partnership, agency, safe keeping or deposit, charge, assignment of debt, guarantee and bailment.

At least two parties must be represented in concluding a contract.

The parties can be individuals, a group of people or even a legal entity such as a company.

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Key points



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Throughout the history of Islamic commercial law many concrete treatises and contracts have been made for which documents exist to demonstrate that transactions between Muslims and non-Muslims were not uncommon, including partnerships and joint ventures. The only exception is limited to contracts that require religion as the basis of performance, such as the appointment of a manager under hire or agency contract to manage a mosque or any other holy place in Islam.

The same restriction applies to one type of partnership in Islamic commercial law known as Shirkah al-Mufawadah, which allows the partners to have absolute rights on behalf of the other partners to transact with any third party. The liability under this form of partnership is, however, not limited to the respective financial contribution by the partners but may extend to the personal liability of the individual partners. Therefore, aspects of religion may be relevant to the entering into contracts that are non-compliant by a non-Muslim party without any prior approval from his Muslim partners(s). This will obviously complicate the management and liability of the company.

Exercise 5.4Explain why it is imperative that when entering into a contract, one must have the legal capacity to do so (this means that, one is not a minor, a drunken person or a person of unsound mind).

5.5.8 Object of the contract

In addition to the contracting parties and offer, as well as acceptance, the object of the contract is integral to the formation of a valid contract. The object of the contract refers to the subject matter that relates to the contract. The subject matter could possibly be an asset, service, money, capital, liability, rights and receivables.

In a sale contract, for example, the subject of sale is a particular asset that the buyer is interested to purchase from the seller. This could be a house, a car or equipment. In a currency exchange, the asset is one of the currencies to be exchanged for another. The object in this currency sale is the currency provided by the seller, whereas the currency provided by the buyer is deemed as consideration.

As for an Ijarah contract, the object of the contract is the services provided either by an asset or a person. These are some common examples of an object in any contract. Islamic commercial law has prescribed a few conditions to render this asset compliant to Shari’ah principles. Among these requirements are:

a) The object must be an approved asset from the Shari’ah perspective. This condition is required by the religion perspective that deems some assets as either impure or not approved. These prohibited assets include pork, liquor etc. For services and activities they include entertainment, and pornographic and gambling activities. Therefore, an IFI cannot finance a customer under Murabahah to purchase, for example, equipment that produces only special bottles for liquor production.

b) This object must be made known and determined to avoid any element of Gharar (uncertainty). Gharar would normally lead to a dispute among the parties. An object that cannot be known and identified such as a foetus in the womb of an animal, protection under modern insurance schemes or an object to be discovered later is not a valid subject matter. The exception is given to both Istina’ and Salam contracts where the subject matter is not yet available at the time of contract. However, the object under both Salam and Istina’ must be able to be identified by certain specifications. This is to avoid uncertainty. In this respect, the doctrine of mistake is established in common law. A mistake is an incorrect understanding by one or more parties to a contract and may be used as grounds to invalidate the agreement. Therefore, the requirement to be certain about the object of contract in Islamic law is to avoid the invalidation of the contract.

c) The object must be able to be delivered at the contracted time of delivery. The purpose of entering into a contract is to enjoy the benefit of an object of a contract (from the buyer’s perspective). Therefore, any object that cannot be delivered because of its unavailability, such as lost property or due to legal caveat or encumbrance, is not a valid or complete contract. The sale of an encumbered asset is voidable pending on the consent of the pledge or mortgage.

A Muslim party can conclude a contract with a Muslim and a non-Muslim party alike•

Key point



d) The nature of the objects must suit the respective contracts. For example, for an Istisna’ contract, the subject matter must be an asset to be constructed or manufactured. It cannot be an asset that is already in existence as Istina’ requires some transformation of raw material into a finished product. As for a lease or Ijarah contract, the object must be something where the substance of the asset will remain intact after usage. Thus, one may lease a vehicle or house but things like fruits or vegetable or petrol as the substance of these assets once consumed will not remain intact.

5.5.9 Consideration

The last requirement for a valid contract is the aspect of payment or consideration. This is a payment normally paid by the buyer or lessee to the seller or lessor respectively. In the sale contract, it is known as the price and in the contract of lease it is known as the rental. There is a possibility that the payment will be in the form of a fee paid for services rendered, particularly under the Wakalah contract. The following are the relevant principles governing the consideration in Islamic law of contract.

(a) Consideration must be Halal in character. This is because consideration in Islamic commercial law could be in the form of money, an asset or even services. A buyer under the Istisna’ contract, for example, could pay the seller either in the form of money or in the form of asset, such as giving the seller a vehicle, or providing services to the seller, such as providing accounting services. Asset and services, if used as consideration, must be religiously approved.

(b) The consideration amount must be made clear and fixed to avoid uncertainty. The amount, the time and place of delivery among others must be clearly agreed in the contract. If a floating rate of rental is being used, such as in an Ijarah contract, the benchmark against which the rental is linked must be made known and be agreed to by the two parties.

(c) Similar to the object of a contract, a consideration must also be capable of being delivered to the other party. The inability of the consideration to be delivered will render the contract void.

Exercise 5.5 What is an alternative term for ‘consideration’ in the context of a contract?

Islamic finance challenge 5.3An entrepreneur intends to operate a business that provides education to students who have failed to gain admission to universities or colleges. For this purpose, he needs to have a building that can accommodate the students. As he has no building and insufficient cash, he plans to engage a contractor to build him the necessary student accommodation. He will purchase the building from the contractor when it is complete in two years’ time and will pay the cost of construction within two years of the date of construction. Would this transaction contradict Shari’ah requirements pertaining to the object of sale?

Solution Essentially, an object of sale must be in existence at the time of contract to avoid Gharar, for example, uncertainty in terms of asset specifications, deliverability, etc. However, Shari’ah principles allow some sales such as Istisna’ and Salam which involve future delivery of assets. For these contracts to be valid, the detailed specifications and the time of delivery of the assets must be determined and agreed upfront. In the above case, the entrepreneur would need to enter into an Istisna’ contract with the builder and the detailed specifications and the time of delivery of the accommodation would need to be agreed when the contract was entered into.

Object of contract refers to the subject matter that relates to the contract.

The subject matter could possibly be an asset, service, money, rights or receivables.

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Wakalah is a contract between an agent and principal. This contract enables the agent to render services and be paid a fee (Ujrah).



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5.6 ConclusionCrucial to your study of Islamic finance is an understanding of the key contracts which underpin this subject. Contracts are the basis for all transactions which are later transformed into Islamic financial products. This chapter introduced you to the technical meaning of contract as well as the meaning and nature of contracts as evidenced in the Qur’an and in the Traditions of the Prophet Muhammad. You were also introduced to the requirements of a valid contract and the essential components that represent a valid and enforceable contract in Islamic commercial law.

In the next chapter you will be introduced to the various contracts classifications according to their behaviour and function.


1. contract is central and fundamental to facilitate the various needs of people in any given society

2. contract is deemed to be fundamental because it expresses the intention of the parties and their consent to the rights and liabilities arising from that contract

3. fulfilment of all obligations arising from contracts is the main theme of the Quranic verse that reads: ‘O ye who believe, fulfill all your contracts’

4. obligations arising from a contract are natural consequences; therefore the consent of both parties to a contract is needed to avoid consuming others’ properties unlawfully

5. in addition to some contracts established in the Qur’an, such as hire, forward sale, guarantee and deposit taking, the Traditions of the Prophet Muhammad illustrates some aspects of a contract to make it compliant, such as the prohibition of uncertainty in the subject matter of sale, for example, the sale of the foetus of an animal

6. the general theory of contract was not presented in any specific discussion in the classical writings of Islamic law; principles and fundamentals, and perhaps, the illustrations of contract are extracted from detailed discussion of sale and its various types

7. contract or ‘Aqd, literally ‘to tie’, is the connection of an offer with an acceptance in a lawful manner that marks its effect on the subject of that connection; contract in Islamic commercial law is distinctive because the effect of this contract must be compliant to Shari’ah principles.

8. six elements are needed to constitute a valid and enforceable contract, (provided the effect of this contract is compliant to Shari’ah principles); these six elements are: offer, acceptance, offeror, offeree, consideration and subject matter

9. offer and acceptance must refer to the same terms and conditions and must be communicated to each other to make them a valid contract - simply ‘the meeting of two minds’

10. Islamic commercial law requires the essential unity of time between the offer and acceptance; this form of unity differs from inter praesentes contract to an inter absentes contract

11. parties to a contract must be of majority age and of sound mind

12. religion is not a requirement in Islamic contracts except in a few limited contracts that requires the parties to be Muslim, such as in Shirkah al Mufawadah.



Chapter 5 AnswersExercise 5.1You could have given many examples in answering this question. Most people conclude a contract or series of contracts everyday in different situations. For instance, when you buy food from a shop or a train ticket, you conclude an effective contract. A contract manifests the intention of two parties to enter into a particular arrangement or transaction be it marriage, a sale, partnership and so on. Essentially a contract is an agreement, usually made between two parties, to sell, lease, form a partnership, guarantee, etc.

Exercise 5.2Having met all the conditions for a valid contract, a contract from an Islamic perspective must result in something that does not contravene Shari’ah principles. It is a requirement that a contract should be enacted in ‘a lawful manner’ that relates to the compliance with both the law of the country as well as Shari’ah principles. This contract would not be good or valid from an Islamic perspective as it involves the production and export of a prohibited item under the Qur’an, for example alcohol.

Exercise 5.3(A) False. Inter-praesentes or a physically present form of contract requires the offer and acceptance

to be communicated to each other almost instantly. This is different from inter-absentes which allows some deferment in time for the offeree to accept the offer provided it is still within an agreed time period.

(B) False. The Qur’an does mention relatively complex and structured contracts such as sale, lease,

pledge, etc. This is an addition to the principle of sanctity of the contract. This means that a valid contract must be fulfilled by both parties.

(C) True. ‘The session of contract’ refers to the unity of time of both the offer and acceptance, even

though the offeror and offeree may be in two different places, for example not physically present in one common place.

Exercise 5.4This requirement is necessary to protect the interests of the parties to a contract. A minor who concludes a contract on his own, without the consent of the guardian, may, for example, bring about loss or harm to his property. The same applies to those who lack sound judgement, for example, those who are drunk or of unsound mind.

Exercise 5.5Consideration can be alternately called price, payment, rental, fee and counter value.

Revi

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Revision Questions

Question 1 Multiple choice1.1 Which of the following is not relevant to a contract?

(A) Consent of parties.

(B) Rights and obligations arising from a contract.

(C) Risk of loss.

(D) Offer and acceptance.

1.2 Which one of the following statements regarding ‘Invitation to treat’ is true?

(A) ‘Invitation to treat’ binds the person who makes the invitation to sell.

(B) An offer is not needed when there is an invitation to treat.

(C) ‘Invitation to treat’ is deemed as a good and valid offer.

(D) Acceptance by the one who responded positively to the ‘invitation to treat’ is not deemed as an acceptance.

1.3 What is meant by ‘essential unity of time’ of both offer and acceptance in terms of rendering a contract valid?

(A) Determent of price is not permissible.

(B) The order of offer and acceptance in terms of sequence is important.

(C) The contract cannot be contingent on any future event.

(D) Both the offer and the acceptance must be linked to each other within the same time period.

1.4 What are the requirements with regard to legal capacity to enter into an Islamic contract?

(A) Being Muslim by religion and of good conduct and character.

(B) Prudence and puberty.

(C) Prudence and good conduct.

(D) Male and being of sound mind.

1.5 In which of the following contracts of Islamic commercial law is the religion of the parties a relevant factor?

(A) Sale involving asset of future delivery (Salam).

(B) Partnership based on absolute right to each of the partners (Shirkah al-Mufawadah).

(C) Lease with an option to purchase (Ijarah muntahia bi tamleek).

(D) Partnership by capital contribution (Musharakah).

Question 2

Which of the following statements are true/false?

1. Communication of acceptance to an offer is not possible through conduct of the offeree.

2. ‘Aqd means a contract that would bind the parties who have entered into that contract with full consent.

3. A contract must always be bilateral, that is, comprising of two parties.

4. An offer is always an expression from someone to sell something to the other party.

5. Deliverability of the subject matter is not a requirement to render a contract valid.

Revision questionsFormation of contracts

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Answers

Question 1 Multiple choice1.1 (C) The risk of loss has no bearing on the validity of a contract, the other three factors are crucial.

1.2 (D) An invitation to treat is simply an invitation to the public at large to give their offer to purchase particular goods. It is up to the one who gives the invitation to accept or otherwise. Above all, this invitation does not bind the one who makes this invitation.

1.3 (D) The concept of the ‘session of the contract’ stipulates that a contract should be entered into in a continuous and not disrupted session whereby the meeting of two minds must take place within the same time period.

1.4 (B) Prudence and puberty are required before a person is deemed to have legal capacity to enter into a contract as prudence represents sound judgment and puberty represents physical and intellectual maturity.

1.5 (B) As the Shirkah al-Mufawadah contract allows one partner to fully act on behalf of the other partner, it is a requirement that the partners are Muslims so as to avoid a situation where the non-Muslim partner may enter into a non-Shari’ah compliant contract that is not valid from an Islamic perspective.

Question 21. False.

Communication can be effected through any means as long as it serves the purpose of communicating the intention of an acceptance by the offeree to the offeror.

2. True.

3. False. A contract in Islamic commercial law could also be a unilateral contract such as a will, a

donation or a waiver. This type of contract is also valid and enforceable.

4. False. An offer can come from either the buyer or the seller. The offer is essentially the first expression to invite another party to enter into a proposed contract irrespective of who has expressed this proposal.

5. False. The ability to deliver an asset is a requirement to render a contract valid. If this were not the

case the subject matter of the sale could be something that cannot be delivered to the buyer.


Classification of contracts


describe the basis of classifications of contracts.•

Learning outcomes

Chapter six



6.0 IntroductionAs stated in the previous chapter, contract is the foundation upon which Islamic finance rests. The creation of financial products results from the ability to use one or more traditional contracts to meet the requirements of the customer. In this chapter you will be introduced to how various contracts are classified. The variety of contract classifications is essential to meet the diversity of relevant commercial purposes. Without a full understanding of each classification Islamic Financial Institutions (IFIs) would be unable to structure products that meet the ultimate aim of clients and customers in a Shari’ah-compliant way. For you, the whole process of product structuring starts from an understanding of Islamic contracts and their various classifications.

6.1 Basis of classification of contractsA contract may have more than one type and classification to meet the various legitimate needs of society, from sale to partnership to collateral contracts. The need for these various motives and intentions is as old as human society itself. It reflects the complexity of human desire, which should be satisfied as long as it can be accommodated within the broader Shari’ah parameters.

The discussion of classification of contract is important to underscore the following:

(a) the behaviour and salient features of each classification

(b) refinement and enhancement of existing contracts for product development in Islamic financial markets

(c) the synergy among these contracts to satisfy a unique and distinctive need of a modern society, for example, hedging instruments.

The following section will explain and illustrate the behaviour and salient features of each classification of contract. Subsequent sections will consider the enhancement and synergy of the various contracts to support the requirements of modern Islamic financial markets and instruments.


Basis of classification of contracts.

Time, payment and delivery of contracts.

Transfer of right to use (usufruct).

Contracts of Partnership, security and safe custody.

Wakalah and Ju’alah

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6.2 Bilateral and unilateral contractsFrom a macro perspective, a contract is essentially divided into two broad clarifications, namely, bilateral and unilateral contracts. The basis of classification is crucial as each have distinctive behaviours and features. A summary of their respective salient features is illustrated in the following table.

Work or services

Safe custody

Gift

Security

Partnership

Leasing

Sale

Loan

Will

Waiver

Donation

Bilateral

Contract

Unilateral

Agency-based

contract

Partnership by

reputation

Partnership by work and

services

Partnership by capital

Partnership by combining

capital and work

Transfer of debt

Guarantee

Pledge

Financial

lease

Operating lease

Subject matter

Currency

Rights/

intangible properties

Receivable

Tangible

asset

Cost or profit

Time of payment

Time of delivery of object

Future

Spot

Future

Spot

Discounted-based sale

Cost-based

sale

Negotiated sale

Cost plus profit

Figure 6.1 Overview of classification of contract in Islamic commercial law

Commission- based

contract

Issues Bilateral Unilateral

Contracting parties Two parties One party

Consideration Requirement Not a requirement

Acceptance by the offeree Requirement Not a requirement

Purpose Commercial Gratuity

Element of uncertainty (Gharar) Prohibited Tolerated



6.2.1 Bilateral contracts

A bilateral contract is one that takes place between two parties who have full legal capacity. Parties enter into such contracts to attain some form of commercial gain. It is therefore logical that any element of uncertainty, either in terms of price, object of exchange, time and manner of payment and delivery must be specified to avoid any dispute. Disputes tend to arise only when those that enter into a contract for a commercial purpose fail to realise their desire due to elements that make the contract unfavourable to them. Under Islamic law all bilateral contracts must be free from Gharar to render these contracts valid.

6.2.2 Unilateral contracts

A unilateral contract is normally where people wish to give a kind of favour to the other party (recipient) without expecting any return. The motive could be love and care or gratuity. In doing so, the acceptance as well as consideration from the recipient (to whom the offer and favour is dedicated) are no longer required to make the contract valid. In addition, the presence of any element of uncertainty or Gharar in any terms of the contract is tolerated.

6.2.3 Uncertainty - Gharar

The reason that uncertainty can be tolerated in a unilateral contract is because certainty is only required in a contract if two parties are to benefit. Without it the quality of consent of one of the contracting parties would be lost. In a unilateral contract, which is mainly gratuitous, the issue of the quality of consent is not relevant as the recipient does not need to accept or pay any counter value or consideration. Gratuitous contracts, because they are motivated by acts of love and kindness, do not require the necessity for certainty.

A sale contract is a typical bilateral contract. It takes place between the buyer and seller to the effect that both must exchange consideration or price and objects to each other respectively. Any element of uncertainty in the price or object and other essential terms will render this contract void or voidable. The sale of an object, whose quantity or quality is not specifically known to the buyer, is not a valid contract. Likewise, the sale of a particular object for an uncertain price will also be deemed void. Compare this position with a gift or donation or something contained in a will, the contents of which are not known to the recipient. A donor/offeror may offer to give away a portion of his assets either through a gift or donation or a will contract without providing any details pertaining to the asset of the contract. These unilateral contracts are valid even though there is no specific disclosure of the subjects because fraud or misrepresentation are not relevant in these contracts. This is acceptable for the reason that the recipient or the counter party in unilateral contracts will never offer any consideration in exchange of the gift, donation or will. Therefore non-disclosure of specifications of the asset will not lead to any cases of fraud or misrepresentation and the like.

6.2.4 Nature of the objects of the contract

The nature of the objects must suit the respective contracts. This is to make the entire contract logical and consistent with the objective and salient features of any given contracts. For example, for an Istina’ contract, the subject matter must be an asset to be constructed or manufactured. It cannot be an asset that is already in existence. As for lease or Ijarah contract, an object must be something where the substance of the asset will remain intact after usage.

6.2.5 Islamic insurance or Takaful and uncertainty

In Islamic finance, the distinction between a bilateral and a unilateral contract has proved useful in Islamic insurance or Takaful. Conventional insurance works on the premise that the insurer sells protection for a premium. However, as the sale of protection is uncertain and speculative, it is deemed invalid and void from a Shari’ah perspective. The insurance industry works entirely on the principles of uncertainty of risk. Islamic insurance, like conventional insurance, has no option but to deal with this fact in providing protection and indemnity. However, given the objection to selling protection due its uncertainty, Islamic insurance, has developed a model around a donation contract to deal with the uncertainty of protection and premium in a way that is compliant to Shari’ah principles.

Under donation (Tabarru) contracts, the policyholders/participants will donate to a Takaful fund from which protection can be made available to any participant who suffers loss or damage. The amount to be donated by each participant throughout the period of Takaful and the amount to be received by a participant in the case of valid claim are not certain. However, this is acceptable as uncertainty



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in unilateral contracts is tolerable. This is the merit of having a unilateral contract to facilitate the act of donation in both the contribution (premium) and compensation. Without this donation contract, Islamic insurance could not have replicated the economic benefits of a traditional insurance scheme, which works primarily on uncertainty of risk premium and compensation.

Exercise 6.1

Explain why a promise by one party constitutes a contract from an Islamic perspective.

A promise also forms a contract in English law as long as it involves a consideration to be paid by the promisee. A promise by someone to sell his car to another person is an offer which binds the offeror. Having said this, a promise in unilateral contracts is not enforceable in English law.

6.3 Common unilateral contractsUnder the unilateral contract family there are a few contracts that are of common application in practice. These include a will contract, or Wasiyyah in Arabic, where a testator leaves behind a valid will and testament in favour of some identified beneficiary. However, in Islamic law the nominee of a will must not be one of those who are the recipients or beneficiaries of the inheritance.

The list of the beneficiaries of an inheritance and their respective shares are clearly detailed out in the Qur’an to avoid any dispute with regard to distribution of estate according to Islamic law of inheritance. A will is valid to a beneficiary who is not listed up to one-third of the total estate of the testator. Again, this is to protect the interest of the inheritance beneficiaries against other beneficiaries.

In addition to a will, contracts such as waiver (Tanazul) and discount (Ibra’) are common. A waiver reflects the consent of the owner of a particular entitlement to waive whatever is due to him from another party. A waiver could be practised as and when the ‘donor’ wishes or, alternatively, it could be put in a contract up front. In asset management or where a specialised fund is managed by a professional manager, investors may agree up front that if returns were to exceed a particular rate, that is, the hurdle rate, they will waive the remaining returns to the fund manager as an incentive fee.

As for a discount (Ibra’), the creditor may decide to discount or rebate the outstanding amount of a debt owed to him, normally when the debtor wishes to repay early. In Islamic commercial law, this rebate must be exercised by the financier at his sole discretion. A pre-agreed arrangement is not permissible under Islamic commercial law as this may render the selling price uncertain from the beginning. This is because the selling price could be a full payment or a full payment less some rebate, hence it would be uncertain. However, where rebates are given as and when the need arises, uncertainty in the price is no longer an issue because this is meant to retire the outstanding debt payment.

Islamic finance challenge 6.1Explain how a donation or Tabarru’ contract removes any elements of uncertainty in a Takaful scheme, thus making Takaful acceptable as an Islamic finance product.

Solution Takaful schemes like conventional insurance are not free from elements of uncertainty. No contract can remove this uncertainty as the insurance business, be it Islamic or conventional, is linked to uncertain elements in many respects. The contract of donation was not meant to remove this uncertainty as uncertainty is integral to Takaful practice. However, the donation contract will render all elements of uncertainty (Gharar) acceptable or tolerable because uncertainty does not invalidate unilateral contracts. The existence of uncertainty in a unilateral contract such as donation will not make the contract null and void.

A contract may have more than one type and classification in order to meet the various legitimate needs of society.

From a macro perspective, a contract is essentially divided into two broad classifications, namely bilateral and unilateral contracts.

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Exercise 6.2While explaining to some friends that an element of uncertainty would not make a unilateral contract null and void, someone reminds you that you have previously said that Gharar is to be avoided in Islamic contracts. How would you explain this apparent contradiction?

6.4 Bilateral contractsA bilateral contract, unlike a unilateral contract, requires the consent of both parties as it involves the payment of the consideration for an exchange. The elements of Gharar and Riba are relevant in this group of contracts. A loan contract or Qard in Islamic law could affect money as well as fungible items such as food items. An overriding principle in a loan contract is that the lender should not benefit from his lending, either in cash or in kind.

This is based on a tradition of the Prophet Muhammad, which states that ‘every loan that draws benefit (to the lender) is tantamount to Riba’.

Any loan of money where the borrower is obliged to repay the principal plus some premium (interest) is definitely prohibited.

Although a loan contract in Islamic commercial law is not interest based, it does not necessarily prevent the borrower from paying more than he borrowed, provided that this is not contractually agreed in the contract. The extra payment is paid as a gesture of good faith in appreciation of the act of lending for no interest payment.

In another tradition of the Prophet Muhammad, it has been reported that ‘best among you is the one when he settles his loan or debt, he will settle in the best manner possible’.

An Islamic loan, commonly translated into English as a benevolent loan (Qard / Hassan), is not a donation contract. It is still a liability contract whereby the borrower has an established liability and obligation to repay the loan. A charge or any form of security can be imposed on the borrower for this obligation. If the borrower were to die, the liability shall be transferred to his or her heirs.

An Islamic loan contract would allow the borrower to repay the loan in the future and not on a spot basis. As mentioned, where there is an exchange of money for money of the same currency (or of different currency), the exchange must be simultaneous, otherwise it becomes Riba al-nasiah (Riba by the deferment).

However, in the context of an Islamic loan the requirement of a spot delivery and exchange is tolerated because the loan’s purpose is to assist the borrower when he needs some time to repay. However, any imposition of extra payment, in cash or in kind, is strictly prohibited because Islamic loans are meant to help the borrower instead of making a profit.

A unilateral contract normally takes place where people wish to give a kind of favour to the other party (recipient) without expecting any return.

A bilateral contract is one that takes place between two parties who have full legal capacity.

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Qard / Hassan is a loan contract.

Any loan of money where the borrower is obliged to repay the principal plus some premiums is prohibited in Islam.

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6.5 Sale contractsThe most important group of contracts in Islamic commercial law is the sale contract. Throughout history sales have been crucial. The Qur’an has singled out sale (Bay’) as the alternative to Riba or interest-based loan (Qur’an: chapter 2, verse 275). The term Bay’, as it occurs in the Qur’an, includes both the sale of ownership and the sale of the usufruct or right to use. The following section relates to the sale contract that ends up with the transfer of legal ownership of an asset to another person. The transfer of services or usufruct will be dealt with under a section on lease contracts (section 6.10).

Generally speaking, a sale contract involves an exchange of one commodity for another commodity (barter trading) or a commodity for money (sale) or of money for money (currency exchange). As highlighted, Riba may exist in the sale of a commodity for another commodity as well as in the exchange of money for money if the relevant requirements are not met. However, Riba is detached from any transaction involving a sale of commodity for money because the two counter values involved in this transaction are not usurious items when exchanged for each other. The requirement of a spot transaction of equal amount and quantity of the two counter values is not applicable. It makes a sale contract (other than barter and currency exchange) distinct and free from an element of outright interest. However, a sale contract may be susceptible to Gharar, which normally affects the quality of knowledge about the prescription of goods and consideration or price.

Contracts of sale include a number of contracts categorised into many respective classifications. However, these classifications that explain the features and functions of each sale contract may overlap.

6.6 Sale of trust (Amanah)Islamic commercial law recognises the importance of honesty and full disclosure of the actual cost price of any commodity for the benefit of the buyer. Following this principle, sale contracts are normally divided into two classifications, namely sale of trust (Amanah) and sales that are not based on trust. The latter type of sale may arise where the price depends on bargaining skills without any reference to the cost or profit margin. Under the sale-of-trust principle, the seller must disclose the actual cost price to the prospective buyer. Non-disclosure or dishonest disclosure would render the sale contract null and void ab initio. In such cases the commodity must be returned to the seller/owner for the return of the consideration to the buyer.

There are three types of sale contracts that come under the purview of trust sale, namely Bay’ al-Murabahah, Bay’ al-Tawliyah and Bay’al-Wadiah.

6.6.1 Cost-plus or Bay’ al-Murabahah

Bay’ al-murabahah literally means ‘increase’ or ‘profit’. In classical literature, it has been defined as the sale of a commodity at cost price plus a known profit. The profit may be declared in exact value such as in the statement of the vendor: ‘I purchased this commodity at £10,000 and I am selling it at the profit of £1,000 so the selling price is £11,000’. The profit may also be fixed in ratio or percentage such as ‘10% of the cost price’. As part of a trust sale, the vendor must state either their cost price or the profit for the knowledge of the buyer.

6.6.2 Not-for-profit or Bay’ al-tawliyah

Bay’ al-Tawliyah is also a trust sale even though the vendor will sell their asset at the cost price without any profit. The trust feature arises from the requirement of the disclosure of the actual cost price. The buyer relies on this statement before making a decision to purchase or otherwise, and therefore a strict duty of disclosure is imposed on the vendor.

6.6.2 Discounted price or Bay’ al-Wadiah

Bay’ al-Wadiah is a sale below the cost price or at a discounted price. This sale also requires honesty on the part of the vendor since any reference to the cost price might induce the buyer to purchase

Bay’ is a sales contract.

Sales contracts involve an exchange of one commodity for another commodity (barter trading) or a commodity for money (sale) or of money for money (currency exchange).

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believing that the vendor is honest in his disclosure. This kind of sale is deemed as a trust sale because the buyer will not be in the position to know whether an asset is being sold below the cost price as claimed by the seller or otherwise. The only statement he can rely on is the statement made by the seller that the seller has purchased a particular asset at, for example $5,000, and has now sought to sell the same asset at, for example $4,000. A prospective seller may use this statement to influence the buyer to purchase. It is for this reason that a strict and honest disclosure of the cost price is required. The contract is null and void if the statement made is found to be untrue.

* The cost must be disclosed in all contracts because the trust principle requires the seller to disclose honestly the actual cost incurred by the seller in purchasing these goods from the vendor.

6.7 Negotiated sale or MusawamahSale contracts that are not based on trust are generally known as Musawamah. This is a normal sale concluded through negotiations between the seller and buyer where no reference was made to the original cost price. Any reference to either the cost price or profit will render this contract no longer Musawamah and it will revert to a trust sale. However, it is not to be inferred that Musawamah could not bring profit to the seller as the actual profit to be made by the seller is not known to the purchaser unlike in the case of Murabahah. Some IFIs have used Musawamah in their financing schemes in which no reference is made to either the cost price or the profit margin. What appears in the statement of claim or invoice is one figure that is the selling price payable by the buyer to the seller without disclosing the cost price or profit.

There is no requirement that payment under these contracts must be either spot or deferred. In other words, the payment arising from Murabahah, Tawliyah, Wadiah and even Musawamah could be on a spot basis or on an instalment basis. The feature of spot or deferred payment is not integral to this classification. However, the delivery of the asset under all these contracts must be on a spot basis to distinguish them from a forward contract or a deferred delivery sale.

The three types of sale contracts that come under the purview of trust sale are Bay’ al-Murabahah, Bay’ al-Tawliyah and Bay’al-Wadhiah.

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Trust (Amanah) Sale

Types Cost* Selling price Profit Loss

Murabahah £1,000 £1,100 £100/10%

Tawliyah £1,000 £1,000

Wadiah £1,000 £800 £200

Table 6.2 Various types of trust (Amanah) sale

Contracts Delivery Payment Remarks

Musawamah Spot Spot/deferred • No disclosure of cost

• Price would be at profit or cost or loss but not known to the purchaser

Murabahah Spot Spot/deferred • Disclosure of cost

• Price at cost plus mark-up

Tawliyah Spot Spot/deferred • Disclosure of cost

• Neither profit nor loss

Wadiah Spot Spot/deferred • Disclosure of cost

• Sale at loss

Table 6.3 Summary of contract features



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The previous table explains that the basis of classification of these four main types of sale is basically the disclosure or non-disclosure of the cost price. Also, it explains that in some sale contracts, a profit or loss can be distinguished clearly in contrast to some contracts, namely Musawamah, wherein the profit or the loss to the seller cannot be ascertained by the purchaser. However, all four contracts require that the delivery of underlying goods must be on spot basis, but the payment of the selling price could either be on spot or on deferred basis as agreed by both parties.

6.8 Time of paymentSales can be classified according to the time of payment of the price or consideration. In some contracts the payment must be deferred, such as in Bay’ al Mu’ajjal or a deferred payment sale. In other contracts, full payment must be paid in advance such as in a Salam contract. A Salam sale is a forward sale where the purchaser must pay the full payment in advance for a commodity to be delivered to him in the future. Under this sale, both the buyer and seller have locked the price in anticipation of future price movements. Also, in currency exchange contracts, both of the counter values must be exchanged for each other on a spot basis. In this sale transaction involving two different currencies, one of the currencies is the object, while the other is the price.

There are other contracts wherein the payment can be made on a spot or deferred basis based on the agreement of the parties. This applies to all other contracts other than Bay’ al-Mu’ajjal, Salam sale and currency exchange. Islamic commercial law also recognises down-payment (‘Urbun) as a kind of sale that gives the buyer a right (not an obligation) to proceed with the sale contract if he so wishes. If he proceeds, then the amount paid, that is, ‘earnest’ money, will be deemed as part of the selling price. Otherwise, this amount of money will be forfeited in favour of the seller. The summary of the above sale contracts with regards to the time of payment is illustrated in table 6.4 below.

Sales contracts that are not based on trust are generally known as Musawamah.

This is a normal sale concluded through negotiations between the seller and buyer where no reference was made to the original cost price.

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Islamic finance challenge 6.2Murabahah is a trust sale. It is essentially a sale of an asset to a person in which the cost price of the asset is disclosed and from which the actual profit margin or mark-up can be ascertained by the buyer. In a typical situation, a seller will inform the buyer that he has purchased an asset, for example, equipment or furniture at €10,000 and the seller now intends to sell the same asset to the buyer at €12,000 which is payable for example within two years. The buyer may agree to purchase this asset at €12,000 although the ‘market price’ is only €10,000 if it is paid on spot. Explain why a buyer would agree to enter into this kind of transaction.

Solution Probably the most important consideration here is that the buyer is getting a credit sale facility. This enables him to own an asset now while paying for it later. In addition the buyer might find this method more suitable for him because he would know the actual cost that the financier has paid, and hence the profit margin being earned by the seller. A judgement can be made as to whether the buyer finds the selling price acceptable, knowing what the seller paid for the asset.



The above table illustrates that for some sale contracts, the time of payment must be made according to the requirements of the contract type. Salam and currency exchange require a spot payment basis to achieve their validity, otherwise they become null and void. As for an ‘Urbun sale, some payment must be made on spot to entitle the buyer to pay the remaining amount within the specified period.

Exercise 6.3 Outline the main differences between a Salam and ‘Urbun sale.

6.9 Time of deliveryIn some contracts, the delivery of the asset must be on a spot basis because they are sold based on the identification of their physical nature. These include all spot delivery sales such as Murabahah, Musawamah, Tawliyah and Wadiah. Any deferred delivery involving a particular ascertained asset that is already in existence is not permissible. In addition, an object such as currency must also be delivered on the spot because it is a usurious item.

In other contracts such as Salam and Istisna’, the asset must be delivered in the future. While Salam is a forward sale, Istisna’ is a construction contract. Under Istisna’ the purchaser purchases a completed asset to be constructed by the contractor. The asset will only be delivered to the purchaser upon its completion. The reason these assets must be delivered in the future is that the parties have entered into contracts with the purpose of delivering or acquiring an asset that is identified by description and not by reference to a particular physical nature. Assets identified by description only could not have been in existence.

Type of sale contracts Spot payment Deferred payment Remarks

Bay’ muajjal Agreed as such by two parties

Bay’ al-salam Deferment of payment is not permissible

Bay’ al-urbun

(part of the payment)

(the remains of the payment)

Deposit will be forfeited if the contract is terminated

Bay’ al-sarf

(currency exchange)

Both counter values must be exchanged with each other on spot basis

Other sale contract As agreed by the parties

Table 6.4 Summary of sales contract time of payment

Type of sale contracts Spot delivery Deferred delivery

Salam and Istisna’

Currency exchange contract

Other than Salam and Istisna’ contracts

Table 6.5 Summary of sales contracts – time of delivery



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The previous table shows that while in Salam and Istisna’ sales the delivery of the goods must be deferred to a future date, other sale contracts require the opposite, that is, spot delivery. As for a currency exchange contract, the reason for spot delivery is to avoid Riba in return for a delay in the exchange. Other sales contracts require a spot delivery because the underlying asset is ascertained by its physical identification, therefore its delivery cannot be delayed to the future. The exception of deferred delivery is only given to the Salam and Istisna’ sales.

Exercise 6.4Is a Murabahah transaction valid in the case where the asset is to be delivered in the future?

6.10 Transfer of the right to use (usufruct)The second major classification of contracts relates to the transfer of usufruct or the right to use. Unlike a sale contract, this contract will effectively transfer the right to use a particular asset from the owner to the user. This type of contract is known as Ijarah in Islamic commercial law and consists of both hire and lease contracts. In a hire contract, a person ‘sells’ their services to another person and the consideration is normally a wage or salary. Most of the services contracts belong to this sub-division of the Ijarah contract. This is known in Arabic as Ijarah ‘ala al-Ashkash (hire of persons). Another sub-division of the Ijarah contract is known as Ijarah al-A’yan (lease of the asset). The owner of the asset is called the lessor while the user is called the lessee. The lessee will benefit from the usufruct of the asset and for this he has to pay rental. This type of Ijarah contract would be more relevant in financial markets.

The salient features of Ijarah, particularly the lease of usufruct, are inter alia as follows:

(a) the lessor must be the owner of the leased asset or the agent of the legal owner; the lessee, with the consent of the lessor, can sub-lease the leased asset to a third party, that is, the sub-lessee

(b) the leased asset must be of benefit to the lessee and, above all, should be lawful from the Shari’ah perspective; for example, the lease of a centre for gambling activities is not permissible

(c) the rental must be fixed and known to both parties; a floating rental rate is also permissible provided the benchmark or basis on which the rental is periodically revised is fixed and agreeable to both parties upfront, the benchmark could have any reference basis, provided it is always in existence and can be referred to for the purpose of determining the newly revised rate of rental payment

(d) the ownership risk should be borne by the lessor, which includes any cost to maintain the property, such as major maintenance and the cost of insurance, if required, to insure the asset from fire and natural disaster; the cost arising from the use of the leased property must be borne by the lessee - examples of this include water bills for leased property and road tax for a leased vehicle

(e) the leased asset should be treated in trust (Amanah) in the hands of the lessee; any damage caused to the leased asset without any negligence or misconduct by the lessee will not be a liability on the lessee

(f) total damage to the leased asset will render the lease contract null and void unless the lessor is able to substitute the damaged asset with another asset of the same features of the usufruct; partial damage will give an option to the lessee to continue with the contract with or without a proportionate reduction of the rental payment

(g) an Ijarah contract is a binding contract to the effect that one party cannot amend the terms of the contract unilaterally such as to revoke the contract or revise the rental; any amendments must be jointly agreed on by both parties.

6.11 Operating and financial leasesAn Ijarah involving a usufruct has two main types, namely an operating lease (Ijarah Tashghiliyah) and a financial lease (Ijarah muntahia bi tamleek).

6.11.1 Operating leases

An operating lease is a straightforward lease where the owner/bank will purchase the asset from the vendor and subsequently leases it to the lessee/customer at an agreed rate of rental for a defined



period. Upon the expiry of the lease contract, the lessee must return the leased asset to the lessor. At this point the lessor may continue to lease the asset to the same lessee or decide to lease it to a third party. The lessee has no right to purchase the leased asset from the lessor.

6.11.2 Financial leases

Another type of lease is Ijarah muntahia bi tamleek, which is loosely translated into English as a financial lease or an Islamic hire and purchase contract. It refers to the transfer of the usufruct of a particular property to another person in exchange for rent. The lease will end with the transfer of the leased property from the lessor to the lessee. Under this scheme, the lessee has an option to ‘put’ to the lessor to sell the leased asset to him according to an agreed manner of transfer of ownership. In other words, the lessor has given his promise or undertaking (Wa’d) to sell this leased asset to the lessee as and when required. The price and manner of payment to transfer the ownership are normally agreed in advance.

The above table illustrates that the only distinction between these two types of Ijarah is on the obligation of the lessor under a financial lease to sell the leased asset to the lessee once the lessee exercises their option to purchase. Other features are common to both.

Exercise 6.5Which contract is most suitable where the lessee wishes to purchase the leased object either at the end of the leased period or at any time during the lease period?

Features Operating lease Financial lease

Contract Ijarah Ijarah coupled with an undertaking by the lessor to sell the leased asset to the lessee.

Ownership risk and cost (on the lessor) (on the lessor)

Usage risk and cost (on the lessee) (on the lessee)

Rental Fixed or floating Fixed or floating

Ownership transfer

Asset No restriction provided it is beneficial and compliant

No restriction provided it is beneficial and compliant

Table 6.6 Summary of operating and financial leases

Ijarah contract transfers the right to use a particular asset from the owner to the user.

In an operating lease or Ijarah Tashghiliyah, the lessee has no right to purchase the leased asset from the lessor.

In a financial lease or Ijarah muntahia bi tamleek, the lessor gives his promise or undertaking (Wa’d) to sell the leased asset to the lessee as and when required.

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6.12 Contracts of partnershipAnother classification of contract is contract of partnership, which consists of Mudarabah and Musharakah. Mudarabah is a contract of partnership in profit whereby one party provides capital and the other provides labour and management. While profit is to be shared between the two based on an agreed ratio, the loss must be borne by the capital provider alone. The manager only risks the loss of his time, effort and expected profit. Musharakah, on the other hand, is a partnership contract in which the two parties must contribute capital to the joint venture. The management can be undertaken by either or both of them, or it can be outsourced to a third party. The element of work and management is not integral to Musharakah. As for profit sharing, it may be shared according to an agreed ratio, but as for the loss it must be distributed according to proportionate capital contribution.

6.13 Contracts of securityContracts of security are another important type of contract in Islamic commercial law. The purpose of having this contract is to protect the party in whose interest the contract has been entered. There are three main contracts of security: Hiwalah (transfer of debt), Rahn (pledge) and Kafalah (guarantee).

6.13.1 Hiwalah

Hiwalah means transferring the right to a claim for a payment of debt to another party (transferee) who will later claim from the principal debtor. In a case where A owes B a particular amount of money and, at the same time, B also owes C a particular amount of money, then Hiwalah is possible. Ideally, in order to settle this respective obligation, A will pay to B and B will have to settle his debt owing to C. However, under a Hiwalah arrangement, B, who is the creditor to A but the debtor to C, can simply transfer his claim of debt on to C (transferee). Once the transferee has accepted the transfer of debt, the transferor (B) would be released from his obligation towards C, who is the principal creditor/transferee. The transferee can only claim his right from A, who is the principal debtor in this transaction.

Islamic finance challenge 6.2In contracts of sale, the price, irrespective of the various contract classifications, must be certain and hence fixed. Can you explain why the rental payment under a lease contract can be either fixed or floating.

Solution The object of a sale is fixed and therefore the selling price must equally be fixed. For example in a Murabahah contract, where 100 computers are valued at £1,000 each, and each is sold to a customer at a Murabahah price of £1,200 each, payable within five years, the price of £1,200 for each unit cannot change. It does not matter if the market price rises in the future because the sale price was agreed on the day of contract and the assets, in this case the computers, were transferred to the customer immediately after completing the Murabahah sale contract. Under Ijarah, the object of the lease is not the asset itself but rather its usufruct. Usufruct or services are not delivered one-off at the time of contract but are to be made available by the lessor, throughout the lease period. Therefore, the consideration or rental for this usufruct can be revised periodically subject to the consent of both parties. The newly revised rental will only apply to a future usufruct or services and cannot be applied in retrospect. Thus, the rental could either be fixed or floating as agreed by two parties.

Mudarabah and Musharakah are the two main contracts of partnership.

Mudarabah is a contract of partnership for profit, whereby one party provides capital and the other provides skills and management.

Musharakah is a partnership contract in which the two parties must contribute capital to the joint venture.

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6.13.2 Rahn

Rahn or pledge is to use property as a security in respect of a right of claim, the payment of which may be taken from the value of the property. In a typical case of indebtedness, the debtor will have to furnish a kind of security or pledge to the creditor/financier. The debtor is called a pledgor and the creditor is known as a pledgee. If the pledgor fails to settle the payment as agreed, the pledgee has a right to dispose of the pledged asset to get back the amount of money owed to him. The pledge makes a creditor a secured creditor and is normally ranked higher than other creditors who have no pledge or security.

6.13.3 Kafalah

Kafalah means to add another obligation to an existing obligation in respect of a claim for something. Kafalah may relate to a person, financial obligation or particular act of performance. Kafalah relating to a person involves the production of the person for whom the Kafalah (bail) has been given. Kafalah relating to financial obligation implies an obligation on the guarantor to pay in the event that the principal debtor (guaranteed person) fails to pay the agreed payment to the creditor. Kafalah, unlike Hiwalah, would not release the principal debtor in whose favour the contract is concluded because it provides a guarantor to the existing obligation, not a transfer of the obligation. The creditor may have recourse to either the debtor or the guarantor, although in practice the creditor will only have recourse to the guarantor once he has exhausted all other means to get the payment from the debtor.

Exercise 6.6Which one of the following statements is true?

(A) Both Kafalah and Hiwalah release the obligation of the principal debtor.

(B) Hiwalah releases the obligation of the transferor, who is also a debtor. Kafalah does not release the obligation of the principal debtor.

Figure 6.2 Pre-Hiwalah

A owes B$1,000

B owes C$1,000

A B C

Obligation to Obligation to

Figure 6.3 Post-Hiwalah

A B C

3. B will not require A to pay $1,000

1. A Pays $1000

2. C will not require B to pay $1,000



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6.14 Wakalah and Ju’alahIslamic law also recognises contracts to do work. This is a contract where a party engages another party to do work on their behalf. The contract looks similar to a hire contract. This type of contract consists of two specific contracts: Wakalah (agency) and Ju’alah (commission-based). As for Wakalah, the principal will appoint an agent to undertake a particular assignment or work for them. All rights and liabilities will be assumed by the principal. The agent could be paid for their service as the fee is not integral to the wakalah contract. If a fee is agreed to in the Wakalah contract, the agent will be paid for their service regardless of whether they have achieved the intended objective. With regards to Ju’alah, the fee will only be paid upon the specific performance by the appointed party. The fee paid is conventionally known as a commission.

6.15 Contracts of safe custody - WadiahThe last category or classification of contract is a contract of safe custody. This is typically a contract between a depositor who deposits their assets and a custodian who receives the deposited asset and keeps it under their safe custody. The custodian receives this asset on the principle of Amanah (trusteeship) in the sense that they will not be liable for damage or loss to the deposited item if there is no negligence or misconduct on their part.

The deposited items could include almost all types of assets that could be delivered physically to the custodian. A safety deposit box in a bank is a good example of a safe custody contract. This contract also accepts money as a deposited item. However, when money is being deposited, the nature of the contract is transformed into a loan contract because it could potentially give extra benefit to the depositor, thus the possibility of Riba. The reason for this transformation is explained in section 9.1.1 of chapter nine.

Exercise 6.7A company has invented a new product that it intends to market quite aggressively. For this purpose, it intends to appoint sales people across the country. However, to reduce the cost of marketing, the company is planning to reward its sales persons by way of commission on their actual sales of the new product. What would be the most suitable contract between the company and its sales people?

6.16 ConclusionThis chapter explained how various Islamic contracts are classified according to their behaviour and function. It also introduced you to how financial products are created as a result of the ability to use one or more traditional contracts to meet the requirements of the customer. You should have seen that the variety of contract classifications provides flexibility in the products which can be offered within Islamic finance. You should now have a good appreciation of the various features of each contract.

In the following chapter we will compare and contrast various classifications of contract in order for you to appreciate the different behaviour of distinct contracts. This will also help you understand how to apply a particular contract to meet a specific purpose.

Hiwalah, Rahn and Kafalah (guarantee) are three main contracts of security.

Hiwalah means transferring the right to a claim for a payment of debt to another party (transferee) who will later claim from the principal debtor.

Rahn or pledge is to use property as a security in respect of a right of claim, the payment of which may be taken from the value of the property in the case of non-payment of the debt or liquidation.

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Key points




1. the classification of contracts is important in order to appreciate the salient features of each contract as they subsequently add value to product development in Islamic finance

2. the two major broad classifications of contract are bilateral contracts and unilateral contracts

3. from a perspective of the duty to disclose the actual cost price, sale contracts are categorised into sale of trust, which consists of Murabahah, Tawliyah and Wadiah, and negotiated sale known as Musawamah

4. sales from time of payment perspective can be divided into three classifications: mandatory spot payment (Salam and currency), spot payment with the rest to be made later within a specified period (‘Urbun), sale contracts that are open to either spot or deferred payment as agreed by the parties

5. the time of delivery of an asset in a sale contract also forms the basis of particular classifications of sale contracts. Essentially, some sale contracts require spot delivery and some contracts such as Salam and Istina’ are used where deferred delivery is required

6. Ijarah refers to the right to use for rental and could be an operating or financial lease

7. a partnership contract could be either Mudarabah or Musharakah; Mudarabah is a partnership between a capital provider and an entrepreneur, however, Musharakah requires both partners to contribute capital into the venture

8. a security contract is aimed at protecting the interest of the main creditor or a person in whose favour the contract is entered into; it includes contracts of pledge, guarantee and assignment of debt.

9. contracts to do work on behalf of or for the benefit of someone are also recognised in Islamic commercial law; the contract can be based on Wakalah or Ju’alah

10. a safe custody contract or Wadiah is a contract of a depositor depositing their asset with a custodian.



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Chapter 6 AnswersExercise 6.1In a unilateral contract, although only one party is bound to provide the object of the contract and although he receives no consideration, this is deemed to be a valid and enforceable contract because it binds one party and it might create a situation that is detrimental to another party. For example, Khalid has promised or agreed to donate his car to Ismail. Relying on that promise, Ismail has sold his car in anticipation of receiving the car from Khalid. This could put Ismail in a disadvantageous position if the promise by Khalid to donate his car was not deemed to be an enforceable contract. A promise by one party is a binding unilateral contract in Islamic law binding only the promisor.

Exercise 6.2Uncertainty or Gharar only affects bilateral contracts as these contracts are normally based on the exchange of something for a price. Bilateral contracts also aim to make commercial gains. Any element of uncertainty will render a bilateral contract void or voidable. These two considerations are not present in unilateral contracts. This means that unilateral contracts will remain valid even though they may contain an element of uncertainty. The main purpose of this contract is not for commercial gain but rather for love, care and as a token of appreciation to others.

Exercise 6.3While the full payment of selling price under a Salam sale contract must be paid in advance, the selling price under ‘Urbun sale contract is partially deferred. A small down payment will bind the seller under an ‘Urbun sale not to sell the goods reserved for the buyer to another party within the time frame agreed for the buyer to settle the remainder of the sale price. Another difference is that the goods under a Salam contract do not necessarily have to be in existence at the time of contract. Under an ‘Urbun sale contract, the asset must be in existence at the time of contract. Both contracts share the feature that the goods under negotiation are to be delivered at some time in the future.

Exercise 6.4A Murabahah transaction, in the case where the asset is to be delivered in the future, would not be a valid transaction. Contracts other than Salam and Istisna’, such as Murabahah, require the object of the contract to be delivered on a spot basis. The exception to deferred delivery is only granted to Salam and Istisna’ contracts.

Exercise 6.5An Ijarah muntahia bi tamleek contract is a lease arrangement whereby the lessee has the right to purchase/own the leased asset. The lessor has given his promise or undertaking to sell the leased asset to the lessee when requested to by the lessee but subject to certain terms and conditions.

Exercise 6.6 (B) True.

The immediate effect of Hiwalah is to transfer the liability of the transferor who owes some payment to the principal creditor. Kafalah makes the guarantor jointly liable together with the principal debtor.

Exercise 6.7The Ju’alah contract (commission-based contract) would be the most effective and useful contract as the payment to the sales people will be linked to actual sales of the product.

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Revision Questions

Question 1 Multiple choice1.1 What is meant by the term Tanazul?

(A) To waive the risk of loss.

(B) To compensate for the lack of profit.

(C) To give away a proportion of the profit to another party.

(D) To take a share in the profit.

1.2 What is the basis of sale of trust (Amanah)?

(A) Deferred payment sale.

(B) Disclosure of the actual cost price.

(C) A mark-up on the sale price.

(D) Disclosure of the quality of the asset.

1.3 Which of the following is the correct description of a Salam sale?

(A) Spot payment against future delivery.

(B) Payment based on progress of delivery.

(C) Spot delivery against spot payment.

(D) Deferred payment and deferred delivery.

1.4 What is the main distinction between an operating lease and a financial lease?

(A) Rental payment must be fixed in a financial lease.

(B) Ownership risk must not be borne by the lessee in a financial lease.

(C) Financial lease is not compliant to Shari’ah principles.

(D) A financial lease gives the lessee the right to purchase the leased asset at the end of the lease.

1.5 When the transferee accepts the transfer of debt under a Hiwalah contract, what is the consequence of the contract?

(A) The transferor and principal debtor jointly owe the debt payment to the transferee.

(B) The liability of the transferor to pay the debt is extinguished.

(C) The liability to pay the debt is transferred to the guarantor.

(D) The transferee has recourse to the transferor in the case of non-payment by the principal debtor.

Question 2

Match the following descriptions to the corresponding subject matter


1. Unilateral contract A. Deferred delivery sale where the payment could be either on spot or deferred payment basis.

2. Ju’alah B. Down payment sale whereby some payment must be made on spot and the remaining must be paid within the agreed period. This payment will be forfeited if the remaining payment is not paid within the agreed period.

3. Musharakah C. A contract that tolerates an element of uncertainty in both the subject matter and price.

4. Istisna’ D. A fee is only paid based on certain agreed performance.

5. ‘Urbun E. Partnership wherein both parties contribute capital to the venture.

Revision questionsClassification of contracts

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Answers

Question 1 Multiple choice1.1 (C) A waiver reflects the consent of the owner of a particular entitlement to waive whatever is

due to him from another party.

1.2 (B) Under the sale-of-trust principle, the seller must disclose the actual cost price to the prospective buyer simply because the buyer has relied on his statement or disclosure of the cost price.

1.3 (A) A Salam sale is a forward sale whereby the purchaser must pay the full payment in advance for a commodity to be delivered to him in the future.

1.4 (D) A financial lease allows for the lessee to purchase the leased asset at the end of the lease period. If the lessee decides to purchase the leased asset, the lessor/owner must sell the asset to the lessee.

1.5 (B) Hiwalah is the transfer of debt obligation. Once a person has transferred a debt to someone else, for example, the transferee, he or she is no longer obliged to pay that debt. The principal creditor can only claim the payment of the debt from the transferee, who is the principal debtor.

Question 2


1. Unilateral contract C. A contract that tolerates element of uncertainty in both the subject matter and price.

2. Ju’alah D. A fee is only paid based on certain agreed performance.

3. Musharakah E. Partnership wherein both parties contribute capital to the venture.

4. Istisna’ A. Deferred delivery sale where the payment could be either on spot or deferred payment basis.

5. ‘Urbun B. Down payment sale whereby some payment must be made on spot and the remaining shall be paid within the agreed period. This payment will be forfeited if the remaining payment is not paid within the agreed period.


Comparison of classifications of contract


compare and contrast various classifications of contracts

apply respective contracts to a specific case for a specific purpose.

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Learning outcomes

Chapter seven



7.0 IntroductionFollowing on from the previous two chapters, which introduced you to the nature of contracts and how they are classified, this chapter shows you how to compare and contrast various classifications of contract in order for you to appreciate the different behaviour of distinct contracts. You will also be shown how to apply a particular contract to meet a specific purpose. Understanding the various classifications of contract and their distinctions will allow you to apply what you have learned thus far to specific financial products. By the end of this chapter you should be able to assign the correct contract to a particular financial product. If by the end of the chapter you feel unable to do this we would recommend that you refer back to the previous two chapters as they lay the foundation of both this and the following three chapters.

7.1 Comparison of various contracts highlighting the similarities and dissimilarities between themThe previous chapter explained the classification of contracts and their bases. This chapter will compare and contrast the various contracts with a view to determining whether there is any common ground between them. Naturally, such comparisons will also lead to the discovery of some dissimilarity. Knowledge of this is useful in understanding Islamic financial product design as well as in contributing to product development and enhancement.

7.2 Intention of the parties to the contractThe first aspect that is relevant is the intention of the parties when entering into a contract to purchase a particular asset either at the time of contract or in the future. The parties have entered into the contract for one common purpose, that is to transfer ownership or acquire ownership. Ironically, this objective can be achieved through more than one contract, namely the sale contract, the lease with an option to purchase and the diminishing partnership or Musharakah Mutanaqisah. All facilitate the purchase of a particular property. While the sale transfers ownership on the spot, the lease, with an option to purchase, will transfer ownership rights when the lessee exercises his option to purchase. The same is true with regard to Musharakah Mutanaqisah wherein the ownership of a jointly-owned property will be transferred to one of the joint owners progressively by virtue of buying back the shareholding of the other joint owner. Ultimately, under Musharakah Mutanaqisah, one party (who is normally the asset seeker) would own this asset through the redemption of the other joint owner’s shareholding and interest in the said asset. Redemption is as good as a sale contract in the sense that one partner purchases the share of another partner, but it is done progressively. From this perspective, all these contracts share the same feature that allows a transfer of ownership.


Comparing and contrasting classifications of contracts.

Understanding the intention of the parties to a contract.

Differences in contract types.

The application of the right contract.

Flexibility of sales contracts.

Transforming classical contracts into products that are commercially viable.

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Although these three structures belong to a different classification of contract, they are in the position to serve a common purpose that is to transfer the ownership to the customer via the respective mode of financing. However, each structure has its own distinctive features.

Exercise 7.1Given the volatility of the cost of funds or the Base Lending Rate (BLR) in your home country, propose with reasons the most suitable long term Islamic finance contracts for house financing.

7.3 Partnership contractsIt can be inferred from the previous chapter that some contracts may share some common ground, but differ from each other in particular features, for example partnership contracts. These contracts are Mudarabah and Musharakah. Essentially, these are neither sale nor lease contracts. They allow both parties to jointly contribute capital and work to undertake a common business venture, whereby income is to be generated and not fixed. Both parties will only benefit from their investment if the said business venture has realised a net profit after netting the cost and returning the capital to the provider(s). However, both Mudarabah and Musharakah have distinctive features.

Table 7.2 simply illustrates that both Mudarabah and Musharakah share some common features. These are prescribed by Islamic commercial law through either text provisions or Ijtihad of the scholars.

Transfer of ownership mechanisms

Sale contract Lease with an option to purchase

Diminishing partnership

Payment as consideration of purchase price.

Payment of consideration by the lessee to purchase or through the gift by the lessor to the lessee for no consideration.

Progressive redemption of shares from one of the joint owners of the other’s shareholdings.

Table 7.1 Transfer of ownership

In Musharakah Mutanaqisah, the ownership of a jointly-owned property will be progressively transferred to one of the joint owners by virtue of buying back the shareholding of the other joint owner.

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Key point

Features Mudarabah Musharakah

Limited liability ¸ ¸

Profit is negotiable ¸ ¸

No fixed income ¸ ¸

Damage in the case of negligence and misconduct ¸ ¸

Third-party guarantee on capital ¸ ¸

Table 7.2 Similarities between Mudarabah and Musharakah



Table 7.3 illustrates that although both Mudarabah and Musharakah may have common aspects, they also have distinctive features, especially with regard to how they are constructed. Mudarabah, unlike Musharakah, is a partnership contract whose features are illustrated in table 7.2.

Under both the Mudarabah and Musharakah contracts losses are borne by the capital providers. In the case of the Mudarabah partnership the entrepreneur does not contribute capital, but is entitled to an agreed share of profits. Where a loss occurs, the capital provider is left to suffer this alone. In the case of Musharakah partnerships all partners are capital providers, hence, while profits are shared according to agreed ratios, losses are also shared in proportion to the capital contributed.

7.3.1 Mudarabah

Mudarabah is based on one party providing the capital to the partnership and the other providing work and management. There cannot be a situation where both contribute capital or work. To be consistent with this contract construction, all losses must be borne by the capital provider only. The manager will only lose his time and effort. Also, the capital provider cannot be in charge of the administration and management of the venture. These are to be assumed by the manager.

7.3.2 Musharakah

A Musharakah contract imposes on both parties to contribute capital. The loss must be borne by both parties in proportion to their capital contribution. However, the profit, as in Mudarabah, is negotiable based on certain ratio or percentage. Also, both parties under Musharakah can participate in the management of the business venture, although either one of them or both have the right not to be involved. In the latter case, they may appoint another person or company to manage the business venture for the partnership. Having said this, the most interesting feature in a Musharakah contract, unlike Mudarabah, is that it would entitle the partner(s) to be actively involved in the administration and management of the partnership. This is a feature that would give some value in terms of executive powers and rights compared with a Mudarabah contract.

Features Mudarabah Musharakah

Capital from one party and management from another ¸

Capital from both parties ¸

Loss borne by all parties ¸

Management in business venture ¸

Table 7.3 Differences between Mudarabah and Musharakah

Islamic finance challenge 7.1An IFI has invested $100 million in a construction contract to build a new power plant. Neither the manager nor the contractor provided any capital. Instead it was agreed that the manager would provide expertise and project management. The IFI subsequently discovers that there has been mismanagement on the part of the entrepreneur/contractor that has lead to a cost over-run and a potential delay in completion, thus late delivery to the client. Explain how the IFI could resolve the situation.

SolutionThe existing contract is based on a Mudarabah contract. Under this contract, the capital provider is not authorised to manage or to be involved in the management of the business venture. One solution might be to convert the Mudharabah contract into a Musharakah contract. This will require the agreement of the manager to put some capital into the project. If this suggestion is accepted, the IFI will then have the right to oversee the management of the project. This is because a Musharakah contract gives executive power to all partners. The issue here will be in getting the other parties to agree to this change of contract.



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7.4 Functions of security contractsIn the context of a security contract, there are some distinctive features that differentiate one contract from another. These features suit different circumstances in real market practice. One feature that is common to all contracts in this category is that they are not primary contracts with original rights and liabilities. The need for a security contract arises only to secure the rights and liabilities that originate from primary contracts, such as sale, lease and, to some extent, investment contracts. In other words, in the absence of a primary contract, these security contracts are meaningless because they have no ‘interests’ to protect. However, in protecting the interests of the principal creditor, they have different features that should be recognised. These distinctive features can be summarised as follows.

Table 7.4 outlines the specific features of each of these security contracts. While the Hiwalah contract will release the transferor from any liability once the transferee has agreed to the transfer of debt, both pledge and guarantee will not release the liability of the principal debtor until and unless the payment or performance has been made to the satisfaction of the principal creditor. In other words, under Hiwalah, the transferor, who is also the debtor to the principal creditor, will be released from any liability towards the principal creditor once the transferee, who is also the principal creditor, agrees to accept the payment by the principal debtor who owes the transferor.

Actual payment of debt by the transferor to the principal creditor is not a requirement to render their liability extinguished. However, to have the benefit of this feature, there must be three parties who happen to owe to each other. As a consequence, the principal creditor, upon accepting the transfer of debt, is not entitled to recourse to the transferor (their immediate debtor) unless in the case of death and insolvency of the principal debtor. Different applications and types of securities can be pledged, for example, they could be possessive whereby the pledgee would hold the pledged asset preventing the pledgor using it. The pledge could alternatively be non-possessive, which is more common in practice, whereby the pledge will only create caveat on the transfer of ownership but the asset will remain in the possession of the pledgor. The guarantee is, however, meant to ensure performance by the principal debtor or to produce a person before the court of law (bailment). As for Hiwalah, the transferee may or may not be related to the transferor. If the transferee, prior to the transfer of debt, was the creditor to the transferor, then it is called restricted Hiwalah.

Islamic commercial law also allows non-restricted Hiwalah whereby the transferee is a third party who agrees to collect the payment from the principal debtor but is also willing to advance to the transferor an amount of money equivalent to the money to be collected. This practice resembles factoring in many aspects. It is possible for one obligation to be secured by more than one contract. In Islamic house financing, based on Murabahah, for example, there is no objection to a creditor requiring that the debtor

Features Pledge Guarantee Transfer of debt

Parties 2 parties 3 parties 3 parties

Effect Original debt is not extinguished

Original debt is not extinguished

Original debt is extinguished

Types 1. Possessive pledge

2. Non-possessive pledge

1. Performance

2. Bailment

1. Restricted

2. Non- restricted

Recourse right to debtor

Non-applicable-(except in the case of death and insolvency of the principal debtor)

Additional asset to be provided by the debtor

Consent of the principal debtor

Table 7.4 Features of security contracts

In a Mudarabah contract, all losses must be borne by the capital provider. The manager will only lose his time and effort.

In Musharakah, the loss must be borne by both parties in proportion to their capital contribution.

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Key points



provide a pledge as well as a guarantor from whom the creditor can claim should the debtor fail to pay what is due under the Murabahah sale. Obviously, the application of Hiwalah is unique as it requires some prerequisite in terms of parties to the contract and the nature of financial obligation.

Exercise 7.2The ABC bank has extended Murabahah financing to the XYZ company over five years. The XYZ company has invested in some compliant shares and sukuks which are free from any encumbrances. These assets form part of the assets of the XYZ company.

(a) What would be the best means of security to ABC Bank?

(b) Would your answer be different if XYZ company had no assets which were free from any encumbrances?

7.5 Flexibility of contractsSome sales contracts are more flexible than others. The following are examples.

The following table summarise a comparison between the various types of sale contracts.

Table 7.5 and table 7.6 show that sale contracts include various features which could offer some flexibility in some specific cases and needs. Although both Salam and Istisna’ are of deferred delivery sales, Istisna’ is more flexible in terms of the method of payment. Here, payment for any construction or manufacturing contract can be made on a spot basis or during its progress. This gives more room for IFIs product development to suit the need of their customers. However, mention should be made that Salam and Istisna’ are applicable to different subject matter. While Salam is normally used for goods that need no construction, such as agriculture and metal, Istisna’ is only valid on assets that need some form of construction or manufacturing, such as a building, power plant or highway.

The need for a security contract arises only to secure the rights and liabilities that originate from primary contracts, such as sale, lease and, to some extent, investment contracts.

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Key point

Forward Sale/Deferred Delivery Sale

Features Salam Istisna’

Payment Advance Flexible payment

Delivery Future Future

Subject matter Agriculture produce Asset to be constructed or manufactured

Security

Table 7.5 Flexibility of contracts

Sale Contracts

Features Murabahah Musawamah Istisna’ Salam

Payment Spot future Spot future Flexible Advance

Delivery Spot Spot Future Future

Security (Future payment) (Future payment) (Future delivery) (Future delivery)

Profit margin

Asset Identification by physical reference

Identification by physical reference

Identification by description

Identification by description

Table 7.6 Comparison of sales contracts



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The flexibility of the sales structure is made clearer in table 7.6. A brief comparison, between Murabahah, Musawamah, Istisna’ and Salam has shown that an IFI may use the relevant sales contract to satisfy the need of its client. Obviously, IFIs can use a Murabahah or Musawamah contract to finance the purchase of a house or factory that is already constructed. However, if a customer obtained financing to own a property still under constructions then Istisna’ would be more practical.

The above discussion aims to highlight that each contract has its own distinctive characteristics that need to be appreciated. It will also help you to understand product development and enhancement in Islamic finance as all Islamic financial products and services are essentially based on contracts.

The features and characteristics are integral to, and not detachable from, a contract that will subsequently be transformed into a commercial product. For example, a product of Islamic project financing based on Istisna’ will have to internalise all the features of Istisna’ as prescribed by Islamic commercial law, as well as established principles formulated by jurists. Obviously, if the finance was meant to purchase an asset that can be physically identified by reference to a particular existing asset, Istina’ in this case will not be possible. A Murabahah sale would be more appropriate.

Exercise 7.3Why is there a distinction between the position of assets in relation to Murabahah or Musawamah vis-à-vis Istisna’ and Salam?

7.6 Contracts to do workIslamic law also recognises a contract where a party engages another party to do work on its behalf. The contract looks similar to a hire contract. This type of contract consists of two specific contracts: Wakalah (agency) and Ju’alah (commission-based). For Wakalah, the principal will appoint an agent to undertake a certain assignment or work. All the rights and liabilities will be assumed by the principal. The agent could be paid for their service as the fee is not integral to the Wakalah contract. If a fee is agreed, the agent will be paid for their service regardless of whether they have achieved the intended objective. With regards to Ju’alah, the fee will only be paid upon the specific performance by the appointed party. The fee paid is conventionally known as a commission. The basic difference between these two contracts is depicted in the following table.

This table attempts to explain that although both Wakalah and Ju’alah are of the same category, they differ with regard to the scheme of reward or compensation. A fee paid under Wakalah is due once the Wakil (agent) has performed his duties, irrespective of the quality or degree of performance. A fund manager will be paid, for example, 1.5% of the Net Asset Value (NAV) of the fund on a yearly basis for his management services. The fact that the fund performs to the expectations of the investors or otherwise is irrelevant. However, under Ju’alah, the fee is only paid once and the worker, or perhaps the fund manager, is able to achieve some rate of return, that is, the hurdle rate. This fee structure is useful to incentivise and reward the fund manager for their performance.

Salam is normally used for goods which do not involve construction.

Istisna’ is only valid on assets such as a buildings, power plants or highways, which require some form of construction or manufacturing.

In Istisna’, the payment for any construction or manufacturing contract can be on a spot basis, progress based or any other manner agreed by both parties.

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Key points

Contracts to do work

Features Wakalah (agency contract)Ju’alah (commission-based contract)

Identified work

Payment/ fee /

Condition for payment WorkPerformance or achievement of certain standard

Table 7.7 Differences in contracts to do work



Exercise 7.4Can you identify which contracts the ‘Urbun principle does and does not apply to and provide reasons for your answer? You may wish to make reference to table 7.6 above.

7.7 Potential and actual application of these contracts to various Islamic financial products and services.Islamic financial products and services are structured to meet the legitimate needs of society. Islamic contracts are resourceful in satisfying the commercial needs of customers, both retail and corporate. These contracts are important in order to substitute the function of lending for interest – the main contract in all conventional banking products.

The application of these various products adds diversification to Islamic finance in terms of product offering. It also makes Islamic finance more challenging as practitioners and advisers have to vet many different and various principles contained in a single product. These principles have a significant impact on legal and taxation issues as well as relevant risks such as market risks, rate of investment return risk and operational risk. These financial products are obviously more complicated and diversified compared with simple loan transactions.

7.7.1 Using historic contracts to meet today’s requirements

All the contracts explained in the previous chapter existed in the past. However, they did not constitute banking products as until recently there were no Islamic banks. The challenge is how to use these contracts to suit the financial intermediary function of an Islamic bank as well as other Islamic institutions and markets such as Islamic insurance and an Islamic stock market. This has been done successfully by using relevant financial engineering skills, but without diluting the very features of the contracts concerned.

Istisna’, for example, is a contract designed to enable a purchaser to order an item to be constructed and delivered in the future. The payment could be made in advance or any manner agreeable to both the purchaser and the seller/contractor. Typically, as in the past, both the purchaser and the seller are the ultimate purchaser and seller respectively. An advance payment or payments based on the progress of the construction, if applicable, would help the contractor finance his cost of construction.

7.7.2 Financial engineering

Where the purchaser, of say a house, lacks sufficient capital, then banks accept that a different product is required. Realising that an Islamic bank is neither an ultimate purchaser nor an ultimate seller or contractor, jurists have put forward an alternative structure that is based on proper and approved financial engineering. This structure, called parallel Istisna’ (Istisna’ Muwazi) refers to a contract of two independent and non-related contracts of Istisna’. The first contract is entered into between the bank acting as the seller/contractor and the customer as the purchaser. Under this contract, the customer may pay the Istina’ purchase price at, for example, £120,000 payable in five years. Subsequent to that first contract, the bank, acting as the purchaser, will enter into another contract of Istisna’ with another party, which is the seller/contractor, at for example, £100,000, which is paid according to the progress of the construction. These two contracts must be independent in the sense that if the contractor in the second contract fails to deliver the required asset as specified in the contract, this will not exempt the bank in the first contract, as the seller, from delivering the asset as requested to the customer.

The liability of both buyer(s) and seller(s) in these two parallel Istisna’ contracts are not contingent upon one another. They have to be stand-alone contracts to reflect the real Istisna’ venture entered into by IFIs. By doing some financial engineering to the original structure, it is clear how a classical contract such as an Istisna’ contract can be used effectively in modern banking environment, not only for retail but also for corporate customers.

Fees paid under Wakalah are due once the Wakil (agent) has performed his duties, irrespective of the quality or degree of performance.

In Ju’alah, the fee is only paid once the worker has achieved the prescribed targets, as agreed in the contract.

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7.7.3 Augmenting historic contracts

In other cases, a classical contract is adopted but is subject to additional requirements to make it viable from a commercial perspective. A contract per se is compliant to Shari’ah principles but is defective in meeting rigorous and prudent banking standards. A good example is the Murabahah contract. Murabahah,as practised in the past, presupposes the seller to already own an asset before he can sell it to a customer at a marked-up price. This approach, although compliant, poses many risks, especially to the financier. Such problems include:

(a) difficulty in identifying the assets that are most likely required by the customers; it would be almost impossible for the financier to purchase all consumer goods as these are not only diverse but also different within the same group of asset in terms of colour, design, etc

(b) storage costs, where the financier has to purchase all assets that it intends to sell to customers at a marked-up price and store them in a warehouse while waiting for customers to approach the financier for Murabahah financing

(c) non-productive use of capital as the capital has been used to purchase items and assets that are not necessarily sold within a short period of time; hence, the loss of opportunity to invest in other investment schemes for the benefit of both the depositors and shareholders; the worst scenario is that these assets could have expired or be obsolete due to some technological or demand reasons; their value will decrease or the bank could lose the whole value entirely

(d) there is no guarantee that the customers will approach the financier to get these assets in a Murabahah sale; therefore, the financier has taken an excessive market risk.

7.7.4 Making financial products commercially viable

In order to overcome the above issues, some additional components have to be added to make the financial product commercially viable. These include, among others, the following:

(a) a promise or an undertaking by the customer to purchase a particular asset from the financier upon the purchase of the assets from the vendor by the financier; this is to avoid the customer breaching the contract and to protect the financier

(b) it is only upon the request and promise by the customer that the financier would purchase the requested asset from the vendor.

These two additional components convert the classical Murabahah into a financial Murabahah, called Murabahah li al-Amir bi al-Shira or ‘Murabahah to the purchase orderer’. Examples of this Murabahah and parallel Istisna’ facility illustrate the application of contracts to modern Islamic financial products and services.

Islamic finance challenge 7.2A company has been given a concession to build and operate a highway. This company intends to seek Islamic financing to cover the cost of construction and maintenance of the highway. Propose as many contracts as possible that could be considered for this purpose.

SolutionMore than one contract could facilitate the above financing. These contracts include:

a. Mudarabah whereby the investors provide the capital and the company provides the work and management relating to construction and operation of the highway

b. Musharakah whereby the investors and the company jointly contribute the capital to cover the cost of financing to build and operate the highway

c. Murabahah financing to finance the purchase of raw materials, equipments cranes and other assets needed to build and maintain the highway, however, Murabahah cannot provide working capital requirements to pay the salaries and other cash-based costs

d. Istisna’ financing using a parallel Istisna’ concept. Here both the financier and operator contribute capital toward the cost of building and maintaining the highway.



Exercise 7.5Both classical and financial Murabahah are based on the same principles and are both Shari’ah compliant. Can you explain why financial Murabahah is used in preference to classical Murabahah?

7.8 ConclusionThis chapter explained how it is possible to meet the needs of different customers by understanding the features of the various contracts. You were shown how to compare and contrast various classifications of contract in order to appreciate the different behaviour of distinct contracts and to apply a particular contract in order to meet a specific purpose. This chapter should have reinforced your understanding of the different classifications of contract and their economic functions in real business transactions.

In the following chapter we turn our focus to how traditional contracts are used in Islamic finance to arrive at specific Islamic financial products.


1. although contracts are different from each other in terms of features, they may be used to finance a common financial need such as the purchase a house. Contracts such as Murabahah, Ijarah muntahia bi tamleek and Musharakah Mutanaqisah are relevant to this common purpose

2. Musharakah is different from Mudarabah, not only with regard to capital structure, but, more importantly, it provides the opportunity for the IFI to participate in the management of the business venture

3. each pledge, guarantee and transfer of debt has different functions and requisites with regard to providing securities to the creditor; the application of the right contract or contracts of security to secure either the payment or delivery is important

4. flexibility of some sales contracts can be used to finance different financing requirements; while Murabahah or Musawamah can be used to purchase a house that has been completed, Istisna’ can be used to pay for a house that is still under construction

5. payment of a fee based on a performance that is linked to an agreed benchmark, as embodied in the contract of Ju’alah, could be more appealing compared with a fee under a Wakalah contract for the work done by the Wakil/agent; both are, however, useful in their respective context

6. the manifestation of both parallel Istina’ and financial Murabahah is clear evidence of how classical contracts, such as Istina’ and Murabahah, can be transformed to products that are commercially viable.



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Chapter 7 AnswersExercise 7.1House financing could be effected through Murabahah, Ijarah muntahia bi tamleek or diminishing Musharakah. All three contracts could be used to structure a financial product for house financing. However, given the above scenario, both Ijarah muntahia bi tamleek and Musharakah Mutanaqisah are likely to be more appropriate because the rental can be revised according to the prevailing cost of funds. A Murabahah contract would expose the Islamic Financial Institution (IFI) to increasing interest rate risk or the cost of funds rising particularly for long term house financing.

Exercise 7.2(a) Given the above scenario, the ABC Bank could create a charge on the company’s shares and

Sukuk and other unencumbered assets. A charge (Rahn) and guarantee (Kafalah) are both possible in the case where the customer/company has some assets

(b) Where the customer/company has no assets upon which a charge can be created, the ABC Bank could require the XYZ company to produce a guarantor to guarantee the payment of Murabahah financing. Only a guarantee (Kafalah) is possible in such cases.

Exercise 7.3Both Murabahah and Musawamah require spot delivery of the asset under consideration. Therefore the asset must already be in existence. In the case of Salam and Istisna’, which are based on the principle of deferred delivery, at the time of the contract, the asset can only be identified by a description of what needs to be produced or manufactured.

Exercise 7.4‘Urbun, which is a down payment scheme, is applicable in the case of Murabahah, Musawamah and Istisna’ as these sale contracts accept deferred payment arrangements. ‘Urbun cannot apply to Salam as this contract requires the full payment in advance.

Exercise 7.5Financial Murabahah suits the function of the IFI as an intermediary rather than a trader. Problems of storage, market risk and meeting the specific needs of customers are effectively removed simply by having this concept which relies on the fact that demand precedes supply. There is no need, therefore, for the IFI to purchase the goods prior to the request of the customer for Murabahah financing. Classical Murabahah presupposes that the financier owns the item before the sale is initiated.

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Revision Questions

Question 1 Multiple choice1.1 Both Ijarah muntahia bi tamleek and Musharakah Mutanaqisah help IFIs to finance a customer

to purchase a house. What is the basic difference between these two products?

(A) While Ijarah muntahia bi tamleek is based on sale, Musharakah Mutanaqisah is based on partnership.

(B) While transfer of ownership under Ijarah muntahia bi tamleek takes place at the end, it takes place progressively under Musharakah Mutanaqisah.

(C) Ijarah muntahia bi tamleek is only suitable for financing for a completed house whereas Musharakah Mutanaqisah suits both a completed house and a house under construction.

(D) Unlike Ijarah muntahia bi tamleek, Musharakah Mutanaqisah is based on rental which must be fixed.

1.2 An investor in a business venture wishes to participate in the management of the business venture. Which of the following contract(s) are suitable?

(A) Mudarabah.

(B) Musharakah and Mudarabah.

(C) Musharakah.

(D) Ijarah.

1.3 Which of the following contracts of security is suitable for securing the interest of a financier under Murabahah financing?

(A) Pledge.

(B) Guarantee.

(C) Assignment of debt.

(D) Pledge and guarantee.

1.4 Which of the following descriptions does not apply to a Wakalah contract?

(A) The agency contract for no fee consideration.

(B) The agency contract for a fixed fee consideration.

(C) The agency contract is for a fee consideration but is based on a specified performance or benchmark.

(D) An agency contract stipulating that an agent will work on something on behalf of the principal.

1.5 What is the main reason for adopting financial Murabahah in preference to classical Murabahah?

(A) It is more compliant to Shari’ah principles.

(B) It is more commercially viable to both the bank and the customer.

(C) It is more economical for the customer.

(D) It is easier for the IFI to arrange and requires less administrative work to service it.

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Question 2

Pledge or guarantee?

Fill in the blank column with the most suitable contract or product for the description given. You will need to choose from the following: Financial Murabahah, Musharakah Mutanaqisah, Istisna’ or parallel Istisna’, Salam and Ju’alah contracts.

Description Product or contract

Financing house under construction.

The bank desires to avoid storage cost in providing consumer financing under a sale contract.

Investors seek to compensate the fund manager only for his excellent performance based on certain rate of investment return.

Customers seek to buy the ownership of a house progressively.

Advance payment to set the delivery in the future to hedge the risk of market risk.


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Answers

Question 1 Multiple choice1.1 (B) The transfer of ownership under Ijarah muntahia bi tamleek takes place at the end of

the lease because it is a lease contract with the option to purchase the asset. In the case of Musharakah Mutanaqisah, the ownership is transferred progressively through the redemption of the partnership by the customer.

1.2 (C) Only the Musharakah contract allows the investor to take part in the management of the business. Under the Mudarabah contract the management of the business is performed exclusively by the manager.

1.3 (D) There is no objection under Shari’ah to a creditor requiring the debtor to provide both a pledge and a guarantor, from whom the creditor can claim should the debtor fail to pay what is due under Murabahah sale financing.

1.4 (C) A fee paid under a Wakalah cannot be linked to any performance or benchmark; otherwise it becomes a Ju’alah contract.

1.5 (B) Under the classical Murabahah concept, the seller must own the asset prior to receiving a request for Murabahah financing from the buyer. This is different from financial Murabahah, where the seller/financier will only purchase the desired asset after receiving a request from the buyer.

Question 2

Description Product or contract

Financing house under construction. Istisna’ or parallel Istisna’.

The bank desires to avoid storage cost in providing consumer financing under a sale contract.

Financial Murabahah.

Investors seek to compensate the fund manager only for his excellent performance based on certain rate of investment return.

Ju’alah contract of management.

Customers seek to buy the ownership of a house progressively.

Musharakah Mutanaqisah.

Advance payment to set the delivery in the future to hedge the risk of market risk.

Salam.


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Traditional Islamic contracts and Islamic finance


illustrate the flexibility of Islamic commercial law to meet financial needs without resorting to lending for an interest

describe the relationship between traditional contracts and Islamic finance products and services.

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Learning outcomes

Chapter eight



8.0 IntroductionIn this chapter you will be introduced to the process by which Islamic Financial Institutions (IFIs) select the appropriate contracts to meet the needs of their clients. The chapter will also introduce you to the process of transforming particular traditional contracts into financial products. This process is known as financial engineering. It is not an exaggeration that most if not all contemporary Islamic financial products are the result of this financial engineering. As a result simple contracts have been used to create products that effectively satisfy modern financial needs. This chapter attempts to guide you through this interesting and challenging task.

8.1 Flexibility of Islamic commercial law to meet financial needs without resorting to interest-based lending8.1.1 Contracts

Contracts are the result of the meeting of two minds, the offeror and offeree, on common grounds or terms. The grounds or terms of the contract are what distinguish one contract from another. For example, a sale contract is different from a lease contract and the two cannot serve the same purpose at the same time. While one is dedicated to satisfying the transfer of ownership, the other affects the transfer of the right of use or usufruct while retaining ownership or title with the owner/lessor.

8.1.2 Contracts - the basis of Islamic finance products

You will have gathered by now that the products and services of Islamic finance are based on a variety of contracts. The various contract types are explained in the glossary of contract and features. When a contract type has been chosen, specific features and terms are attached to make them workable and Shari’ah compliant. The selection of a particular contract is relatively easy compared with the incorporation of all the relevant terms and conditions to render a product both Shari’ah-compliant and commercially viable. Therefore, a viable contract to suit each Islamic financial product must take into consideration all relevant Shari’ah principles pertaining to that contract and product. It is in this context that the appropriate knowledge and understanding of Shari’ah principles are critical, not only to ensure compliance but also to help develop competitive and innovative products and services.

Exercise 8.1In previous chapters, you were introduced to many principles of law relating to the various contracts used in Islamic finance. Without reference to these chapters, can you give examples of the principles that apply to sale, lease and partnership contracts? You may wish to think about conditions for sale, lease and partnership.


The traditional contracts available.

The selection of proper and relevant contracts.

The incorporation of all the leading principles governing that contract.

The need to enhance a contract to make it commercially viable.

Incorporating new features to render the product viable and feasible.

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The above diagram shows that the creation of successful Islamic financial products is the result of selecting proper and relevant contracts as well as incorporating all leading principles of that contract in the product. When a contract has been selected or identified as the basis of a financial product, there is no option from a Shari’ah perspective but to incorporate its salient principles into all aspects of the product.

Islamic finance challenge 8.1A discussion of a contract in Islamic commercial law cannot be detached from its underlying principles and features. The principles and features are the effective elements in making one contract distinct from other contracts. On the same basis, Islamic finance, which is based on specific contracts, is distinct from conventional finance.

Provide a real example that can illustrate the above statement.

Solution There could be more than one illustration to describe the above. In accepting a deposit on the basis of Mudarabah from the depositors, the IFI is willing to share the profit, if any, with their depositors as Mudarabah, unlike a loan in a fixed deposit account, is a profit-sharing concept. In a restricted Mudarabah investment account the nature and full disclosure of investment activities must be disclosed to the depositors. These disclosure requirements make the Mudarabah contract different from both other Islamic contracts and conventional fixed deposit accounts. In conventional insurance protection is sold for a premium. In Islamic insurance or Takaful, the Takaful company does not sell protection and does not receive any premium. Premiums are paid as donations by the policyholders to a fund that is managed by the Takaful operator to compensate or indemnify the participants if the prescribed risk occurs. The contract of donation and its features are very distinct from other contracts and at the same time make it different from conventional insurance.

Contract

Principles of law governing contract

Islamic financial products

Figure 8.1 Constituents of an Islamic financial product

A successful Islamic financial product is the result of the selection of proper and relevant contract(s), as well as the incorporation of all the leading principles and features of that contract(s) in the financial product.

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8.2 Conventional banking modelConventional banking works exclusively on the premise of lending by charging interest and borrowing by paying interest. A savings account reflects borrowing by the bank from the depositor(s) and for this the bank will undertake to pay interest to the depositor(s) for the loan. It is a liability in the records of the bank. On the other hand, when the bank finances a customer, say, to purchase a house, the bank simply arranges a loan to the customer to allow the latter to purchase a house. The bank charges the customer interest on the loan. Normally, the bank charges interest on such loans at a higher rate from that which it pays to the depositors. The spread between these two rates is the bank’s net interest income.

This brief summary of the nature of conventional banking implies that the basis of all banking activities is an interest mechanism. In other words, the mobilisation of funds from the surplus unit in the society (depositor) to the deficit unit (borrower) is made possible through the intermediation of interest, which is basically a charge or premium on money when it is loaned out. Money has been deemed as a commodity and for that reason money has a premium, whereby the lender expects to be compensated for lending out his money.

8.3 Islamic banking8.3.1 Meeting the needs of customers

Given that the receiving and paying of interest are specifically forbidden under Shari’ah law, IFIs have had to develop a banking system without resorting to the interest mechanism. This requirement has to be seen, however, in light of three key facts:

1. shareholders in these IFIs expect a Return On Equity (ROE) when they invest their capital in an Islamic bank

2. Islamic banks must be effective in mobilising funds to finance both the retail and corporate sectors of the economy

3. as with conventional banks most Islamic banks set out to make a profit.

Satisfying these three requirements requires flexibility in the application of Islamic commercial law. The prohibition of lending money in return for interest in Islamic commercial law does not mean that Islamic commercial law is unable to satisfy a commercial need that is normally satisfied through a loan contract. Unlike conventional finance, where the borrower agrees to repay the principal plus an extra amount of money called interest, in Islamic finance the financial institution will finance the customer for the purchase of, say, a car or house or provide a letter of credit by means of sales, leasing or other types of contract.

8.3.2 Real economic activities

Muslims believe that money cannot earn money by itself, but that it should be put into real economic activities, such as trading, leasing and investment to earn extra income.

The Qur’an states that trading or sales are accepted but not Riba or an interest-based transaction. Chapter 2, verse 275 of the Qur’an reads: “God has made trade lawful and Riba unlawful”.

A linkage between money and profit or income is to be established through commodity, services or investment contracts. The whole idea is to involve money in real economic activities for Islamic banks to earn a profit.

8.3.3 Finding the right contract

Sales contracts, leasing contracts and partnerships or joint-venture contracts, among others, can be used to provide the same economic benefit that a conventional loan contract offers. A house seeker in Islamic finance may approach an Islamic bank to obtain appropriate finance because the ultimate aim is to be able to acquire a house on credit. Instead of lending the required money to this customer, the Islamic bank, based on the request of this customer, will purchase the selected house from the vendor at a purchase or cost price. The Islamic bank will then sell the same house to the customer at the purchase price plus a margin of profit and allow the customer to pay this selling price on an instalment basis. By so doing, the bank earns extra income, not from lending for interest, but by trading on a marked-up sale, whereby the differential amount between the purchase price and the selling price would be seen as profit earned by the bank. This type of transaction is based on a Murabahah contract.



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Ultimately, the customer is able to acquire their preferred house on credit, without paying any interest to the bank. However, they have to pay a higher price under a credit sale compared with the cash sale. The sale contract used is an alternative to a term loan facility to purchase a house under a conventional banking scheme. The following table outlines the differences between a conventional house loan and an Islamic house purchasing arrangement.

Exercise 8.2Based on the information given in the table above, calculate the final repayment amount under a conventional house loan facility and the final selling price under an Islamic house financing facility.

Conventional house loan facility Islamic house financing facility

1. Customer approaches the bank for a loan, for example £100,000 to purchase a particular house.

1. Customer approaches the bank and seeks to purchase from the bank a particular house where the cost price of the house is £100,000.

2. The bank advances a loan of £100,000 to the customer for a fixed-interest rate of 4% per annum for 10 years.

2. The bank purchases the house from the vendor at £100,000.

3. The customer purchases the house at £100,000 using the loan facility provided by the bank.

3. The bank sells the house to the customer at £100,000 plus 4% profit per annum (Murabahah).

4. The customer pays back the principal and interest every month.

[£100,000 x 4/100 x 10 years = principal + interest]

4. The customer pays the selling pricing comprising of the cost and profit every month.

[£100,000 x 4/100 x 10 years = selling price]

Table 8.2 Conventional vs. Islamic house financing

Islamic finance challenge 8.2Some critics of Islamic finance have suggested that financial Murabahah is no different from a term loan facility to finance the purchase of a house. In both cases the bank, whether Islamic or conventional, simply acts as an intermediary. What in your view are the similarities and differences?

SolutionFrom the point of view of economic benefit, both facilities serve the same purpose of allowing a customer to own a house and to pay later with a margin of profit or interest as the case may be. The similarity of the ultimate result therefore should not be a contentious point. The methods of achieving this result are however different. The term loan facility offered by conventional banks charges interest - premium on money loaned by the bank. Islamic finance brings the concept of sale instead of loan to finance the customer. The Islamic bank has to purchase a house from a vendor at ‘x’ amount and sell it to the customer at ‘x+y’ amount. These are two real transactions whereby the Islamic bank actually purchases a house before it can be sold to the customer. In many jurisdictions, stamp duty regulations have been amended to avoid the possibility of double taxation on these two transactions (refer to chapter one, section 1.4.5, which covers stamp duty implications relating to Islamic finance).



8.4 The relationship between traditional and Islamic financial products and servicesAll products and services offered by IFIs originate from traditional contracts. This section explains how a classical or traditional contract can be transformed into a viable Islamic banking product. The flexibility and functionality of these contracts are crucial in supporting the Islamic banking business environment. Islamic commercial law supplies a variety of contracts to facilitate Islamic financial business to compete with conventional or interest-based financial products.

8.4.1 Purpose of the product

In order to select the correct type of contract it is necessary to appreciate the purpose of a product and its salient features. Once a contract type has been selected checks and assessments must be carried out to ensure how feasible the contract is in meeting that particular purpose. In section 8.3.3 above, we saw how a Murabahah contract could be selected to facilitate Islamic house financing and meet the respective needs and expectations of both the financier and the customer.

8.4.2 Searching for the correct Islamic contract

Other classical contracts, with different salient features, may have been available to facilitate the purchase of a house. The selection and deployment of a classical contract to support or facilitate a modern Islamic financial product or service are centred on three activities:

(i) a search for a potential contract, or combination of contracts, which could satisfy the ultimate purpose of a particular financial product

(ii) the selection of a particular contract or combination of contracts to be the main underlying contract or template for the proposed product

(iii) the transformation of this traditional contract into a commercial product by either enhancing its features or refining some of its features to suit the market realities.

The relationship between these three activities can best be explained by an example. Vehicle financing is conventionally facilitated through a hire purchase contract. A vehicle hire purchase contract is a lease contract in which an option is given to the lessee to purchase the vehicle by paying all instalments as prescribed in the schedules. The customer is deemed to purchase the vehicle after making all the scheduled payments by the end of the hire purchase period. The lease payments include an element of interest to reflect the fact that deferred payment terms have been agreed.

IFIs need to offer a similar product maintaining similar features. The conventional features of this product are:

(i) the customer leases a vehicle for a rental payment

(ii) the customer is given an option (not an obligation) to purchase the vehicle; if this is exercised it binds the financier

(iii) full payment of the scheduled rentals means the transfer of the title of the vehicle to the customer without a need to enter into a sale contract.

The key feature of this product is that it is a lease contract, but with the rights of the lessee to purchase the leased asset and the obligation of the financier to sell the vehicle if this option is exercised by the lessee. This is basically the purpose of this product, known as hire purchase.

Exercise 8.3Given the features of conventional hire purchase, indicate the features relating to the transfer of ownership, which might potentially be non Shari’ah compliant and explain the concern.

A traditional contract can be transformed into a viable Islamic banking product due to its flexibility and functionality to support the Islamic banking business environment.

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8.5 Choosing the correct Islamic contractAs noted above the first activity is to look for a contract that is likely to achieve the intended purpose. Leasing is the key term in this transaction - the lease of or use of a corporeal property or usufruct. Therefore, a leasing contract, and not a hire contract for a personal service, seems to be relevant. This is the first dimension of the relationship of a classical contract with a modern Islamic financial product, known as hire purchase.

8.5.1 Ijarah or leasing

The Islamic contract of Ijarah to all intents and purposes meets the requirements of leasing as it allows for the transfer of the right to use an asset, but does not transfer the ownership of the leased asset to the user or the lessee. However, another contract is needed to satisfy the purpose and features of a conventional hire purchase, to allow for the subsequent transfer of ownership at the end of the lease period. Another search must be done to select a contract or contracts to complement the Ijarah contract to allow for the effective transfer of the title of the leased asset to the customer/user of the usufruct.

8.5.2 Ijarah muntahia bi tamleek or transferring the title

Under Islamic commercial law there is more than one contract that could legally and effectively transfer the ownership from one party to another, including sales, gifts and waivers. Therefore, a financier under Islamic hire purchase may transfer the title to the customer/user by arranging to sell the leased vehicle or by giving it away on a gift basis at the end of the lease period. The Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) has shown that Ijarah and Ijarah muntahia bi tamleek can effectively transfer the title of the vehicle under Shari’ah Standard No 9.

“In Ijarah muntahia bi tamleek, the method of transferring the title of the leased asset to the lessee must be evidenced in a document, using one of the following methods:

1. by means of a promise to sell for a token or other consideration, or by accelerating the payment of the remaining amount of rental, or by paying the market value of the leased property

2. a promise to give it as a gift (for no consideration)

3. a promise to give it as a gift, contingent upon the payment of the remaining instalments.”

These provisions clearly mention the sale mechanism either by (a) paying a token and a nominal value or (b) by considering the remaining Ijarah rentals as the price for the purchase, or (c) by paying an amount of money, which is equivalent to the market value of the vehicle intended to be purchased by the customer. Alternatively, the transfer can be affected by the financier/owner including a gift contract. This gift contract could be conditional or non-conditional.

Exercise 8.4Based on your understanding of the product of Ijarah muntahia bi tamleek, identify relevant contracts which are used to construct this product.

8.6 Ensuring viability of the chosen Islamic productIn order to transform these two contracts into a viable and compliant product, the transfer of the title must be executed separately from the Ijarah contract. A mere signing of the Ijarah contract will not affect the transfer of title, as it will in the case of conventional hire purchase. Another contract must be executed when the transfer of title is sought. In addition, to make this product viable and similar to a conventional hire purchase agreement, a sale undertaking or Wa’d (unilateral promise by one party to sell) is incorporated. Here the lessor/owner undertakes to sell the leased vehicle to the lessee upon the exercise of an option by the lessee/user. This is to maintain the function of ‘option’ in conventional hire purchase. A sale undertaking by the financier/owner will be an obligation on the financier to sell the leased asset as and when required by the customer/user. In addition, the customer/user will give his Wa’d to purchase back the leased asset at an agreed price if he defaults on the rental payments. This Wa’d is binding upon him.

The illustration of the Islamic financial product known as Ijarah muntahia bi tamleek (lease ending with ownership) or Ijarah Thumma al-Bay’ (lease followed by a sale), or simply translated as Islamic hire and purchase, shows how classical contracts can be linked to modern and sophisticated Islamic financial products. Contracts like lease, sale and promise are simple contracts. However, when



they are combined for a purpose they form a new product that is more relevant to the current environment to facilitate customers in this case to acquire vehicles following Shari’ah principles.

Exercise 8.5An IFI has purchased a vehicle from the supplier at $50,000 at the request of a customer. The vehicle is then leased out to the customer under Ijarah muntahia bi tamleek. The IFI, failed to incorporate a clause on wa’d to commit the lessee to purchase the leased asset should he default on payments. The customer did default and the Ijarah muntahia bi tamleek is terminated. What can the IFI do in this situation?

(a) Continue charging the rental payment

(b) Sell the leased asset to the market and bear all the market risk/loss.

(c) Sell the leased asset to the market and require the customer to make good any shortfall between the cost and market price.

(d) Repossess the leased asset until the customer pays the debt.

Exercise 8.6What are the two methods AAOIFI Shari’ah Standard No 9 on Ijarah and Ijarah muntahia bi tamleek provides for effecting the transfer of ownership of a leased asset?

8.7 ConclusionIn this chapter we explained the process by which IFIs select appropriate contracts to meet the needs of their clients. We also introduced you to the process of transforming particular traditional contracts into financial products. The chapter should have equipped you with the skills to transform a traditional contract into an acceptable Islamic financial product.

In the following chapter we will introduce you to the leading Islamic financial products and services in the banking, Takaful (insurance) and capital market sectors.


1. the basis to all Islamic financial products and services are the traditional contracts that are available in the texts of the literature of Islamic commercial law

2. when a financial product is being developed, emphasis should be given to the selection of proper and relevant contracts, as well as the incorporation of all the leading principles governing that contract

3. while the receiving and the payment of interest are categorically forbidden, IFIs must work on a structure that would benefit the shareholders to the IFIs, effectively mobilise funds in the society and generate profit to IFIs; this could be achieved, for example, through sale or lease, instead of lending money for interest

4. money will earn money or extra income when it is put in real economic activity such as sale transactions and leasing contracts, as well as partnership contracts; having financing using Musharakah can replace the conventional house loan

Islamic finance challenge 8.2From the above it is clear that Wa’d can enhance certain Islamic contracts. An example of this is vehicle financing using the Ijarah principle or contract. What would be the effect on an IFI’s Capital Adequacy Ratio (CAR) if Wa’d could not be incorporated in such financing arrangements?

SolutionWa’d is very important to the financier as it protects him in the case of default. Without Wa’d, the financier incurs market risk when he has to sell the leased asset on the open market to recover the financing amount. From a risk management perspective, without this ’put option’ or Wa’d, the risk weightage of the IFI would be higher, thus affecting their CAR.



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5. the selection of a suitable contract for any proposed financial product must take into consideration the purpose of that product to match the character of the selected contract; the resulting contract may need some enhancement to make it commercially viable; for example, a lease with an option to purchase or a lease with a possible gift by the lessor is a good selection to finance vehicle financing

6. in some cases, a new feature or contract must be incorporated to render the product viable and feasible; an undertaking by the lessor to sell the leased asset to the lessee under Ijarah muntahia bi tamleek is a feature to make this product viable.



Chapter 8 AnswersExercise 8.1Each contract has its own distinctive principles or features. The following examples are not meant to be exhaustive, but are illustrative of these distinctions.

Exercise 8.2(a) The repayment amount of the loan consisting of both principal and interest: £140,000

(b) The selling price consisting of both purchase price and profit margin: £140,000.

Exercise 8.3The key feature of conventional hire purchase is that it assumes that the ownership of the leased asset is transferred to the lessee/customer once the final payment has been made. The conventional hire purchase agreement combines a lease and sale in one contract. Islamic finance requires a distinction between lease and transfer of ownership whereby one contract must precede the other and the method of transfer of the asset must be clearly identified.

Exercise 8.4(a) Ijarah or lease of the asset by the lessor to the lessee.

(b) Wa’d or promise by the lessor to sell or gift the leased asset.

(c) Wa’d or promise by the lessee to purchase (in the case of default or early termination of Ijarah contract) by the lessee.

(d) Actual sale or gift to transfer the ownership of the leased asset to the lessee.

Exercise 8.5(b) Sell the leased asset to the market and bear all the market risk/loss.

Exercise 8.6(a) Sale at either token or market price or at price, which is equivalent to the

outstanding rentals.

(b) Conditional or outright gift of the leased asset by the lessor to the lessee.

Sale Lease Partnership (Musharakah)

Transfer of ownership. Right to use the asset. Combination of two sources of capital .

Sale price must be fixed. Rental can be fixed or floating.

Profit sharing ratio can be negotiated and can be revised.

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Revision Questions

Question 1 Multiple choice1.1 Which of the following is not the correct description of the contract and its inherent principles

or features?

(A) Sale contract is based on certainty of asset and price and will result in the transfer of ownership.

(B) Pledge or Rahn does not transfer the ownership right to the pledgee though the pledgee has a right to ask the court to dispose of the pledge to pay the outstanding payment to the pledgee.

(C) Ijarah contract can be for fixed or floating rental and can transfer the ownership of the leased asset to the lessee.

(D) Musharakah contract starts with a joint capital contribution by two parties on condition that the loss must be borne by both of them proportionately.

1.2 Which of the following statements reflect the requirement for Islamic finance to be engaged in real economic activities as an underlying principle to enjoy profit?

(A) The bank, upon the request of the customer, advances money to the vendor and later charges the customer the principal and profit for the facility.

(B) The bank contributes $100,000 to a customer’s existing business valued at $50,000 to enhance working capital for a profit and loss sharing arrangement between the bank and the customer.

(C) Upon accepting the customer’s deposit, the bank uses the deposit for its investment but promises to pay the depositor his principal and profit.

(D) Being a partner to a customer, the bank provides an additional loan to the customer if the business venture were to exceed the original paid-up capital.

1.3 Which of the following describes the order followed by an Ijarah muntahia bi tamleek financial contract?

(A) Lease of the asset and purchase of the asset by the lessee.

(B) Lease of the asset with a promise by the lessor to sell or gift the asset and the eventual sale or gift to the lessee.

(C) Promise to sell or gift by the lessor, lease of the asset and eventual sale or gift to the lessee.

(D) Promise to purchase by the lessee, lease of the asset and sale or gift to the lessee.

1.4 Which of the following is not a valid lease structure for Ijarah muntahia bi tamleek ending with ownership transfer?

(A) Ownership transfer through a sale at market value.

(B) Ownership transfer through a conditional gift by the lessor.

(C) Ownership transfer through a sale at a token price.

(D) Ownership transfer through the payment of all rental payments.

Question 2What is the role of Wa’d in Ijarah muntahia bi tamleek?

Question 3Having read this chapter, explain what steps need to be taken in order to develop a viable Islamic financial product. Your answer should be logically structured to indicate the sequence of the necessary steps.

Revision questionsTraditional Islamic contracts and Islamic finance

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Answers

Question 1 Multiple choice1.1 (C) Ijarah contract does not transfer the ownership of the leased asset on its own. The transfer

of ownership can only be affected through either sale or gift contract.

1.2 (B) Providing capital to a business venture and risk taking in the outcome of the venture reflects that capital has been converted into real economic activity. The capital has diluted its monetary form to become a real asset, and this reflects a real economic activity. Other activities do not reflect the transformation of money into real assets.

1.3 (B) The proper sequence under Ijarah muntahia bi tamleek is a lease contract that incorporates the promise by the lessor to either sell or gift the leased asset to the lessee based on certain terms and conditions; it eventually results in the transfer of ownership through either sale or gift.

1.4 (D) Under Ijarah muntahia bi tamleek, the asset will be transferred though the payment of a purchase consideration on top of the lease payments or through the act of the lessor gifting the asset to the lessee, upon full payment of all rental obligations.

Question 2The important feature of Wa’d is that it imposes on the lessor the duty to sell the leased asset to the lessee once the lessee exercises his option to purchase. The Wa’d is an undertaking to sell by the lessor, which can be invoked as and when required by the lessee. The customer also gives his Wa’d or undertaking to purchase the leased asset from the lessor in the case of default.

Question 3Essentially, developing a new financial product will start from understanding its ultimate purpose followed by selecting a relevant contract to achieve that purpose and the incorporation of all of its principles and features to suit the product behaviour. Let us assume that the ultimate purpose is to allow the IFI to share in the profit of a business venture as compared to a fixed amount of profit arising from a financing product. This suggests either the Mudarabah or Musharakah contract rather than Murabahah or Salam or Istisna’ or even Ijarah contract. Then, specific features of the intended product need to be examined. For example, if the IFI seeks to have executive powers, Musharakah would be more relevant as compared to Mudarabah. The process of identifying the commercial features of the product will continue until the full version of a new product is completely supported by relevant Shari’ah principles.

Overview of Islamic banking, Takaful and capital market products


understand and explain Islamic banking products

understand and explain Takaful products

understand and explain Islamic capital market products.

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Learning outcomes

Chapter nine




9.0 IntroductionIn this chapter you will be exposed to the leading Islamic financial products and services, not only in the banking industry but also in the Takaful and capital market. You will also be introduced to relevant contracts that form and create these products and, to some extent, to the reason(s) why a particular contract is able to meet a particular financial aim and objective. This chapter, in addition to giving an overview of the products that are currently available in the market, will link these products with the original contracts that dictate their behaviour.

9.1 Directory of Islamic banking products and their underlying contractsIslamic Financial Institutions (IFIs) offer many products and services to meet their clientele’s needs, both in the deposit and financing sides of a bank. These products and services are important to make IFIs competitive with conventional banks in terms of product offering.

In relation to Islamic savings or deposits, there are three main categories of account, namely an Islamic savings account, an Islamic current account and an Islamic investment account. Some Islamic banks may have an account for their depositors called an Islamic fixed income deposit or account. The following section will briefly outline the product features of these various accounts and their underlying contracts. Before we proceed to give a detailed illustration of each and every product, a summary of these deposit products and their underlying contracts, is depicted in the following table.

9.1.1 Savings accounts

Savings accounts aim to facilitate the keeping of depositors’ money in an account that is safe whilst giving the depositors the flexibility to withdraw their money and opportunity to benefit from some income from the savings. The contract that could facilitate this purpose could be Wadiah (safe custody), Qard / Hassan (interest-free loan) and Mudarabah (profit sharing). Although each of these contracts has their distinctive features, they are able to satisfy the above aim and objective in their own way.


Introduction to Islamic banking products.

Stock screening as an aid to investors.

Introduction to Takaful products.

Introduction to Islamic capital market products.

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Product types Underlying contracts

Islamic savings account Wadiah yad dhamanah

Qard / Hassan

Mudarabah

Islamic current account Wadiah yad dhamanah

Qard / Hassan

Hybrid of Wadiah or Qard / Hassan and Mudarabah

Islamic investment account (both restricted and unrestricted)

Mudarabah

Islamic fixed-income deposit Murabahah tawarruq

Table 9.1 Islamic deposit accounts



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9.1.1.1 Qard / Hassan

Qard / Hassan, being an interest-free loan, allows the borrower to borrow the money from the lender without any obligation to pay interest in addition to the loan repayment. The liability of the borrower is just limited to the repayment of the principal amount of loan. The borrower may, however, award some benefit to the lender at his sole discretion (Hiba). Such gifts cannot be contracted in any form to avoid interest in this loan facility. As for an Islamic savings account, which is based on Qard / Hassan, while the depositor is in the position of the lender, the bank is the borrower. The money deposited in this account is deemed the bank’s where the bank has a liability to repay the principal on demand. The bank may give some return to the depositors, which cannot be agreed or promised in advance to avoid the equivalent of an interest payment as this is prohibited.

9.1.1.2 Wadiah

A Wadiah contract, on the other hand, simply means a safe custody contract. A depositor by depositing their money with a bank for safe custody purposes has entered into a Wadiah contract. On the other hand, the bank will give its undertaking to be liable for any loss to the deposited item, namely the money deposited in this account. This has changed the contract of Wadiah from being a mere trusteeship contract to a liability contract on the part of the custodian, that is, the IFI. This shift in the nature of a Wadiah contract from trusteeship to suretyship is necessary to allow IFIs, as custodians, to use the monies for their investment and financing activities.

Muslim scholars view guaranteed safe custody contracts (safe custody plus liability) involving the lending of money as contracts which cannot promise any extra benefit to the depositor. This is because the deposit of money under the safe custody contract could give the custodian the opportunity to use the money to pay interest to encourage more deposit. This resembles money lending for interest under the Qard / Hassan contract, which is prohibited.

9.1.1.3 Mudarabah

A Mudarabah contract has also been used to facilitate this account. Unlike both Qard / Hassan and Wadiah contracts, depositors under the Mudarabah savings accounts will share profit with the bank on an agreed profit-sharing ratio. As there is no lender-borrower relationship in a Mudarabah contract, any promotional gift and extra benefit are permissible when opening this account based on the Mudarabah contract.

9.1.2 Current accounts

The same contracts are used to structure Islamic current accounts. Account holders under both Qard / Hassan and Wadiah contracts are deemed to be lenders to IFIs and the rules and principles regarding money lending would be the same as those that relate to Islamic savings accounts. However, the Mudarabah contract is not used as a primary contract in Islamic current accounts. Currently, Mudarabah is coupled with either a Qard / Hassan or Wadiah contract to make it more feasible. This account is simply a hybrid of both a liability contract, represented by either a Qard / Hassan or Wadiah contract, and an investment contract, represented by a Mudarabah contract. It is a condition of such accounts that they must maintain a minimum balance to enjoy Mudarabah features, otherwise they will be treated under a liability contract with no profit-sharing feature.

9.1.3 Investment accounts

An Islamic investment account is typically based on a Mudarabah contract in which depositors provide the capital and IFIs provide the work and management. The profit, if any, is to be shared between the depositors whereas any loss will mean that the bank loses time, effort and expected profit. A Mudarabah investment account could be a restricted as well as an unrestricted investment account. The detailed features and procedures of these two accounts will be discussed in Study Guide 2 (section 4.5.1).

9.1.4 Fixed income account

An Islamic deposit account can give a fixed income to the depositors. The contract used is Tawarruq, which is simply a sale transaction involving three independent parties or more. For this account, the depositor, for example, will appoint IFIs to purchase a particular asset from a prime broker at ‘x’ amount on cash basis and will subsequently, thereafter, sell the same asset to this bank at ‘x+y’ to be paid, let us say, after one year, which corresponds to the tenure of this deposit account. Under this contract and structure, the depositor is deemed to deposit the ‘x’ amount in the bank but will get ‘x+y’ as the return in the future. This account is discussed in detail in Study Guide 2 (section 4.6).



Exercise 9.11. What are the three main objectives of a savings account?

2. Outline the key differences between the principle of Qard / Hassan and the principle of Wadiah?

3. What is the arrangement between the bank and the depositors in a Mudarabah investment account?

4. How are Islamic fixed income accounts different from conventional fixed deposit accounts?

9.2 Financing products IFIs offer several categories of products and services to their clients who seek financing. These can be classified into equity-based financing and debt-based financing. The main purpose of providing this financing is to facilitate customers to obtain the necessary assistance to either acquire or use a property, or to meet particular expenses in a project. These products and services will be explained briefly with special reference to their underlying contracts. The detailed features of these products will be explained in Study Guide 2 (chapters 5 and 6). The following table summarises some leading financing products and their respective and underlying contracts.

There are four main categories of Islamic savings or deposit accounts, namely Islamic savings account, Islamic current account, Islamic Fixed income account and Islamic investment account.

The common contracts applicable in Islamic savings or deposit accounts are Wadiah, Qard / Hassan, Mudarabah, Tawarruq and any combination of these contracts.

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Key points

Equity-based Debt-based

Product Contract Product Contract

1. Project financing MudarabahMusharakah

1. House financing Murabahah Ijarah muntahia bi tamleek Istisna

2. Trade financing Musharakah (letter of credit)

2. Asset financing Murabahah Ijarah muntahia bi tamleek

3. Venture capital financing

Mudarabah Musharakah

3. Letter of credit Murabahah

4. House financing Musharakah Mutanaqisah

4. Overdraft ‘Inah Tawarruq Sale and lease-back

5. Asset financing Musharakah Mutanaqisah

6. Cash financing ‘Inah Tawarruq

7. Personal financing (education, travel, medical, etc.)

Ijarah ‘Inah Tawarruq

8. Credit/charge card Tawarruq ‘Inah Kafalah

Table 9.2 Financing products



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9.2.1 Equity-based financing vs debt-based financingEquity-based financing is different from debt-based financing. Under equity-based financing the customer owes no financial obligation to the bank as the customer and the bank have agreed to share the profit, if any, and to bear the loss where relevant. The bank has no recourse to the customer in the event of non-payment of expected profit unless a case of negligence and misconduct is found against the customer who is the manager or managing partner in a Mudarabah and Musharakah contract respectively. On the other hand, debt-based financing creates an obligation upon the customer to pay a particular amount of money to the bank in all circumstances whereby the obligation of payment is not linked to any attainment of profit. Upon entering into debt-based financing, a customer is under an obligation to make payment according to agreed terms and schedules.

Exercise 9.2What key feature makes debt-based financing distinct from equity-based financing?

The two main contracts used in equity-based financing are Mudarabah and Musharakah.

9.2.1.1 Equity-based financing - Mudarabah

The first contract is called Mudarabah, where one party provides the finance and the other provides the expertise and management. Profits are shared on a pre-agreed basis, but losses are borne only by the provider of the capital.

It is envisaged that this contract would apply to some products such as project financing and venture capital financing. This contract is ideal for these financing products as the customer, who is normally the project owner or contractor or investee company, would need a capital injection to start the work. In practice, this contract rarely takes place in real banking products. It is, however, not uncommon to capital market products, particularly in the form of Sukuk and asset management.

9.2.1.2 Equity-based financing - Musharakah

The second contract is called Musharakah, loosely translated as a ‘joint venture’ under which both profits and losses are shared by the joint-venture partners, one of which is typically an Islamic bank. Unlike Mudarabah, both partners must contribute the capital to the joint ventures, be it in cash or kind. Profits are distributed in pre-agreed ratios, while losses are allocated in proportion to capital contributions. Unlike Mudarabah the presence of this contract, in the realm of banking products, is

Islamic finance challenge 9.1With reference to table 9.2:

(a) Do you think that Islamic financing products can satisfactorily substitute all conventional financing products, both retail and corporate?

(b) In what areas that you think current Islamic financing products are not able to meet the financial needs of the customers in a manner that is Shari’ah compliant.

Solution (a) The above list of Islamic financing products can offer a good alternative to most

conventional financing products. Conventional banks would normally offer the above facilities but on the basis of an interest-based lending arrangement. You should compare these Islamic financing products with the list of products that are typically available at any commercial bank in your town.

(b) There are areas where Islamic financing is lacking, especially in corporate financing. These include amongst others, factoring facilities whereby in conventional practice, a bank will purchase the receivables from a client on a discounted basis and will claim the full payment from the party who owes the client this amount. In other words, the client would factor or transfer the full risk of collection, including credit losses, to the bank. There is no equivalent Islamic factoring in the global market though there is a Malaysian version of Islamic factoring based on sale of debt which is not acceptable in other jurisdictions.



relatively more significant and it is often applied to trade financing by virtue of letters of credit (LC). Both the bank, (the issuer of the LC) and the customer (importer) will contribute some capital to cover the amount required for the LC. The resulting proceeds from the sale of the imported goods will be shared between the bank and the customer on an agreed profit-sharing basis. Losses, if any, will be borne by both parties proportionately as per their respective capital contribution.

Musharakah is also widely used to finance the acquisition of assets, be it a house or equipment. In this case Musharakah is structured to decline or diminish over time and is known as Musharakah Mutanaqisah, whereby the dominant partner, normally the bank, will allow the other partner, normally the user of the service of the asset, to redeem the bank’s shareholding over time. At some time in the future all ownership in the asset will be vested with the customer.

The following discussion briefly outlines some of the leading financing products offered by IFIs that are essentially based on debt-based contracts.

9.2.1.3 Debt-based financing - Murabahah

The most widely used contract for asset financing is Murabahah, which can be loosely translated as ‘cost plus’. This is a sale under which the seller must disclose to the buyer the cost and mark-up of an asset to be sold to the buyer. This contract avoids interest and promotes interest-free transactions through a sale mechanism. Under this contract the bank, being the financier, will simply purchase an asset from the vendor as required by the customer at ‘x’ price and subsequently sell the same asset to the customer at ‘x+y’. This constitutes the Murabahah selling price that will be settled in the future. This contract is, therefore, suitable for any form of asset financing, be it a house, consumer goods or working capital in terms of raw material, etc.

9.2.1.4 Debt-based financing - Ijarah muntahia bi tamleek

Asset financing with the purpose of transferring ownership of an asset to the customer may be done through Ijarah muntahia bi tamleek or a lease ending with the transfer of ownership. It is a combination of lease and sale. Typically, the bank will lease an asset to the customer for a particular period of time with an undertaking to sell the same asset (leased asset) to the customer at the request of the customer. This has been used widely in house and vehicle financing respectively.

9.2.1.5 Debt-based financing - cash financing

Islamic banks also provide cash financing, as well as personal financing to their customers. Cash financing is structured using the ‘Inah contract in some jurisdictions such as in Malaysia, or Tawarruq in jurisdictions inclusive of Malaysia. As explained, Tawarruq has to have at least a three-party contract to sell and buy an asset to facilitate cash financing. Unlike Tawarruq, ‘Inah is simply a sell-and-buy-back agreement between two parties. The purpose is to obtain some cash for the customer. The customer, under both a Tawarruq and ‘Inah contract, owes the bank the selling price that comprises the principal and profit which is payable in the future.

Personal financing can also be affected through ‘Inah and Tawarruq. Personal financing, to cover the cost of education, travel and medical treatment can also be affected via an Ijarah or lease contract. A service provider would normally lease a specified service to the bank at ‘x’ amount of money for the bank to sub-lease this to a customer who requires this service for ‘x+y’.

Islamic financing products can be classified into equity-based financing and debt-based financing.

Equity-based financing is equitable in character in that both parties are willing to put in the capital and work to share the future profit. They are equally willing to bear the loss arising from the venture.

Debt-based financing creates an obligation upon the customer to pay a particular amount of money to the bank in all circumstances whereby the obligation of payment is not linked to any attainment of profit.

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Exercise 9.3What is the basic difference between Murabahah financing and Tawarruq financing?

9.3 Islamic insurance (Takaful)The previous paragraphs briefly outlined financing products commonly offered by IFIs. The following section will consider contracts used for Takaful products.

Islamic insurance is a way of providing indemnity or compensation to policyholders in accordance with Shari’ah principles. Conventional insurance is a contract in which one, the insurer, agrees to indemnify another, the insured, for a consideration called a premium. In short, it is a contract providing indemnity in exchange for a premium. Conventional insurance is based on a sale contract that is affected between the insurer (the insurance company) and the insured (policyholder).

9.3.1 Prohibition of Gharar in Islamic commercial law

Islamic commercial law, as previously explained under the discussion of Gharar or uncertainty, requires the subject matter and the price to be certain. In the case of conventional insurance the subject matter and premium are not certain as they depend on many events that are beyond the control of the parties. For example, one policyholder may pay the premium throughout the tenure of the policy, while another may only pay a few instalments before dying. While the latter policyholder will receive insurance compensation, the former will not.

Conventional insurance has been viewed as non-compliant because it contains the element of Gharar, that is, uncertainty. Also, insurance policy monies are normally invested in conventional-based instruments such as equities, which are not approved, or financial products, which are interest-based. Islamic insurance or Takaful removes this issue by adopting a contract of donation (Tabarru’) instead of a sale contract. Essentially, each and every policyholder will donate a sum of money, a contribution, to a Takaful fund. This contribution is based on a Tabarru’ contract which does not aim to gain commercially. For this reason, any uncertainty with regard to the amount, time, etc, is tolerated because no party will be disadvantaged.

9.3.2 Tabarru’ contract as the basis of Takaful

A Tabarru’ contract, being a unilateral contract, tolerates any uncertainty in terms of, for example, total payment or entitlement to compensation. Under Islamic commercial law an element of uncertainty can be tolerated in all unilateral or gratuitous contracts, such as wills, rebate, donations waivers and gifts. A unilateral contract is normally meant for gratuitous purposes wherein the consent and consideration from an offeree or recipient are not required to make the contract valid. Following this principle, the certainty of any object to be given away to the recipient is no longer relevant as the recipient has no obligation to pay any counter value. Thus, a donation of any amount of money that is not disclosed to the recipient is still valid simply because it would not trigger an argument of injustice and unfairness due to the absence of a consideration from the recipient. In the context of Takaful, a donation contract or Tabarru’ has been viewed and accepted as the best possible contract to replace the sale contract in conventional insurance.

9.3.3 Takaful as mutual Insurance

Takaful is based on mutual help among the participants. The Takaful operator is not the insurer. There is an insurer-insured relationship in an Islamic insurance contract between participants. A contract of Takaful takes place between the participants themselves. Each and every participant has to donate an amount of money to the Takaful fund, which is managed by a third party referred to as the Takaful operator. The Takaful fund operates on the basis of mutuality and mutual help among the participants to the effect that if one were to suffer an accident, the fund would provide them with an indemnity. This is the meaning and philosophy of the mutuality; that all the participating members are themselves both the insured and the insurers providing no particular advantage to one member over the other.



Notes on the operational and contractual flow

1. Participants transfer an amount of money or pay the premium to the Takaful fund, which is to be divided according to agreed ratio and channelled into the donation and investment fund.

2. Participants appoint a Takaful operator to manage the business activities and the investment of Takaful funds under the Wakalah (agency) contract.

3. The Takaful operator will manage the Takaful fund according to the standard operating procedures of a prudent insurance scheme such as underwriting policies, payment of claims, marketing and subrogation.

4. The Takaful operator manages the Takaful investment fund.

5. The total of the Takaful fund plus investment profit less Takaful costs is deemed a surplus.

Exercise 9.4Which one of the following descriptions is correct in relation to Takaful?

A. Takaful is a mutual insurance scheme between the participants/policy holders and Takaful operator.

B. Takaful business does not contain any element of uncertainly or Gharar.

C. Takaful is a mutual insurance scheme among all participants/policy holders.

D. Takaful is not necessarily based on the Tabarru’ contract.

Figure 9.1 A Takaful scheme

Participants

Surplus

Investment

1

2

3

4

Takaful

operator

Takaful fund

5

Islamic insurance provides indemnity or compensation to policyholders according to Shari’ah principles.

Conventional insurance has been viewed as non compliant because it contains the element of Gharar, that is, uncertainty.

Insurance policy monies are normally invested in conventional-based instruments such as equities, which are not approved, or financial products, which are interest-based and therefore non-Shari’ah compliant.

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Key points



160

9.4 The Islamic capital market Islamic capital markets can be broadly split into two main classifications, namely the equity market and structured products comprising both securitisation and derivative products. The whole idea of a capital market, be it Islamic or conventional, is to facilitate fund raising and mobilisation in a manner that is time-efficient and cost-effective. An Islamic capital market is distinctive because all products used are Shari’ah-compliant. The next section will briefly explain how Shari’ah principles relate to both equity and structured products. A more detailed discussion will be provided in Study Guide Three.

9.4.1 Screening compliant stocks

In the equity market, the most important task is to screen what stock is compliant and what is not. Investment in shares through the contribution of capital is obviously compliant because it is free from Riba as there is no lending and borrowing in the contract. Investors or shareholders will share the profit and loss among themselves proportionately, based on a Musharakah contract which is permissible.

Contemporary Shari’ah scholars, such as the Shari’ah board of the Dow Jones Islamic Index Market (DJIM), have established criteria to screen stock to ensure compliance. The stock screening criteria as per DJIM standard are both qualitative and quantitative.

The qualitative aspect of the screening means a Muslim investor is not allowed to invest in companies that deal primarily with activities deemed non Shari’ah compliant. The list of prohibited activities and industries is listed in the following table:

The quantitative aspect requires that stocks deemed to be compliant are then evaluated according to several financial ratio filters, which look at the leverage and composition of cash and interest-bearing accounts, as well as accounts receivable. A detailed discussion of this screening process will be undertaken in Study Guide Three.

9.4.2 Sukuks

In addition to the equity market, the Islamic capital market also provides products such as Sukuk, which roughly corresponds to conventional bonds and notes, and some derivatives products. Sukuk are securities issued by either the government or corporations to raise funds directly from investors. The issuing of these securities provides liquidity to the financial market as well as allowing corporations to have direct access to funds. Sukuk or Islamic securities are tradable in the secondary market.

To some extent, Sukuk are products that mirror the behaviour of conventional bonds. A conventional bond is a debt security in which the issuer owes the holders a debt. The obligation to repay the principal and interest (the coupon) at a later date is in the form of a security that can be traded freely in the secondary market. As bonds are issued to enable the issuer to finance a long-term investment with external funds, the same is true with Sukuk. The issuance of Sukuk would benefit both the issuer and the investor respectively.

Sukuk are essentially the product of securitisation. Securitisation, or Taskeek in Arabic, refers to the division of tangible assets or rights into units of equal value and the issuance of those units to investors. In simple terms, securitisation describes the process of aggregating assets and packaging them into marketable securities. In the Taskeek model, Sukuks are often issued by a special purpose vehicle established to own the assets.

Interest-based financial institutions Production of non-Halal food and drink

Entertainment Conventional insurance

Weaponry Tobacco-related products

PornographyOther activities which may be deemed non-compliant

Table 9.3 Prohibited activities/industries



A Sukuk is frequently referred to as an Islamic bond, but a more accurate translation of the Arabic word would be an Islamic investment certificate. The distinction being that, at its simplest, a conventional bond is a contractual debt obligation whereby the issuer is contractually obliged to pay to bond holders on a particular date, interest and principal. In comparison, under a Sukuk structure, Sukuk holders each hold an undivided beneficial ownership interest in the underlying assets. Consequently, Sukuk holders are entitled to share in the revenues generated by the Sukuk assets. Sukuks are therefore monetary-denominated participation certificates of equal unit value to be issued to investors.

9.4.3 Sukuk al-Ijarah

There are many structures of Islamic Sukuk in contemporary Islamic fixed-income securities. The details of these structures will be discussed in Study Guide Three. This section will consider a single Sukuk that is based on an Ijarah contract. Sukuk al-Ijarah is based on a sale and lease back concept whereby the issuer, who is in need of financing, will first sell their asset to the investors for the financing amount. This asset is then leased to the issuer for a lease rental - the Islamic financial obligation. The issuer will issue the bonds or Sukuk al-Ijarah to the investors. The Sukuk evidences the undivided proportionate ownership of the investors over the leased asset, giving them the right to the lease rental. Sukuk are tradable on the secondary market because they are backed by real tangible assets and not pure indebtedness in the form of monetary receivables.

The above diagram illustrates the basic structure of asset-based securitisation in the form of Sukuk al-Ijarah. The company is a party who needs capital. To facilitate this, the company or originator will identify an asset that can be sold to the Special Purpose Company (SPC), lets say at $500 million. The SPC, as the purchaser, will issue a Sukuk to purchase the asset and will lease the asset back to the originator. By subscribing to these Sukuks investors are deemed to be the beneficial owners of the asset. The proceeds of the sale amounting to $500 million will be channeled by the SPC to the company/originator for the latter’s use. Subsequently, the SPC will lease the asset to the corporate/originator at $500 [cost of fund x spread] x number of years which will be equivalent to the rental payment. The proceeds of the rental payment will be distributed amongst the Sukuk holders proportionately. The investors receive the full payments of the rental proceeds as there are no costs to be deducted from these proceeds except the insurance and maintenance costs.

Company

Investor

Special purpose

company

SPC leases asset to corporate for 5 years

Figure 9.2 A diagrammatic structure of a basic Sukuk al-Ijarah

12

34

5

6

Payment of ‘x’ amount

to company

SPC issues sukuk to investors (sukuk represents pro-rata ownership in the asset)

Payment of purchase price

Company pays lease rental for 5 years

Islamic capital markets can be categorised into two main classifications; the equity market and structured products.

The objective of a capital market is to facilitate fund raising and mobilisation in a manner that is time-efficient and cost-effective.

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Key points



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(i) what is meant by an Islamic capital market

(ii) the role of Shari’ah scholars, such as the Shari’ah board of DJIM

(iii) how Sukuks have helped in the development of Islamic capital markets.

9.5 ConclusionThis chapter introduced you to the leading financial products and services which are currently offered in the Islamic banking, Takaful and the capital market sectors. Once again you were introduced to the contracts used to generate such financial products. You should now understand how the characteristic traits of each contract can be used to meet the intended financial aim and objective of each financial product. You should now also have an understanding of the link between Islamic financial products and the relevant contracts and how this dictates the way the products behave in the financial markets.

In the following chapter we will explore the reasons why particular contracts might be chosen to fulfil a particular financial need.


1. an Islamic savings account uses the concept of Wadiah (safe custody), Qard / Hassan (interest free loan), Mudarabah (profit sharing) and Tawarruq (sale contract for the purpose of cash facility)

2. Qard / Hassan allows a person to borrow without having to pay interest; the borrower may at his discretion offer a gift to the lender for providing the loan provided but such gifts cannot form part of the original financing agreement.

3. Wadiah is used by banks as a contract to safeguard the depositors’ cash

4. a Mudarabah contract is used as the basis for investment accounts whereby the bank and the customer enter into an agreement to share profits from an investment; any losses however will be borne solely by the customer

5. Tawarruq assists in providing a fixed income account to the customer by entering into a sale transaction involving the customer, the bank and the market

6. under equity-based financing, the customer owes no financial obligation to the bank; the relationship is based on a profit and loss sharing agreement

7. debt-based financing creates an obligation upon the customer to pay a fixed amount of money to the bank arising from either sale or lease contract

8. asset financing is principally effected through Murabahah and Ijarah muntahia bi tamleek (hire purchase)

Islamic finance challenge 9.2Having studied the components of Islamic finance, which are basically comprised of Islamic banking, Islamic insurance and Islamic capital market, do you see any synergy and correlation between these components?

Solution The synergy and correlation between the three components of Islamic finance can be illustrated as follows. A customer may seek Islamic house financing under Murabahah or Ijarah financing. To secure the interest of the bank, the bank may impose on the customer to subscribe to mortgage Takaful. Under this scheme, if the customer were to die during the financing period, then the Takaful fund, which is based on donation, will settle all outstanding financing amount to the bank. On the other hand, a Takaful company will also have to invest the Takaful contribution or premium in approved shares and fixed income instruments. The Islamic capital market will provide products for this purpose. Also, Islamic banks may need to hedge some risks in their operations. Islamic risk management tools or Islamic derivatives provided by Islamic capital market will be useful in this respect.



9. Islamic cash financing is also available in Islamic finance either through the contract of Inah as practiced in Malaysia or Tawarruq as practiced in Malaysia and elsewhere

10. Takaful adopts the principle of Tabarru’ (donation) to implement a concept of mutual help among participants

11. stock screening is key to Islamic equity investors to allow them to select the Shari’ah-permissible companies to invest in

12. Sukuks are monetary denominated participation certificates of equal unit value issued to investors; essentially Sukuk represent an ownership right in the underlying asset, which would generate income to be distributed among the Sukuk holders.

Chapter 9 AnswersExercise 9.11. There are three main objectives of a savings account:

(a) the safekeeping of depositor’s money

(b) to allow depositors the flexibility to withdraw money

(c) to give depositors the opportunity to benefit and receive income from their savings.

2. Qard / Hassan is an interest-free loan given by the lender to the borrower. Wadiah is a safe custody contract between the depositors and the bank, which acts as the custodian. In this way the customer deposits his money in the safe custody of the bank.

3. The following arrangement exists in a Mudarabah investment account.

(a) The depositors provide the capital, while the IFI provides the work and the management.

(b) The profit is shared between the depositors and the IFI, while losses are borne by the depositors only.

4. An Islamic fixed income account is based on a sale transaction instead of a loan contract. The depositor will get a fixed return simply because he purchased an asset at ‘x’ and sells to the bank at ‘x+y’. The ‘y’ portion is his fixed income. Conventional fixed deposits simply guarantee interest paid on the loan.

Exercise 9.2Under debt-based financing, the customer has an obligation to pay the bank irrespective of whether the customer is in a profitable situation or not. Under equity-based financing, there is no such obligation to pay. The bank only has the right to share profits, if any, according to a pre-agreed profit sharing ratio.

Exercise 9.3Murabahah financing facilitates ownership of an asset which is essentially sought by the customer. Tawarruq financing allows the customer to obtain cash instead of an asset. He may however use the proceeds of a Tawarruq contract to purchase an asset.

Exercise 9.4C. Takaful is a mutual insurance scheme among all participants. The Takaful operator is just a

manager. Like conventional insurance business, Takaful business contains many aspects of uncertainly which are peculiar to the insurance industry. However, since the basis of Takaful is a Tabarru’ contract, these uncertainties are acceptable and tolerable.

Exercise 9.5(i) An Islamic capital market is where one can raise and mobilise funds efficiently with regard

to time and cost using financial products that are Shari’ah compliant according to particular Shari’ah principles. An Islamic capital market can be broadly categorised into the Islamic equity market and the market for Islamic structured products.

(ii) Shari’ah scholars have established criteria to screen equities to ensure their compliance. Stock screening is the most important task to ensure stocks are free from Riba and not involved in activities that are non complaint.

(iii) The issuing of Sukuk provides liquidity to the financial market as well as allowing corporates to have direct access to funds. Sukuk are also tradable in the secondary market.

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Revision Questions

Question 1 Multiple choice1.1 Which of the following is the basis of the Qard / Hassan concept?

(A) Discounted loan.

(B) Interest free loan.

(C) Sale contract.

(D) Purchase contract.

1.2 Profit sharing practice under Mudarabah is done through what?

(A) The measurement of contribution .

(B) The measurement of revenue.

(C) A pre-agreed profit sharing ratio.

(D) The measurement of cash level.

1.3 In a Musharakah partnership a loss is borne by whom?

(A) All partners on an equal basis.

(B) The majority partner.

(C) All partners based on their capital contribution.

(D) The manager of the business.

1.4 Tawarruq is a form of which type of financing?

(A) Purchase financing.

(B) Sales financing.

(C) Mark up financing.

(D) Cash financing.

1.5 Which of the following best describes the concept of Tabarru’?

(A) A donation.

(B) Revenue.

(C) A purchase consideration.

(D) Taxation.

Question 2Which of the following activities are permissible for Islamic equity investors to invest in? Tick ( ) the permissible activities and cross ( ) the non permissible activities.

Tobacco manufacturing

Computer manufacturing

Conventional Bank

Film Distributor

Automobile manufacturer

Revision questionsOverview of Islamic banking, Takaful and capital market products

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Answers

Question 1 Multiple choice1.1 (B) Qard / Hassan is the concept of interest free loan, whereby the lender cannot impose on

the borrower to pay more than the sum he has borrowed.

1.2 (C) Under Mudarabah, the profit-sharing practice is done through a pre-agreed profit-sharing ratio between the Mudarib (manager) and the Rab al-mal (investor). This ratio can be negotiated.

1.3 (C) Under Musharakah, loss is shared by all partners based on the amount of capital contributed. The loss is limited to their respective capital contribution.

1.4 (D) Tawarruq is a form of cash financing that involves the process of buying and selling of asset between many parties. The purpose is to facilitate the obtainment of cash for the customer.

1.5 (A) Tabarru’ is the concept of donation. This concept is widely applied Takaful products as uncertainty, which is a peculiar feature of the Takaful business, is acceptable or tolerable in donation based contract.

Question 2

Tobacco manufacturing Tobacco because it is harmful to one’s life.

Computer manufacturing

Conventional Bank A conventional bank typically pays and charges interest which is prohibited.

Film Distributor Relates to entertainment industry which potentially contains prohibited elements or activities.

Automobile manufacturer


Application of Islamic contracts in Islamic finance


explain the reasons why some contracts are preferable over other contracts in Islamic finance

discuss briefly product development in Islamic financing using the traditional contracts.

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Learning outcomes

Chapter ten



10.0 IntroductionThis chapter introduces you to the reasons why a particular contract (or contracts) is chosen to meet a particular financial need. It also explains in practical terms the development of financial products that are comparable with conventional financial products and reinforces the previous discussion on contracts, classifications of contracts and the transformation of contracts into financial products.

10.1 Choosing the correct contract in modern Islamic financeThe previous chapter explained the classification of contracts and their bases. This chapter will compare and contrast the various contracts with a view to determining whether there is any common ground between them. Naturally, such comparisons will also lead to the discovery of some dissimilarity. Knowledge of this is useful in understanding Islamic financial product design as well as in contributing to product development and enhancement.

Although all Islamic contracts are essentially Shari’ah compliant, some of these contracts are less popular than others. There are many reasons why some Islamic contracts are viewed less favourably, including complicated structuring, issues in relation to their compliance with respective legal requirements, tax implications, risk tolerance and marketing.

This section will introduce you to the problems faced by financiers with regard to their selection of particular contracts to meet particular purposes. It will also help you appreciate why different jurisdictions and markets have adopted different contracts and structures to satisfy similar needs. Except for a few controversial contracts from the Shari’ah compliance perspective, the adoption of a variety of contracts for one common banking business may reflect both the impediments facing that product in various market conditions as well as the flexibility that Islamic commercial law has accorded to product development in Islamic finance, for example, there are sometimes several correct solutions to the same problem.

10.2 Wadiah, Qard / Hassan and MudarabahWe saw in the last chapter that it was possible to have a number of contracts that met the requirements of common products. In both savings and current accounts, three contracts are used, namely Wadiah, Qard / Hassan and Mudarabah. The selection of either Wadiah or Qard / Hassan is normally down to personal preference as both assign liability to the banks as the custodian and borrower respectively. What is applicable to one is also applicable to another in terms of features, terms and conditions. Although both contracts are fundamentally different from each other, they will have the same contractual effect when the subject matter is money on deposit. This is because under both contracts money received must be returned to the owner, raising the possibility of Riba. In other non-monetary assets, both contracts are essentially distinct from one another because the possibility of money giving more income to the lender or depositor is removed.


Choosing the correct contract.

Product development in conventional and Islamic finance.

Selecting the correct contract.

Selecting the correct solution.

Combining contracts to achieve synergy and form new hybrid contracts.

Areas of challenge - the Islamic credit card.

Product enhancement.

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10.2.1 The Mudarabah contract

The Mudarabah contract allows savings or deposit account holders the opportunity to benefit from sharing with the bank the profit generated from the bank’s investment using this pool of funds. The selection of the Mudarabah contract implies willingness by the depositors to take on investment risk in order to benefit from profit sharing. These two aspects of risk and profit sharing are absent in both Wadiah and Qard / Hassan-based savings and current accounts.

In addition to the above, under Mudarabah-based savings and current accounts, gifts are permissible and can be given to depositors upon opening a Mudarabah account. This additional feature can also be advertised prior to the opening of an account based on the Mudarabah contract. Such gifts are not possible under Wadiah and Qard / Hassan-based accounts where advertising gifts on opening an account would be tantamount to Riba (usury/interest) as Wadiah (when depositing money) and Qard / Hassan are loan contracts. Therefore, any premium to the lender, in cash or in kind, is not permissible. A gift, particularly one preceded by an advertisement, is deemed as a premium payable to the lender in kind.

10.2.2 Combining Qard / Hassan and Mudarabah

The situation becomes clearer when a combination of Qard / Hassan and Mudarabah contracts are adopted in both savings and current accounts. The features of the product indicate, among others, that if the balance on deposit is maintained at or above a particular amount on a daily basis, it will be treated as a Mudarabah account, otherwise it will be treated as a Qard / Hassan account.

This reflects why preference is given to one contract over the other in deposit-based products. It is because of reasons that ultimately support the preference of one contract, for example Mudarabah, over other contracts. This allows some depositors to share the risk of investment with the bank and entitles them to benefit from any profit generated. This flexibility, particularly in an account combining both Wadiah or Qard / Hassan and Mudarabah contracts, would entitle the depositors to benefit from profit sharing at a particular agreed ratio, provided they maintain the amount of deposit at a particular level. Normally, this feature is used for Islamic current accounts.

Exercise 10.1Why would many depositors generally prefer to open an investment account instead of a savings account based on either Wadiah or loan contract?

10.3 Murabahah sale, Ijarah muntahia bi tamleek and Musharakah MutanaqisahThe same methodology of selection of a particular contract to support the financial needs of a bank is true with regards to Islamic financing products. From the Shari’ah perspective, financing someone to purchase a house could take the form of a Murabahah sale, Ijarah muntahia bi tamleek or Musharakah Mutanaqisah.

10.3.1 Murabahah sales

Under a Murabahah sale, there will be two sales transactions, namely between the financier and the vendor and later between the financier and the customer or homebuyer. These transactions involve two separate contracts. To be registered and legally effective, the relevant documents must

Table 10.1 Islamic deposits

Mudarabah Wadiah or Qard / Hassan

Advertised gift prior and upon opening an account is permissible.

A share of the profit.

The account holder bears the loss of capital.

•

•

•

Advertised gift prior and upon opening an account is not permissible.

No share of the profit (but a Hibah/gift may be granted at bank’s sole discretion).

No bearing of loss by the depositor. On the contrary, the money will be guaranteed or deemed as liability on the bank.

•

•

•



be stamped, resulting in the payment of stamp duty. As there are two contracts, both technically resulting in the payment of stamp duty on each contract, the double payment of stamp duty would make the product uncompetitive, as such extra costs are normally charged to the customer. Therefore, for countries and jurisdictions that adopt a Murabahah facility involving landed property, stamp duty, if any, will be an impeding factor.

This issue has been resolved in Malaysia where stamp duty is now only imposed on the first transaction. This is based on the argument that the bank is buying a property not for itself but to facilitate house financing for a customer. Similarly the UK, where the relevant stamp duty legislation was amended in 2006, ensures that under a Murabahah house-buying facility stamp duty is only charged once. Singapore has adopted a similar position. In addition, Malaysia has amended its real property gains tax to avoid unnecessary taxation on the profit arising from the sale of a property to a customer after purchasing the property from a vendor.

10.3.2 Ijarah muntahia bi tamleek or Musharakah Mutanaqisah sales

In other jurisdictions, such as the UK, USA, and the United Arab Emirates, house financing could take the form of Ijarah muntahia bi tamleek or Musharakah Mutanaqisah. Among other benefits these two financing structures allow the financier to convert the ownership rights over leased assets or properties into securities or Sukuk, which are tradable in the secondary market. Finance houses using either Ijarah muntahia bi tamleek or Musharakah Mutanaqisah allow the financier to sell their assets to a third party, such as a mortgage corporation, which will then issue securities in the capital market. The proceeds from the sale of the securities would be used to purchase these assets from the financiers/owners.

The ability to turn Ijarah muntahia bi tamleek or Musharakah Mutanaqisah into securities is a value-added benefit that can make the financing an off-balance sheet item. Receivables under Murabahah, unlike Ijarah and Musharakah, once securitised, cannot be traded freely at market value as they reflect monetary assets that can only be traded at face value according to the Accounting and Auditing Organisation for Islamic Financial Institutions’ (AAOIFI) Shari’ah standards. The securitisation of assets and receivables will be discussed in Study Guide 3.

Both these structures are essentially based on an Ijarah contract designed to generate income for the financier or, in a joint venture, for the financier and the customer. This would allow the financier to have a floating rental rate to suit market conditions, particularly given the fluctuations of the cost of funds and the issue of a mismatch of assets and liabilities for the bank/financier. If a Murabahah contract were to be adopted, there is no possibility that the margin rate of profit can be revised and adjusted. The bank and the customer would have to be content with a fixed rate sometimes for quite a long financing term. Financing an asset for a fixed rate and for a long time poses many issues that can be avoided through either Ijarah muntahia bi tamleek or Musharakah Mutanaqisah as the contract of Ijarah would allow the rate of rental to be floating and adjusted for particular market conditions. Under Musharakah Mutanaqisah it is also possible for the customer to benefit from their shareholding portion by withdrawing cash from their accumulated shareholding.

Murabahah has a feature that may be preferable to both Ijarah muntahia bi tamleek and Musharakah Mutanaqisah. As the ownership of the asset is passed to the customer once the bank has sold the asset to him on a Murabahah arrangement, the cost of insurance and major maintenance and so on, which are related to ownership expenses, are borne by the customer as the owner. This is not applicable to Ijarah muntahia bi tamleek and Musharakah Mutanaqisah. The ownership of the asset under these two financial arrangements is still vested with the bank. Therefore the bank, from a Shari’ah perspective, is responsible to the cost of ownership expenses such as insurance and major maintenance. Also in the case of total damage to the property or asset, the rental ceases to be operative until the usufruct of the asset is available to the lessee.



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The preference, and thus adoption, of a particular contract as the basis of a particular product in a particular place or market is motivated primarily by the added values that the contract could bring compared with other contracts.

10.4 Product development in Islamic financing using traditional contractsProduct development as well as product enhancement are critical in both Islamic and conventional finance. Product development in the conventional banking system is centred on the loan contract. However, in Islamic finance, product development involves many varieties of contract that make the exercise more complex. While product development in the conventional banking system mainly concerns the features of a particular product, such as the method of payment or manner of interest calculation, product development in Islamic finance involves both the structure of contracts and the features of the product.

10.4.1 Product development - conventional vs Islamic finance

Under conventional finance a term loan for house financing, which is simply a loan in return for capital repayment and interest, will still operate on the basis of a loan for interest. Product development tends to deal with matters of technicalities only without changing the basic contract of lending money for interest. Such technicalities include issues such as the method of calculating interest by either charging the interest on the outstanding balance or otherwise, a rebate for early repayment, whether the interest is based on daily or monthly interest and the ability to reschedule the tenor of repayment.

Product development in Islamic banking is wider in scope. It may offer a new contract entirely to substitute or complement an existing compliant contract. It may also change some of the features of the existing compliant contract. The latter refers to product enhancement instead of product development. An example of this may relate to an Ijarah-based financing product. In the early stages of Islamic finance, all Ijarah-based financing products were based on fixed rental payments. However, recently, some IFIs have started offering the same product but the rental is floating, based on an

Table 10.2 Islamic house financingMurabahah vs. Ijarah muntahia bi tamleek/Musharakah Mutanaqisah

MurabahahIjarah muntahia bi tamleek/ Musharakah Mutanaqisah

Fixed margin of profit.

No securitisation with possible free trading of Sukuk on the secondary market.

Ownership risk on the customer.

•

•

•

Fixed and floating rental rate.

Securitisation with possible free trading of Sukuk on secondary market according to international Shari’ah standards.

Ownership risk on the financier.

•

•

•

From the Shari’ah perspective, financing someone to purchase a house could take the form of a Murabahah sale, Ijarah muntahia bi tamleek or Musharakah Mutanaqisah.

•

Key point

Islamic finance challenge 10.1Why is the securitisation of the assets of an Islamic Financial Institution (IFI) important to the IFI?

Solution Securitisation will enable the IFI to package all its assets, such as ijarah assets, to be sold to the SPV/issuer for a cash payment. The proceeds of the sale of the assets will inject more funds into the IFI. This will allow it to undertake more financing activities. Otherwise, these assets will be reflected in the balance sheet of the IFI throughout the tenor of financing. Securitisation also indirectly reflects the rating of the IFI. This is because the securities to be issued will be rated and this rating will be mainly based on the quality of assets and the reputation of the IFI that manages those assets.



agreed benchmark or formula. This represents a change to the features of the rental payment and both products are compliant. Both of these will be discussed in this section to allow for a better understanding of the flexibility of Islamic finance.

10.4.2 Islamic contracts and product innovation

As previously stated, products are essentially based on contracts. A new contract will theoretically offer a new product with a new set of features, which differ from the features of another contract. Product development is, however, a more challenging task because it requires a thorough and comprehensive knowledge of all available contracts in Islamic commercial law and their salient features. Knowledge of the financial behaviour of a product vis-à-vis an existing legal and taxation framework is essential to the process of product development.

Initially, a good understanding of all available contracts in Islamic commercial law is required before undertaking product development. This is a wide area of knowledge and in most cases advice is normally sought from Shari’ah advisers as they are expected to understand or at least be able to research these contracts. Unfortunately, there is as yet no list that puts all these contracts in one place for easy reference as the coverage of the subject matter and its supporting literature is too wide.

10.4.3 Forward lease or Ijarah Mausufah fi al-dhimmah

A good example of a contract which was once widely rejected but which is now gaining favour is the Ijarah Mausufah fi al-dhimmah or simply forward lease. This contract was not approved by the majority of classical Muslim jurists in the past. It was, however, advocated by a few jurists in the Hanbalis school of law. The basic argument of this contract is simple. If a sale on forward delivery, namely Salam or Istisna’ is permissible, provided the object of the sale is specified to a degree that removes uncertainty (Gharar), the same logic would also apply to an Ijarah contract. This contract of forward lease would allow the lessor of a future asset to collect rental in advance, although the leased asset is yet to be delivered to the lessee. However, if the delivery of the leased asset to the lessee fails for any reason, or the delivery does not conform to agreed specifications, the rental paid must be refunded to the lessee under this forward lease. The forward lease could replace the function of the Istina’ contract in financing a project where the construction or manufacturing of an asset is required.

This contract, although not widely accepted in the past, has been promoted as an innovative product that could facilitate areas such as project financing. The AAOIFI Shari’ah Standard on Ijarah and Ijarah muntahia bi tamleek (No.9) has accepted this contract as a legitimate means of financing.

The adoption of this contract in the AAOIFI Shari’ah Standard, and the implementation of this new contract in the industry, demonstrates the flexibility of Islamic commercial law towards product development. In project financing, an Islamic financier may consider this forward lease contract as a potential product in addition to more established contracts and products such as Istina’ (parallel Istina’), Mudarabah and Musharakah. This ongoing approach to product development simply attempts to utilise already established contracts, particularly those that are not well known but are useful to modern requirements.

Exercise 10.2Project financing can be financed using parallel Istisna’ financing. Which other contract can duplicate this mode of financing?

‘Clause 3/5 of the standard provides: “An Ijarah contract may be executed for assets undertaken by the lessor to be delivered to the lessee according to accurate specifications, even if the asset so described is not owned by the lessor. In this case, an agreement is reached to make the described asset available during the duration of the contract, giving the lessor the opportunity to acquire or to produce it. It is not a requirement of this lease that the rental should be paid in advance as long as the lease is not executed according to the contract of Salam (or Salaf). Should the lessee receive an asset that does not confirm to the agreed description, then he is entitled to reject it and demand an asset that conforms to the description.”



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10.4.4 Tawarruq

Another example of product innovation is the contract of Tawarruq, which is a transaction between three or more parties allowing one of them to obtain cash through a sale mechanism. Tawarruq would facilitate this purpose by having a financier as the purchaser of an asset from a vendor. Upon delivery of this asset to the financier, either actually or constructively, the financier would sell the same asset to the customer who is seeking cash or personal financing at a mark-up price, that is, cost price plus a particular margin of profit, for example, £120,000. The customer is granted a deferment to pay this selling price to the financier, for example, within 12 months. Upon the delivery of asset, the customer may dispose of it in the market at a cash price, for example, at £100,000. By having this facility based on a Tawarruq contract, the customer will have ‘cash financing’ amounting to £100,000 via a sale contract with the financier and later with the market.

The adoption of a Tawarruq contract is an innovative development because it provides cash financing to customers. All other available sale contracts are meant to assist the customers to own a particular asset. Tawarruq, on the other hand, through a sale mechanism, will facilitate cash financing. Tawarruq is currently being used on the London Metal Exchange (LME) to facilitate the transaction of commodities between brokers, banks and customers. The detailed structure and flow of contract involving these parties is explained in Study Guide Two, chapter 5, section 5.8.2.

10.5 Synergy and the combination of productsProduct development can also take place in the form of synergy, the combination of two contracts, which results in the effect the customer is seeking.

10.5.1 Ijarah muntahia bi tamleek

The flexibility of owning a house through a lease contract with an option to purchase is well demonstrated in Ijarah muntahia bi tamleek. This ‘product’ is a hybrid of both a lease contract and a contract that can transfer ownership, such as a sale or gift contract. In order that the customer can exercise this option, a sale undertaking based on Wa’d (unilateral promise) is added so the customer/lessee can request that the financier/lessee sell the leased asset to the customer. The financier is under an obligation to sell as he has given an undertaking to sell as and when requested or exercised by the customer/lessee. This product can apply to many types of assets including houses, vehicles and equipment, provided they relate to a valid lease contract.

10.5.2 Musharakah Mutanaqisah

Musharakah Mutanaqisah is also a hybrid combining the joint venture or Musharakah contract, the lease contract and a sale undertaking by the financier to sell their shareholding in the venture to the customer/lessee through progressive redemption.

Product development in Islamic banking is wider in scope where it may offer a new contract entirely to substitute conventional products. While product development in conventional banking is largely based on adjusting the loan contract or features, product development in Islamic finance may use a new contract altogether, for example Murabahah house financing to Ijarah house financing to Musharakah Mutanaqisah house financing.

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10.6 Product development - finding contracts to match existing product offeringsConventional finance has developed over many centuries. The variety of products on offer is almost limitless. Each of these conventional products has been developed to meet the needs of particular users. In order for Islamic finance to meet the needs of its customers, which in many ways mirror those of the conventional market, a key requirement is to find a contract or group of contracts that mirror the features of an existing conventional product, but in a Shari’ah-compliant way. In attempting to match conventional products the Islamic finance product must be able to achieve the same economic benefits as the conventional product. Adjustments are acceptable, provided they do not change the basic structure of the product and its framework.

10.6.1 Islamic debit and credit cards

The introduction of Islamic debit cards and charge cards was relatively easy as they are not revolving in character. Under both cards, the cardholder, that is the customer, is under an obligation to settle the full payment outstanding as printed on the statement. A debit card, for example, requires the cardholder to have sufficient funds in their banking account. Any purchase made by him or her using this card will be debited from their account almost immediately. If the amount in their account is not sufficient, the usage of the card to effect the payment will not be processed, that is, it will be blocked. A debit card is meant to facilitate the payment without cash. This product is essentially based on Hiwalah (transfer of debt). The cardholder transfers their debt owed to the merchants to the bank, which holds a deposit account of the cardholder’s account.

The merchant, instead of demanding the payment from the cardholder, will debit the amount from the customer’s account at the bank. The debit card typically has the bank’s name printed on the card and will contain detailed account information about the cardholder. Through this mechanism, all the payments are settled and there is no revolving feature.

The same feature of the full settlement of any outstanding amount is also provided by a charge card, for example, an American Express charge card. The charge card allows its holder to pay for the purchase of goods and services whereby the merchant can claim payment from the card issuer, for example, the bank.

From a Shari’ah perspective, this could be structured as a Qard / Hassan or an interest-free loan contract that is provided by the card issuer to the cardholder. This works well because the cardholder under this scheme must pay all amounts outstanding to the card issuer as shown in the statement. Full payment by the cardholder means no revolving feature as the cardholder is not allowed to carry forward their obligation. All payments outstanding under this interest-free loan must be settled in full.

The introduction of Islamic credit cards was more of a challenge, as one of the features of a conventional credit card is the option given to the cardholder to make only minimum payments

Figure 10.1 Hybrid products

Hybrid

products

Ijarah muntahia

bi tamleek

Musharakah Mutanaqisah

Lease

Sale or gift undertaking

Sale or gift

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Joint venture/Musharakah

Lease

Sale undertaking via progressive redemption of the shareholding of the financier

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toward the outstanding balance. The consumer is able to continue to use the credit card as long as they remain within their overall credit limit and make the minimum payments each month. In return for this facility, a financial charge will be levied in the form of interest that reflects a premium imposed on the money advanced.

10.6.2 Replacing the interest charge

As charging of interest is specifically prohibited under Shari’ah law. This is where product development is required to create something as flexible as the conventional credit card that does not require the charging of interest.

Some IFIs have adopted the contract of Tawarruq as the underlying contract for Islamic credit cards. A Tawarruq contract allows the customer to withdraw money from the account through an automated teller machine (ATM) or by using the card to purchase goods and services. In the latter case the merchant debits the payment of goods purchased to the credit card account. Under the contract of Tawarruq, the cardholder is also obliged to pay the selling price at a mark-up price as he is effectively using ‘credit’ from the bank/issuer. Refer to section 10.4.3.

This contract also allows for a revolving feature whereby the customer may use their credit card and pay all or part of their financial obligation (under Tawarruq selling price) until they reach the limit of the selling price arising from the Tawarruq contract entered into by both the card issuer and cardholder prior to the credit card being issued. This structuring process does not change the existing features of a credit card except in two aspects, namely that there is a limit to the use of the card, the amount of selling price arising from the Tawarruq contract and the card’s usage will be blocked for some lines of business, such as gambling and the purchase of non-Halal food and drinks. All of these will be documented in the contract as a matter of limitation of the product as well as for proper disclosure.

The cardholder may also withdraw cash using their card. Essentially, they are withdrawing their money from their own account which is created out of a Tawarruq contract. The card issuer will impose a fixed fee for administering the cash withdrawal. This fee cannot be a percentage linked to the amount of money withdrawn.

10.6.3 Maximum credit allowed

As with conventional credit cards, the issuer of the Islamic credit card will agree to a financial limit for the card. This limit is equivalent to the selling price created under a Tawarruq contract. For example, a customer seeking to have a credit limit of $50,000 will approach the bank for an Islamic credit card facility. In order to facilitate this, the bank will purchase an asset at $50,000 from a prime broker using, normally, a broker at the London Metal Exchange. Thereafter the bank will sell this asset to this customer at $70,000 payable within for example three years. Subsequently the bank will facilitate the customer to sell his asset to another prime broker of metal at $50,000. This $50,000 will be credited to the customer account.

The customer now has $50,000 in his account, but owes the bank $70,000, payable in the future. It is against this background that an Islamic credit card is issued to the customer having a credit limit of $50,000. Any purchase of goods and services by the cardholder will be charged to this account. If the cardholder, for example, has purchased house furniture worth $10,000 using his credit card, he will normally be given a grace period to make the full payment to the card issuer. If the cardholder is able to make the full payment, he will not be asked to pay any profit. The payment of $10,000 will be debited from his account that has $50,000 at any point in time. However, if he is unable to pay all or part of the payment, this credit card account will record a profit payable to card issuer. However, this extra payment will be treated in line with the Tawarruq selling price that is owed to the card issuer, for example $70,000 (principal plus mark-up).

An Islamic credit card allows for a revolving feature whereby the holder may use the credit card and pay all or part of his financial obligation until they reach the limit of the selling price arising from the Tawarruq contract entered into by both the card issuer and cardholder.

10.6.4 Non Shari’ah-compliant purchases

Purchases made under a Tawarruq contract will be blocked for some lines of business, such as gambling and the non-Halal food and drinks. Prohibited purchases will be documented in the contract between the card issuer and holder as a limitation of the product as well as for proper disclosure. However, the terms and conditions of the Islamic credit card cannot control the entire transactions of the cardholders. The credit card company or issuer can only block the use of the card in obvious prohibited



lines of business that are recognised by particular codes in the market. Any transactions that are accidental or mixed will not be taken into consideration. This is obviously one of the challenges facing Islamic credit cards, particularly with regard to their usage.

Exercise 10.3A credit card holder has a credit limit of $20,000. He has used the card to pay for goods purchased totalling $18,000. He subsequently received a statement asking him to pay the $18,000 to the card issuer/bank. He was unable to pay the amount within the allocated time. How will the non-payment be reflected in his statement for the subsequent month?

10.7 Product enhancementProduct enhancement is no less important than product development. Unlike product development, product enhancement aims to improve the features of a contract to make the financial product more attractive, competitive or more secured by offering a third-party guarantee. Many of these issues will be discussed in Study Guide Three.

Product enhancement is also common in conventional banking, although enhancement features are confined to the loan contract only. Whatever enhanced features are introduced to conventional deposits or funding, they are still centred around a loan contract for interest to the lender, for example the depositor. In a conventional deposit account, there could be a deposit account that gives extra benefit in terms of interest if a particular balance is maintained throughout the year. Another may give extra interest if the depositor were to pay regular amounts into the account each month. These are features introduced to make particular deposit accounts attractive. Although these are enhanced features, they are still based on a loan contract that gives interest to the lender (depositor). The extra benefit received is still in the domain of interest out of lending activities.

Islamic finance challenge 10.2As explained above, Islamic credit cards have been structured on the basis of a Tawarruq contract that was entered into prior to issuing the card. The card holder, when using his card to purchase goods and services or to withdraw money from an ATM machine, is actually using his own money or account that was initially created by the Tawarruq contract. Explain whether this is technically a credit card?

Solution The features of this card as explained do not match the technical features of a conventional credit card. To some extent, the features of an Islamic credit card resemble the features of debit card more than a credit card. This is simply because the credit facility is backed by an account which is created prior to the issuance of the credit card.

Product development can also take place in the form of a synergy involving the combination of two or more contracts.

In attempting to match conventional products, Islamic finance products must be able to achieve the same economic benefits as that of conventional product.

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Product development in conventional finance centres on the enhancement of some features pertaining to interest payable to depositors. Products are still fundamentally based on lending for interest.

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10.7.1 The contract of Murabahah

As with conventional finance, there are many examples of product enhancement in the Islamic finance industry. The impetus to enhance is to add value to a product, either for the benefit of the financier, the customer or both. As previously explained a hybrid account of both Wadiah or Qard / Hassan and Mudarabah is a good example of an enhanced Islamic current account. Another example is the financial Murabahah vis-à-vis traditional Murabahah.

The traditional contract of Murabahah presupposes that the seller already owns an asset before he can sell it to a customer at a mark-up price. This contract has been adopted by some IFIs, such as the Kuwait Finance House.

Traditional Murabahah requires the seller to own the asset first prior to the subsequent sale to the customer under Murabahah. That is to say that the seller (the bank) shall have already purchased and owned the assets before it can enter into Murabahah financing. This practice would pose the problem of, for example, storage and risk of non-saleability. However, other IFIs have enhanced the original contract of Murabahah by adopting a financial Murabahah known as al-Murabahah li al-amir bi al-shira (Murabahah to the purchase orderer).

Under the Murabahah to the purchase orderer arrangement the bank will only purchase goods from the supplier upon the request of the customer. The customer is also required to give an undertaking or promise to purchase the said goods from the bank under the Murabahah contract once the bank has purchased the same from the supplier. Following this approach, which is a kind of product enhancement, the bank faces no problem with regard to storage as the bank will only purchase the assets as and when approached and requested by a customer.

10.7.2 Other enhancement features

Product enhancement features can also come in the form of payment and other incentives given to the customer. For example, payments could be arranged in such a way that the customer pays a smaller instalment in the first few years of financing, but the amount gradually increases in subsequent years. This facility would be an attempt to match the customer’s potential earnings as they may have earned less early in their careers, but are expected to earn more in subsequent years.

Islamic principles of Murabahah do not require regular or fixed instalments to be paid by a customer/buyer. Technically, any kind of arrangement towards the manner and amount of payment is permissible provided that the selling price of Murabahah (cost plus mark-up) has been agreed at the time of the Murabahah contract. Any variation of payment is permissible so long as this agreed selling price is not changed.

10.7.3 Interrelated accounts

Incentives or bonuses are always appealing to both Islamic and conventional customers. As mentioned above, the Islamic credit card allows the customer/card holder to withdraw cash. Normally the customer would need to have corresponding funds kept in an escrow account that could be either a current or investment account. To make the product more competitive and attractive, these funds could be deposited in the Islamic investment account under the principle of Mudarabah. The money in this account could be invested and the profit could be distributed on a daily basis. The profit generated can also be used to offset against the outstanding payment as the result of using the Islamic credit card to purchase goods or services.

In conclusion, although traditional contracts look simple and unsophisticated, they can be transformed into products that can meet modern financial requirements yet remain compliant to Shari’ah principles. This flexibility is useful in both product development and product enhancement.

Exercise 10.4The flexibility of products and incentives are as important to Islamic finance as they are to conventional finance. How could flexibility be added to Murabahah financing?

Product enhancement aims to improve particular features of an existing compliant product in an attempt to make the financial product more attractive, competitive or more secure.

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Key point



10.8 ConclusionIn this chapter we explained the reasons why a particular contract is chosen to meet a particular financial need. We then outlined in practical terms the product development of Islamic financial products in comparison to conventional financial products. This chapter should have reinforced the previous discussion on contracts, classifications of contracts and transformation of contracts into financial products. It should also have highlighted to you the fact that the interrelationship of the various contracts enables a great degree of product enhancement within Islamic financial products.

In the following chapter we will explain the objective of Shari’ah standards and the attempts that have been made by Shari’ah Scholars to ensure harmonisation of standards across the industry.


1. as contracts are central to product development the application of the right contract or their combination is very important in supporting Islamic finance

2. there are sometimes several contract solutions to one financial need and preference of one contract over another may be due to some features that are not available in other contracts; while Murabahah is superior to Ijarah muntahia bi tamleek and Musharakah Mutanaqisah in house financing in some features, both Ijarah muntahia bi tamleek and Musharakah Mutanaqisah are superior to Murabahah in different features of a product offering.

3. product development in conventional finance centres on the enhancement of some features pertaining to interest payable to depositors; products are still fundamentally based on lending for interest

4. product development in Islamic finance may take different forms of contract, from sale, to lease, to partnership in order to facilitate perhaps one common financial need

5. in the spirit of product development, a contract that may have been advocated by a minority of scholars could be promoted as an innovative product to meet contemporary financial challenges, for example, a forward-lease contract

6. the offering of a Tawarruq contract in selling and buying a commodity in the London Metal Exchange to facilitate cash financing represents the application of a traditional contract in a sophisticated manner

7. a combination of contracts could be synergised to form a new hybrid contract to address the specific needs of a product, such as Ijarah muntahia bi tamleek and Musharakah Mutanaqisah

8. in some areas, product development becomes more challenging. One example is the Islamic credit card, which typically offers a credit facility through a revolving feature; Islamic credit cards based on Tawarruq, among others, can solve most of the issues with regard to Shari’ah compliance

9. product enhancement is equally important to make the product more appealing, competitive and prudent; the adoption of financial Murabahah by most IFIs instead of traditional Murabahah reflects the legitimate need to enhance some features in the contract to suit modern financial requirements.



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Chapter 10 AnswersExercise 10.1Where the customer is willing to take the risk of loss of capital in an anticipation of a higher rate of return, an investment account is preferable compared to the historical rate of return he would earn under the discretionary gift available with either a Wadiah or loan contract savings account.

Exercise 10.2A forward lease contract could duplicate the function of Istisna’ in many respects. In the case of parallel Istisna’, the IFI as the financier, will provide the cost of construction to the ultimate contractor by progress payments whereby the ultimate purchaser/customer will pay the purchase price of the completed asset to the financier over a longer period in line with their financing requirements. In a forward lease arrangement, there are only two parties involved in this arrangement. The IFI, being the financier, will advance the rental payment to the client to finance the cost of construction. The proceeds of this advance rental payment will be used to cover the cost of the construction. Hence, financing the cost of construction of an asset to be delivered in the future, can be achieved through parallel Istisna’ as well as forward lease.

Exercise 10.3If he fails to make the payment as requested, the next statement will show an amount charged on the outstanding balance equivalent to a profit margin at a rate as agreed in the initial Tawarruq contract. This amount is, however, not interest but profit payable to the bank as originally agreed under a Tawarruq contract.

Exercise 10.4Although Murabahah financing refers to fixed sale financing, the quantum to be paid periodically can be made flexible or ‘floating’ to suit the financial position of the customer, provided it does not alter the agreed selling price, which is agreed at the time of contracts. Under this arrangement, the customer may choose to make lower monthly payments in the first few years and later pay higher amounts to suit their financial capabilities.

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Revision Questions

Question 1 Multiple choice1.1 Why is a hybrid Islamic current account based on Wadiah or Qard / Hassan and Mudarabah

contracts deemed to be more appealing to depositors?

(A) There is risk taking involved.

(B) The profit share is fixed.

(C) It offers the possibility of sharing in the profit.

(D) One’s capital is guaranteed.

1.2 Which of the following is not a correct description of Murabahah house financing?

(A) The profit rate can be floating.

(B) The tenor of payment is normally long.

(C) The cost of insurance is vested with the house owner.

(D) The instalment payment is still due to the bank even after the house is destroyed.

1.3 What is the aim of product development in Islamic finance?

(A) To produce new products that are compliant to Shari’ah principles.

(B) To review existing conventional products to eliminate prohibited elements and features.

(C) To produce new products that are not only Shari’ah-compliant but also compete favourably with conventional products.

(D) To enhance the key features of existing Shari’ah-compliant products.

1.4 An Islamic credit card could be structured on the basis of Tawarruq. How is an enhancement relevant to this product different from a conventional credit card?

(A) The card can be used to pay the purchase price as well as to withdraw cash advances.

(B) A rebate on the payment outstanding can be given using the profit generated from a Mudarabah deposit.

(C) In the case of loss and damage, the card can be replaced.

(D) The card can be used only to purchase Halal goods and services.

1.5 If a traditional Murabahah were to be adopted by IFIs, what would be the consequence?

(A) The promise by the customer to purchase would be binding.

(B) IFIs would be able to provide all assets required by the customer more effectively.

(C) The IFIs would face increased storage problems.

(D) The guarantee on the safety of the asset would be vested with the customer.

Question 2Are the following statements true or false?

1. Murabahah house financing is based on a fixed profit margin.

2. Securitisation, with possible free trading of Sukuk on the secondary market is acceptable for Murabahah house financing.

3. Ownership risk is bourne by the financier in the case of Musharakah Mutanaqisah house financing.

4. Ijarah Muntahia Bittamleek house financing can be based on either a fixed or floating rental rate.

5. A hybrid of Islamic contracts cannot be used for Islamic house financing.

Revision questionsApplication of Islamic contracts in Islamic finance

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Answers

Question 1 Multiple choice1.1 (C) The hybrid contract with Mudarabah allows the depositor to take on some risk and be

rewarded through the sharing of profit.

1.2 (A) Under Murabahah, the mark up portion of the sale price must be fixed as per the requirement of the sale contract. Any floating rate of profit in a sale contract will render the contract uncertain, thus invalid.

1.3 (C) The product development process in Islamic finance aims to produce Shari’ah compliant products that will offer an effective alternative to conventional products.

1.4 (B) Card holders will be able to reduce the outstanding payment from the usage of the card by offsetting it against the profit that is generated from the account of Tawarruq, which is placed in the Mudarabah investment account.

1.5 (C) Traditional Murabahah requires that the seller owns the asset before receiving the request for Murabahah financing from the buyer. This would lead to, amongst other things, storage problems. In the case of IFIs that provide financing for the purchase of cars, they would have to own warehouses to keep the cars before they could enter into a Murabahah with the buyer. This situation would present a storage issue for them. Also, cars purchased and stored may not be sold as the appetite of customers changes. Some models may be less preferred, thus, the risk of non-salability.

Question 21. True.

2. False. Securitisation based on Murabahah is not acceptable for free trading in the secondary

market as the Murabahah sale price manifest receivables only that are deemed as financial or monetary assets. These can only be sold at par value.

3. True.

4. True.

5. False. Islamic house financing may be structured on Ijarah muntahia bi tamleek or Musharakah

Mutanaqisah, which comprises of more than one contract to facilitate these products.


Implementation of Shari’ah standards, policies and rulings in Islamic finance


describe the objectives of Shari’ah standards

explain how to deal with different rulings arising from different interpretations of the sources and techniques of law

identify solutions to enhance Shari’ah compliance.

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Learning outcomes

Chapter eleven



11.0 IntroductionThe previous chapters have highlighted that there could be many Shari’ah interpretations on a particular case. Although this reflects the dynamism of Islamic law, it could affect the financial market. In this final chapter you will be introduced to the objective of Shari’ah standards, the attempts being made by Shari’ah scholars to ensure harmonisation of standards across the industry and some of the solutions proposed. You will discover whether Islamic finance has achieved a kind of harmonisation if not standardisation. Finally, you will be introduced to a variety of proposed solutions aimed at achieving this objective.

11.1 Objective of Shari’ah standards You may wonder what a standard is. You may also question why we need a standard, especially a Shari’ah standard, in contemporary Islamic finance. Briefly, a standard is something by which other similar things are measured. A standard is needed to ensure that practices are consistent and applicable to all cases or persons, or circumstances, irrespective of different backgrounds.

Exercise 11.1Can you think of a standard that is related to the working environment?

As with any other standards, Shari’ah standards aim to achieve a common platform or base that is applicable to the same industry or market and against which others can measure their performance. These standards seek to achieve harmonisation and convergence in the concepts and applications emerging from the various Shari’ah supervisory boards of IFIs. Such standards help avoid contradictions or inconsistencies between the Fatwas and applications by these institutions. The development of Shari’ah standards also provides a base against which the performance of Shari’ah compliance can be measured or benchmarked, which is meant for global application. Deviations from the standard should be exceptions to the rule and should be justified by those creating them. Where exceptions continue or are used by Islamic institutions they will become standards in themselves as they start to gain wider acceptance.


Introduction to Shari’ah standards.

The development of a Shari’ah standard to achieve harmonisation.

The International Islamic Academy of Fiqh and Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI).

Achieving common standards.

Solutions to enhance Shari’ah compliance.

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Shari’ah standards aim to achieve a common platform or base that is applicable to the same industry or market and forms a benchmark which is measurable and comparable across jurisdictions in terms of compliance.

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11.2 Established Shari’ah standards and standard setters11.2.1 International Islamic Academy of Fiqh

Since its establishment in Jeddah, the International Islamic Academy of Fiqh is regarded as the highest reference with regard to any decisions and resolutions on any issue on Islamic law.

This academy is part of the Organisation of Islamic Conference (OIC), which is the umbrella organisation for all Islamic countries. The Academy is represented by scholars who are appointed by their respective countries. They are assisted by a group of Shari’ah experts who prepare research papers and studies to be deliberated on by the Academy. Resolutions endorsed by the Academy are accorded great respect and would be adhered to by member countries. Essentially, these resolutions represent a kind of consensus among contemporary Muslims scholars on any point of law that has been deliberated by the Academy.

The Academy is not dedicated to serve the Islamic finance industry per se. Its charter is wider and covers other issues as well. The Academy has examined issues such as Zakat, donation and Waqf, medical issues that have a Shari’ah bearing, such as organ transplantation. Members of the Academy are also not necessarily experts on Islamic commercial law. These two factors made the Academy unsuitable to address issues relating to Islamic finance Shari’ah standards on a regular and organised basis. Hence, a need was felt to establish another body to undertake this task more effectively.

11.2.2 The Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI)

The AAOIFI was established in 1991. Its main tasks are to develop the accounting, auditing and governance standards relating to the activities of Islamic financial institutions. Essentially, its aim is to develop standards in Islamic accounting and auditing with Shari’ah issues being central to the issue. With Islamic financial institutions applying various concepts and practices, even on the same contract, the Shari’ah board of the AAOIFI was set up to harmonise the Shari’ah Fatwas to facilitate such application.

The Shari’ah board of the AAOIFI is composed of not more than 15 members appointed by the board of trustees for a four-year term. Members are drawn from among Fiqh scholars who represent Shari’ah supervisory boards in IFIs that are members of AAOIFI and the Shari’ah supervisory boards in central banks. The powers of the Shari’ah board of AAOIFI include, among others, the following:

(a) achieving harmonisation and convergence in the concepts and application among the Shari’ah supervisory boards of IFIs to avoid inconsistency between their Fatwas and applications; this provides a pro-active role for the Shari’ah supervisory boards of IFIs and central banks.

(b) helping in the development of Shar’iah approved instruments, thereby enabling IFIs to cope with developments taking place in the fields of finance, investment and other banking services

(c) examining any inquiries referred to the Shar’iah board from IFIs or from their Shari’ah supervisory boards, either to give divergent points of view or to act as an arbitrator

(d) reviewing the standards that the AAOIFI issues in accounting and auditing and its code of ethics and related statements throughout the various stages of the due process; this is to ensure that these issues are in compliance with the rules and principles of Islamic Shari’ah.

Exercise 11.2 Explain how AAOIFI Shari’ah standards relate to the decisions of the International Islamic Academy of Fiqh of OIC?

Zakat is a form of religious levy on the wealth of Muslims. It is based on wealth that exceeds the specified quantum for a defined period (where relevant) and is meant for the poor and needy as well as other specified beneficiaries mentioned in the Quran. It is the third pillar of Islam and is made obligatory for Muslims who have the financial means to discharge such obligations.



11.3 Achieving a common standardA key objective of the Islamic finance industry concerns the need to achieve common standards in all the concepts and applications of IFIs. Islamic financial products are based on particular contracts that may have contradicting salient features and terms according to various schools of law. This need for standardisation also relates to the implementation of the various products across the industry. IFIs may have different practices that are not common to each other. Shari’ah standards aim to set parameters to eliminate wide discrepancy of practice in the industry.

11.3.1 Setting standards

The creation of a standard starts with identifying a particular contract that is used in the industry. A group of researchers, including both Shari’ah advisers and academics, are appointed to undertake a thorough research, combining both the concepts and actual implementation of this contract across countries and institutions. Their findings will be discussed in a working group appointed by the Shari’ah board of the AAOIFI. Comments and views are then incorporated into the research and an exposure draft prepared. Both the research work and the draft will be further discussed by the Shari’ah board of the AAOIFI. The final version of the exposure draft will be endorsed by the Shari’ah board and discussed in a public hearing. Comments and views are documented and if they are of significant merit will be tabled again before the Shari’ah board. Otherwise, a standard can be issued for reference by the industry.

11.3.2 Binding effect of standards

Some jurisdictions have made Shari’ah standards, issued by the AAOIFI, binding on all IFIs operating under their regulatory framework. These include, among others, Bahrain, Sudan and the Dubai Financial Services Authority (DFSA). In these countries, a kind of standardisation of Shari’ah opinions and Fatwas is likely. Other countries, such as Kuwait, Malaysia, Indonesia, Saudi Arabia and Qatar, although they regard AAOIFI Shari’ah standards as of a high quality that warrant adherence, have not established legal or statutory provision to ensure compliance.

These standards have become very persuasive, if not binding, benchmarks for other IFIs outside the above mentioned jurisdictions. Both the resolutions of the Islamic Academy of Fiqh and AAOIFI Shari’ah standards are, relatively speaking, conclusive and persuasive documents that all IFIs are recommended to adopt and follow.

The fact that Islamic financial products are based on contracts that may have contradicting salient features and terms according to various schools of law means that there is a need for standardisation.

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11.4 Measuring complianceAnother objective of having these Shari’ah standards is to be able to measure the degree of compliance by IFIs across the globe. A benchmarking exercise is not possible without having a common standard that is prescribed by all the parties. This is very clear in Islamic accounting standards vis-à-vis, say, the financial performance of a bank.

By 2007 there have been 21 Shari’ah standards issued, which cover both banking and capital market products and services. These 21 standards are as follows:

These Shari’ah standards guide IFIs in their products offerings and, at the same time, are useful in achieving a certain degree of harmonisation in the future. Benchmarking exercises will only be relevant if an increasing number of IFIs adopt these Shari’ah standards as a matter of policy. Such benchmarking could lead to the proper rating of IFIs.

Figure 11.1 AAOIFI Shari’ah Standards

6. Conversion of conventional bank to an Islamic bank

5. Guarantees

4. Settlement of debt by set-off

3. Default in payment by a debtor

2. Debit card, charge card and credit card

1. Trading in currencies

7. Hawala (transfer of debt)

8. Murabaha to purchase orderer

9. Ijarah and Ijarah muntahia bi tamleek

10. Salam and Parallel Salam

11. Istisna’ and Parallel Istisna’

12. Shirkah (Musharakah) and modern corporations

13. Mudarabah

14. Documentary credit

15. Ju`ala (commission)

16. Commercial papers

17. Investment Sukuk

18. Possession (Qabd)

19. Qard / Hassan (loan)

20. Sale of commodities in organised markets

21. Financial paper (shares and bonds)

AAOIFI Shari’ah standards



Islamic finance challenge 11.1AAOIFI is a standard setting body whose task is to ensure the development of global standards for global application. In your opinion, what would be the implication(s) if there were no bodies like AAOIFI in Islamic finance industry?

SolutionThe absence of standard-setting bodies such as AAOIFI would mean that standards would be more difficult to set. This might lead to differences of opinion even in the same region as the Ijtihad decisions of individual scholars might lead to a variety of fatwas being formulated. Also, the task of measuring the performance of IFIs would not be possible as IFIs would be working on different premises and bases. It is equally interesting to note that finance is a regulated market and therefore, a standard must be established to ensure proper regulation of the industry. That includes accounting treatment, risk management and in the context of Islamic finance, Shari’ah compliance. To a large extent, the establishment of standards through AAOIFI has made Islamic finance practice more appealing to the global market because it has promoted the practice to the level of a standard.

An objective of having Shari’ah standards is to be able to measure the degree of compliance by IFIs across the globe.

•

Key point

11.5 Dealing with different rulings arising from different interpretations of the sources and techniques of lawThe previous section and much of chapter three highlighted that Islamic law, although based on revelation, has to resort to deliberation or Ijtihad to address issues that are not provided for in the texts or in cases where the texts are given, but are speculative and probable in character. This has been a common phenomenon throughout the history of Islamic law. Differences of opinion among scholars enrich the flexibility and dynamism of Islamic law and are well documented in the body of Islamic law books and literature.

The same phenomenon is not uncommon to the Islamic finance industry as Islamic finance is part of the wider coverage of Fiqh al-Muamalah or Islamic commercial law. The classical differences on a particular contract, for example, will always be relevant in the modern context.

11.5.1 The contract of Istisna’

An example of a contract that has divided scholars in the past on its object or deliverables is the contract of Istisna’, which is a construction or manufacturing. Debate ranges around whether it is possible to conclude an Istisna’ contract on an existing asset, or whether it should be made on a future asset yet to be constructed or manufactured? Some scholars particularly the Shafi’is have viewed an Istisna’ contract on existing assets as permissible, but the majority of scholars consisting of the Malikis, the Hanafis and Hanbalis have not. The argument of the majority of scholars is that the Istisna’ contract, logically has to construct new assets, which are not yet in existence. If the asset to be sold under the Istisna’ contract is something that is already available, the meaning of Istisna’, which is an order sale is lost. Contracts such as Murabahah would be more relevant in such a circumstance.

The AAOIFI Shari’ah board has pronounced that an Istisna’ contract is permitted only for raw materials that can be transformed from the natural state by a manufacturing or construction process involving labour. Therefore, it is not permissible that the subject matter of an Istisna’ contract is an existing asset. This is an illustration of how AAOIFI Shari’ah standards attempt to deal with such differences of opinion. Shari’ah standards do not accept the practice of Istisna’ on an asset that is already in existence as this contradicts the very logic of an Istisna’ contract. In this context, AAOIFI Shari’ah standards has preferred one view over the other when they conflict, which is quite a logical approach. Having said this, some IFIs may decide to use an Istisna’ product on an asset that already exists and they may quote the view of the Shafi’is to support their action. This could possibly happen because the meaning of Shari’ah compliance is quite wide.



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11.6 AAOIFI Shari’ah standards - methodologyAAOIFI has adopted a general methodology to accommodate as many juristic perspectives as possible as long as the subsequent Shari’ah standard is supported by some authority and is expected to benefit the industry significantly. However, where a minority view is supported by a juristic opinion, as well as by a valid analogy to another case, and this view is likely to benefit the industry at large, the AAOIFI Shari’ah board is likely to adopt the view of the minority.

This was the case with regard to forward lease or Ijarah al-Mausufah fi al-dhimmah. Juristically speaking, the forward lease was advocated by few scholars, but it had some appeal to an analogy on forward sale, that is, the sale of something that is not yet available, which is permissible in Islamic commercial law. It also has legitimate benefits. Based on these arguments, among others, the AAOIFI Shari’ah board has endorsed the contract of forward lease in Standard No (9) that provides that ‘an Ijarah contract may be executed for an asset undertaken by the lessor to be delivered to the lessee according to accurate specifications, even if the asset so described is not owned by the lessor’.

Other international agencies may have adopted the same approach as the AAOIFI when dealing with issues of cross-border transactions. As with international standards, some of the principles have to be reviewed and amended as circumstances change. The review and amendment does not, however, reduce the integrity of previous principles or standards, as the case may be. From an Islamic legal perspective, a new principle or standard is only valid and effective from the date of pronouncement and this new Fatwa has no retrospective effect on the previous Fatwa, rule, principle or the like. This maxim is important to maintain the stability of the law and, at the same time, allow room for improvement and enhancement.

11.7 Standards and ‘best fit’The Shari’ah standard of any contract or product does not claim to be comprehensive and all-embracing. The Shari’ah standard is the best effort to standardise the concept and application of a particular contract. A new practice that the market may have produced has, however, two possible scenarios with regard to AAOIFI Shari’ah standards.

11.7.1 Example 1 - settlement of debts by set-off

In the first scenario, a new product could be in line with the existing standard, according to its spirit. Therefore, an accurate understanding of the standard is equally important to ensure it does not restrict something that is basically a logical extension or application of the relevant standard. In the Shari’ah standard of the settlement of debts by set-off (Muqasah), the definition of set-off is centred on the discharge of a debt receivable against a debt payable. The basic requirement for a set off to take place is the meeting of two debts that could cancel each other. In the market, the practice of set off is normally tied together with the right of consolidation of all relevant accounts that one has in the bank.

The consolidation clause normally gives a financier the right to consolidate all the accounts of the customer who owes a financial obligation to the financier under some Islamic financing scheme such as a Murabahah sale or rental under an Ijarah contract. The purpose is to set off the debt owed by the customer against all their accounts held by the bank. Therefore, the bank/financier cum creditor can set off what the customer owes the bank from all the customer’s accounts that they have with the bank.

Islamic finance challenge 11.2Islamic finance is new and still developing and may need some time to achieve maturity. Given this hypothesis, are Shari’ah standards needed to govern this immature industry or might such standards impede its development?

SolutionThere are arguments for and against Shari’ah standardisation. On the plus side, standards are needed to govern the industry so as to avoid the issue of ad hoc issuance and treatment of Shari’ah Fatwas. On the other hand, the establishment of standards at this stage may impede the desired growth of the industry. To address both views, standards must be flexible enough to accommodate change but at the same time capable of driving the agenda of standardisation and harmonisation.



Usually, ‘set off’ in the banking industry takes place between a debt and a right instead of another debt as the result of a prior agreement by the parties. Set off is the discharge of two debts or two financial obligations without any need to settle by way of actual payment. However, the practice has been extended to allow the setmoff between a debt owed by the customer and a right that the customer has in the bank. This takes place when a set off is agreed between a financial obligation arising from a Murabahah sale or lease rental, for example, a rental to be set-off against an investment account that the customer has in the bank. The set off takes place despite the fact that the investment account based on Mudarabah is not a debt or liability of the bank and therefore would not normally be set off against any debt that the investment account holder owes to the bank under either Murabahah or Ijarah financing. This is not contradictory to the standard as it requires the set-off of two debt obligations. This approach is permissible based on the fact that the customer can settle the payment outstanding by debiting the investment account, although the latter is not a debt or a liability on the bank.

11.7.2 Example 2 - Shari’ah Fatwas that contradict a standard

The second scenario relates to a practice or a term that obviously contradicts the provision of a particular section of the relevant Shari’ah standard. This new practice or term, although not in tandem with AAOIFI Shari’ah standards, has obtained a Shari’ah Fatwa or endorsement on its permissibility by a Shari’ah board.

An specific example may help clarify the position. Shari’ah Standard (No 21) on Financial Papers (Shares and Bonds) has the following provision on future contracts involving shares: ‘The contract of Salam is not permitted in shares.’ By virtue of this clear-cut provision, it is not permissible for a bank or fund to buy or sell forward or future on shares. The basis for the impermissibility of Salam in shares is that the subject matter of Salam should be a debt and not an ascertained thing, for example, shares of corporations. In addition, the constant availability of specified shares in the market, such as British Telecom shares, and the ability of the seller to deliver them at the end of the period is something that cannot be guaranteed.

However, some Islamic institutions, particularly Islamic funds, have used the contract of Salam on shares to replicate the functions of a short-sale in the conventional market. By deploying Salam, either the buyer or seller of Salam has to take the market risk. A seller of Salam, for example, could sell a basket of shares to a buyer on a Salam contract for a price. The expectation of the seller would normally be that the price of the same shares at the time of delivery would be lower than the contracted Salam price. Above all, the seller has received a full advance payment from the Salam buyer and the proceeds could generate an income during the tenure of the Salam period up to the delivery date. The buyer would normally expect to benefit from a capital gain of the disposal of these assets on the delivery date if there is an increase in price from what was originally paid.

Ideally, IFIs must, on a best effort basis, adhere strictly to all the provisions of AAOIFI Shari’ah standards. However, if they or their Shari’ah board decide to adopt a contract or practice that is different to AAOIFI Shari’ah standards, then they have to put forward a comprehensive reason and argument as to why they have done so. Relevant stakeholders would then be aware of this departure and the reason for so doing.

Exercise 11.3 Explain why Shari’ah Standard (No 21) does not allow the forward sale/purchase of shares such as XYZ shares.

AAOIFI Shari’ah standards are useful in removing and eliminating unnecessary conflicts and contradictions of Fatwas and resolutions by various Shari’ah boards. However, these Shari’ah standards are not rigid in the sense that they are open for review and amendment. Many new practices could be included in the existing provisions directly or indirectly. Where practices are in direct conflict with the relevant AAOIFI Shari’ah standard provisions, a concerted effort must be made to bridge the gap, if not to eliminate it entirely. However, some recognition can be given to a differing Fatwa as long as it is supported by conclusive and valid arguments. Islamic law is flexible enough to allow interpretation that may result in more than one decision.



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(i) why there can be more than one opinion on a particular issue

(ii) how AAOIFI Shari’ah standards resolve the issue of any divergence of opinion on a particular issue

(iii) whether a Shari’ah board can depart from Shari’ah standard provisions issued by AAOIFI.

11.8 Proposed solutions to enhance Shari’ah complianceBy now it should be clear that Shari’ah compliance is central to the whole philosophy and activities of Islamic finance. This has resulted in the production of high quality Shari’ah standards by the AAOIFI. These standards depend on other relevant agencies and approaches to enhance Shari’ah compliance. The following list includes proposed solutions to enhance Shari’ah compliance.

(i) The establishment of a dedicated Shari’ah board that is supervisory in character. The members of the board would be well qualified to understand not only the design and structure of a product but also the supporting legal documents, accounting treatment and its IT solutions, appropriate risk management strategies, if relevant, and other services that have Shari’ah implications. The function of the Shari’ah board is not only to issue a decision but also to supervise the day-to-day operations of IFIs in accordance with the decisions issued by the Shari’ah board.

(ii) The appointment of a dedicated full-time Shari’ah officer who acts as the Shari’ah compliance officer. This post will relate closely to the duties of a Shari’ah supervisory board as the officer will help members of the board to review the practices of IFIs in all aspects of compliance.

(iii) Incorporation of a Shari’ah review exercise in the audit committee of IFIs. More often than not, the existing audit committee is detached from a Shari’ah review. An integrated approach of internal auditing would add value to the quality of Shari’ah compliance. According to AAOIFI’s Governance Standards for Islamic Financial Institutions No.3 (Internal Shari’ah Review), ‘the internal Shari’ah review shall be carried out by an independent division/department as part of the internal audit department, depending on the size of an Islamic Financial Institution. It shall be established within an IFI to examine and evaluate the extent of compliance with Islamic Shari’ah rules and principles, Fatwas, guidelines and instructions issued by the Shari’ah board’.

(iv) Imposition of an external Shari’ah audit by the respective regulator is a long outstanding effort to ensure compliance with Shari’ah principles is a critical requirement.

(v) An annual Shari’ah compliance report is believed to improve compliance with Shariah principles. The report should be comprehensive and objective in highlighting areas of compliance and areas of non or less compliance.

(vi) Active participation by shareholders will definitely contribute to a better achievement of Shari’ah compliance.

(vii) A clear statement by the management in the annual report that the management is responsible for properly complying with Shari’ah principles and Fatwas issued by the bank’s Shari’ah board. Also, a letter of representation by the management that all of the operations are conducted according to Shari’ah principles is another mechanism to make the management accountable and responsible for Shari’ah compliance.

(viii) The rating of IFIs in terms of their Shari’ah compliance process would be useful to enhance the objective of Shari’ah compliance. Unlike a normal credit rating exercise, which evaluates the solvency of financial institutions and their capability of payment towards their financial obligations, an Islamic rating is concerned with issuing an independent opinion about the quality of Shari’ah compliance for financial institutions, securities or financial products. Among other things, an Islamic rating will examine the procedures of authentication of the products and schemes offered by IFIs. In looking at the Fatwas, the independence of the scholars will be of ultimate importance. An Islamic rating does not aim to give a Shari’ah opinion on Islamic financial products or to comment on the decisions of the Shariah boards of banks and financial institutions or to correct their Fatwas. It is expected to examine whether there is a mechanism within the institution to evaluate its compliance with Shari’ah and whether their Shari’ah board has sufficient authority to conduct the examination and evaluation, and also the necessary information and resources to do so.



A synergy between these efforts would make the requirements of Shari’ah compliance more attainable. It goes without saying that a recognised and reputable global rating or ranking would stimulate the culture of Shari’ah compliance not only at the banks’ or regulator’s level but, more importantly, within the public and media at large. This is important because IFIs have a duty to all stakeholders with regard to Shariah compliance. Here lies the importance of transparency and duty of disclosure as Shari’ah compliance is the most important pillar of Islamic corporate governance.

Exercise 11.5Which of the following relates to an Islamic rating?

(A) Shari’ah compliance

(B) The quality of Shari’ah compliance.

(C) Financial ability to pay from a Shari’ah perspective.

(D) The independence of Shari’ah scholars to issue Fatwa.

11.9 ConclusionNo introduction to Islamic finance would be complete without a look at the attempts which have been made to harmonise practices across the world. Islamic law is dynamic and, as the previous chapters highlighted, various schools of law have developed and are dominant in different parts of the world. The nature of Ijtihad means that numerous acceptable interpretations could be made based on a single case. These differences in interpretation could adversely affect the Islamic financial market. This chapter explained the importance of developing acceptable Shari’ah standards which would set agreed boundaries on interpretation. The chapter also introduced you to the attempts that have been made by Shari’ah Scholars to ensure harmonisation of standards across the industry, including specific solutions which have been proposed. You should now understand that while standardisation is an ideal which has yet to be achieved, Islamic finance has already achieved a level of harmonisation which allows it to operate successfully.

Having completed this study guide you should now be in a good position to move on to the remaining three study guides which will introduce to you in more detail to the subjects of Islamic banking, Takaful, Islamic capital markets and the accounting and analysis of Islamic financial institutions.

Islamic finance challenge 11.3It could be said that Islamic finance is fundamentally centred around Shari’ah compliance. Products, mechanisms and standards are all clustered around the same principle. It has been explained throughout this guide that compliance is decided by the IFI’s Shari’ah scholars who operate at less than arm’s length from the IFI. Explain how the industry could ensure that there is no loss of confidence in society with regard to the processes adopted for ensuring Shari’ah compliance.

SolutionThere are many steps that are essential which include:

(a) disclosure of the fullest version of the Fatwa for the information of the public and other stakeholders

(b) emphasis being placed on the quality of the scholarship of the scholars used

(c) the avoidance of any conflict of interest between the scholars and the IFIs.



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11.10 SummaryHaving read this chapter, the main points that you should understand are as follows:

1. the development of a Shari’ah standard is aimed at achieving harmonisation in products and services by providing a basis for avoiding contradictions between the Fatwas and applications by various IFIs

2. Shariah standard setting is currently represented by two main bodies, namely the International Islamic Academy of Fiqh and Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI)

3. relatively speaking, the AAOIFI is more specialised and devoted to issuing relevant Shari’ah standards addressing issues of harmonisation of concepts and applications, and product development; it also acts as a focal point of reference for any Shari’ah query relating to Islamic finance

4. achieving a common standard is important to standardise contracts and their application; this is achieved through the setting up of standards based on a relatively global consensus and making them binding on IFIs

5. being a standard, it should prevail over any other view that is contradictory. In the case of an Istisna’ standard, for example, an Istisna’ contract is not allowed where an asset is already in existence - although there is a juristic view to the contrary

6. A Shari’ah standard could also incorporate a minority view, provided it can accommodate the industry better; a good case is the permissibility of forward lease (Ijarah Mausufah fi al-dhimmah)

7. there are two possible responses to Shari’ah standards being issued by the AAOIFI; the first relates to Fatwas that enhance and extend existing standards, while the second scenario contradicts the prevailing standard

8. proposed solutions to enhance Shari’ah compliance, either to Shari’ah principles in general or AAOIFI Shari’ah standards in particular, may take different forms; these may include an establishment of a Shari’ah, the appointment of a full-time Shari’ah officer for an IFIs, an internal Shari’ah review, an external Shari’ah audit, an annual Shari’ah compliance report, and an Islamic rating exercise to rate and rank the degree of Shari’ah compliance in terms of infrastructure.



Chapter 11 AnswersExercise 11.1Depending on which country you are studying in there may be a variety of standards applicable to the working environment. You may have a standard working day (often eight hours), you may have a standard working rate per hour or you may have a standard educational requirement before you can work in certain areas of employment. The point about these standards is that actual hours worked or wages paid can be judged against the standard. In the context of Islamic finance, a standard could be related to a substantive Shari’ah viewpoint or a governance standard. A substantive Shari’ah view, for example in a standard on Murabahah financing, is that the asset to be financed under a Murabahah contract should not already have been sold to the customer by the original vendor. The asset must be owned by the vendor prior to Murabahah financing because the sequence of contracts requires the Islamic Financial Institution (IFI) to purchase the asset from the original vendor before the IFI sells the asset to the customer at a mark-up sale. A governance standard could be, for example, that the appointed Shari’ah board members must be independent from the management or ownership structure of the IFIs.

Exercise 11.2The Shariah standards issued by the AAOIFI are narrow and are specific to financial matters, whereas the decisions of the International Islamic Academy of Fiqh are wider in coverage and include matters other than financial issues.

Exercise 11.3Salam is a forward sale contract whereby the full payment is paid in advance with the delivery of the asset being deferred. The asset must be something that is generally available in the market. Shares of a particular company do not meet the requirements of Shari’ah Standard (No 21) as there can be no guarantee that the company will be in existence in the future, for example it could be liquidated.

Exercise 11.4(i) There could be more than one opinion in any commercial issue as many of these issues are

subject to Ijtihad.

(ii) The AAOIFI, whose Shari’ah board consists of globally acknowledged scholars, may decide to prefer one opinion over another to settle a divergence of opinion on a particular issue.

(iii) Departures from AAOIFI Shari’ah standards are not encouraged, but any Shari’ah board may adopt a different view, provided it is supported by an established authority and argument.

Exercise 11.5(B) The main task of an Islamic rating is to signify that the recommended processes for

ensuring Shari’ah compliance have been performed by the relevant IFI. This is about ensuring consistently high quality processes in achieving Shari’ah compliance and does not relate to the status of Shari’ah compliance per se.

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Revision Questions

Question 1 Multiple choice1.1 Which of the following are not desired objectives of having a Shari’ah standard?

(A) To achieve harmonisation and convergence in the Fatwas.

(B) To avoid Fatwas contradicting each other.

(C) To reduce the function of the Shari’ah board.

(D) To measure the performance of IFIs with regard to Shari’ah compliance.

1.2 Why is the AAOIFI more effective in issuing Shari’ah standards on Islamic finance than the International Islamic Academy of Fiqh?

(A) The AAOIFI is a global establishment.

(B) The AAOIFI has a strong Shari’ah board.

(C) The AOIFI is an independent body.

(D) The AAOIFI was established primarily to issue standards inclusive of Shari’ah standards.

1.3 Why is the benchmarking of IFIs based on Shari’ah compliance not feasible at the present time?

(A) Standards are incomplete.

(B) Only a few IFIs have adopted AAOIFI Shari’ah standards as a matter of policy and law.

(C) There is no urgent need for Shari’ah compliance benchmarking.

(D) External Shari’ah audit is optional in most jurisdictions.

1.4 What is the proposed methodology when a Fatwa issued by a Shari’ah board contradicts existing Shari’ah standards?

(A) The Fatwa of this board is deemed invalid and not enforceable.

(B) Revision of the Fatwa.

(C) Disclosure of the basis of the Fatwa for the consideration of the standard setting body.

(D) Revision of the standard.

1.5 Which of the following is an accurate description of an internal Shari’ah review?

(A) An internal Shari’ah review is undertaken by the board of directors of the IFI on behalf of its shareholders.

(B) An internal Shari’ah review is similar in purpose to an external Shari’ah audit.

(C) An internal Shari’ah review has no provision in any standard of Islamic governance standard.

(D) An internal Shari’ah review is part of the internal audit exercise undertaken by IFIs.

Question 2What are the roles of the Shari’ah board of the AAOIFI?

Question 3What is the coverage of Shari’ah compliance?

Question 4Compare and contrast the following terms

(A) Shari’ah adviser vs Shari’ah officer.

(B) Internal Shari’ah review vs external Shari’ah audit.

(C) Shari’ah standards vs Fatwa.

Revision questionsImplementation of Shari’ah standards, policies and rulings in Islamic finance

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Answers

Question 1 Multiple choice1.1 (C) The objective of having a Shari’ah standard is to encourage uniform practice in the industry.

A Shari’ah board is still required to oversee and make sure that these standards are adhered to.

1.2 (D) The AAOIFI was established with the objective of issuing standards. Therefore its activities are focused towards such an objective which is in line with its charter as a standard setting body.

1.3 (B) It is quite hard to benchmark IFIs when many of them adopt different Shari’ah compliance practices and norms. It will be comparatively easier when IFs adopt a similar standard.

1.4 (C) As the research and development process in Islamic finance is always ongoing, there are bound to be cases where a Shari’ah board might issue a new Fatwa based on new findings. These findings should be shared with the standard-setting organisation in order for modifications to be made to the current standard, if required.

1.5 (D) Audit is a practice that ensures that the IFIs maintain compliance with certain standards. These standards include the need to be Shari’ah compliant.

Question 2The roles of the AAOIFI Shari’ah board includes efforts to achieve the harmonisation of Fatwas as well as the development and creation of more compliant products. In addition, the roles of the board extend to examining any inquiries posed to it and also to reviewing standards on accounting, auditing and code of ethics and other related statements issued by the AAOIFI.

Question 3Shari’ah compliance deals with all aspects of an IFIs adherence to Shari’ah standards in all aspects of finance, such as product structure, legal documentation, accounting treatment, IT solution, marketing and advertising and risk management methodologies.

Question 4

(A) A Shari’ah adviser is a scholar sitting on the Shari’ah board, but he is not a full-time employee of the IFI.

A Shari’ah officer is a full-time employee to assist in the day-to-day compliance of IFIs.

(B) An internal Shari’ah review produces a report for internal consumption.

An external Shari’ah audit produces a report on compliance, especially to regulators.

(C) A Shari’ah standard is a Fatwa that has gone through a process of deliberation and been accepted as a global standard.

A Fatwa is a view or decision issued by some individual scholars or some Shariah boards that did not go through a process of deliberation, and did not gain any adoption by a relevant international standard setting body.



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CIMA Certificate in Islamic Finance, Module One in Islamic Commercial Law

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CIMA Certificate in Islamic FinanceModule One: Islamic Commercial Law

1. What does Shari’ah refer to?

(A) An Islamic law introduced by the jurists after the demise of the prophet Muhammad.

(B) An Islamic law referring to transactions in economic activities.

(C) Commands, prohibitions, guidance and principles of human activities based on the religion of Islam.

(D) Principles laid down by the Islamic scholars pertaining to Zakat management.

2. What is Islamic finance?

(A ) Financial business that is mostly practiced in the Middle East jurisdictions.

(B ) Financial business that is accordance with Shari’ah principles and rules.

(C ) The newly-formulated methodologies of interest free banking.

(D) The process of wealth distribution between the government and citizens.

3. In Islamic banking, which of the following customer/banker contractual relationships is not permitted?

(A ) Depositor-custodian.

(B ) Interest bearing borrower-lender.

(C ) Investor-entrepreneur.

(D) Principal-agent.

4. All transactions made by Islamic Financial Institutions must:

(A ) Always involve at least one Muslim party.

(B ) Always be profit and loss sharing.

(C ) Be free from uncertain contractual conditions.

(D) Have interest financing of less than 5 %, in the case of sale transaction.

5. Which of the following would be deemed as Gharar?

(A) An agreement to sell and deliver an item in that is specified by description in Salam sale.

(B ) An interest free loan.

(C ) The sale of an option.

(D) The sale of pork products.

6. Which of the following is a salient feature of Islamic finance?

(A) A long term capital guaranteed investment.

(B) The elimination of risk.

(C) The sharing of ownership of an asset.

(D) The sharing of profit and loss.

Sample examinationThis sample paper gives an indication of the type of questions that appear in the final test, which is administered by computer.

This sample examination consists of 40 multiple choice questions. For each item you should mark your chosen answer by circling the answer A, B, C or D.

In all cases there is only ONE correct answer.

The answer key is given at the end of the examination.


Sample exam

inationCIMA Certificate in Islamic Finance, Module One in Islamic Commercial Law

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7. How can money be put to productive use through Islamic financial activities?

(A) Money can be generated from a Zakat distribution agency.

(B) Money must be mobilised into a fixed income deposit of another financial institution in the same country.

(C) Money must be mobilised into real business activities to earn extra money.

(D) The bank must invest the money into a government bond of an OIC member country.

8. What is the essential criterion for a business entity to be deemed Shari’ah compliant for investment?

(A ) All the shareholders must be Muslim.

(B ) The company must be engaged in Halal and profitable business activities.

(C ) The company must be engaged in profitable business activities.

(D) The company must have a Shari’ah board to review business decisions.

9. Which of the following are sources of law in Islam?

(A) The Fatwa issued by the Islamic Fiqh Academy in Saudi Arabia.

(B ) The Quran and the law of the Islamic States.

(C ) The Quran and the Traditions of the Prophet Muhammad.

(D) The Traditions of Prophet Muhammad only.

10. Which of the following combinations of legal matters are dealt in Islamic law?

(A) Ritual, marriage, divorce, succession, commercial transactions and penal laws.

(B) Ritual, marriage, divorce, succession, commercial transactions, penal, labour and land law.

(C) Ritual, marriage, divorce, succession, commercial transactions, penal and arbitration methodology.

(D) Ritual, marriage, divorce, succession, commercial transactions, penal and custom duty law.

11. The Traditions of the Prophet Mohammed are relevant to Islamic law because:

(A ) the Traditions are historical accounts on Prophet Muhammad life and success

(B ) the Traditions involve systematic compilation of Prophet Muhammad’s life

(C ) the Traditions confirmed Prophet Muhammad as leader of the Ummah

(D) the Traditions explain and interpret divine guidance for legal solutions.

12. In the context of Islam, what is meant by the term ‘primary source of law’?

(A) Law that is based from the Traditions of the Prophet Muhammad only.

(B) Law that is based on human interpretation and reasoning.

(C) Law that is based on primary information of all leaders in the history of Islam.

(D) Law that is based on revelation and divine guidance through the Qur’an and the Traditions of the Prophet Muhammad.

13. What is the difference between Shari’ah and Fiqh?

(A) Shari’ah can be changed and developed into a better form while Fiqh must remain fixed.

(B) Shari’ah is divinely prescribed; Fiqh relates to formulation of rules and law by the scholars.

(C) Shari’ah is applicable to the Arab Muslims while Fiqh applies to others.

(D) Shari’ah is the law for Islam while Fiqh focuses on Islamic finance.


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14. What, in most cases, does Ijtihad rely on?

(A) Case studies of previous issues, problems and practices.

(B) Intuition of Shari’ah opinion and rulings.

(C) References to the majority opinion of the scholars.

(D) The exertion of faculty of mind and reason guided by the primary sources of Shari’ah.

15. On what matters are Islamic schools of law always in agreement?

(A) The authority of the Qur’an and the Traditions of the Prophet Muhammad.

(B) The status of injunctions in Islamic finance law.

(C) The status of other schools of law in dealing with matters of Islamic finance.

(D) The unity of the major schools of thought in Islam.

16. Which of the following correctly describes Qiyas?

(A) A case in Islamic finance that describes the importance of honouring a promise or Aqad.

(B) A case in Islamic law that extends a ruling already applied to a new but different case.

(C) A method of Fiqh in applying the ruling for an existing case to a new but similar case.

(D) A form of Shari’ah that extends a ruling already applied to a new but similar case.

17. The process of Ijtihad is particularly relevant to Islamic finance because:

(A) it allows jurists to reach Shari’ah compliant solutions to new problems

(B) it allows the auditor to ensure the products in Islamic finance comply with Shari’ah requirements

(C) it enhances the correct corporate governance issues in Islamic finance

(D) it helps to provide the transparency of the business operations in Islamic finance.

18. What is the legal method employed to express opinion on Sukuk al-Ijarah?

(A) Custom.

(B) Istihsan.

(C) Ijtihad.

(D) Qiyas.

19. An ‘original Ijtihad’ is one which:

(A) describes the importance of honouring a promise or Aqad in Islamic finance

(B) extends a ruling already applied to a new but similar case

(C) has not occurred in the past, but is based on very similar previous views

(D) is new and distinctive as opposed to being based on previous views.

20. The correct term for Islamic commercial law is:

(A) Fiqh al-Ibadah.

(B) Fiqh al-Muamalah.

(C ) Fiqh al-Munakahat.

(D) Fiqh al-Musyarakah.

21. Which of the following lists the elements for a valid and enforceable contract under Islamic commercial law?

(A ) Offer, acceptance, offeror, offeree, object, consideration.

(B) Offer, acceptance, offeror, offeree, chargeable fee, cash.

(C) Offer, acceptance, offeror, offeree, Halal transaction, cash

(D) Place, time, offer, acceptance, object, consideration.


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22. How do the contracts of Ijarah muntahia bi tamleek and Musharakah Mutanaqisah differ in terms of application with regard to an IFI customer’s house property financing?

(A) Ijarah muntahia bi tamleek is based on sale, while Musharakah Mutanaqisah is based on partnership.

(B) Ijarah muntahia bi tamleek is only suitable for property under construction whereas Musharakah Mutanaqisah is suitable for both completed property as well as property under construction.

(C ) Transfer of ownership asset under Ijarah muntahia bi tamleek takes place at the end, whereas transfer of rights of equity claim takes place progressively under Musharakah Mutanaqisah.

(D) Unlike Ijarah muntahia bi tamleek, Musharakah Mutanaqisah is not fully Shari’ah compliant.

23. Which of the following contracts is suitable for an investor or financier who also wishes to actively participate in the management of a business venture?

(A) Ijarah.

(B) Mudarabah and Qard / Hassan.

(C ) Musharakah and Mudarabah.

(D) Musharakah.

24. Which of the following is a basic requirement for an offer to be recognised under Islamic law?

(A ) Clear, absolute and communicated to the offeree.

(B ) Clear, absolute and communicated to the offeree and the witness.

(C ) Clear, absolute and communicated to the offeree but must get prior approval from Shari’ah board members.

(D) Clear, absolute but communication to the offeree is optional.

25. When is acceptance of a contract deemed to have occurred in the case of a face to face meeting?

(A ) At anytime during the conversation between the two parties.

(B ) At the time and place that it is heard by the offeror.

(C ) At the time when both parties are about to disperse the meeting.

(D) The immediate moment when both parties meet face to face to offer and accept accordingly.

26. What is the minimum number of parties required to render an exchange contract legal?

(A) Three.

(B) Three with a witness.

(C) Two.

(D) Two with a witness.

27. What are the basic classifications of contracts for Islamic commercial law?

(A ) Aqad and Muamalat.

(B ) Shari’ah and Fiqh.

(C ) Unilateral and bilateral.

(D) Unilateral and multilateral.

28. Which of the following is a salient feature of an Ijarah contract?

(A ) The title of the leased asset is transferred to the lessee at inception of lease.

(B ) The lessee must renew the Ijarah contract on an annual basis.

(C ) The lessor must be the owner of the leased asset.

(D) The lessor must sell the leased asset at the end of the contract period.


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29. How can shareholders’ funds of IFI be mobilised in a profitable manner which is Shari’ah compliant?

(A) By utilising the funds for investments in securities.

(B) By pooling the shareholders funds with other deposit funds for investment in Shari’ah approved financing.

(C) By pooling the funds with other deposit funds for loans and advances.

(D) By pooling the funds to assume risk exposure of investment accounts.

30. In developing a new financial product, what is the principal consideration to ensure feasibility and its compliance?

(A ) Selection of a suitable contract.

(B ) Selection of a suitable contract together with its governing principles.

(C ) Legal compliance and transparency.

(D) Consent of the contracting parties.

31. Which of the following best describes the concept of Tabarru’?

(A ) A donation.

(B ) A purchase consideration.

(C ) A sale.

(D) A lease.

32. In Musharakah partnership, how is loss borne by the partners?

(A) All partners share losses based on their capital contribution.

(B ) All partners share losses based on agreed loss sharing ratio.

(C ) The lead partner assumes all losses.

(D) The managing partner of the business does not bear any loss.

33. Which of the following is based on the Qard / Hassan concept?

(A) Discounted loan.

(B ) Interest free loan.

(C ) Purchase contract.

(D) Sales contract.

34. What is the advantage of structuring an Islamic credit card on the basis of Tawarruq?

(A) The card can be used to withdraw cash as well as pay the purchase price.

(B ) No annual fee is charged to the customer regardless of the outstanding balance.

(C ) The card can be used only for purchasing Halal goods and services.

(D) A rebate on the outstanding payment can be given using the profit generated from a Mudarabah deposit.

35. Why do depositors generally prefer a hybrid Islamic current account based on either Wadiah or Qard / Hassan with Mudarabah contracts?

(A) There is no element of risk taking.

(B) Their share of the profit is fixed.

(C) They can receive a share of eventual profits if the balance of the deposits exceeds certain amount.

(D) Their capital investment is guaranteed.


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36. Based on AAOIFI standards, who approves the appointment and dismissal of member of a Shari’ah board?

(A) Shareholders.

(B) Other members of the Shari’ah board.

(C) The board of directors.

(D) The regulators.

37. Which of the following describes a Shari’ah compliance officer?

(A ) A Shari’ah audit officer appointed by the regulator.

(B ) A full time officer who ensures that the financial institution complies with Shari’ah principles.

(C ) A representative of the board of directors

(D) A member of the audit committee of the bank.

38. To be deemed Shari’ah compliant a product must adhere to:

(A ) All Shari’ah principles and timelines required in a given contract.

(B ) All Shari’ah principles governing contracts and all supporting materials and processes.

(C ) Regulations issued by regulators and AAIOFI.

(D) The Fatwa of a Shari’ah board.

39. What is the appropriate course of action in the case where a Fatwa issued by a Shari’ah board contradicts existing Shari’ah standards?

(A) Revision of the existing standard to reflect the findings of the Shari’ah board must take place within six months.

(B ) The Fatwa should be submitted for the consideration of the standard setting body.

(C ) The Fatwa of the Shari’ah board is deemed invalid and unenforceable.

(D) The Fatwa of the Shari’ah board is revised with immediate effect.

40. Why is the international benchmarking of IFIs based on Shari’ah compliance currently snot feasible?

(A ) International audit guidelines are adopted in most jurisdictions.

(B ) Standards and best practices are formulated for the Islamic Financial Services Industry (IFSI).

(C ) Only a few jurisdictions have adopted AAOIFI Shari’ah standards as a matter of policy and law.

(D) There is no urgent need for Shari’ah compliance benchmarking.

Answers

1- (C) 8-(D) 15-(A) 22-(C) 29-(B) 36-(A)

2- (B) 9-(C) 16-(C) 23-(D) 30-(C) 37-(B)

3- (B ) 10-(A) 17-(A) 24-(A) 31-(A) 38-(B)

4- (C) 11-(D) 18-(C) 25-(D) 32-(A) 39-(B)

5- (C) 12-(D) 19-(D) 26-(C) 33-(B) 40-(C)

6- (D) 13-(B) 20-(B) 27-(C) 34-(D)

7- (C) 14-(D) 21-(A) 28-(C) 35-(C)


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Glossary of terms and contracts

Absentes – a contract where the parties are not present at the time of agreement

Al-kharaj bi al-daman – the concept that reward should correspond to risk involved

Amanah – is not a contract as such, but is a feature or a requirement in some specific contracts that impose on one of the parties to disclose the actual cost price, such as in Murabahah sale as compared to negotiated price sale (Musawwamah) with no requirement for such disclosure. Amanah relates to the part of the buyer/seller relationship that is based on trust. This might occur where the financial institution buys goods from a third party vendor on the request of the institution’s customers, which will subsequently purchase the goods from the financial institution. Upon purchasing the goods from the vendor, the financial institution assumes risks relating to the specified asset until the point of purchase by the buyer. An Amanah, or trusteeship, is required of the seller/financier to disclose the actual cost of the goods purchased from the vendor before selling it to the customer at cost plus mark-up.

Another example of Amanah being introduced into an Islamic financial arrangement would be Wadiah Yad-Amanah, which is where a bank as the custodian undertakes the task of safekeeping the assets or funds deposited by a customer in a safe custody contract, based on trusteeship. It is executed between two parties, namely the depositor (owner) and the bank (custodian). The liability of the custodian triggers only in cases of negligence and misconduct. This is to distinguish between safe custody contracts, which are based on liability, and this safe custody contract, which relies on trusteeship. It establishes the liability of one of the parties, whereby a contract that is featured as Amanah will not inflict any legal liability on the part of the custodian, except in the case of negligence and misconduct.

Key principles of Amanah

Requires a true and honest disclosure of the cost price in all Amanah-based sales.

Establishes liability on trustees only in cases of negligence and misconduct.

‘Aqd – contract

Ashum – shares

Bay’ mu’ajjal – deferred payment sale

Bay’ – sale

Bay’ al-dayn – the sale of debt

Bay’ al-murabahah – sale of a commodity at cost price plus a known profit

Bay’ al-tawliyah – sale at cost without profit or loss

Bay’al-wadiah – sale below the cost price or at a discounted price

Bayt al-mal – government treasury

Bulugh – physical puberty

Dayn – a debt or the obligation to deliver an asset

Diminishing Musharakah – see Musharakah Mutanaqisah

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Fiqh – Islamic substantive law

Fiqh al-muamalah – Islamic commercial law

Gharar – uncertainty

Gharar fahish – major uncertainty

Gharar yasir – minor uncertainty

Halal – acceptable and lawful

Hanafi – particular school of law

Hanbali – particular school of law

Haram – unacceptable or prohibited

Hasuna – pleasing, appealing or nice

Hiba – gift

Hiwalah – transfer of debt/right to claim

Hukm – a ruling in the Qur’an or the Traditions of the Prophet Muhammad, or derived through reasoning of jurists

Ibra’ – can be defined as a discount or rebate. An example of Ibra’ in practise might be where a bank which is owed a set amount from one of its clients and accepts less for early payment. This practice of discount or rebate avoids unjust enrichment and maintains the competitiveness of the bank.

Key principles of Ibra’

Relates to the forfeiting of rights to claim.

Involves a discount or rebate for early repayment of an amount owed.

Ijarah – a lease contract

Ijarah ‘ala al-ashkhas – hire of people

Ijarah al-a’yan – lease of the asset

Ijarah mausufah fi al-dhimmah – forward lease

Ijarah muntahia bi tamleek – where an option to transfer the title of the asset to the customer is provided for in the lease, the lease arrangement is Ijarah muntahiah bi tamleek. It is also known as Ijarah Thumma al bay’ (lease followed by sale) or Ijarah wa al-iqtina’ (hire and purchase). The objective of this financing is to transfer the legal title of the leased asset to the lessee at the end of the lease period. At the end of this contract, the bank will surrender its ownership of the asset to the client in consideration of the total accumulated rental claim that is inclusive of the profit. The concept Ijarah muntahia bi tamleek is an alternative to finance leasing and in particular hire-purchase financing. There are several forms of Ijarah muntahia bi tamleek financing which reflect the different modes of transferring the ownership of the asset such as gift, sale and transfer of equity claim from the lessor to the lessee.

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Key principles of Ijarah muntahia bi tamleek

Involves a lease with an option to purchase the leaseed asset.

At the end of the lease period title transfers to the lessee.

Several forms exist to reflect the mode of transfer of ownership.

Ijarah tasqhilliyyah – refers to an operating lease, where the financial institution transfers the usufruct (right of beneficial use) of a particular property to another person in exchange for a rent claimed from the lessee. The financial institution, such as a bank, will purchase an asset, for example plant and machinery, from a vendor and lease it to the lessee or client at an agreed rate for a defined period. The operating lease will clearly state that the lessee has the right over the usufruct in exchange of a rental claim. The ownership of the asset will not be transferred to the lessee during the period of the Ijarah contract. At the end of each Ijarah period, the bank will negotiate a new lease with the lessee and the lease period will continue until the bank chooses to scrap the asset. No option or right to purchase is granted to the lessee.

Key principles of Ijarah tasqhilliyyah

Involves a straightforward operating lease.

At the end of the lease period title does not transfer to the lessee.

At the end of the lease period the owner of the asset will negotiate a new lease or sell/scrap the asset.

Ijarah thumma al bay’ – see Ijarah muntahia bi tamleek

Ijarah wa al-iqtina’ – see Ijarah muntahia bi tamleek

Ijtihad – interpretation

Ijma’ – consensus or agreement of all Muslim scholars over interpretation

‘Illah – effective cause or ratio legis

In rem – action relating to property rather than the person

Inter absentes – not physically present

Inter praesentes – contract physically present

Istihsan – equity consideration

Istishab – presumption of permissibility

Istisna’ – is a contract to build, manufacture, construct or develop the object of sale at a definite price, over a defined period of time, according to agreed specifications between the parties. An Istisna’ contract can be established between a bank and contractor, developer or producer that allows the bank to make progress payments as construction progresses. Istisna’ financing is provided in the form of advance progress payment(s) to the customer who builds, manufactures, constructs or develops the object of sale. Upon completion of the project, the asset is delivered to parties who agreed to take delivery of the asset. Parallel Istisna’ arises when the party that intends to take delivery provides advance progress payment to the bank to engage the builder, manufacturer, contractor and developer. Variations of timing and cash flow expectations, between the purchaser and the parties that deliver the object of sale, are bridged by the bank.

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Key principles of Istisna’

Involves the purchase of an item that has yet to be built, manufactured or constructed.

Progress payments are normally made by instalments as construction progresses.

On completion of the project the asset is delivered to those that originally commissioned it.

Parallel Istisna’ is where those that commission the asset make progress payments to the financier as the asset is constructed by another contractor or developer .

Parallel Istisna’ allows for any mismatch in the timing or amount of cash flows between those that commission the asset and those that construct it.

Istisna’ muwazi (parallel Istisna’) – see above

Ju’alah – commission-based

Kafalah – is a contract of guarantee or surety that provides assurance in terms of performance and value when the object of the transaction is exposed to adverse change due to varying outcomes. In trade financing, a bank guarantee is issued when the owner of goods discharges the liability for the goods on behalf of a third party. Such guarantees are often used in cases of goods being imported. The exporter knows that the goods will be paid for and can feel free to allow the goods to be uplifted by the importer. The importer may be required to offer some form of collateral as surety and will normally pay a fee for the service. The purpose of a Kafalah contract is to facilitate international trade.

Key principles of Kafalah

Involves a guarantee or surety.

Used when something being bought or sold could change in value if exposed to adverse conditions.

Often used when importing/exporting goods.

Facilitates international trade.

Litera legis – literal rule

Madhhab – schools of Islamic law

Madhahib – plural of Madhhab

Mafsadah – evil and harm

Maisir – gambling

Majallah al-ahkam al-adliyyah – the Islamic Civil Code of the Ottoman Empire

Mejelle – English translation of Majallah al-Ahkam al- Adliyyah

Maliki – particular school of law

Maqasid – objectives and ultimate purposes of Islamic law

Maslahah – what is good or beneficial

Maslahah mursalah – benefit or interest / unrestricted public interest

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Mudarabah (capital provider – Rabb al-mal, entrepreneur – Mudarib) – a Mudarabah contract is a profit sharing contract. Under a Mudarabah contract, the capital provider agrees to share the profits between themselves and the entrepreneur at an agreed ratio or percentage. (1) As a source of capital for a business venture, a businessman might consider undertaking a commercial project financed by funds from a bank under a Mudarabah contract. If agreeable, the bank supplies the finance to the businessman on the understanding that both parties will share the profits of the venture. (2) As a deposit taking activity, money deposited in a bank by an individual or institution under a Mudarabah contract is treated as an investment in the bank by the individual or institution. The bank will use this investment to help make profits from its trading activities, i.e. financing of individuals and businessmen. Under the Mudarabah contract, the bank will have agreed to give the depositor a share of its profits in return for the investment, based on a pre-agreed ratio.

Investment financing through Mudarabah is a commitment to participate in the risk associated with business ventures, with the aim of sharing the profit generated from a given business venture. Parties to the Mudarabah contract will only benefit if the venture is successful. Should the project fail, the financier will lose his investment, whereas the businessman will only lose the time and effort expended on the project.

In general, conditions imposed and agreed on by both parties limit the mobilisation of the funds raised under a Mudarabah contract, such as pooling with other funds, types of business venture or investment, as well as profit and loss sharing among the funds. In the case of a savings account, a Mudarabah contract without conditions and restrictions is usually adopted, which is intended for public and retail investors. Mudarabah, unlike Musharakah, does not entitle the capital provider to an executive function in the management of the business venture.

Key principles of Mudarabah

Profit sharing contract.

Returns depend on a profit being earned.

Conditions could apply to what the investment can be used for.

Requires a commitment to participate in the risk associated with business venture.

The businessman only loses the time and effort expended on the project, where the financier assumes the financial loss.

Does not entitle the financier to any say in the running of the venture.

Mudarabah muqayyadah – This type of contract is used in specific bank accounts known as restricted investment accounts (RIAs), where the bank acts as an agent for the investor(s) simply by acting upon their instructions. Here, the funds deposited based on the Mudarabah contract are never really under the control of the bank because the depositor(s) determine the manner as to where, how and for what purpose the funds are to be invested. Commingling of the funds raised under this type of contract with the bank’s shareholder and other deposit funds is usually restricted or prohibited. The returns distributed to restricted investment account holders (RIAHs) is based on an agreed profit sharing ratio confined to the returns earned on a designated specific investment portfolio involving the funds agreed upon by the RIAHs.

Any distribution between the bank and the depositor will be in accordance with an agreed profit sharing ratio, or agency fee if the contract is based on wakalah or agency for investment. Mudarabah profits or income distributable to RIAHs are derived from the performance of designated financing assets or investments managed by the bank.

Key principles of Mudarabah muqayyadah

Financial institutions act as entrepreneurs or agents for investors.

Investors decide where funds will be invested.

Commingling of funds is either restricted or prohibited.

Returns paid to investors come only from returns earned on the specified investments.

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Mudarabah mutlaqah – unlike Mudarabah Muqayyadah, this contract relates to investment accounts where the account holder fully authorises the bank to invest the funds without restrictions imposed by the account holder and is in accordance to the Shariah principles and rules. The funds are pooled with the bank’s shareholder funds and other deposits to facilitate financing and investments by the bank. The returns depend on the level of profits earned, and are shared and distributed across the varying classes of investment account holders based on different investment horizons from one to 60 months or more. Usually, returns to investment account holders are computed and accrued on a month-to-month basis. The investment account holder must submit written notice to Islamic banks prior to the withdrawal of funds and a minimum notification period is required. Mudarabah profits or income distributable to unrestricted investment account holders are derived from the performance of the banks’ financing assets and investments.

Key principles Mudarabah mutlaqah

• Financial institutions fully authorised to invest deposited funds without restrictions.

• Commingling of funds can take place.

• Returns paid to investors come only from returns earned across all investments of the financial institution.

• Returns paid to investors depend on class and time horizon of investment.

Muhammad – the Last Prophet of Islam

Mujtahid – the person who performs Ijtihad

Muqasah – set-off

Murabahah – a Murabahah contract refers to a cost plus mark-up transaction between parties. Murabahah financing is the prevalent mode of asset financing undertaken by a large number of Islamic banks. It represents a significant portion of Islamic bank financing of either short term or long term asset financing. Under this contract, a three party arrangement is made where the customer places an order with the financial institution to purchase goods from a supplier. The customer can pay a security deposit with the financial institution and the amount of financing outstanding can be secured either in the form of collateral or a guarantee. The financial institution, having purchased the goods from the supplier, then sells them to the customer at a credit price including mark-up, with a fixed credit period. The nature of the buyer and seller relationship is based on the principle of trust (Amanah), mentioned above, where the seller upon purchasing the goods from the vendor must honestly disclose to the customer the actual cost price of the purchase, prior to selling the asset to the customer under a Murabahah.

Under this contract, the customer is always aware of the mark-up, i.e. it is set in advance, and pays the Murabahah selling price either on an instalment basis or at the end of the financing period. The mark-up or profit agreed in the price does not change over the period. Hence there is a price ceiling for the Murabahah financing to ensure certainty in the price. Rebates may be granted for early settlement, provided the rebate provision is not contractually documented in the contract. On the other hand, provision for penalty charges for delinquent payments could be included in the contract as a form of compensation but to bedistributed to charity as the provision is only to deter moral hazard behaviour. The bank may take some of this compensation money to cover the actual cost incurred by the bank due to the default. Compensating for loss of opportunity cost or cost of funds is not acceptable.

Key principles of Murabahah

Cost plus mark-up arrangement.

Usually involves a financial institution, the customer and a third party vendor.

Based on a relationship of trust between the parties.

Can be secured by collateral or guarantee.

Sets a fixed priced between the financier and customer.

The price is paid over an agreed period of time.

Early repayments are allowed and can result in a reduction of the overall price charged.

Penalties can be applied for late payment as a deterrent.

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Murabahah-tawarruq – contract to realise cash

Murabahah li al-amir bi al-shira – Murabahah to the purchase orderer

Musharakah – a Musharakah contract is a form of equity partnership investment. It is similar to equity investment in a conventional capital market but the investments made must be confined to stocks and financial securities or other assets that are consistent with the principles of Shari’ah. Note, partnership contracts come in three forms, namely Shirkah al-Amal (work partnership), Shirkah al Wujoh (partnership by reputation) and Shirkah al-Amwal (partnership by capital). Musharakah financing is based on Shirkah al-Amwal (partnership by capital).

As a form of equity based financing, like Mudarabah investment financing, Musharakah financing is a commitment by the financier to participate in risks associated with business ventures. Musharakah also means a joint enterprise in which all partners share the profits or losses of the venture. While the profit sharing ratio may be negotiated, the loss sharing ratio must always be proportionate to capital contribution. It also allows the institution to be involved in the executive decision on administration, operations and management of the business activity. The financial institution would be able to mitigate any form of operational risks by assuming an element of control in the conduct of business.

The Musharakah financing mechanism operates on a capital contribution basis for a defined existing or potential project or assets. The outstanding financing amount could increase or decrease depending on the demands for funding during the financing period. At any point in time, the outstanding capital contribution provides the basis for determining the profit or loss sharing ratio. As a profit and loss sharing arrangement, Musharakah takes various forms, depending on the parties’ capital contribution and their effort in managing the venture. Musharakah is considered as the most flexible form of equity financial claim that can be adopted for various economic sectors, including services, production and distribution.

Key principles of Musharakah

Profit and loss sharing contract.

The financier invests in the venture.

Requires the participants to work in partnership.

The financial institution or lender has a say in the running of the project.

Relates to a specific project or asset.

Returns depend on a profit being earned.

Allows for the level of finance outstanding to fluctuate up or down.

Requires a commitment to participate in the risk and loss associated with business venture.

Musharakah mutanaqisah – is a variety of Musharakah contract, where the term Mutanaqisah means ‘to diminish’. Thus, Musharakah mutanaqisah, also referred to as Diminishing Musharakah, means a form of partnership which creates an avenue for the capital provider to reduce or be free of the joint ownership after the initial investment period has been satisfied. As mentioned above, a normal Musharaka contract allows for fluctuating levels of investment, but a Musharakah Mutanaqisah contract specifically relates to a reducing investment.

Diminishing Musharakah provides an avenue for the financial institution to systematically reduce its exposure over the financing period, with planned and scheduled redemption of the contribution amount. This form of finance is often used in the purchase of a house in the form of a joint venture. The financier contributes the bulk of the house price with the individual customer contributing the remaining balance. The joint venture accepts rental repayments from the individual who is now living in the house. The rental is split between the financial institution and the homebuyer with the homebuyer’s share going toward the redemption or dilution of the financier’s shareholding.

Key principles of Musharakah mutanaqisah

As with Musharakah above.

Allows for planned diminution in investment to the point where the financier exits the venture

Effectively finances the customer to acquire an asset through a joint venture scheme.

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Musawamah – negotiated sale

Musawamah, Tawliyah – negotiated sale at agreed price

Parallel Istisna’ – see Istisna’ – two contracts operated in parallel

Parallel Salam – see Salam – two contracts operated in parallel

Praesentes – where the parties to the contract are present at time of agreement

Qard / Hassan – interest free loan

Qiyas – analogy

Qiyas al-tard – extension of a legal rule from one case to another due to a material similarity

Qur ‘an – the Holy Book revealed to the Prophet Muhammad

Rahn – pledge

Ra’y – personal opinion

Ratio decidendi – legal basis

Rem – see in rem

Riba – interest/usury

Riba al-fadl – interest by an excess of countervalues

Riba al-nasiah – interest by deferment in the delivery

Ribawi – usurious or interest-based

Rushd – prudence

Sadd al-dharai’ – blocking the means

Sahm – a share

Salam – refers to the purchase of a commodity for deferred delivery in exchange for immediate payment. Thus, in a Salam contract, the price is paid in full and in advance while the commodity is deferred to an agreed date in the future. This type of contract might be used where the commodity price is subject to change. The buyer is locked with the purchase price at contract date and thus hedged against price increase. Stringent conditions are applied to ensure a binding and legally enforceable contract such as reasonableness of delivery and specifications of quality type and quantity of commodities. Any variations of quality and quantity of goods as well as timeliness of delivery would not affect the agreed price.

The object of a Salam contract must be commodities that can be specified clearly, due to the non existence of the object of sale at the time when the contract is concluded. The detailed features and specifications of the product of sale must be agreed upon to avoid ambiguity that would render the contract unknown to the parties. When there arises a disparity or mismatch in terms of types, quality and timing of delivery, the buyer has either the choice to take delivery without discount or premium on price, or to revoke the contract. Advance payment made by the bank to the seller or exporter to deliver or produce the goods constitutes Salam financing. Parallel Salam is based on two independent Salam contracts whereby the financier will be both the seller and the buyer in this

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arrangement. In the first Salam contract, the IFI will be the buyer of the Salam asset by providing a full payment to the seller against a future delivery of an asset. Then, this IFI may enter into a Salam contract as a seller with another party for a shorter period of delivery of the asset. the spread between the first and second Salam contracts is the profit earned by the IFI through this parallel Salam arrangement.

Key principles of Salam

Involves a forward purchase of a commodity

Full payment is made at the beginning of the contract period

Goods are received at the end of the contract period

The goods must be clearly identifiable

Remedies available for failure to complete the contract as specified

Parallel Salam is useful to finance the ultimate producer as the IFI is neither the ultimate producer nor the user.

Sanadat al-dayn – certificates of debt

Shafi’i – particular school of law

Shari`ah – sacred law revealed by God Almighty

Shirkah – partnership

Shirkah al-mufawadah – equal partnership

Sukuk – certificates of investment

Sukuk al-ijarah – certificates of investment in leased assets

Sunnah – The Traditions of The Prophet Mohammad

Ta’awun – cooperation

Tabarru – donation contracts

Takaful – is an Arabic term derived from the root word kafala, meaning to guarantee. To be more precise, it is derived from the verb ‘Takafala’ meaning to mutually guarantee and protect one another. Therefore, literally, it means mutual help and assistance. It can be noted that the contract of Takaful is based on the concept of helping one another, whereby each and every participant contributes to the common fund in order to provide financial assistance to any member who needs help, as defined in the mutual protection scheme. In principle, Takaful is very similar to conventional mutual insurance in terms of its philosophy and structure. However, it differs significantly from conventional mutual insurance as all its operations should be based on Islamic principles, including investment activities, the establishment of the Shari’ah board and causes for legitimate claim, which exclude causes such as suicide and death under the influence of alcohol.

Key principles of Takaful

Relates to the idea of mutual guarantee.

Used in the context of mutual help of assistance.

Similar to conventional mutual insurance. but differs in terms of investment portfolio and legitimate causes for claims.

Claims restricted under Shari’ah principles.

Takharuj – exit from partnership by selling the shares to another party

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Tanazul – is an act to waive certain rights of claim in favour of another party in a contract. In Islamic finance, it is applied where the right to share some portion of the profits is given to another party. For example, in a Mudarabah contract, the capital providers may agree to limit the rate of return to a defined percentage whereby the excess can be given to the manager as an incentive or performance fee. The decision of the investors to waive their right to the profit is based on the principle of Tanazul that is specified as a condition of the contract to waive such a right.

Key principles of Tanazul

Involves the waiving of rights in favour of someone else.

Often seen where the capital providers agree to waive their right to a portion of the profits in a venture in favour of, say, a manager on the project.

Taskeek – securitisation

Tawarruq – buy spot and sell deferred payment or vice versa to facilitate cash liquidity

Tijarah – private commercial transactions

Ujrah – fee

Ummah – Islamic nation

Umum balwa – common plight and difficult to avoid

‘Urf – customary practice

‘Urbun – is essentially a down payment made by a buyer to a seller after both parties have entered into a valid contract. The down payment represents the commitment to purchase the goods. If the buyer is able or decides to pay the remaining outstanding payment during a prescribed period, the amount paid as down payment will be counted as part of the purchase price. Otherwise, the down payment will be forfeited by the seller. This is the original version of ‘Urbun in Islamic commercial law. This feature is often used to mirror the behaviour of conventional options by providing an opportunity to the buyer (the person making the down payment) to benefit from the market up-side (call option) of the underlying asset and by limiting the potential loss to the amount paid under the down-payment scheme.

Key principles of ‘Urbun

Involves the payment of a down payment to secure an option or right to purchase something in the future.

Mimics the economic benefits of purchasing conventional options.

If the option to complete the purchase is not taken up the down payment is forfeited.

Usufruct – the right to use

Usul al-fiqh – Islamic legal theory providing principles and guidelines on interpretation

Wa’d – is a feature attached to a contract and is a unilateral promise made by one party to another, binding on the party that makes the promise. In financing transactions this feature provides assurance that the transaction will be executed as per the specifications of the contract. For example, an importer who has foreign exchange transaction exposure in terms of payment of imports in foreign currency upon delivery of goods might hedge the risk of appreciation of foreign currency by undertaking a promise to buy the foreign currency in the future that matches the real exposure to currency risk of import transaction upon delivery.

Key principles of Wa’d

Involves a unilateral promise made by one party to another.

Binds the promisor to fulfil some obligation in the future.

Ensures that the contract is fulfilled as set out in the terms

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Wadiah – safe custody

Wadiah yad dhamanah – guaranteed safe-custody deposit contracts

Wakalah – is a contract between an agent and principal. This contract enables the agent to render services and be paid a fee (Ujrah). For example, in a case where the importer applies for a letter of credit based on Wakalah, the importer will authorise the bank to issue the letter of credit on his behalf to the exporter’s bank. The issuing bank will act as the agent to process the issuance of the letter of credit and for this will impose a fee on the importer for the services rendered.

Key principles of Wakalah

Involves an agency contract between an agent and principal.

Used as a facility to enable transactions to take place.

The agent earns a fee (Ujrah) for his services.

Wakil – agent

Waqf – permanent endowment

Wasiyyah – will contract

Zahiris – literalists

Zakat – is a form of religious levy on the wealth of Muslims. It is based on wealth that exceeds the specified quantum for a defined period (where relevant) and is meant for the poor and needy as well as other specified beneficiaries mentioned in the Quran. It is the third pillar of Islam and is made obligatory for Muslims who have the financial means to discharge such obligations. Methods of Zakat computation are prescribed to facilitate determination of Zakatable wealth as well as the prescribed rate. In the case of investment or deposit funds, there is no specific date set for the payment of zakat, but it should be paid on all accumulated wealth for the period twelve lunar months. Zakat is not payable on the value of the individual’s home, furniture, transport or ‘tools of trade’, nor is it paid on personal jewellery.

Key principles of Zakat

Religious levy on wealth of Muslims who possess a certain amount of specific assets.

Payable on all accumulated wealth held for the period of 12 lunar months.

Not payable on specified items that are personal in character.

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Index

Accounting and Auditing Organisation for Islamic

Financial Institutions (AAOIFI) 44, 184

Amanah 20, 110, 114

Anas, Malik bin 67

‘Aqd 91-93

Bay’al-murabahah 110

Bay’al Mu’ajjal 112

Bay’al-tawliyah 110

Bay’al-wadiah 110

Contracts 90-100

application in Islamic finance 166-177

bilateral 107-109

classification 104-119

comparison of classifications 124-133

sale 110

security 128

traditional Islamic 140-147

unilateral 107-108

Credit cards 173-174

Current Accounts 154

Financing products 155-157

Fiqh 65, 184

Fixed income account 154

Gharar 20, 22, 24, 28, 98, 107, 109, 158, 171

Hanbal, Ahmad bin 68

Hanifah, Abu 67

Hiwalah 97, 116

Idris al-shafi’i, Muhammad bin 68

Ijarah 146

Ijarah al-Mausufah fi al-dhimmah 171, 189

Ijarah muntahia bi tamleek 114-115, 146, 157, 169, 172

Ijarah Tashghiliyah 114-115

Ijma’ 61

Ijtihad 60, 66, 76-86

‘Illah 62

International Islamic Academy of Fiqh 184

Investment accounts 154

Islamic banking products 153-157

Islamic capital market 160

Islamic commercial law 54-69

sources 56-66

Islamic finance compared to conventional finance 29

Islamic finance-features 23

Islamic finance-meaning 20

Islamic schools of law 67

Hanbali 68

Hanafi 67, 78, 82

Maliki 67, 78, 82

Shafi’i 68, 78, 82

Istihsan 63

Istishab 64

Istisna’ 113, 129, 131, 171, 187

Ju’alah 118, 130

Kafalah 117

Maslahah 63, 81

Mudarabah 24, 83, 113, 116, 126, 127, 154, 156,

167, 168

Murabahah 20, 129, 143, 156, 168, 176

Musawamah 111, 112, 113, 129

Muskarakah 24, 30, 116, 126, 127, 156

Mutanaqisah 125, 169, 172

Qard / Hassan 109, 154, 167

Product development 170

Profit and loss sharing 24, 29

Qiyas 61, 82

Qiyas al-tard 61

Rahn 117

Riba 21, 26-28, 77, 109

Roman law 79

Sadd al-dharai 63

Salam 112, 129, 171, 189

Savings Accounts 153

Shari’ah advisory and supervisory boards 42-45

Shari’ah compliance 38-47, 190

features 40-41

officers 46

regulators 42-45

shareholders 45

stakeholders 42

Shari’ah standards 183-191

Shirkah al-Mufawadah 98

Sukuk 85, 160

Sukuk al Ijarah 161

Tabarru’ 158

Takaful 22, 107, 158

Tawarruq 172

Tawliyah 113

‘Urbun 113

‘Urf 64

Usufruct 114

Wadiah 113, 118, 154, 167

Wakalah 99, 118, 130

Zakat 184

Islamic Finance is a fascinating and dynamic

multi-disciplinary area of the international

financial services sector. As an established niche

of the finance industry it is set to grow at an

exponential rate over the next few years. The

current annual industry growth rate is estimated to

be between 15% and 20%.

As a result of the rapid growth experienced in this emerging area most individuals and finance organisations have minimal exposure to and understanding of its unique and profound nature, leading to a significant skills shortage. To date, few institutions offer qualifications in the subject nor do any professional bodies offer a global qualification. CIMA, through its Centre of Excellence, and in conjunction with the International Institute of Islamic Finance Inc., has developed the Certificate in Islamic Finance to meet this global shortfall in human capital.

The Certificate comprises of four modules which build a strong foundation of knowledge and skills based on standards and industry wide experience to assist candidates in meeting the challenges of this exciting and fast changing area of finance:

• Islamic Commercial Law

• Islamic Banking and Takaful (Products and Services)

• Islamic Capital Markets and Instruments

• Accounting and Analysis of Islamic Financial Institutions.

The CIMA Certificate in Islamic Finance learning system includes:

• comprehensive syllabi leading to a higher professional qualification in Islamic Finance

• step by step subject coverage directly linked to specific learning outcomes

• fusion between theory and practice

• chapter summaries

• contemporary and user friendly glossary of Islamic Finance terms

• self learning and self assessment approaches

• extensive question practice

• revision sections for each chapter

• easy to follow format

• full length mock examination at the end of each guide.

All materials included in the CIMA Certificate in Islamic Finance have been subject to the scrutiny of a global advisory panel comprising experts in all the areas covered within the modules.

CIMA is proud to be the first professional accounting body to offer a truly global product in this area – your passport to success in Islamic Finance.

www.cimaglobal.com/islamicfinance

cima cert if 1

Documents

islamic nance chapter

application of islamic

eld of islamic nance

overview of islamic

traditional islamic

major areas of islamic

contentsislamic commercial

learning companionwe