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Islamic Finance in the Netherlands

A study of the Attitude towards and the Interest in Islamic Finance by young Muslims

and the factors that determine them.

Erasmus University Rotterdam Rotterdam School of Management Finance and Investment, June 2009

Hicham Chara (Student no: 260061)

Coach: Co-reader: Msbc Ying Xu. Dr. Ir. P.W.J. (Peeter) Verlegh Department of Finance and Investment Department of Marketing Management

2009, Hicham Chara All rights reserved . No part of this paper may be reproduced or transmitted in any form or by any means electronic or mechanical, including photocopying, recording, or by any other information storage and retrieval system, without permission in writing from the author.

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In the Name of Allah, The All-Merciful, The Ever-Merciful

The author declares that the text and work presented in this Master thesis is original and that sources other than those mentioned in the text and its references have been used in creating this master thesis.

The copyright of this Master thesis rests with the author. The author is responsible for its content. RSM Erasmus University is only responsible for the educational coaching and beyond that can not be held responsible for the content.

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ACKNOWLEDGEMENTS

This thesis has made it possible for me to combine my religious belief with my field of study. The research I did for this study was a pleasure and has left me with a feeling of great fulfilment.

This thesis owes much to my coach Ying Xu, my co-reader Peeter Verlegh and especially a distant advising professor Hans Visser. Thank you all for your remarks and comments. The book Western Muslims and the future of Islam was the inspiration to choose this subject, therefore I want to thank Tariq Ramadan.

Special thanks to my brothers (Nordin, Rachid and Mohamed) and my sister Assia who have supported, stimulated and pushed me to get this far. Our love goes deep and has kept us close, although we do differ, I thank Allah (swt) for this special bond between us.

To my dear wife Lemyae, I could not have done it without you, thank you for your patience, support, love and cheering words when I was downhearted, uninspired or lazy. You are my true love and I am grateful for your precious presence everyday.

And then there are my parents. My dear mother and father who raised me, nurtured me and made me the person that I am today. Their lifes choices always and foremost were made to ensure we, the children, would have the chances they never had, they deserve my deep gratitude. Their efforts, endurance and perseverance have made it possible that in one generation the step from illiteracy to a university degree was made, although normally it would have taken several generations. I would be pleased if I could give my children (InshaAllah) half of what my mother and father have given me.

I pray to my Lord, The Protector for His forgiveness. That He may protect us from evil and lead us to the right way, for He is my hope and my Light!

Our Lord! Perfect our Light for us, and grant us Forgiveness. ((((Quran 66:8)Quran 66:8)Quran 66:8)Quran 66:8)

Hicham Chara

Rotterdam, June 2009.

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Table of Content of Thesis.

EXECUTIVE SUMMARY ............................................................................................................ 6 INTRODUCTORY ......................................................................................................................... 9 1 SHARIAH ON FINANCE .................................................................................................. 12

1.1 SHARIAH ..................................................................................................................... 12 1.2 SHARIAH ON FINANCIAL TRANSACTIONS ........................................................ 16

1.2.1 The prohibition of Riba ........................................................................................... 17 1.2.2 The prohibition of Gharar ...................................................................................... 24 1.2.3 Rationale ................................................................................................................. 26

2 ISLAMIC FINANCIAL PRODUCTS .................................................................................. 29 2.1 IJARA (operating lease) and IJARA WA IQTINA (financial lease)............................. 30 2.2 MUSHARAKA (Profit and Loss Sharing)..................................................................... 32 2.3 MUDARABA (limited partnership)............................................................................... 35 2.4 MURABAHA (cost-plus sales) ...................................................................................... 37 2.5 SALAM AND ISTISNA (Islamic forwards) ................................................................. 38

3 OTHER ISLAMIC PRODUCTS .......................................................................................... 41

3.1 EQUITY AND INVESTMENT FUNDS ....................................................................... 41 3.2 FIXED INCOME FUNDS ............................................................................................. 43

3.3 TAKAFUL (permissible insurance) ............................................................................... 45 4 GOAL, CONDITIONS AND CRITIQUE OF ISLAMIC FINANCE .................................. 47 5 FACTORS DETERMINING ATTITUDES TOWARDS ISLAMIC FINANCE ................ 49

5.1 COMMERCIAL BANKING ......................................................................................... 49 5.2 ISLAMIC FINANCE ..................................................................................................... 50 5.3 CONCLUSIONS ............................................................................................................ 54 5.4 CONCEPTUAL FRAMEWORK .................................................................................. 54

5.4.1 Religiosity ............................................................................................................... 54 5.4.2 Attitude towards Riba prohibition .......................................................................... 55 5.4.3 Awareness and knowledge of Islamic Finance principals and products ................ 55 5.4.4 Education and Income level .................................................................................... 56 5.4.5 Age and Marital status ............................................................................................ 56 5.4.6 The conceptual model ............................................................................................. 57

6 METHODOLOGY ............................................................................................................... 58 6.1 RESEARCH DESIGN ................................................................................................... 58

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6.2 DATA COLLECTION ................................................................................................... 59 6.2.1 The questionnaire and the questionnaires administration...................................... 59

6.3 DATA CLEANING ....................................................................................................... 60 6.3.1 Outliers and Missing values.................................................................................... 60 6.3.2 Inconsistencies ........................................................................................................ 61 6.3.3 Recoding reverse coded items ................................................................................. 61 6.3.4 Conclusion .............................................................................................................. 61

7 SURVEY............................................................................................................................... 62 7.1 UNIVARIATE ANALYSES ......................................................................................... 62

7.1.1 Demographics ......................................................................................................... 62 7.1.2 Riba Prohibition and Awareness on Islamic Principles ......................................... 64 7.1.3 Attitude towards Islamic Finance ........................................................................... 66 7.1.4 Conclusions ............................................................................................................. 68

7.2 SCALE EVALUATION ................................................................................................ 68 7.2.1 Factor Analysis ....................................................................................................... 69

7.3 BASIC DATA ANALYSIS ........................................................................................... 71 7.4 REGRESSION ANALYSES ......................................................................................... 74

7.4.1 Regression model 1 (Dependent variable= Attitude towards Islamic Finance) .... 74 7.4.2 Regression model 2 (Dependent variable= Islamic Products Interesting) ............ 75

7.5 EVALUATION OF THE HYPOTHESES .................................................................... 76 8 CONCLUSION ..................................................................................................................... 80

8.1 DISCUSSION ................................................................................................................ 80

8.2 ACADEMIC IMPLICATIONS ..................................................................................... 83 8.3 GOVERNMENT AND BUSINESS IMPLICATIONS ................................................. 84

8.4 LIMITATIONS AND FUTURE RESEARCH DIRECTIONS ..................................... 87 References ..................................................................................................................................... 89 Appendix A: European council for fatwa and research on mortgages in the West ...................... 92 Appendix B: Conditions for Murabaha transactions. (Usmani, 2000) ......................................... 95 Appendix C: Regression model 3 (Dependent = Positivity towards Islamic Finance)................. 98 Appendix D: Regression model 4 (Dependent= Lack of Islamic Finance bothersome) .............. 99 Appendix E: Survey Questionnaire ............................................................................................ 100

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EXECUTIVE SUMMARY During this era of economic and financial crisis, governments around the world are contemplating the role of the financial system and the lack of ethics and control that has led to this instable situation. Throughout the world Islamic Finance is seen as a new and interesting way of financing. Muslims around the world try to abide with their religious injunctions on all areas, including their financial dealings. Muslim majority countries and nations with large Muslim minorities are providing their Muslims citizens the opportunity to utilize Islamic Financial products. In the Netherlands the government, several organizations and banks have investigated the opportunities in this market but so far without introducing it.

The purpose of this study is to give a detailed and extensive portrayal of Islamic Finance, including the theological basis; the assortment of Islamic Finance products as they now exist and their implications; as well as an empirical research to The Attitude towards and the interest in Islamic Finance by young Muslims and what factors determine them.

Islamic Shariah has the basic principal that all trade and transactions are permissible unless they transgress the prohibitions of Riba (interest or usury), Gharar (uncertainty) and Maysir (gambling). These are seen as exploitative, unfair, involving unnecessary risk or involving speculation, which are contradictory to the goals of broader Shariah placing emphasis on ethical, moral, social and religious dimensions to enhance equality and fairness for the good of society as a whole. (Iqbal, 1997) To ensure that Muslims abide by these prohibitions scholars and jurists have formalized several financing products/principals that adhere to Shariah, the most important ones are Ijara (lease), Musharaka (profit/loss sharing or partnership), Murabaha (cost-plus sale), Mudaraba (limited partnership), Salam and Istisna (Islamic forwards).

Only a few empirical researches in this field have identified factors that determine the attitude towards Islamic Finance, these factors are religiosity (in this research inner and actual), awareness of Islamic principles, education levels and the attitude towards the Riba prohibition. This study has collected enough primary information on these factors and individual characteristics from young Muslims through an online survey.

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The goal was to capture the attitude of young Muslims towards Islamic Finance and measure to what extend they were interested in Islamic Finance. On the basis of the factors already mentioned several hypothesis regarding their influence on the attitude towards and interest in Islamic Finance were formulated. The sample of 116 respondents consisted of mainly young, highly educated, ethnically divers Muslims; although a large portion (66%) either are 1st or 2nd generation Moroccan immigrants. Consequently, the results of the following data analysis can be generalized to a Muslim population with these characteristics and this group will be a substantial market share of the entire market for Islamic Finance.

The results of the survey found that the attitude of young Muslims towards Islamic Finance was positive (18%) or very positive (57%) and only 6% of respondents had a negative or very negative attitude. Most Muslims (64%) see the lack of Islamic Finance as bothersome. More than 90% were interested in at least one Islamic financing product, especially demand for housing financing (80%), Islamic Pension plans (63%), Islamic current accounts (69%) and Islamic savings accounts (68%) is high. The sample did not have a preference for a certain institution, whether it was a Dutch institution with Islamic products, a Islamic institution from the Islamic world or a Western Islamic institution did not matter much. However it was found that respondents have a strong preference for a mixture of international and national scholars in the Shariah board of such a Islamic financing institution. When asked which factors respondents regard as important for a possible switch to a Islamic Financial institution the service, the composition of the Shariah board and the image were named frequently. The results also stated that Muslims find costs and yields should be comparable to regular financing, indicating that the institution should not ask for a large premium for offering Islamic products.

The statistical analyses of the data provided interesting findings regarding factors that determine the attitude and interest in Islamic Finance. Among all factors examined in this study The Awareness of Islamic principals was found to be the most important driver of the attitude towards Islamic Finance and the interest in Islamic Finance. A significant positive attitude was found, meaning that the higher the awareness of Islamic Principals was the more positive the attitude towards and the higher the interest in Islamic Finance. Other factors that positively influence the attitude towards Islamic Finance were the attitude of Muslims towards the Riba

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prohibition and the actual religiosity. This actual religiosity measured the extent to which a Muslim practices the Islamic rituals such as prayer, morning prayer, mosque attendance and collective Friday prayer. It was found that the higher the actual religiosity the higher interest in Islamic products. It was also found that the higher the age the more negative the attitude towards Islamic Finance.

This study has its limitations and therefore sets out future research directions. However, it should be highlighted that this empirical study successfully identified several factors that determine the attitude of young Muslims towards Islamic Finance. The findings contribute to the formation of a theoretical framework that describes the determinants of the attitude towards Islamic Finance and their interest in Islamic financing products. It also has implications and gives recommendations for businesses, institutions and organizations that desire to offer Islamic products in the future.

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INTRODUCTORY slamic Finance is the result of several laws within Islamic law, Shariah, which includes the prohibition of Riba, meaning interest, usury or overcharge (see the discussion of the meaning of Riba in paragraph 1.2.1). Shariah, literally the way, is a blueprint for the way

a Muslim should lead his life and the way an Islamic society should be organized (Clark, 2004). In the first half of the 20th century several Islamic thinkers have derived from Shariah that an Islamic economy should be formed opposing the western capitalistic system and the eastern communistic system (Sardar, 1996; Kuran, 2006). This is to ensure that Muslims keep their own identity and obey the Divine Law, like the first Muslims did in the first Islamic state from the time the Prophet Muhammad (Peace Be Upon Him, PBUH) founded the first Muslim community, in 622, until the death of the last of the 4 rightly guided Caliphs1 in 661 (Clark, 2004). Even after that, Islamic modes of finance were widely used in the Muslim World throughout history and some were even adopted later by western financiers (Iqbal, 1997). Syed Maududi (1903-1979) the founder of Jamaat e-Islami in the forties in British India, Sayyid Qutb (1906-1966) one of the leaders of The Muslim Brotherhood' in Egypt and Muhammad Baqir al-Sadr (1931-1980) a Shii scholar in Iraq were among the ones criticising both socialistic and capitalistic forms of economy and were strong believers in a more fair and just system based on Shariah principles which incorporated the idea of The Islamic Economy (Visser, 2007).

In the second halve of the 20th century these ideas have led to the founding of several Islamic financial institutions in several Islamic countries. The first is believed to be a small bank in Egypt in 1963-1964, The Misr-Ghams bank. This bank was an experiment and did not project an Islamic image because of the fear that the regime would characterize the bank as a form of Islamic fundamentalism. Islamists like Qutb and Al-Banna (1906-1949) were outlawed and imprisoned and even put to death, because of their thoughts/ideas about the necessity to return to an Islamic Society, which includes the establishment of new leadership (Qutb, 1964). During the seventies the climate in the Middle East changed for Islamic thinkers and Muslim supporters of an Islamic economy which resulted in the founding of several Islamic financial institutions in

1 Caliph means the successor or representative of The Messenger of Allah (Subhanahu wa ta'ala=glorious and

exalted is He) Mohamed (PBUH). The first four Caliphs are seen as the four rightly guided; Abu Bakr, Umar, Uthman and Ali (May Allah be pleased with them).

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several countries. The Dubai Islamic Bank (1975), The Faisal Islamic Bank in Soedan (1977) and several other Islamic banks followed in the years after in countries like Malaysia, Philippines, Bahrain, Kuwait etc. (Ariff, 1988) In the Eighties Iran and Soedan even went as far as prohibiting al other forms of financing (Visser, 2007). The term Islamic Financial system or Islamic Finance is relatively new, appearing only in the mid eighties.

Since then Islamic Finance has been booming in several other Muslim countries and even western countries with a Muslim minority. The HSBC Group in 1998 started HSBC Amanah as its Islamic banking branch; Lloyd TSB has also introduced Islamic windows were Muslims can utilise several Islamic financing products in the UK. The Islamic Bank of Britain was founded in 2004 as the first stand alone Islamic bank in the UK. In several other western countries there are several Islamic financial institutions or Islamic windows among these countries are the US (Lariba and Devon Bank), Canada and Germany. Islamic windows are normal commercial banks that have incorporated Shariah compliant products in their assortment and offer these at special windows. Not only Islamic banking was introduced but also Islamic insurance etc.

As several other western countries are offering their Muslim minorities access to Islamic

products, one could ask why The Netherlands have not. Several organizations and academics have been researching whether or not Islamic Finance is a real option in the Netherlands. Among them are The Rabobank, ABN Amro, The Ministry of Finance and Bilaa-Riba. Bilaa-Riba is the first company that has tried to offer Shariah compliant products. Bilaa-Riba was founded in 2006 and closed down in 2008. Until now all these efforts are unfruitful because of two main problems. Firstly the interest deductibility in Dutch tax laws, making Islamic Finance more expensive than regular finance, due to the fact that the costs are not deductible because they are not interest. Secondly the Dutch real estate laws, causing double taxation due to the sale and resale of a house within Islamic Finance. Although these problems are not easy to solve the Minister of Finance, Wouter Bos, has expressed the hope that The Netherlands can become the Mecca of the financial world. Worldwide the market for Islamic Finance has passed the 400 billion dollars, making Islamic Finance very attractive (Hustinx, 2007). One might say that before these two problems have been solved Islamic Finance does not have a future in The Netherlands, but I personally believe that there is a future in Islamic Finance as long as the

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demand is sufficient. This demand depends on the attitude of Muslims towards Islamic Finance and their interest in Shariah compliant products. This should be thoroughly researched, before any further attempts are to be made to bring Islamic Finance to The Netherlands.

The purpose of this study will be to give a detailed and extensive portrayal of Islamic Finance, including the theological basis; the assortment of Islamic Finance products as they now exist and their implications; as well as an empirical research to The Attitude of young Muslims towards and their interest in Islamic Finance and the factors that determine them. Factors that can influence this attitude could be, age, income, education, knowledge of Islam, what generation immigrant, land of origin, how pious someone is as a Muslim, etc. The research question is:

What is the Attitude towards and the interest in Islamic Finance by young Muslims and

what factors determine them?

The answer to this research question should be interesting to several parties; companies that are interested in this niche market to find out how large the possible market is and what factors influence the attitude, the Dutch government, Muslim organizations that are trying to create bigger understanding for Islamic Finance, the Muslim community to get a better picture of Islamic Finance and the academic world to get a better understanding of the factors that determine the attitude towards and interest in Islamic Finance.

Before focussing on the attitude of Muslims towards Islamic Finance on the basis of a conducted survey, the basic rulings on Finance from Shariah will be outlaid in the first chapter. In the second and third chapter the principles and products that exist now in Islamic Finance will be explained and discussed. After that the reader will have had a comprehensive overview of Islamic Finance in order to understand the theological basis as well as the principles and products themselves. The remaining of this study will focus on the factors that determine the attitude of Muslims towards Islamic Finance and the methodology and findings of the survey. Finally the conclusions and recommendations will be made.

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1 SHARIAH ON FINANCE

1.1 SHARIAH hariah is not merely a collection of do's and don'ts, nor just a code of criminal laws prescribing punishments for certain crimes. Though it does contain both, its content is much broader and deeper, encompassing the totality of man's life. Shariah literally

means a 'clear path'. It is the path that man, in Islam, must walk as he toils and strives to reach his Creator. It is the yearning deep within to seek the Lord and the Master that Shariah translates into steps, concrete and specific, on the pathway of life. Shariah is the fulfilment of the total man- inner and outer, individual and corporate-as he seeks to live by the will of his one and only God (Khurram, M). Or as T. Ramadan puts it; if the idea of establishing rules is indeed contained in the notion of Shariah (from the root sha-ra-a), this translation does not convey the fullness of the way it is understood, unless its more general and fundamental meaning is referred to as the path that leads to the spring. (2004)

The goal of Shariah is broadly accepted to be; to promote the welfare (masalih) of human beings. The five points that Shariah caters most are: religion, life, intellect, lineage and property, the objective of Shariah (maqasid al-Shariah) is to protect these five basics (Al-Ghazali, 1055-1111). Shariah envisages the need for Justice and Equity throughout society. Justice is perceived in terms of equivalence (in exchange transactions) and reciprocity (in social relationships), but equity (ihsan) to the needy is urged on top of justice, ergo giving more than is due according to the standard of equivalence and reciprocity to ensure survival with dignity for all. Care for others tempers the self-interest that is ingrained in human nature. If the latter is necessary for survival at the individual level the former is crucial for survival as a group, at the social level. (Siddiqi, M.N, 2004).

How do Muslims know the will of Allah (swt2) and Shariah? It is based on 4 fundamentals/ sources of law (Usul al-fiqh) firstly formulated by imam al Shafii (767-819) and widely praised

2 SWT stands for: Subhanahu wa ta'ala is an Islamic Arabic phrase meaning, "glorious and exalted is He (Allah)."

(http://en.wikipedia.org/wiki/Subhanahu_wa_ta%27ala, 15-4-2009)

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as a framework by the scholars of all legal schools and Muslims (Ramadan, 2009) although there are differences in the 4th source:

1.The Quran: The holy book of Muslims, which was revealed to Mohammed (pbuh) by the angel Gabriel, Jibril in Arabic, between 610 and 632, The Quran is seen as the direct word of Allah (swt) and therefore any orders and bans in the Quran are to be obeyed. The Quran's main emphasis is unquestionably on faith and the moral conduct of men and nations; but it does lay down, both explicitly and implicitly, though with brevity, the principles, broad outlines and necessary rules and regulations which are essential for the formation of the community of Islam. For one cannot be realised without the other; the trust of Shariah cannot be fulfilled without the presence of moral fibre of the highest quality. (Khurram, M)

The Quran is seen as guidance from Allah (swt) to mankind: That is the Book, there is no suspicion about it, a guidance to the pious, Who believe in the Unseen, and keep up the prayer, and expend of what We have provided for them, And who

believe in what has been sent down to you, and what was sent down (even) before you, and they constantly have certitude in the Hereafter. Those are upon guidance from their Lord

and those are they who are the prosperous. (Quran 2:2-5)

In the Quran the Muslim is ordered to obey Allah (swt) and obey his Messenger (pbuh) on several occasions:

To follow and obey the Prophet is the only way one can love his God and be loved by Him and have one's sins forgiven (Quran 3: 31-32).

All matters which cause differences or disputes are to be referred to God and His Prophet as the final authority (Quran 4: 59).

No one can be truly a believer unless he accepts the Prophet as the final arbiter in all affairs and submits to his decisions, willingly and free from all misgivings (Quran 4: 65).

The Prophet has the authority to permit and prohibit (Quran 7: 157). Whatever the Prophet gives must be taken; whatever he forbids

must be eschewed (Quran 59: 7).

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To obey Allah (swt) one has to seek knowledge in the Quran, which is the Divine word of Allah (swt). But the above verses, which are clearly stated in the Quran, imply that a Muslim should obey The Messenger (pbuh) as well, which is the second source of Shariah (Clark, 2004).

2. The tradition of Mohammed (pbuh): this tradition (Sunna) consists of thousands of written traditions about sayings of The Messenger (pbuh), his acts and his silent approval of acts of other people. These traditions are called aHadieth. This second source is seen as extremely important, because The Messenger (pbuh) lived by and explained the Quran and as seen above the Quran ordered Muslims to obey The Messenger (pbuh). Allah (swt) says speaking to the Messenger (pbuh) in the Quran: And thus We have revealed to you a Spirit of Our Command. In no way did you realize

what the Book was, nor the belief; but We have made it a Light, whereby We guide whomever We decide of Our bondmen. And surely you indeed guide to a straight Path, The Path of Allah, to Whom belongs whatever is in the heavens and whatever is in the

earth. Verily to Allah all Commands are destined to Him. (Quran, 42:52-53)

As seen in these verses The Messenger (pbuh) invites to the way of Allah, explaining to the people what is not clear of Allahs disposition (AlQaradawi, 2004). A good example is the prayer which is ordered in The Quran but it is not explained how this prayer should be performed. The obliged prayers that Muslims do 5 times a day are done like the example of Muhammad (pbuh) derived from Ahadieth.

There are several Hadith collections the most reliable and extensive are the ones collected by Imam Bukhari (810-870) and Imam Muslim (817-874), these two are known in Sunni3 tradition as the two most important authentic collections. There are other important collectors like: Abu Dawud (817-888), At-Tirmidhi (824-892) and Al-Malik (715-796). The determination of the authenticity of a hadith is based upon the science of hadith, one part of the authenticity is the chain of narration, the other part is the narrated itself, each hadith is constructed of these two

3 Sunni Muslims are the largest denomination of Islam (80-85%)slam is also referred to as Sunnism or as Ahl as-

Sunnah wal-Jamh (people of the example (of Muhammad) and the community) which implies that they are the majority, or Ahl as-Sunnah for short. The word Sunni comes from the word Sunnah (Arabic: ), which means the words and actions[1] or example of the Islamic prophet Muhammad. (http://en.wikipedia.org/wiki/Sunni, 15-4-2009)

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things. The chain of narration must end with one of the companions of the Prophet. All names between the one telling the hadith to the hadith collector until the original source, one of the Companions (mAbpwh4), need to be known as trustworthy and no breaks are allowed within the chain to be seen as authentic. The narrated itself should be in line with Quran and other known authentic Ahadieth.

3. Consensus (ijma): This consensus is revered to as ideally the consensus of the Ummah (The community of Muslims). It finds it basis in the hadith of Mohammed (pbuh) which states:

Allah has protected you from three things: that your Prophet should not invoke a curse on you and should all perish, that those who follow what is false should not prevail over those who follow the truth, and that you should not you should not you should not you should not all agree in an errorall agree in an errorall agree in an errorall agree in an error. (Dawud; book

35: hadith 4240)

This consensus implicates that the entire Muslim community (Ummah) should be on the same line on an issue before it can become a source for Shariah. Because if they all agree, following with the above hadith, which states that the entire community can not agree in an error by the protection of Allah (swt), therefore they must be right if a consensus is agreed. Later on this consensus was seen as the consensus of scholars (ulama) of a certain generation in a certain school of thought/law (Madhab)5. After a consensus is reached this consensus is seen as a third guideline, next to The Quran and The Sunna. Any consensus which has a historical continuity from the days of the four Caliphs and the Companions of the Prophet is accepted to be binding. Any other consensus serves as a strong precedent but one which is nonetheless replaceable by another consensus. Ijma' (within the limits set by the Quran and the Sunna) provides a mechanism for the Ummah to undertake legislation collectively on issues and problems it may face in an ever-changing world, and even venture fresh thinking on past interpretations. (Khurram, M)

4 mAbpwh stands for: May Allah be pleased with him (her) an Islamic Arabic phrase asking Allah (swt) to be

pleased with a certain Muslim of significance in Islamic history. 5 In Sunni tradition there are 4 schools of law or thought that are widely accepted all named after their founders:

Hanafi/Maliki/Shafii and Hanbali. These schools are not seen as sects, every Muslim is automatically part of one school and the schools do not fight each other or deny each others right to exist. (Clark, 2004)

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4. Analogy (Qiyas): This is the process of analogical reasoning from a known injunction to a new injunction. So by this fourth source the rulings of Quran and Sunna may be extended to a new problem if the issue addressed in Quran and/or Sunna and the new issue share the same cause (illah). The cause is the specific set of circumstances that trigger a certain law into action. An example of this is the example of alcohol and drugs, alcohol is prohibited in Quran and Sunna, logically the reason for this is that alcohol intoxicates. Intoxication is bad because it removes the Muslim mind from mindfulness of Allah (swt) and His rules. Using analogy the scholars have also prohibited drugs for the same underlying reason, drugs intoxicates and removes the mind from mindfulness of Allah (swt). Using Qiyas, analogy, several new issues have been prohibited or allowed in Shariah law.

Qiyas is actually a form of Ijtihad: all exercise of reason and judgment by the scholars to determine Shariah is called Ijtihad. (Khurram, M) There are other forms of Ijtihad the main ones are: Istihsan (striving for the good), Istislah (striving for the right), ray (opinion), alurf (custom) and darurah (necessity). Ijtihad is used as a precursor for Ijma and has to be exercised within the framework provided by The Quran and the Sunna, this principle has made Shariah flexible on several issues throughout history. (Khurram, M; Clarke, 2004)

1.2 SHARIAH ON FINANCIAL TRANSACTIONS hariah has an influence on the everyday live of a Muslim; Shariah also includes several restrictions on financial transactions. The main restrictions regarding finance and investment are Shariah rulings on Riba, Gharar (uncertainty) and Maysir (gambling).

The basic principle in Shariah is that exploitative contracts based on Riba or unfair contracts that involve unnecessary risk or speculation (Gharar) or gambling (Maysir) are un enforceable. However the Quran does not contain a condemnation of morally acceptable investments that yield fair/legitimate profits and economic/social added-value. (Siddiqi, 1999) So finance is permissible as long as it does not contain unjust or unfair components. To make the Islamic Finance System something that only is interest-free is not correct, one should see the system in the context of Islam and the broader Shariah as a system that places equal emphasis on the ethical, moral, social, and religious dimensions, to enhance equality and fairness for the good of society as a whole (Iqbal, 1997).

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In the next sections the emphasis will be on the theological outlay of the prohibition of Riba and on Gharar purely based on Divine authority. Modern day Muslim Scholars always explain and emphasize this side of the prohibition, but many today also add their rational for the prohibition. Because one should not only know that something is Haram (forbidden) but should also try to figure out what the cause (illah) is of the prohibition. The rational, the advantages of an interest-free or usury free world are the same as given throughout history by several non-Muslims, these will also will be discussed in the last section of this paragraph.

1.2.1 The prohibition of Riba or 1400 years Muslims and Muslim Scholars have debated and contemplated the meaning of the word Riba. In this study it is chosen to leave the word Riba untranslated except in this part where the meaning is discussed. Some Muslims have stated that it

means usury or overcharging; these people argue that the prohibition does not apply to modern interest. As it does not inhabit an overcharging of interest, as is the case with Usury. However most Muslim Scholars throughout history of Islamic Jurisprudence (Fiqh) have disagreed with this view and have determined that any amount above the principal is seen as Riba, and therefore interest is entirely forbidden, this will be shown later on in the Quran verses. (Kahf, M) The majority, that claims that Riba is all forms of an extra amount added to the principal, says that there does not have to be an Ijma (consensus) about it because of the direct prohibition of Riba in Quran and Sunna. The group that states that modern interest rates are not Riba declare that there is no Ijma that interest is Riba and therefore there can be no such thing as a prohibition of Interest.

The prohibition of Riba is unquestioned, but the definition of Riba lies open to debate. This issue of non-consensus has made it one of the most difficult and most discussed prohibitions in Islam. Sources going back to one of the Companions of The Prophet (pbuh) declare that Umar the 2nd Caliph (mAbpwh) said: the verses of Riba are among the very last revealed verses, and the Prophet (pbuh) died before he fully explained it to us; thus avoid Riba and things that are similar to it. (Ibn Kathir, 14th century)

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Among those whom state that the prohibition of Riba does not automatically imply a prohibition of interest is an organisation of American Muslim Scholars: Minaret of Freedom. They argue that the word Riba has never been clearly defined and compared the Quranic meaning of the word Riba to the definitions of interest, usury and overcharging. They conclude that the latter two are, depending on the context, better translations of the term Riba than the word interest. According to them the Quranic verses (which are discussed in the next paragraph) about Riba make four things abundantly clear: (1) It involves amounts which are in some sense large; (2) Its distinction from legitimate trade is so obvious that only a madman could confuse the two; (3) It may be contrasted to charity; (4) It is unjust (Imad-ad-Dean Ahmad, 1993).

At the root of the attacks on interest is the assumption that by one standard or another it is unearned, the capitalist making money without doing something. There is a certain amount of risk a capitalist takes when investing his money (acting like an entrepreneur) and this is incorporated in the interest percentage. The problem is that interest not only constitutes this risk, but also constitutes other factors according to Bhm-Bawerk (1959). He showed that a substantial part of interest is the time-preference, when an investor does not have the power of disposal to his funds he suffers a diminution of the subjective value of capital unless a compensatory interest rate is also offered. If this rate is not offered, the investor suffers a subjective loss of his capital sum because he is not able to use it and isnt offered any form of compensation. It is actually this time-element compensation for a subjective loss that the majority of scholars have said is Riba; any addition to the capital sum (see below). Someone who lends out money should not do that for personal gain but out of charity towards the needy. But they are opposed by the libertarian view that the time element is not the defining element of Riba. According to them the time-compensation is not only Halal within trade, offering discounts for cash payments or a surcharge for deferred payment, but this is also allowed in financing as long as there is no overcharging or fine when the debtor is in default (usury). This means that the interest rate should be in line with the applicable market-interest rate, because if this compensation is not offered the investor will suffer a subjective diminution of his capital sum which is seen as Riba, he will get less subjective value back by the deferral (Imad-ad-Dean Ahmad, 1993).

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However, as stated before, the above view is not the majority standpoint for Muslims or Muslim scholars; the majority of scholars think that Riba covers the interest stipulated at the time of the contract in case of loans as well as the subsequent increases in case the loan or the debt arising from sale on credit is rolled over because the debtor does not pay it at the time stipulated in the contract (Badawi, 1964). In the next pages it will be showed what the main sources of Shariah (Quran and Sunna) say about this issue and it will become clear how Traditionalist Scholars derive from this sources that interest is Riba and therefore Haram.

Quran on Riba s usual in the Quran any prohibition comes in the revealed Text in stages, the prohibition of Riba is no different than others. The first stage is building moral resentment against taking Riba:

And whatever you bring in Riba, that it may augment upon (other) persons wealth, then it does not augment in the Providence of Allah; and whatever you bring in Zakat, willing to

seek the Face of Allah, then those are they who will get (recompense) manifold. (Quran 30:39)

This verse came to the Prophet (PBUH) several years before the prohibition of Riba, after this verse other verses were revealed that included a condemnation of Riba as a facet of disobedience that is a reason to earn the anger of Allah (swt). These verses tell the Muslims about what people did before them:

So, for the injustice (on the part) of (the ones) who have Judaized, We have prohibited them good things that were lawful to them, and for their barring from the way of Allah many

(people), And for their taking of Riba, and they were already forbidden it, and eating (up) the riches of mankind untruthfully; and We have readied for the disbelievers among

them a painful torment. (Quran 4:160-161)

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This verse speaks of the prohibition of Riba for Jews, and their barring away from it. The Torah/ Old Testament includes a prohibition of Interest or Usury6, but in history it is clear that both religious groups Jews and Christians have almost entirely given up on this prohibition, this was so in the time before the Prophet (pbuh) and still is so in modern day economics. Years after this verse was revealed another verse came to the Prophet (pbuh) which included a final prohibition of Riba:

O you who have believed, do not eat Riba, doubled (and) redoubled, and be pious to Allah that possibly you would prosper. (Quran; 3:130)

After the total and complete prohibition of Riba comes the last stage that declares Riba as one of the gravest sins in Islam and explains better what Riba is. Especially this specific Riba al-jahiliyyah; it is the practice that pre-Islam Arabs used when a debtor could not make the payment date of a debt, the debt was then doubled or redoubled as a punishment for not making the payments on time. It is the classic case of usury, where the debtor becomes totally dependent on the lender. This form of Riba can also be seen as the resale of the current debt to the debtor for a higher price and a longer deferment period (El-Gamal, 2000). Some Scholars have used this resale of debt to the debtor to prohibit all re-sales of debt, which has large consequences for commercial banks as the re-sale of debt has become an ordinary practice in western finance.

In the last verses the gravity of the sin is pointed out, it is important because it explains that Muslims should not take Riba lightly, as described earlier it is one of the most difficult issues in Islam, for scholars as well as ordinary Muslims. The following verses about Riba where revealed as last:

The ones who eat (up) Riba will not rise up except as he whom Ash-Shaytan ever smites with the touch rises up. That is because they have said, Surely selling is only like Riba.

And Allah has made selling lawful, and has prohibited Riba. So he to whom an

6 Many scholars in the western world in the middle ages and even going back to the ancient Greeks were strongly

against interest and usury; Thomas of Aquino, Aristotle, Dante etc. Some used theological reasoning, derived from the Bible but other also used secular reasons the main one being that money does not have a natural gain. The Catholic church strongly opposed Usury well into the Middle ages and eventually after the reformers (Calvin and Luther) interest became a normal thing in the Western world.

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admonition has come from his Lord (and) so has refrained (in obedience), then he will have whatever is bygone, and his case is for Allah; and whatever goes back, then those are the

inhabitants of the Fire, and they are therein eternally (abiding). (Quran; 2:275)

Allah expunges the Riba and He augments donations, and Allah does not love every most disbelieving most-vicious person. (Quran; 2:276)

O you who have believed, be pious to Allah and leave behind what remains of Riba, in case you are believers. So in case you do not perform (that), then take notice of a war from Allah and his Messenger (against you). And in case you repent then you will have your capitals of your riches; you will not do injustice, and you will not be done injustice. And in case any person is under difficulty, then he should (be granted) a respite to (the time of) ease; and that you donate (alms) is more charitable for you, in case you know. (Quran; 2:278-280)

In these verses the severity of the sin is described; it is the only sin that contains a notion of war from Allah and his Messenger for the sinners. There are also several aHadieth about the severity of the sin and the punishment on devouring Riba which will be discussed later on. Another point made clear in the above verses is that Riba is seen as unjust and seen as the opposite of giving charity or donations. Scholars also refer to these verses when they formulate the answer to the delicate question: Is interest Riba?:

And in case you repent then you will have your capitals of your riches; you will not do injustice, and you will not be done injustice.

This sentence is the main source for most Scholars and Muslims throughout history to believe that any excess above the capital (principal) in a lending contract is seen as Riba (Kahf, M). If one repents from the sin of Riba he will get back his capital sum, he will have suffered no injustice nor will he inflict injustice. Taking more or less then the capital sum back will mean that the practice is still Riba and that it either means that he inflicts injustice (increase of the amount) or means that he suffers injustice (decrease of the amount) (Gamal, 2000). But as discussed above the libertarian view also uses the same verse to make clear that interest can

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take away the subjective depreciation of the value of the capital sum, and they say the that if this depreciation is not compensated the capital sum loses value, which is Riba (Imad-ad-Dean Ahmad, 1993).

Sunna on Riba here are several Hadiths on Riba in the hadith collections, some about the severity of the sin and others about what Riba is:

Abu Sa'id al-Khudri (Allah be pleased with him) reported Allah's Messenger (may peace be upon him) as saying: Gold is to be paid for by gold, silver by silver, wheat by wheat, barley by barley, dates by dates, salt by salt, like by like, payment being made hand to hand. He who made an addition to it, or asked for an addition, in fact dealt in Riba. The

receiver and the giver are equally guilty. (Muslim; book 10; hadith 3854)

Most traditionalist scholars have derived from this hadith using Qiyas (analogy) that money is also one of these goods that should be traded in equal amounts and hand-to-hand. Gold and silver are seen as the original currency, the paper money we now have today are seen as the same kind of currency and therefore the same rules that apply to gold and silver also apply to money (El-Gamal, 2000). Any violation of the above hadith will result in one of two forms of forbidden Riba:

1. Riba al-fadl: increasing the amount of one compensation when trading goods eligible7 for Riba with goods of the same genus immediately with no deferment. (Al-Zuhayli, 2003)

2. Riba al-nasiah: the deferment of a liability in return for an increase (which is also called Riba al-jahiliyya), or the delay of receiving one of two compensations when trading goods eligible for Riba for goods of the same genus. (Al-Zuhayli, 2003)

7 Jurists agreed on the prohibition of surplus Riba in the seven goods listed in the Hadith: gold, silver, wheat,

barley, dates, raisins and salt. Thus trading any of those goods for goods of the same genus is forbidden. However jurists from the schools disagreed over the prohibition of trading in the same genus in different amounts for other goods:

The Zahiris restricted the prohibition to the listed goods. The Maliki and Shafii schools restricted the prohibition to monetary numeraire and nutritious and storable

foodstuffs. The Hanafis and Hanbalis restrict the prohibition to any goods that are measured by weight or volume. (Al-Zuhayli, 2003)

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The second one is the one that is common practice in western finance, to repay the lender the time value of money the borrower makes interest payments. As we have shown this is seen in Islam as Riba by most Scholars, and this is what the Prophet (pbuh) said about the ones that deal in Riba:

Ubaidullah b. Abu Yazid heard Ibn 'Abbas (Allah be pleased with them) as saying: Usama b. Zaid reported Allah's Apostle (may peace be upon him) as saying: There can be an element of interest in credit (when the payment is not equal). (Muslim; book 10; Hadith

3877)

Abdullah ibn Masud reported The Messenger of Allah (pbuh) cursed the one who devours Riba, the one who pays it, the one who witnesses it, and the one who documents

it. (Abu Dawud; book 22; hadith 3327)

These Hadiths make clear that it is not only Haram to devour Riba, but also to pay Riba, to be a witness of it or to be the one that documents it. This has serious consequences for every Muslim, but especially the ones that do not have the opportunity to engage in Islamic Finance or do not live in an Islamic country. Because of the important role interest plays in western finance,

economics and daily life it is extremely difficult, to not say impossible, for a Muslim in the western world to stay away from Riba. Working at a western financial institution or any other companies for that matter, having a simple savings account, or taking on a mortgage can cause

the Muslim to have internal struggle and conscience issues. That is why Islamic Finance can play a very important role in the life of Muslims in the West and elsewhere.

Although that interest is considered as Riba and should therefore be avoided according to traditionalist scholars, there have been some different opinions. Several religious rulings (fatwas) permit banking interest. The most famous is the ruling of Dr. Muhammad Sayyid Tantawi (then the Mufti of Egypt), in 1991, permitting all banking interest in all parts of the world. (Al-Zuhayli, 2003) Some other scholars give some space for the Muslim living in a western country where there is no form of Islamic Finance. In 1999 there was a council of respected and well known scholars in Detroit, headed by Dr. Yusuf AlQaradawi, which issued a legal statement (fatwa) considering and explaining the law of need (al-hajah) concerning mortgages, see appendix A.

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Two key points need to be present according to this fatwa before taking a mortgage becomes permissible for a Muslim. First, all other possibilities for financing in a Halal way are exhausted, meaning that there are no forms of Islamic Finance available, or other interest-free possibilities (community, family etc). The second one, the need (al-hajah) is less objective, and can only be determined or assessed by the concerned person himself. He knows for sure his needs, he knows what creates hardship for him, what is essential and what is not. One must realize that one is dealing with Allah (swt) Who knows best and is aware of everything, i.e., things that we keep in our hearts and things that we reveal. The assessment of hajat (plural of al-hajah) differs from one person to another; this is correct and natural. Needs that are recognized by the fatwa are: the need to have a suitable neighborhood to live in, decency, non-involvement in drugs and crime, good schools, availability of rental housing with comparative cost, availability of housing for large family, closeness to Muslim and/or non-Muslim peers, the tax effect and the final cost, building equity, etc. This permission only exists for Housing finance because it is fairly hard to save for this yourself and housing is a essential part in human life. (Kahf, M islamonline.net)

Another key point is that Muslims should strive as a community to make Islamic Finance possible in these countries.

1.2.2 The prohibition of Gharar he best translation of the word Gharar is uncertainty or risk, or the danger of losses. There are several Hadiths forbidding Gharar sales, and specifying what they are. One of these Hadiths returned in almost every Hadith collection:

Abu Huraira reported the Prophet (pbuh) prohibited the pebble sale and the Gharar sale.

Lots of classical examples of Gharar were mentioned in the Hadiths. They were mostly about the sale of products that were not certain like the sale of fish in the sea, birds in the sky, an unborn calf, a runaway animal, the semen and unfertilized eggs of camels, un-ripened fruits on trees etc. In all cases it is in the interest of the trading parties to be very specific about what is being sold and for what price (Gamal, 2000). Another Hadith that specifies Gharar is the next:

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Abu-Said Al-Khudriy reported that the Prophet (pbuh) has forbidden the purchase of the unborn animal in its mothers womb, the sale of the milk in the udder without

measurement, the purchase of spoils of war prior to their distribution, the purchase of charities prior to their receipt, and the purchase of the catch of a diver.

This Hadith explains several forbidden transactions, scholars later derived that the Gharar lies in the uncertainty regarding these sales. This means that one should try to make the sale as clear as possible to reduce the uncertainty and both parties know what they are trading. In the case of the diver for example it means that one can not purchase the catch of a diver for a certain price. But one can pay a fixed price for a fixed period of time in which the diver will work for the other party, and whatever the diver finds will belong to the buyer. In this case the object of sale is clear and well-defined namely the divers labour. In many cases Gharar can be eliminated from contracts by carefully stating the object of sale and the price to eliminate unnecessary ambiguities (Gamal, 2000). The higher the risky nature of a transaction the more the trade becomes similar to gambling (Maysir) which is Haram:

O you who have believed, surely wine and games of chance, and altars (for idols) and divining are only an abomination of Ash Shaytans doing, so avoid it, that possibly you

would prosper. Surely Ash Shaytans would only (like) to excite enmity and abhorrence among you by means of wine and games of chance, and to bar you from the remembrance of

Allah, and from prayer. Will you then be refraining? (Quran; 5: 90-91)

The problem with this prohibition, unlike the prohibition of Riba, is that it is relative. A sale is prohibited only if, in the sale, the major component is Gharar (bayu al-Gharar). On the other hand, minor (yasir) Gharar does not render a sales contract invalid, because no contract can be entirely free of Gharar. Thus, the legal scholars differ in determining which contracts are defective, due to differences in opinion regarding the extent of Gharar inherent in each: whether it is substantial and invalidates the contract, or minor and retains the contracts validity (El-Gamal, 2000).

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Al Darir (1997) lists four necessary conditions for Gharar to invalidate a contract: 1. It must be major. 2. The potentially affected contract must be a commutative financial contract (this includes

sales but excludes gifts and charitable contributions, including sharing arrangements). 3. The Gharar must affect the principal components of the contract (e.g. the price and object

of sale, language of the contract, etc) 4. That there is no need met by the contract containing Gharar which cannot be met

otherwise.

In contemporary financial transactions, there are two areas where Gharar most profoundly affects common practice and they are insurance and financial derivatives. It is clear that within the insurance business the product that is actually sold is unclear and highly uncertain. On the one hand one might pay lots of money for an insurance policy without ever getting anything back for it, on the other hand one can also pay for an insurance policy while the cost of, for example, ones illness is much higher than all of the payments made. This way it remains unclear and uncertain what will happen. The argument that both parties in the trade, the insured and the insurance company willingly signed the agreement does not hold, for the same reason a contract between two gamblers or a Riba transaction is not Islamically correct. The transactions are not based on justice and equality, nor are they free of bias and ambiguity (AlQaradawi, 2003). More on Insurance will follow in the paragraph on Takaful in chapter 3.

The second set of relevant contracts which are rendered invalid because of Gharar are forwards, futures, options and other derivative structures. The uncertainty here is clear and therefore it is perceived as Gharar and sometimes even Maysir and these financial products are therefore not permitted by Shariah within Islam. Islamic Finance has come up with some alternatives such as Salam and Istisna which will be discussed in the next chapter.

1.2.3 Rationale sury and interest has been around for thousands of years and it seems that during this time it also has been criticised throughout history by all kinds of religions (Judaism, Christianity, Islam, Hinduism and Buddhism), but also by great U

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philosophers/politicians of ancient times among them Plato, Aristotle, the two Catos, Cicero, Seneca and Plutarch (Birnie, 1958), and even Modern economists who are/where flat out anti-interest like Silvio Gesell and Margret Kennedy (Visser/ McIntosh, 1998). Because interest has only become to play a bigger and more important role in everyday life of the modern day man, and modern day world economics it seems that these critiques should be looked at carefully and should be taken into account by individuals, groups, communitys and nations when looking at themselves and the way that their society is built up. The rationale from all these very different people in different times, from different religions and convictions are very much similar to the rationale Muslim Scholars give on the Islamic prohibition of Riba today, they can be divided in several categories for critique:

Usury as unearned Income: One important argument given by the Christian Church at The Lateran Council in the year 1515: This is the proper interpretation of usury when gain is sought to be acquired from the use of a thing, not in itself fruitful (such as a flock or a field) without labour, expense or risk on the part of the lender. Dante later on even made clear the severity of the sin, putting usurers in the same circle of Hell as the inhabitants of Sodom and other practisers of unnatural vice (Birnie, 1958). Islam also envisages that interest is unethical because money does not grow out of itself, if one acts and puts in effort one can make a profit, but interest is not the result of hard work, it is predetermined. Aristotle ones said: A piece of Money cannot beget another. (Visser/Mcintosh, 1998)

Usury as exploitation of the Needy and inadequate way of redistribution of wealth: Almost all traditions see this as the biggest issue; the one who needs money for survival, or starting up a good idea, pays an interest rate to the one lending him the money (the richer one). It has an unethical side to it, recognized by all traditions throughout history even in modern times; take a look at the Third World Debts and how much of their current debt consists of the accumulated interest. Despite some Western countries (especially the welfare states) trying to redistribute the wealth in their economies through taxes and welfare systems, one of the most clear and at hand systems that redistributes

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money the opposite way from poor to rich is not seen as unfair or unjust by the mainstream population. (Visser/Mcintosh, 1998)

Usury as an agent of Economic instability: Gesells (1904) main objection to interest is that it is an endemic factor in the instability of interest-based economies, i.e. the cycles of boom and bust, recession and recovery. He stated that interest made it attractive not to spend money but to save it, causing under spending. Others also see this instability as a major problem, the rate of interest is not self-adjusting at the level best suited to the social advantage but constantly tends to rise too high (Keynes, 1936). Modern day Islamic Bankers and Economists point out that reoccurring crisis situations in economies, like the present day Financial/ Economic crisis, are incorporated in interest-based economies; the unnecessary and unethical risks that are taken because of the sheer availability of capital. (Visser/McIntosh, 1998)

Usury as discounting the future: Interest rates are used to discount future values of cash flows to Net Present Values. This simple and widely used principle is rarely questioned. But several critiques have been made on this issue, Pearce and Turner (1990) show that discounting affects the rate at which we use up natural resources- the higher the discount the faster the resources are likely to be depleted. Others like Daly and Cobb (1990) add a logical conclusion and show that discounting can lead to the economically rational extinction of a species, simply if the prevailing interest rate happens to be greater than the reproduction rate of the exploited species. A more economic critique but also ethical is that a consequence of the discounting principle is that in evaluating long term investment projects, particularly those in which the benefits and costs are separated from each other with a long time interval, the net present value rules guide the decision maker to maximise the utility of present generations at the expense of future ones (Kula, 1981).

Maybe it is all of the objections to interest, mentioned above, what Keynes meant when his biographer (Skidelsky, 1992) comments that: Keyness sense that, at some level too deep to be captured by mathematics, love of money as an end, not a means, is at the root of the worlds economic problem.

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2 ISLAMIC FINANCIAL PRODUCTS rade is very important for mankind; Islam does restrict certain kinds of trade, mostly because of the prohibition of Riba and Gharar, but does encourage trade that does not contain either:

Rafi reported that the Prophet (pbuh) was asked: which are the best forms of income generation? He (pbuh) replied: A mans labour, and every legitimate sale.

Therefore any financing conducted through valid trading by mutual consent is permissible. Another important thing is that the Prophet (pbuh) was a trader himself for several years and was known for his excellence herein. Every sale or contract which does not contain certain specific Haram conditions is seen as Halal, but because of the fact that most Muslims do not have sufficient knowledge regarding these various conditions Scholars, jurists and financial practitioners have limited Islamic Finance to a few named contracts or products. These contracts have been studied extensively by Islamic law jurists over the centuries, and their validity is well established through the Prophets (pbuh) own actions (Sunna), or consensus of the early Muslim communities and jurists (Ijma) (Gamal, 2000). The following paragraphs will include a extensive and clear description of several Islamic Finance products. These products encourage risk-sharing, promote entrepreneurship, discourage speculative behaviour, and emphasize the sanctity of contracts (Iqbal, 1997). They all are permissible under the conditions given and do not contain any of the already mentioned and discussed forbidden actions (Riba and Gharar). Even though Islam has formed various ways of financing that are in no form a loan, as seen below, sometimes a person is forced to take out a loan out of mere necessity. This loan should then be provided to him by a lender not under the precondition of Riba but out of mercy and charity. The Muslim borrower should keep in mind that the lender has given him the loan in mercy and out of charity and should strive to repay the loan as soon as possible because of the Sunna of The Messenger (pbuh) which states that he had an aversion to debt like in this hadith narrated by Aisha:

The Prophet used to say, "O Allah! I seek refuge with You from laziness, from geriatric old age, from being in debt, and from committing sins. (Bukhari; book 8; volume 75; hadith

386)

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2.1 IJARA (operating lease) and IJARA WA IQTINA (financial lease) jara is a term that lexically means to give something on rent. The term Ijara is used for two different situations; in the first place it means to employ services of a person on wages given to him as a consideration for his hired services. This type of Ijara includes every

transaction where the services of a person are hired by someone else, it has nothing to do with finance. The second type of Ijara is related to the usufructs of assets and properties, and not the services of human beings. Ijara in this sense means to transfer the usufruct of a particular property to another person in exchange for a rent claimed from him. This type is relevant to finance because it is generally used as a form of investment, and as a mode of financing also (Usmani, 2000). The sale of a usufruct is permissible in Islam, as evidenced by these verses:

So in case they suckle for you, then bring them their rewards. (Quran; 65:6)

One of the two women said: O my father, hire him, surely the most charitable (man) you can hire is the one powerful and trustworthy. He said: Surely I would like to marry you

to one of these, my two daughters, on (condition) that you hire yourself to me for eight pilgrimages. Yet in case you perfect ten, then it will be of your own accord; and in no way would I like to press arduously upon you. You will soon find me, if Allah decides, one of

the righteous. (Quran; 28:26-27)

There also is an important Hadith on rent or lease;

Sad reported that: We used to lease land for what grew by the streamlets and for what was watered from them. The Apostle of Allah (pbuh) forbade us to do that, and commanded to lease it for gold and silver. (Abu-Dawud, book 22: hadith 3385)

The normal Ijara construction is actually a bit different than a normal operating lease construction, one party, the lessor, has to own the leased object and then transfers the usufruct to another party, the lessee, for an agreed period at an agreed price while the object stays in the property of the lessor. The key point is that no middle party, or financer can come into the transaction, the owner and the lessor need to be the same person or entity, and the user and lessee also have to be the same, no sub-lease is allowed within Shariah simply because the lessee is not the owner he is only allowed to benefit from the usufruct. After the lease has been agreed the

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lessor can (partially or wholly) sell his property to a third person or group of persons whom then become the lessor and owner. This way the lease can be securitized which may help create a secondary market for the financiers on the basis of Ijara. For the lessee nothing changes only the ownership of the property, which means that the lessor has changed. This securitization has to be done committing to the rules of Shariah; ergo the owner and lessor have to be the same and have to have the full, or partial to their share, risk of ownership of the property. The same way the risk

of the usufruct has to stay with the lessee for the entire time of the lease agreement. In normal

Ijara the position of Shariah is that at the end of the lease-period the asset is sole property of the lessor, after the expiry of the lease period the lessor shall be at liberty to take the asset back, or to renew the lease or to lease it out to another person. If a lease agreement contains a condition that the property of the asset will be given or sold to the lessee at the end of the period, the agreement becomes invalid according to Shariah law, unless the agreement is set-up as an Ijara wa Iqtina (Usmani, 2000).

The Ijara wa Iqtina construction is an Islamic alternative to conventional lease-purchase agreements. In this contract, a lease is written like the one discussed above, with an additional promise by the lessor that he will agree to sell the leased object at the end of the lease at a pre-determined residual value. This promise should be unilateral and binding for the lessor only, and the lessee has the option of purchasing the item at the end of the lease, or returning it to the owner-lessor (Gamal, 2000). This is because if it is a bilateral agreement it is a full agreement of a sell of an asset on a future date which is prohibited within Shariah. Something else that is allowed by Shariah according to the scholars is that, instead of a separate promise of sale, the lessor signs a separate promise to gift the leased asset to the lessee at the end of the lease-period, subject to his payment of all amounts of rent. This agreement of giving or selling the asset to the lessee by the lessor should be recorded in a separate contract, it can not be part of the original Ijara agreement. This is because within Shariah it is a well settled rule of Islamic jurisprudence that one transaction cannot be tied to another transaction so as to make the former a precondition for the other that is why the selling or giving of the asset to the lessee should always be a unilateral one in a separate agreement and should give the lessee the option to buy or receive as a gift not an obligation (Usmani, 2000).

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2.2 MUSHARAKA (Profit and Loss Sharing) usharaka literally means sharing, in the context of business and trade it means a joint enterprise in which all the partners share the profit or loss of the joint venture (Usmani, 2000). It is the ideal alternative for the interest-based financing

techniques which are prohibited in Islam and is therefore seen as the purest form of Islamic Finance by many Scholars. The importance of Musharaka is actually not based on a solid juristic or religious evidence but rather based on the jurists economic reasoning (Gamal, 2000). It is actually no different from western equity financing, the financier becomes a shareholder of the enterprise sharing in the profit in a pre-agreed ratio but sharing in the loss in proportion to his equity participation, that is why another name for Musharaka widely used in the literature is Profit and Loss Sharing (Zaher and Hassan, 2001).

It seems to be an easy form of Islamic Finance but there are several features that are peculiar and need to be in a contract before the contract of Musharaka is valid by Islamic Law. The proportion of profit to be distributed between the partners must be agreed upon at the time of effecting the contract. The ratio of the profit for each of the partner must be determined in proportion to the actual profit accrued to the business, and not in proportion to the capital invested by the partners. It is also not allowed to fix a lump sum amount for any one of the partners, or any rate of profit tied up to his investment (Usmani, 2000).

The proportion of the profit allocated to the partners in the contract cant exceed their actual contribution in the enterprise according to 2 schools of thought (Maddhab) within Sunni Islam formulated by their founders Imam Malik and Imam Shafii. Imam Ahmed Hanbali disagreed with them, his view and of the school is that the ratio of profit may differ from the ratio of investment if it is agreed between the partners with their free consent. Imam Abu Hanifa, founder of the Hanifa school of thought, presented a third view which can be seen as the middle way between the two above, he says that the ratio of profit may differ from the ratio of investment in normal conditions. However, if a partner has put an express condition in the agreement that he will never work for the Musharaka and will remain a sleeping partner throughout the term of Musharaka, then his share of profit cannot be more than the ratio of his investment. In the case of loss all the imams and schools of thought are in consensus (Ijma), each

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partner shall suffer the loss (which is not limited to their invested funds) exactly according to the ratio of their investment. This means that the liability in Musharaka is unlimited, if the liabilities of the business exceed its assets and the business goes in liquidation, all the exceeding liabilities shall be borne pro rata by all the partners. Unless they have agreed that no partner shall incur any debt during the course of business, then the exceeding liabilities shall be born by the partner alone who has incurred a debt on the business in violation of the condition. (Usmani, 2000)

Another point where the Schools of Thought differ is the nature of the invested funds, Imam Malik and some Hanbali jurists view is that liquidity of the capital is not a condition, therefore the investment of a partner can be made in kind, but the share will be determined in accordance with the market price prevalent at the date of the contract. Imams Abu Hanifa and Ahmad Hanbali do not agree and are of the view that no contribution in kind is acceptable in Musharaka. Imam al-Shafii makes a difference between some commodities that can be part of Musharaka and other that can not. Usmani (2000) mentions in his view that for Imam Maliks view is the simplest and most reasonable one and that it meets the needs of modern day Finance. The normal principle of Musharaka is that any of the partners has a right to take part in its management and to work for it. However the partners may agree upon a condition that the management shall be carried out by one of them, and no other partner shall work for the Musharaka. In this case the sleeping partner(s) should be entitled to the profit only to the extent of their investment, and the rate of the profit allocated to him should not exceed the ratio of his investment.

The termination of a Musharaka agreement, in history and in jurisprudence, has been at the request of one of the partners. If the assets are in cash form they are divided between the partners in accordance with their ratio of investment. If the assets are not liquid they should be sold or the other partners can agree with the partner who wants to sell on a price. This way the Musharaka

can live on without being terminated, especially in modern day economics, continuity of a Musharaka is of huge importance for its success. Usmani (2000) states that this can be resolved with a condition in the Musharaka agreement that the liquidation or separation of the business shall not be effected unless all the partners, or the majority of them wants to do so, and that a single partner shall have to sell his share to the other partners and shall not force them on liquidation or separation. In his view there is no bar from Shariah point of view if the partners

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agree to this by mutual consent at the beginning of the Musharaka. The big advantage of such a condition is that long term projects with large amounts of investments involved can not be terminated at the arbitrary of one of the partners causing the Musharaka great loss, loss to the other partners and even to society if the Musharaka is liquidated or separated. This condition is supported by the general principle laid down by the Prophet (pbuh):

All the conditions agreed upon by the Muslims are upheld, except a condition which allows what is prohibited or prohibits what is lawful.

One model of financing which is based on Musharaka, is a form where the financing agency and the customer share the ownership of real estate. This is mainly known as Musharaka

mutanaqisah (diminishing partnership). In contrast to the Ijara model (leasing), where ownership remains with the lessor as described above, ownership in diminishing partnership is explicitly shared between the customer and the Islamic Financial Institution. The periodic payments made by the customer contain two parts: (i) a rental payment for the part of the property owned by the Islamic Financial Institution, and (ii) a buy-out of part of that ownership. Over time, the portion of the asset which is owned by the customer increases, until he owns the entire asset and needs to pay no more rent. This is slightly different than the Ijara-wa Iqtina agreement where the lessor gives the lessee the option to buy the asset at the end of the lease-agreement at a predetermined price. The diminishing partnership looks a lot like a normal mortgage schedule, in the beginning the rent part of the payments will be bigger, later on (as more payments have been made as buy-out) these rent payments will get smaller as the customer will gain more ownership and ergo will pay less rent for the ownership of the financier.

That the payments can be easily seen as, or be compared with, normal interest based mortgage payments does not matter and can even be an advantage. The difference between the two is simply in the contract, one is forbidden (interest based) and the other is not (Musharaka), but that they can easily be compared gives the devout and intelligent Muslim the chance to know for certain that he is not paying an excessive price to the Islamic Financial Institution (Gamal, 2000).

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2.3 MUDARABA (limited partnership) he difference between Musharaka and Mudaraba is that in Mudaraba the investment does not come from all partners, as in Musharaka, but only comes from one partner who is called the rabb-ul-mal (financier), while the management and work is an

exclusive responsibility of the other partner, who is called mudarib (agent). It is comparable to the western style limited partnership, where the investor provides the capital while the other runs the business and profit is distributed based on a negotiated percentage of ownership. In case of a loss, the investor earns no return or a negative return in its investment and the agent receives no compensation for his effort. It is actually a trust based finance agreement where profits are based on a pre-agreed on ratio (Zaher and Hassan, 2001). The key of the matter is the Trust part. Within Shariah the agent can not be held accountable for a loss because he did not invest anything except his time and effort. But this principle is subject to a condition; that the agent (mudarib) has worked with due diligence which is normally required for the business of that type. If he has worked with negligence or has committed dishonesty, he shall be liable for the loss caused by his misconduct or negligence (Usmani, 2000).

Another difference between Musharaka and Mudaraba is that liability for the single investor (rabb-ul-mal) in a Murabaha agreement is limited to his investment, unless he has permitted the mudarib (agent) to incur debts on his behalf. Another difference is that in Musharaka all partners own the enterprise, in Mudaraba the enterprise is solely owned by the rabb-ul-mal, and the mudarib can earn his share in the profit only in case he manages the enterprise profitably. He is not entitled to claim a share in assets themselves, even if their value has increased; he only has a share in the profit occurring by the usufruct of the assets.

It is necessary for the validity of Mudaraba in Shariah that the parties agree, right at the beginning, on a definite proportion of the actual profit to which each of them is entitled. No particular proportion has been prescribed by Shariah; rather it has been left to their mutual consent. However in Mudaraba like in Musharaka the same condition about lump sum amounts of profit is made. They cannot allocate a lump sum amount of profit for any party, nor can they give a ratio on the investment, the ratio must be made on the profit only. This also means that the mudarib (agent) can not claim any periodical salary or a fee or remuneration for the work done

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by him. The contract of Mudaraba can be easily terminated by either of the two parties, the only condition is to give notice to the other party. If all assets are in cash form the investor gets his capital back and any remainder is divided by the ratio agreed upon. If the assets are not in a liquid form, the mudarib shall be given the opportunity to sell or liquidate them, so that the actual profit may be determined (Usmani, 2000).

The Muslim jurists differ in opinion if a time limit may be set for the end of the Mudaraba agreement. The Hanafi and Hanbali schools are of the view that the Mudaraba can be restricted to a particular term. By contrast Shafii and Maliki schools are of the opinion that the Mudaraba agreement can not be restricted to a particular time. However this difference of opinion is only to the maximum time limit of the Mudaraba. A minimum time limit is not directly discussed by the schools, but it seems that no such limit can be fixed. Each party is at liberty to terminate the contract whenever he seems fit. This unlimited power is again difficult for modern day business, because a new business venture simply needs time to become profitable. They also demand constant and complex efforts; therefore it may be disastrous to the project, if the rabb-ul-mal terminates the Mudaraba right in the beginning of the enterprise. Especially the mudarib can suffer a severe set back, earning nothing despite all his efforts, which is not good for society as a whole because it can lead to the downfall of entrepreneurship of the poor. Therefore Usmani (2000) is of the opinion that the parties can agree on a minimum time the Mudaraba shall not be terminated, because it does not violate any principle of Shariah, as a result of the hadith of the Messenger (pbuh):

All the conditions agreed upon by the Muslims are upheld, except a condition which allows what is prohibited or prohibits what is lawful.

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2.4 MURABAHA (cost-plus sales) urabaha is, in fact a term which refers to a specific type of sale, a seller agrees with the purchaser to provide him a specific commodity on a certain profit added to his cost. The seller should expressively disclose his actual cost for the commodity and

then add some profit thereon, this profit may be in lump sum or may be based on a percentage. This Murabaha sale was initially only used in trade, the payment of the agreed price (with the mark-up) could be made at the spot or can be made later on, by deferred payment. Most banking transactions made today in Islamic Banking are Murabaha contracts and most contain a deferred payment which makes it a financing tool. This is actually not necessary in a Murabaha transaction (Usmani, 2000).

Murabaha in its original Islamic connotation, is simply a sale, not a mode of financing. The only feature that distinguishes it from other kinds of sale is that the seller in Murabaha expressly tells the buyer how much costs he has incurred and how much profit he is going to charge. The ideal mode of financing according to Shariah is Mudaraba or Musharaka which have been discussed earlier. However, in the perspective of the current economic set up, there are certain practical

difficulties in using these instruments in certain areas of financing. Consumer loans and mortgages for example are not easily financed through Musharaka or Mudaraba. Therefore the contemporary Shariah experts have allowed Murabaha as a financing method subjected to certain conditions. These conditions draw a clear line between an interest bearing loan and a transaction of Murabaha and are added in this thesis as appendix B (Usmani, 2000) because they are too extensive to be summarized here. The legal difference between Murabaha and an interest bearing transaction is clear, one is a sale in which price is increased for deferment (profit) and the other is an increase in the amount of a debt for deferment (interest). The first is permitted the second one isnt, this means that as long as a commodity is bought from a seller, and the price is deferred making the seller the debtor, it is permissible to increase the price (debt) with a certain lump sum or percentage. This kind of transactions become very similar to interest on consumer loans but as long as the seller and the debtor are the same person or entity (A) which sells for a certain price with a clear mark-up for deferment to the buyer (B), it is not considered the same. If the debt comes from another person or entity (like a bank) the deal becomes 2 separate transactions, one a simple trade with the owner A who sells to the buyer B (which is allowed).

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Added to this is the Financing from C to B which is simply a debt including interest payments which is Haram (Gamal, 2000). As we noted above financing with Murabaha in deferment creates a debt, and with debt comes the risk of default, therefore it is allowed within Shariah to ask for a collateral (Siddiqi, M.N. 2004).

2.5 SALAM AND ISTISNA (Islamic forwards) he permissibility of Salam and Istisna are exceptions to the general rule of Shariah that prohibits forward sales because of the Gharar (uncertainty) in them (non existing objects) as explained earlier. Salam is a forward that has very strict conditions and is

only allowed because of the following hadith:

Ibn Abass narrated: The Messenger of Allah (pbuh) came to Medina, and found its inhabitants entering in salam contracts (with the price paid in advance) in fruits for one,

two and three years. He (pbuh) said: whoever enters into a salam contract, let him specify a known volume or weight, and a known term of deferment. (Bukhari; book 3; hadith 455)

Salam is a sale whereby the seller undertakes to supply some specific goods to