Islamic Finance & Takaful: An Introduction

Mohd Johan Lee J. Lee & Associates For Kowloon Mosque & Islamic Centre Islamic Finance & Takaful: An Introduction

Sources of the Shariah Framework of Islamic Finance Shariah, Fiqh & Mu’amalat Necessary Requirements of Islamic Finance Riba, Gharar, Maysir & Others Essential Contracts in Islamic Finance Products and Instruments (c) Mohd Johan Lee 2012 Outlines

Primary Sources • The Holy Quran • Sunnah (the sayings, deeds and endorsements of Prophet Muhammad PBUH) (c) Mohd Johan Lee 2012 Sources of the Shariah

Secondary Sources (mostly by the exercise of Ijtihad (reasoning by the learned)) • Ijma (Unanimous decision of the Ulama) • Qiyas (analogy) • Istishan/ Istihab (equity in Islamic law) • Maslahah (necessity of the people) • SurdulDara’ih (Blocking the means) • U’ruf (custom) (c) Mohd Johan Lee 2012 Sources of the Shariah

In general, the framework of Islamic finance is the same framework used by the conventional finance practices. These frameworks are, inter alia legal and regulatory framework, taxation framework, accounting and auditing standards, etc. Might have different or additional framework, such as accounting and auditing standard, etc, due to its peculiarity. In certain jurisdiction, Islamic banking and finance might be regulated by different sets of regulations, either separate or additional, e.g. IBA 1983 (c) Mohd Johan Lee 2012 Framework of Islamic Finance

However, Islamic Finance, as the name suggests, has another framework, which is considered the major element that differentiates IBF from the conventional banking and finance. Any violation of this framework will definitely effect the validity of Islamic finance itself. Shariah Compliance Framework (c) Mohd Johan Lee 2012 Cont’d

Three main interrelated terminologies: Shariah, Fiqh & Muamalat Shariah, when viewed from legal perspective is the fixed elements of Islamic law, i.e. what has been clearly stipulated and mentioned in the text. E.g. five time prayers, prohibition of riba’, etc. As such, it is revealed in nature (c) Mohd Johan Lee 2012 The Shari’ah Framework of Islamic Banking and Finance

Shariah, in this sense, is wide and encompassing various branches of Islam Normally, it comes in its generality and it emphasizes only on the principles and not the detailed rules (not all the time) It is the duty of the judge (qadi), mufti and jurisconsult (ulama’) to exert their intellectual efforts in deriving and applying these principles on certain given scenarios. The result of human reasoning and understanding to the shariah is known as fiqh Fixed v. Flexible Agreements v. Differences (c) Mohd Johan Lee 2012 Shariah & Fiqh

However, in its general usage, it is called al-syariat al-Islamiyyah (Islamic law). • Islamic commercial law is one of the components of Islamic law • Other components of Islamic law include: • Islamic law of purification and worship • Islamic family law • Islamic criminal law • Islamic law of evidence and procedure • Islamic law of inheritance, etc • The main subjects of Islamic commercial law are commercial contracts and the rules governing them (c) Mohd Johan Lee 2012 Fiqh Mu’amalat (Islamic Commercial Law)

Original rule of permissibility: - Initial legal ruling in commercial contract is permissibility - Contrary to acts of devotion (Ibadat) - No legal injunction is needed in sanctioning new contract - Every contract is considered lawful and acceptable if no principle of shari’ah is violated - Open a very wide door for further innovations • Real Economic Activities • Transactions-oriented not loan-based. (c) Mohd Johan Lee 2012 Islamic Finance Paradigm

In Islamic jurisprudence, the main source of law is the Shariàh or Islamic law as contained in the Quran and Sunnah • Underlying rule: all contracts are deemed permissible except when there is contravention of any established principles of Islamic law / Shariàh • Legal maxim (qaìdah fiqhiyyah): “Al Asl fi al Ùqud al Ibahah” • “the original rule in contracts is permissibility” • The parameter: Avoidance of any contravention of the established principles and prohibitions in Islamic law (c) Mohd Johan Lee 2012 WHAT AMOUNTS TO SHARIÀH COMPLIANCE?

Conclusion of contract by mutual consent The avoidance of riba’ The avoidance of gharar The avoidance of transactions involving maysir (gambling) The avoidance of transactions involving prohibited commodities (c) Mohd Johan Lee 2012 What to do and what to avoid

Riba – prohibited in many Quranic verses and sayings of the Prophet s.a.w. Meaning: riba is every excess in return of which no reward or equivalent counter value is paid, in short, every unjust enrichment is riba (c) Mohd Johan Lee 2012 WHAT TO BE AVOIDED

Literally: excess, expand, increase, growth Any unjustified excess above and over the capital, whether in loans (between creditor and debtor) or in trade (with similar commodities) (c) Mohd Johan Lee 2012 The avoidance of riba’

(c) Mohd Johan Lee 2012 PROHIBITION OF RIBA IN THE QURAN 4 STAGES First Stage (30:39) Second Stage (4:160-161) Third Stage (3:130) Fourth Stage (2:275-281) • Compare riba with zakat & charity • Praising zakat & charity, not riba • Attaching the practice of riba with the Jews • Consider the practice as an iniquity (zulm) • Prohibiting the practice of charging double and multiple riba • Conclusively prohibiting all forms of riba • Any excess over the capital is disallowed

“and that which you give in gift (to others), in order that it may increase (your wealth by expecting to get a better one in return) from other people’s property, has no increase with Allah…” (c) Mohd Johan Lee 2012 (Ar Rum 30: 39)

“… and their taking of Riba though they were forbidden from taking it and their devouring of men’s substance wrongfully…. and we have prepared... a painful torment.” (c) Mohd Johan Lee 2012 4:160 - 161

“O you who believe, Eat not Riba doubled or multiplied, but fear Allah that you may be successful.” (c) Mohd Johan Lee 2012 3:130

“those who eat riba will not stand (on the Day of Resurrection) except like the standing of a person beaten by Shaitan leading him to insanity. That is because they say: trading is only like Riba,” whereas Allah has permitted trading and forbidden Riba. So whosoever receives an admonition from his Lord and stops eating Riba, shall not be punished for the passt; his case is for Allah (to judge); but whoever returns (to riba), such are the dwellers of the Fire – they will abide therein forever. (c) Mohd Johan Lee 2012 2: 275

Allah will destroy riba and will give increase for sadaqat (deeds of charity, alms). …. O you who believe, be afraid of Allah and give up what remains (due to you) from Riba (from now onward), if you are really believers (c) Mohd Johan Lee 2012 2: 276 - 278

And if you do not do it, then take a notice of war from Allah and hiss Messenger but if you repent, you shall have your capital sums. Deal not unjustly (by asking more than our capital sums), and you shall not be dealt with unjustly (by receiving less than your capital sums). (c) Mohd Johan Lee 2012 2:279

And if the debtor is in a hard time (has no money), then grant him time till it is easy for him to repay; but if you remit it by way of charity, that is better for you if you did but know. And be afraid of the Day when you shall be brought back to Allah. Then every person shall be paid what he earned, and they shall not be dealt with unjustly. (c) Mohd Johan Lee 2012 2:280 - 281

There are also a number of narrations from the Sunnah on the prohibition of riba • Some of the narrations give general prohibitions of riba, e.g.: “The Prophet of Allah s.a.w. cursed the receiver and the payer of riba, the one who records it and the two witnesses to the transaction and said: they are alike (in guilt)”. (c) Mohd Johan Lee 2012 CONT’D…

Under Islamic law, riba can occur in two main situations, i.e.: • riba al duyun (loan): the riba or excess which occurs in debt and loan transactions because of extension/delay in repayment • riba al buyu` (exchange): the riba or excess which occurs in trading transactions involving the exchange of riba-bearing commodities without observing the required rules (c) Mohd Johan Lee 2012 Cont’d…

(c) Mohd Johan Lee 2012 PROHIBITION OF RIBA (Loan) Surah al-Baqarah, ayat 275 “ … But Allah hath permitted trade and forbidden usury Interpretative Efforts What amounts to Trade Usury • Criteria • Fair exchange of goods or value • Fair distribution of risk & return • Criteria • Oppressive / unfair distribution of risk & return • Unjustified enrichment at expense of others

PROHIBITION OF RIBA (Exchange) (c) Mohd Johan Lee 2012 Sunnah of the Prophet: Gold for gold, silver for silver, wheat for wheat, barley for barley, dates for dates, salt for salt - like for like, equal for equal, and hand-to-hand (spot); if the commodities differ, then you may sell as you wish, provided that the exchange is hand-to-hand or spot transaction.” Interpretative Efforts Application Currency Staple Food Rules • Same denomination • At Par • Spot • Different denomination • Spot • Rules • Same Type • At Par • Spot • Different Type • Spot

(c) Mohd Johan Lee 2012 SUMMARY OF RULES UNDER THE HADITH

In contemporary finance, riba can occur in: • All interest-based lending activities (e.g. all conventional bonds) • Fixed return on deposits in conventional banking (e.g. designated accounts for receivables of the bonds) • In the secondary trading of debt securities – if the transaction is not spot & if there is discounting (according to global Shari`ah standard) • Thus, to be Shari`ah compliant, all contracts in Islamic finance cannot be involved in any of the usurious activities mentioned above (c) Mohd Johan Lee 2012 CONT’D…

Literally: excess, expand, increase, growth Any unjustified excess above and over the capital, whether in loans (between creditor and debtor) or in trade (with similar commodities) (c) Mohd Johan Lee 2012 The avoidance of riba’

(c) Mohd Johan Lee 2012 DIVISION OF RIBA Riba’ al-buyu’ (Riba in exchange contracts ) Riba’ al-Duyun (RIba’ in Loan Contract)

The debtor borrowed money to be paid in certain time, and the amount is more than the amount borrowed • A creditor gives a periodic loan and takes monthly interest. The capital sum lasts until the expiration of the period. Upon expiry, if the debtor cannot pay, the period to pay back the capital will be extended and interest will be charged • Arising out of exchange contract, a buyer must pay a consideration. If he failed to settle on time, the period will be extended by increasing the amount (principle + interest). (c) Mohd Johan Lee 2012 Riba’ al-duyun

Mainly based on the saying of the Prophet: “Gold for gold, silver for silver, wheat for wheat, barley for barley, dates for dates, and salt for salt; like for like, hand to hand, in equal amounts; and any increase is riba’”. (c) Mohd Johan Lee 2012 Riba al-Buyu’

These commodities can be classified under two main categories which make the illah (ratio decidendi) for their prohibition: - i- medium of exchange (currency): Gold and Silver -ii- Staple foods: Wheat, barley, dates and salt • Any other items, even though not mentioned in the hadith but serve the same purpose will be considered as having the same illah by way of qiyas (analogy) (c) Mohd Johan Lee 2012 Cont’d

Riba’ al-duyun in loans and certain controversial contracts (bay’ al-’inah, bay’ al-dayn, etc) • Riba’ al-buyu’ mainly in bay’ al-sarf (exchange of currencies) (c) Mohd Johan Lee 2012 RIBA IN MODERN FINANCIAL TRANSACTIONS

Meaning of gharar: - Literally: risk, uncertainty, hazard - The sale of probable item whose existence or characteristics are not certain, due to the risky nature which makes the trade similar to gambling (c) Mohd Johan Lee 2012 THE AVOIDANCE OF GHARAR

Sale of fish in the sea, birds in the sky • Sale of unborn calf in its mother’s womb • Sale of runaway animal, slave  Involve item which may or may not exist • However, the Prophet did not lay down the principles (qawa’id) for the prohibition of gharar. • Examples given in the hadith were some of the manifestations of the doctrine, but not principles. • This has led to the dispute among jurists on the area and coverage of gharar. (c) Mohd Johan Lee 2012 EXAMPLES OF THIS KIND OF SALEIN HADITH

Meaning: has a range of negative connotations, such as, uncertainty, deception, risk, hazard, ignorance etc. • If there is gharar, the contracting party/ies do not really understand the attributes / consequence of the contract • Under Islamic law, gharar is prohibited because its existence in the contract may deny the parties of equal bargaining power and they cannot make informed decisions; or if there is risks on deliverability of the object of the contract (c) Mohd Johan Lee 2012 GHARAR

(c) Mohd Johan Lee 2012 PROHIBITION OF GHARAR Surah an- Nisa’: ayat 29 “ … squander not your property amongst yourself unjustly (batil) except it be a trade among you by mutual consent…” Interpretative Efforts What amounts to Unjust (batil) Trade by Mutual Consent Criteria • All illegal & defective elements in contracts including gharar & uncertainty • Criteria • Offer & Acceptance, indicating consent • Elimination of mistake, fraud etc

The sunnah uses the word gharar and its derivatives much more extensively than the Qur`an in the sense that several new meanings are added • In relation to commercial transactions, the Prophet s.a.w. in many of his sayings directly prohibited the sale involving gharar (uncertainty) and jahalah (ignorance) • Thus, the prohibition of gharar is made conclusive by the sunnah / hadith of the Prophet s.a.w. • Examples: the prohibition of gharar sale (i.e., the sale contract affected by gharar), the prohibition of the sale of fish in the sea, bird in the air, unborn animals, lost items, etc. (c) Mohd Johan Lee 2012 PROHIBITION OF GHARAR IN THE SUNNAH

In Islamic law, gharar can be of two degrees: • Excessive or major (gharar fahish) • Minor and tolerable (gharar yasir) • Only major /excessive gharar will affect the validity of contracts, where it will render the contract void / voidable, depending on the degree of uncertainty • Gharar affects trading and exchange contracts (mu`awadat); not charitable and unilateral contracts • In banking & finance – gharar can be triggered e.g. – in the sale contract to create the indebtedness if the asset used is uncertain / vaguely identified; the trading of a securitised debt which is unconfirmed / not established, sale of insurance policy (c) Mohd Johan Lee 2012 CONT’D…

Broadly speaking, gharar will effect the validity of contract if it occurs in these areas: - gharar in kind / type / attribute / quantity of the object - gharar due to delivery time - gharar due to the price/ mode of payment - doubt over the ability to deliver (c) Mohd Johan Lee 2012 Application of Gharar

Gharar which is excessive (gharar fahish) occurs in exchange contracts (‘uqud al-mu’awadat) • To prevent gharar, the parties to contract must have adequate knowledge and information on the subject matter: i- Their existence and deliverability ii- Its quality, quantity and attributes are known iii- Time –frame for payment and delivery (c) Mohd Johan Lee 2012 The Benchmark

However, gharar is tolerable if: - i) it is trivial (gharar yasir) - ii) It occurs in other than exchange contracts, such as in gratuitous contracts. -iii) It happens to the ancillary object (appendages) only (not the principal and main subject matter of contract) - iv) the economic need for the contract embodying the risk is substantial (c) Mohd Johan Lee 2012 Tolerable gharar

Transactions involving the prohibited commodities, e.g., pork and liquor • Surah al Maidah (5:3) • Surah al Maidah (5:90) • Transactions involving gambling or maysir/qimar • Surah al Maidah (5:90) (c) Mohd Johan Lee 2012 OTHER THINGS TO BE AVOIDED…

Involves the creation of risk for the sake of risk A combative relationship between two contracting parties, each of whom undertakes the risk of loss and the loss of one means gain for the other Apply to all games of pure chance No economic activities are gained in the practice. The gambler will simply seek to amass wealth without efforts. Gambling is gharar in its worst scenario. Prohibited by al-Qur’an in Surah al-Maidah (5:90) (c) Mohd Johan Lee 2012 The avoidance of transactions involving maysir (gambling)

It is also not allowed to conclude contract on illegal commodities such as pork, liquor etc. • Illegality of certain commodities has been spelt out clearly in the texts of al-Qur’an and Sunnah of the Prophet. • E.g. : - Surah al-Maidah (5:3) - Surah al-Maidah (5: 90) (c) Mohd Johan Lee 2012 TRANSACTION INVOLVING PROHIBITED COMMODITIES

Underlying principles utilised in devising products of IBF is very important as they separate IBF from conventional products. • Contrary to conventional finance, which is specification driven product, Islamic finance is more structure and principle based product • Rules and regulations will differ from one product to another, depending on the structure employed • In general, various underlying Shariah principles have been utilised in devising products of Islamic Banking and Finance. • They can be summarised as below: - Sale based products - Lease based products - Participatory products - Fee based products (c) Mohd Johan Lee 2012 Essential Contracts in Islamic Finance

Banking products IIMM products Capital Market Products (c) Mohd Johan Lee 2012 Examples of the products and underlying principles

SHARI`AH COMPLIANCE: MAIN PRINCIPLES (c) Mohd Johan Lee 2012 CONTRACTS Lawful Contractual Objective Mutual consent Avoid Interest (riba) Uncertainty (gharar) Gambling (maysir/qimar) Other prohibitions e.g. Liquor, pork

The Quran encourages work and trade • The Prophet (s.a.w.) himself was a trader • The encouragement of trade is evidenced by the many instruments of trade available during the Prophet's lifetime and in Islamic history thereafter (c) Mohd Johan Lee 2012 ENCOURAGEMENT OF TRADE BY MUTUAL CONSENT

Islamic Finance & Takaful: An Introduction