Outlines

1. FUNDAMENTALS OF ISLAMIC BANKING:PRODUCTS & INTRUMENTSDR. AZNAN BIN HASANAHMAD IBRAHIM KULLIYYAH OF LAWS,INTERNATIONAL ISLAMIC UNIVERSITY MALAYSIAhaznan@iiu.edu.my

2. Outlines • Framework of Islamic Finance • Shariah, Fiqh & Mu’amalat • Necessary Requirements of Islamic Finance • Essential Contracts in Islamic Finance • Products and Instruments • Standardisation and harmonisation in Islamic Finance

3. Framework of Islamic Finance • 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

4. Cont’d • 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

5. The Shari’ah Framework of Islamic Banking and Finance • 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

6. Shariah & Fiqh • 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

7. Fiqh Mu’amalat (Islamic Commercial Law) • 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

8. Islamic Finance Paradigm • 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.

9. What to do and what to avoid • 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

10. Mutual Consent • al-Qur’an (4:29): “ O you who believe, devour not your property among yourselves by unlawful means except that it be trading by your mutual consent. verse: al-Nisa’ (4:29) • Manifested through expression of the parties • No certain formalities in concluding contract • In general, mutual consent is achieved if it is made freely by a competent person (puberty and prudence)

11. The avoidance of riba’ • 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)

12. DIVISION OF RIBA Type of Riba Riba’ al-buyu’ (Riba in exchange contracts ) Riba’ al-Duyun (RIba’ in Loan Contract)

13. Riba’ al-duyun • The debtor borrowed money to be paid in certain time, and the amount is more that 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).

14. Riba al-Buyu’ • 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’”.

15. Cont’d • 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)

16. RIBA IN MODERN FINANCIAL TRANSACTIONS • 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)

17. THE AVOIDANCE OF GHARAR • 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

18. EXAMPLES OF THIS KIND OF SALEIN HADITH • 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.

19. Application of Gharar • 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

20. The Benchmark • Gharar is excessive (gharar fahish) • Occurs in exchange contracts (‘uqud al-mu’awadat) • Effects the subject matter of the contract directly, not just the appendage • No public need (al-hajah al-’ammah) for the contract in discussion.

21. Cont’d • However, the subjectivity of this benchmark is very obvious • Demarcation on excessive and trivial gharar • Determining the public need? To what extend • Inevitably, this demarcation will be influenced by differences in time, societies, individual taste and preference, technology and the way certain transaction is conducted as well as regulatory framework.

22. Cont’d • 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

23. Tolerable gharar • 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

24. The avoidance of transactions involving maysir (gambling) • 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)

25. TRANSACTION INVOLVING PROHIBITED COMMODITIES • 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)

26. Essential Contracts in Islamic Finance • 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

27. Examples of the products and underlying principles • Banking products • IIMM products • Capital Market Products

28. Islamic Banking ISLAMIC BANKING SOURCES OF FUND APPLICATIONS OF FUND

29. SOURCES OF FUND Sources of Fund Current/ Saving Account General/ Special Investment NIDC SBBA Bay’ al-Dayn Bay’ al-Inah Wadi’ah Yad al-Dhamanah Mudarabah

30. Applications of fund DEBT FINANCING EQUITY FINANCING Lease Based Financing -Ijarah -AITAB Mudharabah Musharakah Fee Based Services Wakalah Kafalah Sale based financing BBA / Murabahah ‘Inah / dayn Salam Istisna Comsumer Banking Corporate Banking

31. IIMM IIMM BNNN NIDC MII GII IAB IPDS Q. Hasan al-’Inah Al-’Inah Bay’ al-Dayn Bay’ al-Dayn Bay’ al-’Inah Etc. Mudh.

32. ISLAMIC CAPITAL MARKET ICM Equity Market Bond Market Derivatives Market? -Future Contract -Options -Swap Musyarakah Mudarabah • Debt Based • ABS • Equity Based Mutual Fund / Islamic REITs Wakalah / mudarabah / musharakah Islamic Hedge Fund

33. Shariah Differences • Not all of these products and instruments are accepted by all jurists. • Some differences arise as to the acceptability or otherwise of these products and instruments • But more convergence than divergence

34. Examples of main divergence • Utilisation of disputable contracts, e.g bay’ al-’Inah & Tawarruq • Underlying Assets and its suitability in becoming SM, e.g. future asset, deferment of both price and SM, financial right and its tradaility), ect. • Terms and conditions of contracts, e.g. cross default, liberty to stipulate terms and conditions • Purpose of Financing, e.g. Valid transaction but to be used for unislamic purposes

35. Reasons for divergence • Differences of interpretation of the meaning of words or intent of any particular injunction in the primary text, either in the Quran or Sunnah: Human Reasoning • Different need base: - Legal framework - Incentive mechanism - Cultural preference - Etc.

36. How Islamic Law Views Divergence • Back to basic: Divergence is the nature of human being. Small or big, principles or branches, anything that involves human thinking, understanding and reasoning, the divergence is inevitable. • Shariah vis-à-vis fiqh: Fixed and flexible • Pluralism has been part and parcel of Islamic law, since its very initial days.

37. Cont’d • Jurists considered it permissible as long as: • there is no clear-cut texts (nas qat`i) on the matter • the opinion is arrived at by using acceptable methodology, such as, by way of analogy (qiyas). • Good or bad: Depends on how it is dealt with

38. Should We Have Full Convergence • Arguably, it is the most desirable one, but • Be realistic • In certain circumstances, divergence might have its advantages • So, the more realistic approach  standardisation & harmonisation • Differences in preference should not be standardise, - e.g. current and savings accounts (wadi’ah or mudarabah) - Takaful structures: wakalah or mudarabah

39. The Needs for Shariah Standard • Universal trading. • Issue of marketability • Consistency & stability to the product • It will facilitate other enhancement process

40. Methods for standardisation/ harmonisation (Domestically / Internationally • Regulations and Guidelines (IBA, Guidelines on the Issuance of Islamic Securities 2004, Islamic REITs etc. • Circular: Circular on Asset Pricing by SC • Supervision: Central Bank Act 1958 (sec 16B) • Basic Guidelines for main contracts: Guidelines for the issuance of Islamic Securities 2004 • International Standard :AAOIFI Syariah Standard

41. Case Study: AAIOFI • The effort to create the standards has started with the establishment of Accounting and Auditing Organization for Islamic Financial Institution (AAOIFI) in Bahrain. • AAOIFI has produced a number of Shari’ah standards for Islamic financial institutions covering both products and services • Enforceability of these Shari’ah standards : • Bahrain and Sudan • Other jurisdictions

42. Cont’d • Members are representative from various continents  can become a mechanism to bridge the disagreement.

43. Round-up Discussion on harmonization / standardization • Disagreement is inevitable • Approach to harmonise and standardise is more practical, rather than full convergence • Administrative and regulatory approach • Continuous interaction among Shari’ah Advisors will help to close gap and standardise understanding • Shariah Advisors: nurturing products which are globally accepted. • International Shariah Advisory Council?

44. Conclusion • Besides various frameworks applied to banking practices (be it Islamic or conventional), Shariah framework is a framework which is peculiar to Islamic finance alone • Yet, it forms the very substance of Islamic finance, without which Islamic finance will loss its Islamicity • As such, in practicing Islamic finance, the do’s and don’ts must be clearly observed • Islamic commercial law, from the fact that it subjects to human interpretation and understanding admits differences of opinion, as long as these differences are grounded by valid evidence, produced by capable personnel, done according to the right methodology

45. Cont’d • Full convergence in all aspects might be too idealistic • More practical is to have standardisation and harmonisation of opinions • More efforts are needed in this aspect

46. THANK YOU WASSALAM haznan@iiu.edu.my 03-61964201 012-2121536