Islamic Finance - Essay Example

?Introduction to Islamic Finance Islamic finance is based on the shariah or “Islamic law” (Ilias Summary Section). Islam frowns on interest rate for loans. However, the abhorrence for interest on loans is not unique to Islam nor confined to Muslims. In the Old Testament, there is a similar attitude on interest rates for loans. A negative view for interests for loans is expressed in Exodus 22:25. On the other hand, conventional non-Islamic finance considers interests as the income of capital for taking risks as well as for sacrificing consumption. Investments have an element of gambling because of the reality of risks. How can modern financial products be acceptable to Muslims? How can notions like “interest”, “speculation”, and “gambling” be excluded in financial products not only in form but in substance? In particular, how can it be possible for conventional financial products to be acceptable to Muslims? In the opinion of this writer, an important key towards designing financial instruments that are compatible with Islam is an understanding what financial transactions are prohibited and permissible under Islam. According to El-Gamal (2000, p. 2-6, 24), Islam prohibits Riba, Gharar, and financial insurance. Transactions that involve prohibited acts under Islam are invalid (batil) and forbidden (haram) under Islam (El-Gamal 2000, p. 1). On the other hand, El-Gamal (2000, p. 10-17) asserted that Islam permits cost-plus sales (murabaha), credit sales (bay’ bi-thaman ‘ajil), forward contracts (salam), and cooperative insurance. More importantly, Islam permits trade even if Riba is a forbidden (El-Gamal 2000, p. 9). According to El-Gamal (2000, p. 9), a trade that is valid from the perspective of Islam takes place “if the seller and buyer exchange an offer and acceptance which specify the object of sale and the price, and they both agree”. Legitimate sales and labour are considered in Islam to be the best forms of income generation (El-Gamal 2000, p. 10). The notion of Riba is narrated by the authority of Abu Said Al Khudriy that goes like this (El-Gamal 2000, p. 3): “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” The same authority of Abu Said Al Khudriy elaborated on the Riba as follows (El-Gamal 2000, p. 4): Bilal visted the Messenger of Allah (pbuh) with some high quality dates, and the Prophet (pbuh) inquired about their source. Bilal explained that he traded two volumes of lower quality dates for one volume of higher quality. The Messenger of Allah (pbuh) said: “this is precisely the forbidden Riba. Do not do this. Instead, sell the first type of dates, and use the proceeds to buy the other.” While usury involves exorbitant interest rates, a Riba takes place when an interest rate is charged regardless of its amount (El-Gamal 2000, p. 9). Thus, the charging of interest rate is prohibited under Islamic laws regardless of whether the interest rate is small or large. The preceding discussion pointed out that while inferior dates is prohibited to be exchanged with fine dates, the transaction can proceed nevertheless by selling the inferior dates and then buying the fine dates from the proceeds. Thus, it can be concluded that while Islam can prohibit certain transactions, the same transactions can essentially proceed by taking certain routes such that the essential of the intended transaction can ultimately take place despite the prohibition under Islam. In short, alternative transactions routes can be executed such that the essentials of the target transaction are eventually realized. According to El-Gamal (2000, p. 6), a good translation of Gharar is “risk” or “uncertainty”. Gharar is “the sale of probable items whose existence or characteristics are not certain, due to risky nature which makes the trade similar to gambling. Selling non-existent objects is categorized as Gharar and is forbidden (El-Gamal 2000, p. 17). At this point, it is important to stress that the promotion of just transactions is the essence of the Islamic prohibition on the Riba and Gharar (El-Gamal 2000, p. 2). Cost-plus sales or murabaha is permissible under Islam and involves sales in which the buyer knows the original price of object to be purchased and the buyer agrees to pay a premium over that original price (El-Gamal 2000, p. 10). In cost-plus sales permitted under Islam, there is no prohibition against lump-sum or percentage profit margins based on the narration of Ibn Masfid (El-Gamal 2000, p. 10). Despite the use of percentage, there is no Riba if the sale meets the conditions of the murabaha or cost-plus sales. Credit sales (bay’ bi-thaman ajil) that are compliant with the laws of Islam combine murabaha transactions or cost-plus transactions in which payment is deferred through instalments over a period of time. At the same time, in credit sales in which payment is deferred, Islam allows the seller to increase the selling price. Some of the relevant concepts are explained by El-Gamal (2000, p. 12) through the following: Salam or forward sales contracts are allowed in Islam provided the volume or quantity of the item to be sold is pre-specified and the term of deferment is known (El-Gamal 2000, p. 17). According to El-Gamal (2000, p. 17), the permission is documented in the Hadith under the authority of Ibn Abbas: The Messenger of Allah (pbuh) came to Madinah, and found its inhabitants entering salam contracts (with the price paid in advance) for one, two, and three years. He (pbuh) said: “whoever enters into a salam contract, let him specify a known volume of weight, and a known term of deferment. Cooperative insurance is permissible under Islam (El-Gamal 2000, p. 26). In a cooperative insurance, subscribers contribute to a pool of funds and members draw from the pool whenever a legitimate claim is filed (El-Gamal 2000, p. 26). The pool of money is invested in an “Islamic manner” and unclaimed profits are distributed among policy holders (El-Gamal 2000, p. 26). However, financial insurance is prohibited under Islam because financial insurance involves a promise to pay for the unforeseen and, therefore, still non-existent damages (El-Gamal 2000, p. 23). In any case, the majority of Islamic jurists have concluded that financial insurance is invalid based on the prohibition against Gharar (El-Gamal 2000, p. 23). Given the overview, we can examine debt-financing, insurance/assurance products, mortgage, futures, option contracts, and risk/gambling/speculation. Debt Financing. Debt financing is possible provided interests are not used and loan contracts are translated into cost-plus service contracts. Insurance/Assurance Products. Insurance and assurance products may be permissible under Islamic laws if insurance/assurance products are both designed and portrayed as cooperative insurance/assurance products. Futures. Futures may be permissible under Islamic laws if they are designed and presented as a form of salam contracts and the conditions for permissible salam contracts are observed: quantities or volumes are known and the period of deferment is clear. Option Contracts. Option contracts can be permissible under Islam based on salam and as long as tangibles are involved. Risk, Gambling, and Speculation. Risk, gambling, and speculation are classifiable as Gharar under Islamic laws. Nevertheless, anything close to risk management instruments or close to gambling and speculation can be redesigned into something similar to salam contracts and can be acceptable under Islamic laws if the conditions for salam sales are observed. Mortgage is not discussed in El-Gamal (2000) but Austrade (2010, p. 8) claims that mortgage can be permissible under Islamic laws through a Murabaha contract wherein an Islamic bank would buy the property and sell it a higher price to the home buyer with the higher price payable in instalments without an interest. In addition to non-Islamic financial instruments that can be redesigned along Islamic lines, Islam has a wide array of financial products. A number of these financial products are enumerated in Omady and Seibel (2006, p. 4-5). In conclusion, we can say that for FINANCIAL transactions to be permissible under the laws of Islam, a minimum of two points should be observed. First, the exchange should involve the exchange of equivalents determined through their monetary values to ensure that there is no diminution of monetary values. Second, sale of items whose existence or characteristics are uncertain or that are similar to gambling is prohibited. However, Ilias (2010, p. 1) in characterizing Islamic finance stressed on five principles: ban on interest, ban on uncertainty, risk-sharing and profit-sharing, ethical investment that serve society, and asset banking or that each transaction must be tied to tangibles. Jobst (2010, p. 1) even argued that derivatives can be permissible under Islamic finance if designed according to the principles of shared risks and lawful activities (halal). References Austrade, 2010. Islamic finance. Australian government: Austrade. El-Gamal, M., 2000. A basic guide to contemporary Islamic Banking and Finance. Houston: Rice University. Ilias, S., 2010. Islamic finance: Overview and policy. United States: Congressional Research Service. Jobst, A., 2010. Risk management of Islamic Finance Instruments. Available from: www.qfinance.com [accessed 22 February 2011]. Omady, O. and Seibel, H., 2006. Principles and products of Islamic Finance. University of Cologne: Development Research Center. Read More