Principles Of Islamic Banking

Principles Of Islamic Banking[This article was published in the 10th issue of Nida'ul Islammagazine, November-December 1995] ________________________________For millions of Muslims, banks are institutions to be avoided. Islamis a religion which keeps Believers from the teller's window. TheirIslamic beliefs prevent them from dealings that involve usury orinterest (Riba). Yet Muslims need banking services as much as anyoneand for many purposes: to finance new business ventures, to buy ahouse, to buy a car, to facilitate capital investment, to undertaketrading activities, and to offer a safe place for savings. For Muslimsare not averse to legitimate profit as Islam encourages people to usemoney in Islamically legitimate ventures, not just to keep their fundsidle.However, in this fast moving world, more than 1400 years after theProphet (s.a.w.), can Muslims find room for the principles of theirreligion? The answer comes with the fact that a global network ofIslamic banks, investment houses and other financial institutions hasstarted to take shape based on the principles of Islamic finance laiddown in the Qur'an and the Prophet's traditions 14 centuries ago.Islamic banking, based on the Qur'anic prohibition of charginginterest, has moved from a theoretical concept to embrace more than100 banks operating in 40 countries with multi-billion dollar depositsworld-wide. Islamic banking is widely regarded as the fastest growingsector in the Middle Eastern financial services market. Exploding ontothe financial scene barely thirty years ago, an estimated $US 70billion worth of funds are now managed according to Shari'ah. Depositassets held by Islamic banks were approximately $US5 billion in 1985but grew over $60 billion in 1994.The best known feature of Islamic banking is the prohibition oninterest. The Qur'an forbids the charging of Riba on money lent. It isimportant to understand certain principles of Islam that underpinIslamic finance. The Shari'ah consists of the Qur'anic commands aslaid down in the Holy Qur'an and the words and deeds of the ProphetMuhammad ( s.a.w.). The Shari'ah disallows Riba and there is now ageneral consensus among Muslim economists that Riba is not restrictedto usury but encompasses interest as well. The Qur'an is clear aboutthe prohibition of Riba, which is sometimes defined as excessiveinterest. "O You who believe! Fear Allah and give up that remains ofyour demand for usury, if you are indeed believers." Muslim scholarshave accepted the word Riba to mean any fixed or guaranteed interestpayment on cash advances or on deposits. Several Qur'anic passagesexpressly admonish the faithful to shun interest.The rules regarding Islamic finance are quite simple and can be summedup as follows:a) Any predetermined payment over and above the actual amount ofprincipal is prohibited. Islam allows only one kind of loan and that is qard-el-hassan(literally good loan) whereby the lender does not charge any interestor additional amount over the money lent. Traditional Muslim juristshave construed this principle so strictly that, according to onecommentator "this prohibition applies to any advantage or benefitsthat the lender might secure out of the qard (loan) such as riding theborrower's mule, eating at his table, or even taking advantage of theshade of his wall." The principle derived from the quotationemphasises that associated or indirect benefits are prohibited.b) The lender must share in the profits or losses arising out of theenterprise for which the money was lent. Islam encourages Muslims to invest their money and to become partnersin order to share profits and risks in the business instead ofbecoming creditors. As defined in the Shari'ah, or Islamic law,Islamic finance is based on the belief that the provider of capitaland the user of capital should equally share the risk of businessventures, whether those are industries, farms, service companies orsimple trade deals. Translated into banking terms, the depositor, thebank and the borrower should all share the risks and the rewards offinancing business ventures. This is unlike the interest-basedcommercial banking system, where all the pressure is on the borrower:he must pay back his loan, with the agreed interest, regardless of thesuccess or failure of his venture.The principle which thereby emerges is that Islam encouragesinvestments in order that the community may benefit. However, it isnot willing to allow a loophole to exist for those who do not wish toinvest and take risks but rather content with hoarding money ordepositing money in a bank in return for receiving an increase onthese funds for no risk (other than the bank becoming insolvent).Accordingly, under Islam, either people invest with risk or sufferloss through devaluation by inflation by keeping their money idle.Islam encourages the notion of higher risks and higher returns andpromotes it by leaving no other avenue available to investors. Theobjective is that high risk investments provide a stimulus to theeconomy and encourage entrepreneurs to maximise their efforts.c) Making money from money is not Islamically acceptable. Money is only a medium of exchange, a way of defining the value of athing; it has no value in itself, and therefore should not be allowedto give rise to more money, via fixed interest payments, simply bybeing put in a bank or lent to someone else. The human effort,initiative, and risk involved in a productive venture are moreimportant than the money used to finance it. Muslim jurists considermoney as potential capital rather than capital, meaning that moneybecomes capital only when it is invested in business. Accordingly,money advanced to a business as a loan is regarded as a debt of thebusiness and not capital and, as such, it is not entitled to anyreturn ( i.e. interest). Muslims are encouraged to purchase and arediscouraged from keeping money idle so that, for instance, hoardingmoney is regarded as being unacceptable. In Islam, money representspurchasing power which is considered to be the only proper use ofmoney. This purchasing power (money) cannot be used to make morepurchasing power (money) without undergoing the intermediate step ofit being used for the purchase of goods and services.d) Gharar (Uncertainty, Risk or Speculation) is also prohibited.Under this prohibition any transaction entered into should be freefrom uncertainty, risk and speculation. Contracting parties shouldhave perfect knowledge of the counter values intended to be exchangedas a result of their transactions. Also, parties cannot predetermine aguaranteed profit. This is based on the principle of 'uncertain gains'which, on a strict interpretation, does not even allow an undertakingfrom the customer to repay the borrowed principal plus an amount totake into account inflation. The rationale behind the prohibition isthe wish to protect the weak from exploitation. Therefore, options andfutures are considered as un-Islamic and so are forward foreignexchange transactions because rates are determined by interestdifferentials.A number of Islamic scholars disapprove the indexation of indebtednessto inflation and explain this prohibition within the framework ofqard-el-hassan. According to those scholars, the creditor advances theloan to win the blessings of Allah and expects to obtain the rewardfrom Allah alone. A number of transactions are treated as exceptionsto the principle of gharar : sales with advanced payment (bai'bithaman ajil); contract to manufacture (Istisna); and hire contract(Ijara). However, there are legal requirements for the conclusion ofthese contracts to be organised in a way which minimises risk.e) Investments should only support practices or products that are notforbidden -or even discouraged- by Islam. Trade in alcohol, forexample would not be financed by an Islamic bank; a real-estate loancould not be made for the construction of a casino; and the bank couldnot lend money to other banks at interest.