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FUNDAMENTALS OF ISLAMIC BANKING: PRODUCTS

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Title: FUNDAMENTALS OF ISLAMIC BANKING: PRODUCTS


1
FUNDAMENTALS OF ISLAMIC BANKING PRODUCTS
INTRUMENTS DR. AZNAN BIN HASAN AHMAD IBRAHIM
KULLIYYAH OF LAWS, INTERNATIONAL ISLAMIC
UNIVERSITY MALAYSIA haznan_at_iiu.edu.my
2
Outlines
  • Framework of Islamic Finance
  • Shariah, Fiqh Muamalat
  • 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
Contd
  • 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 Shariah 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 Muamalat (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 shariah 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-Quran (429) 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 (429)
  • 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
Contd
  • 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 SALE IN HADITH
  • Sale of fish in the sea, birds in the sky
  • Sale of unborn calf in its mothers womb
  • Sale of runaway animal, slave
  • ? Involve item which may or may not exist
  • However, the Prophet did not lay down the
    principles (qawaid) 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-muawadat)
  • 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
Contd
  • 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
Contd
  • 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-Quran in Surah al-Maidah (590)

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-Quran and Sunnah
    of the Prophet.
  • E.g.
  • - Surah al-Maidah (53)
  • - 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
Wadiah Yad al-Dhamanah
Mudarabah
30
Applications of fund
DEBT FINANCING
EQUITY FINANCING
Lease Based Financing -Ijarah -AITAB
Fee Based Services Wakalah Kafalah
Mudharabah Musharakah
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
Contd
  • Jurists considered it permissible as long as
  • there is no clear-cut texts (nas qati) 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
    (wadiah 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 Shariah
    standards for Islamic financial institutions
    covering both products and services
  • Enforceability of these Shariah standards
  • Bahrain and Sudan
  • Other jurisdictions

42
Contd
  • 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 Shariah 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 dos
    and donts 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
Contd
  • 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_at_iiu.edu.my 03-61964201 012-2121536
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