Source: http://www.lai.ut.ee/~stork/english/islamic_finsys.html
Islamic finance is an old concept but a very young discipline in the academic sense. It lacks the required extent and level of theories and models needed for expansion and implementation of the framework provided by Islam. In these circumstances, unawareness and confusion exist as to the form of the Islamic financial system and instruments.
The main difference between the present economic system and the Islamic economic system is that the later is based on keeping in view certain social objectives for the benefit of human beings and society. Islam, through its various principles, guides human life and ensures free enterprise and trade. That is the reason why the conventional banker does not have to be concerned with the moral implications of the business venture for which money is lent.
Socio-economic justice is central to the Islamic way of life. Every religion has the same basic aim. In an Islamic environment, an individual not only lives for himself, but his scope of activities and responsibilities extend beyond himself to the welfare and interests of society at large. The Qur'an is very precise and clear on this issue. There are basically three components of an Islamic economic paradigm:
Human society in Islam is based upon the validity of law, of life and the validity of mankind. All these are natural corollaries of the faith. Islamic laws promote the welfare of people by safeguarding their faith, life, intellect, property and their posterity. God nurtures, nourishes, sustains, develops and leads humanity towards perfection. Even though an individual may be making a living because of his efforts, he is not the only one contributing towards that living. There are a number of divine inputs into this effort and therefore, the results of such an effort obviously cannot be construed as entirely proprietary.
Whereas the Islamic banker has a much greater responsibility. This leads us to a very fundamental concept of the Islamic financial system i.e. the relation of investors to the institution is that of partners whereas that of conventional banking is that of creditor-investor.
The Islamic financial system is based on equity whereas the conventional banking system is loan based. Islam is not against the earning of money. In fact, Islam prohibits earning of money through unfair trading practices and other activities that are socially harmful in one way or another. [ 1 ]
Those who swallow down usury cannot arise except as one whom Shaitan has prostrated by (his) touch does rise. That is because they say, trading is only like usury; and Allah has allowed trading and forbidden usury. To whomsoever then the admonition has come from his Lord, then he desists, he shall have what has already passed, and his affair is in the hands of Allah; and whoever returns (to it) - these are the inmates of the fire; they shall abide in it [Sura 2:275].
Not that there was any ambiguity in the Command of Allah. Far be it from Him to give any order to His Servants, which they can not comprehend. The fact is that those who had surplus money and wanted to earn profit did so either by lending it through riba (usury) or by investing it in trade and hypocrites were not prepared to forgo the first option. Hence, they argued that since both were means of earning profit, they were alike and the prohibition of riba did not stand to reason.
The practice of riba i.e. usury was so deep-rooted in society and continuance of the practice was so undesirable, that Allah warned the believers that if they did not desist, they should be prepared for a war against Allah and His Apostle. This warning was heeded by the Muslim Ummah and for more than a thousand years the economies of Muslim states were free from riba. With the ascendancy of Western influence and its suzerainty over Muslim states, the position changed and an interest-based economy became acceptable. Efforts in Muslim countries to revert to an interest-free economy were hampered by many obstacles. [ 2 ]
The traditional definition of the time value of money leads one to assume that profit maximisation is the objective of investors irrespective of whether or not the earning of profit has made someone else worse off. Some economists have termed the maximisation of profit as the sole objective of corporations. This view cannot be supported or defended since the profit maximisation process may lead to perverse outcomes. When financial operations are removed of moralistic tone, competitive markets fail to achieve the efficient allocation of a country's resources.
In Islam money in itself is not considered, as actual capital only exists when money, along with other resources, is sunk into productive activities. Linking the use of money to productive purposes invariably brings into action the factor of labour, a process from which benefits pass on to society.
Demand for monetary instruments is influenced by the variation and level in the market rate what is meant as the market rate of return. The demand for household monetary instruments is mainly for the purpose of circulation of income. Banks need these instruments for:
What differentiates a traditional financial market from others markets is that no tangible good or service is exchanged for any monetary consideration; only a "financial claim" changes hands in the form of a promissory note or a title to any future flow of income adjusted for any capital appreciation. Not all Islamic instruments are purely financial claims. Some of the instruments also represent ownership of the underlying assets together with a claim to underlying cash flows. Basically there are the following four types of Islamic financial instruments:
The phenomenon of risk plays a pervasive role in economic life. Without it, financial and capital markets would consist of the exchange of a single instrument each period, the communications industry would cease to exist in so far as this market is concerned and the profession of investment banking would be reduced to that of accounting. Risk is further segregated from uncertainty. A situation is said to involve risk if the randomness facing an economic agent can be expressed in terms of specific numerical probabilities (these probabilities may either be objectively specified, as with lottery tickets or else reflect the individual's own subjective beliefs). Situations where the agent cannot (or does not) assign actual probabilities to alternative possible occurrences are said to involve uncertainty.
While it is not always true that a riskier asset will pay a higher average rate of return, it is usually return. Risk is an opportunity in financial markets and also a problem. Risk-averse investors require additional return to be at additional risk and, in effect, in a competitive market higher return is accompanied by higher risk. An investor evaluates an asset in terms of its marginal contribution to his/her portfolio.
The fundamental principal of valuation is that the value of any financial asset is the present value of the cash expected. The process requires two steps:
The following are the Shari'ah compliant risk mitigating features:
But before describing leasing, as aforesaid, let me very briefly touch upon two of the basic or fundamental principles of Islamic finance in order to develop a premise for meaningful discussions on leasing.
Based on the above fundamental principles, the most ideal mode or instrument of financing in Shari'ah are Musharaka and Modarabah followed by Salam and Istinsa.
Morabaha and leasing are not originally modes of finance. However, to meet certain specific needs where ideal modes like Musharaka or Mudaraba are not workable for whatever reasons, they have been reshaped and allowed in Shari'ah subject to certain conditions.
It is the second type of Ijarah which is the subject matter of the discussion here because it is generally used as a form of investment and also as a means of finance.
As described earlier, in the light of the two basic cornerstones of Shari'ah, leasing is a contract whereby usufruct rights to an asset are transferred by the owner, known as the lessor, to another person, known as the lessee, at an agreed-upon price called the rent, and for an agreed-upon period of time called the term of lease.
Leasing differs from sale only in-so-much-as not transferring the corpus or ownership of the property which remains with the transferor. As such in Shari'ah, a lease transaction is governed by a separate set of rules, which we shall outline in the following paragraphs.
Although leasing, as originally conceived, is not a means of finance, the financial institutions and the corporate world have adopted it as such. Due to several factors (including tax concessions, etc.), instead of providing an interest-bearing loan, certain financial institutions in the West started to provide requisite equipment to their customers. To arrive at the rent, the total cost of the asset is calculated plus interest or mark-up to be recovered during the period of lease on a monthly or quarterly basis. This type of lease in the West is known as a finance lease, to be distinguished from an operating lease, wherein various basic features of the leasing transaction are ignored which is tantamount to Riba.
Knowing that leasing is lawfully allowed under Sharia'h, since it meets one of the basic criteria of asset-based finance, a number of Islamic financial institutions have adopted leasing on this model as carried out by conventional financial institutions without making the necessary modifications that really conform to the rules under Sharia'h, particularly in regards to assuming the risk of ownership in the leased asset. Great care needs to be exercised to ensure various Sharia'h requirements, as rendered below, based on the basic two principles of:
The description or definition given above, under part A, contains the following essential ingredients for outlining the basic rules under Shari'ah:
While operating a leasing business, a number of practical issues have cropped up which warrant discussion and interpretation under Sharia'h. An exhaustive and conclusive list of such issues is impossible to make. However, certain important and salient issues need to be taken up in these discussions as follows:
Major hurdles faced by Islamic finance houses are the absence of a necessary legal framework and the lack of adequate infrastructure in the banking and investment fields. [ 6 ]
The modern banking system is based on the concept that money should be treated like any other factor of production and must earn some return over a period of time. It is argued that the establishment of large-scale enterprises, and hence material progress, is not possible unless there is an agency that can mobilise financial resources from the public by paying them some interest, while lending these resources to entrepreneurs. By charging these entrepreneurs a higher interest, these agancies were able to utilise the difference (called a spread) to meet their expenses and to make some profit for the owners of the agency (i.e. share-holders). Banks were established to fulfil this need and from the beginning were only authorised to perform this function. They were legally prohibited from entering into trade or industry. When the Government of Pakistan decided to introduce an interest-free banking system, this prohibition was removed. After a lot of in-house the banks were told in June 1984 that they were allowed to deal in only 1 to 12 means of financing (only two were classified as "Financing by Lending").
These two permitted lending without interest by charging the actual expense incurred by the banks to meet their cost of operation and Qarde Hasana. All the rest were either trade-related or investment-type models. These included the purchase of goods by banks and their sale to clients at an appropriate mark-up price on a deferred payment basis, in case of default there being no further mark-up. This sale of goods on mark-up is known as Murabiha. Other types of financing were hire-purchase, leasing, Musharika or profit- and-loss-sharing, equity participation and purchase of shares, etc.
Since Murabiha was the type nearest to lending and since it did not requre any expertise in buying and selling commodities, bankers limited most of their financing to this type. In order to eliminate the risk of prospective buyers refusing to accept goods purchased by the banks by reason of not being strictly in accordance with the specifications, banks were allowed to appoint the prospective buyer as their agent for the purchase of the goods and later for the sale of the goods to the buyer's firm. Furthermore, to give as much leeway to the banks, as safeguards of public money, as possible, the Ulama did not fixe a waiting period between the two stages of buying and selling.
The banks did not assume the role of trader and Morabiha degenerated into lending on mark-up. The banks rarely hired persons who knew even the basics of trading, nor did they train their existing staff to learn the art. They did not even bother to find out whether their agents had actually purchased the goods or not. The inability, or reluctance of banks and financial institutions to change over their operations from lending to trading has been a serious impediment to the Islamisation of the economy.
The blame does not entirely fall on the bankers. Depositors have become so accustomed to their money remaining safe and yet earning profit that if a bank had really ventured to trade and incurred a slight loss, then the depositors would have immediately demanded their money back causing the bank to go bankrupt. In the existing state of morality this was more likely to happen. It actually did happen to a few investment companies that had started with good intention, but could not go on giving away handsome profits to their depositors.
A lack of seriousness and dedication in those responsible for the implementation was also another great impediment to the achievement the goal of an interest-free economy. Many of these individuals thought that in the present world, there was no alternative to interest, yet something had to be done because of demands from the government. Some, who were more influenced by Western education and culture, thought that interest banking was not prohibited by Islam. Yet others thought that the efforts being made were only superficial and in reality the new system was no different from the existing system.
One weakness in the implementation of the proposals to eliminate interest from the system was that people were not sufficiently motivated to sacrifice a part of their financial interests for the sake of carrying out the commands of Allah (SWT), and The Prophet (SAW). Anyone attempting to change a well-established practice must be prepared to make some sacrifice for this, as arguably no noble cause has been achieved without any sacrifice. The prevailing level of public morality within the existing legal and taxation system of the state made it an up-hill struggle to rid the banking system of interest. And it remains so. Beyond this, there are many avenues of making profit that would have to be forgone and many types of modern banking services which which also could not be provided by a bank working strictly on Islamic principles. For example, they could not keep their surplus cash in fixed or saving deposits. In spite of these difficulties, those who were engaged in the task of Islamisation took it upon themselves to portray as successful the reforms, while those who pointed out the difficulties were labelled as either a cynic or an opponent of the new system. Anyone who uttered a word of caution was regarded as someone who did not want the experiment of Islamisation to succeed. As a matter of fact, reward in the Hereafter (aakhirat) should have been the main purpose of Islamisation. It might not have attracted many people, but the foundation would have been firm.
One great obstacle in the realisation of the goal of an interest-free economy has been absence of a proper environment. Unfortunately nothing has been done to produce an ideal or a near ideal Islamic environment by government or public leaders. The most important pre-requisite for the enforcement of Sharia'h is a'dl [translation!!!!!!]. Establishment of the rule of law and ensuring justice to aggrieved persons should be the first task of an Islamic state, yet nothing has been done to achieve this end.
One very important requirement of an ideal evironment is an inflation-free economy. Inflation erodes the real value of money, meaning that when a person gives a sum of money on loan and receives the same amount back after one year, he has made a net loss. A major source of inflation is deficit financing. The printing of notes to meet budgetary deficit is in fact an injustice to the public, since the real value of their money is consequently eroded. In this respect too, the government's performance is very discouraging. Government borrowings at high interest rates and the quantum of the government's domestic and foregn debts has reached a level which cannot be sustained. There has also been no effort to change the taxation structure so as to bring it to conform with Shari'ah. [ 7 ]
Musharika represents the most desirable form of Islamic financing arrangements. Yet, in terms of its ability to be an effective and efficient instrument for replacing interest-based transactions, it poses formidable problems.
The salient features of the Musharika agreement, as practised by the commercial banks, were as follows:
Some of these features of the instrument attracted criticism. For example, the profit sharing arrangement did not strictly conform to the requirements of Sharia'h particularly in the treatment of losses and the payment of provisional profits or their adjustment through the participation reserve. Secondly, despite being a sharing arrangement, the actual agreement was cast within the framework of a creditor-debtor relationship, and was also protected as such in law. Three, Musharika also demanded securities which were akin to the relationship between a creditor and debtor. Finally, in the absence of a legal framework regulating the operation of Musharika, there was no standardisation of the agreement, and the terms and conditions of various agreements varied considerably.
Modaraba represents another of the more desirable forms of Islamic financing arrangements.
The salient features of Modaraba companies and their operations are as follows:
Evidently, the entire scheme was an elegant formulation of the simple relationship required under a modaraba contract between labour (darib) and capital (rabbul ma'l). The management company was to be renumerated through a fixed management fee paid out of the net income of the modaraba and the remainder was to go to modaraba certificate holders, with adequate provisions for retained earnings to ensure future growth.
To outline the broad features of a strategy which holds the promise of successfully implementing an Islamic system of finance are as follows:
The proposed strategy is based on the clear recognition of the scope implied by the prohibition of Riba. This is critical, for otherwise the solution will continue to elude us. [ 8 ]
(c) 1998 Ravil Hairetdinov. All rights reserved.[Mail]