Transcript 13th Lecture

The Philosophy and Features of Islamic
Finance
The Philosophy and Features of
Islamic Finance
LECTURE
By
Dr. Syed Zulfiqar Ali Shah
The Philosophy and Features of Islamic
Finance
Summary of Last Lecture
• Time Value of Money in Islamic Finance
• Money Monetary Policy & Islamic Finance
Plan of todays lecture
•Money Monetary Policy & Islamic Finance
•Status of Paper Money•Trading in Currencies
•Creation of Money From the Islamic Perspective
•Summary
The Philosophy and Features of Islamic
Finance
Money, Monetary Policy & Islamic Finance
(Cont’d)
4. Currency Rate Fluctuation & Settlement of Debts:
IFIs create debts/receivables by way of trade and
leasing-based modes. What impact inflation has on
their receivables is an area of important discussion.
Before deliberating upon the Shar¯ı´ah position of
linking the debts with any money or a commodity, it
is pertinent to observe that, even in conventional
finance, indexation is not normally used to make up
the loss occurring due to inflation.
The Philosophy and Features of Islamic
Finance
Money, Monetary Policy & Islamic Finance
(Cont’d)
Conventional institutions rather make a provision for a floating rate in
the agreements, keeping in mind the future inflationary pressures. As
such, any new rate is applied on the remaining period, while it does not
affect the liability already accrued.
Islamic banks are not allowed as a rule to link any debt or receivable for
the purpose of indexation. In certain modes/products, however, they are
allowed to stipulate a floating or variable rate. But this does not affect
any debt liability already created. For example, in Ijarah, Islamic banks
can charge rental at a higher rate, if already provided for in the
agreement, for any remaining period of the lease; but the rentals for a
particular period once accrued cannot be indexed.
Here, we shall give only a brief overview of the Shar¯ı´ah position on
indexation. The clear injunctions of the Holy Qur’¯an and Sunnah reveal
that if the financial contribution takes the form of a loan or a debt, it is
to be paid back exactly in the same kind and quantity, irrespective of any
change in the value of the concerned currency or price of the
The Philosophy and Features of Islamic
Finance
Money, Monetary Policy & Islamic Finance
(Cont’d)
commodity lent or borrowed, at the time of return of the loan. This
principle is applicable not only for loans and debts but also for credit,
barter, deferred exchange of currency, delayed payment of remuneration
after devaluation or revaluation, indemnity and a change in the unit of
currency at the time of redemption of the loan.
However, if the currency of the debt becomes extinct or is not available
for any reason, its counter value will be paid to repay the debt and the
rate will be that of the due date. For example, a credit sale executed on
1st July generates a debt of ten Saudi Riyals (SR) payable on 31st
December. On the due date, i.e. 31st December, the purchaser is liable
to pay SR 10 irrespective of the Riyal’s value in terms of any other
currency. If the debtor is obliged to pay in Rupees for any reason, the
exchange rate will be that which is prevailing on 31st December because
he was liable to pay Saudi Riyals on that date.
A change in the value of money, particularly a depreciation of currencies
normally termed inflation, is a general feature of most of present-day
The Philosophy and Features of Islamic
Finance
Money, Monetary Policy & Islamic Finance
(Cont’d)
economies. The main cause of this depreciation is the unlimited creation
of money and credit, creating liabilities for debtors in general and hitting
future generations in particular.
Governments and central banks have used a variety of measures to
combat inflation, including indexation of wages and financial obligations
used largely in Latin American countries in the 1980s. But these
measures could not control prices and inflation rose in a number of
countries to over 2000 % per annum. Ultimately, they had to revise the
strategy and adopt policies other than indexation for combating
inflation.
In Islamic finance it is also sometimes argued that indexation should be
adopted to counter inflationary pressures or that repayments may be
made after taking into account the impact of inflation on the purchasing
power of money. Experience has shown, however, that indexation is
neither a substitute for interest nor has it been able to control the
vagaries of inflation. The Nass (clear text) of the Holy Qur’¯an (2: 279)
The Philosophy and Features of Islamic
Finance
Money, Monetary Policy & Islamic Finance
(Cont’d)
allows only the principal of a loan and debt and declares any addition
over it as Riba. In the presence of the Nass, the idea of linking
loans/debts to the purchasing power of money cannot be justified on
the basis of Ijtihad, because Ijtihad is carried out only where the
guidance of the Qur’¯an and Sunnah does not exist. This approach is
further discussed below.
In the past, the value of bullion money was represented by its content.
The value of debased money or paper money is represented by official
commitments rather than its physical content. During an inflationary
period, the intrinsic characteristics of money, i.e. its role as a medium of
exchange and as a unit of account, remain intact. Only the relative
characteristics change, i.e. the future value of money in terms of its
exchange value; but this has been changing since the introduction of
money, even in respect of full-bodied coins. The value of silver dirhams
depreciated in terms of gold dinars in the time of the early Caliphate.
But we do not find any reference in the whole literature on Islamic
economics and finance to the concept of indexation in that era.
The Philosophy and Features of Islamic
Finance
Money, Monetary Policy & Islamic Finance
(Cont’d)
Shaikh Taqi Usmani, as Judge of the Shariat Appellate Bench, has also
refuted the argument that interest is paid to compensate the loss that a
lender suffers due to inflation. He nullified the suggestion that
indexation of loans can be a suitable substitute for interest-based loans.
In this respect he says:
“But without going into the question whether indexation of loans is or is
not in conformity with Shar¯ı´ah, this suggestion is not practical so far as
the banking transactions are concerned. The reason is obvious. The
concept of indexation of loans is to give the real value of the principal to
the financier based on the rate of inflation, and therefore, there is no
difference between depositors and borrowers in this respect. It means
that the bank will receive from its borrowers the same rate as it will have
to pay to its depositors, both being based on the same measure, i.e. the
rate of inflation. Thus, nothing will be left for the banks themselves, and
no bank can be run without a profit”.
The Philosophy and Features of Islamic
Finance
Money, Monetary Policy & Islamic Finance
(Cont’d)
The learned Justice has admitted the problems created by inflation and
has also referred to various suggestions given by different quarters for
solving the problem.
With regard to the impact of change in the purchasing power of any
currency on a debt, the OIC Fiqh Council in its fifth session (10–15th
December, 1988) resolved the following:
“It is significant that a fixed debt is repaid in its own currency and not by
its counter value, because debts are settled in the same currency. Thus,
it is not permitted to attach fixed debts, whatever their source, to
currency fluctuation”.
The Philosophy and Features of Islamic
Finance
Summary
We have discussed the central ingredients of Islamic finance and some
relevant aspects that could be helpful in achieving Shar¯ı´ah compliance
for Islamic banks’ transactions. The term “Islamic finance” or “Islamic
banking” simply refers to a state of affairs wherein the financial
institutions and the clients have to fulfil the relevant principles of Islamic
jurisprudence. Some conditions have been put in place to ensure that
contracts do not contain the elements of Riba, Gharar and Qim¯ar – the
main prohibitions as discussed in Islamic law.
Some of the major characteristics of Islamic banking can be described as
follows: Islamic Shar¯ı´ah does not prohibit all gains on capital. It is only
the increase stipulated or sought over the principal of a loan or debt
that is prohibited. Islamic principles simply require that the performance
of capital should also be considered while rewarding the capital. The
prohibition of a risk-free return and permission to trade, as enshrined in
verse 2: 275 of the Holy Qur’¯an, makes the financial activities in an
Islamic set-up real asset-backed with the ability to cause “value
addition”.
The Philosophy and Features of Islamic
Finance
Summary (Cont’d)
Profit has been recognized as “reward” for (use of) capital and Islam
permits gainful deployment of surplus resources for enhancement of
their value. However, along with the entitlement to profit, the liability of
risk of loss on capital rests with the capital itself; no other factor/party
can be made to bear the burden of the risk of loss. Therefore, financial
transactions, in order to be permissible, should be associated with
goods, services or benefits. While at a micro level this feature of Islamic
finance leads to the generation of real economic activity and stable
growth, at a macro level it can be helpful in creating better discipline in
the conduct of fiscal and monetary policies.
The Islamic banking system is based on risk-sharing, owning and
handling of physical goods, involvement in the process of trading and
leasing and construction contracts using various Islamic modes of
business and finance. As such, Islamic banks deal with asset
management for the purpose of income generation. They have to
prudently handle the unique risks involved in the management of assets
by adherence to the best practices of corporate governance.
The Philosophy and Features of Islamic
Finance
Summary (Cont’d)
Once the banks have a stable stream of Halal income, depositors will
also receive stable and Halal income.
Islamic banks reflect the movement towards eliminating the role of
interest in human society, in keeping with the teachings of Islam and
other major religions. They mobilize resources through Shar¯ı´ahcompatible ways. The most important of these are demand and
investment deposits as well as shareholders’ equity. Demand deposits
normally do not participate in profit or loss to the banks and their
repayment is guaranteed. In contrast with this, investment deposits are
mobilized on the basis of profit/loss sharing. This should motivate the
depositors to monitor the affairs of their banks more carefully and to
punish them by withdrawing their deposits if the banks’ performance is
not up to their expectations. Islamic banks are, therefore, under a
constraint to manage their risks more effectively. If the banks, with the
money mobilized on the Shirkah principle, conduct business keeping in
mind the Shar¯ı´ah principles of trade and lease, their business will be
Islamic and the return earned and distributed among the
The Philosophy and Features of Islamic
Finance
Summary (Cont’d)
savers/investors will be Halal. They have to avoid Riba – earning returns
from a loan contract or selling debt contracts at a discount or premium –
Gharar – absolute risk about the subject matter of the contracts or the
price – gambling and chance-based games and general prohibitions and
unethical practices.
The rules pertaining to currency exchange contracts (hand to hand and
in equal quantity in case of homogeneous currency) have also been
discussed. Violation of these rules will result in Riba Al-Fadl (where the
quantity of hand-to-hand exchanged money is different) or Riba AlNasiah (where money is exchanged for money with deferment). This
chapter has also explained that money has the potential for growth
when it joins hands with entrepreneurship. Therefore, money has time
value, but this can be manifested in sale/leasing contracts only.
Accordingly, a person can sell any commodity for one price on a cashand-carry basis and for a higher price on a deferred payment basis.
However, this is subject to certain conditions, the fulfilment of which is
necessary to differentiate interest from legitimate profit.
The Philosophy and Features of Islamic
Finance
Summary (Cont’d)
What is prohibited is any addition to the price once mutually agreed
because of any delay in its payment. This is because the commodity
once sold, even on credit, belongs to the purchaser on a permanent
basis and the seller has no right to re-price a commodity that he has sold
and which no longer belongs to him. It further transpires that time
valuation is possible only in business and trade of goods and not in
exchange of monetary values and loans or debts. Loaning is considered
in Shar¯ı´ah a virtuous act from which one cannot take any benefit. The
discussion in the chapter leads to an important conclusion that valuation
of the credit period based on the value of the goods or their usufruct is
different from the conventional concepts of “opportunity cost” or “time
value”.
Islamic economics has the genuine provision of converting money in
assets, on the basis of which one can measure its utility. While it
concedes the concept of time value of money to the extent of pricing in
credit sales, it does not uphold generating rent to the capital as interest
does to in credits and advances, leading to a rentier class in society.
The Philosophy and Features of Islamic
Finance
Summary (Cont’d)
1.
Hence, economic agents in an Islamic economy will have positive time
preference and there will be indicators available in the economy to
approximate the rates of their time preferences, generally determined
by the forces of demand and supply. There is no justification to assume a
zero rate of time preference in real sector business in an Islamic
economy. Besides trading, Islam allows leasing of assets and getting
rentals against the usufruct taken by the lessee. All such things/assets,
the corpuses of which are not consumed with their use, can be leased
out against fixed rentals. The ownership in leased assets remains with
the lessor, who assumes the risks and gets the rewards of his ownership.
Other salient features of Islamic finance are:
Differentiating between trading (definite transfer of ownership of goods
against payment of price), loaning (temporary transfer of ownership of
goods/assets free of any payment) and leasing (transfer of usufruct of
goods against payment of rent).
The Philosophy and Features of Islamic
Finance
Summary (Cont’d)
2.
All gains on principal are not prohibited and the deciding factor is the
nature of the transaction.
3. Lending is a virtuous act – not a business.
4. Islamic banking is a business; lending will not be its regular business.
Rather, banks will be facilitating production and trade just like any
business ventures, charging profit from the business community and
giving ex post returns to savers/investors, getting management
fees/shares for their services.
5. Entitlement to profit is linked with the liability of risk of loss that comes
with the capital itself. Profit is earned by sharing the risk and reward of
ownership through the pricing of goods, services or benefits.
The discussion in this chapter has aimed at removing the myths about
Islamic banking. Major findings in this regard are:
1. A fixed return in the pricing of goods and their usufruct, subject to
fulfilment of the relevant Shar¯ı´ah essentials, is permissible.
The Philosophy and Features of Islamic
Finance
Summary (Cont’d)
2.
3.
4.
5.
6.
Islamic banking is also a business to be conducted by the funds
mobilized primarily from the middle class of the economy. This does not
mean the availability of cost-free money.
Islamic banks earn through trade, lease and services and the income is
distributed among the suppliers of funds on the basis of defined
principles.
It is absolutely normal that in trade, the cash and credit prices of a
commodity are different, provided one price is settled before finalization
of the contract and there is no change in the liability thus created.
While trade profit is permissible, any excess payment sought on loans or
debts is prohibited due to being Riba. The profit margin that banks
charge in their trade operations is permissible if the trading principles
given by Islam are taken care of.
It is true that the preferable modes for financing operations by banks are
Shirkahbased modes (Musharakah and Mudarabah). But trading and
lease-based modes are also permissible.
The Philosophy and Features of Islamic
Finance
Summary (Cont’d)
Banks can use all of these modes, keeping in mind the risk profile of the
savers/investors and cash flow and profitability of the fund users.
The Philosophy and Features of Islamic
Finance
Summary of Today’s Lecture
• Money Monetary Policy & Islamic Finance
– Currency Rate Fluctuation & Settlement of Debts
• Summary
The Philosophy and Features of Islamic
Finance
THANK YOU….
The Philosophy and Features of Islamic
Finance