Financial and Accounting Principles in Islamic Finance – Book Sample
Riba, Usury and Bank Interest
The Qur’an does not provide a deﬁnition of riba. There is a wide consensus that the term covers usurious loan practices, which were common in the Arab peninsular at the time of Prophet Muhammad (pbuh). But a new phenomenon became relevant in the Muslim world since the late nineteenth century CE, namely commercial banks and bank interest. The question to Islamic scholars then was whether bank interest falls under the prohibition of riba (Ayub 2007).
Generally speaking, the practice of riba was based on (1) loan contracts with (2) “excessively” high (explicit or implicit) rates of interest.1 Some scholars argued that riba occurs only when both components loan plus excessive rate of interest occurs. If the rate of interest is not excessive, the loan contract would not be exploitative and would not fall under the prohibition of riba. Paying or receiving moderate (non-exploitative) rates of interest for bank loans or bank deposits would be permissible.
For the majority of Islamic scholars, the rate of interest in a loan transaction is less important. What counts in a loan contract is that the lender does not only have an unconditional claim to the full repayment of the loan amount, but also to an additional beneﬁt (in form of interest or otherwise). It is this combination of claims, unconditional full repayment plus additional beneﬁt, which is considered riba and hence is prohibited (Saleh 1986).
The background for this stricter interpretation is the view that money has no intrinsic value and a loan should be more an act of benevolence than a ﬁnancing tool. A benevolent loan (qard al-hasan) should be given to a person in a distressed situation, and although the lender may have a claim for the repayment, he should not enforce it if that implies a hardship for the borrower (Usmani 2002). The borrower is morally obliged and accountable in the hereafter for the repayment of the loan once he is able to do so without hardship.
1Rates were excessive when the contracting parties knew in advance that the borrower would not be able to repay the loan plus the interest on maturity. Another variant was that the loan was initially interest-free, but the maturity so short that a person who needed the loan to survive after a misfortune was unable on repay on time. In this case, the maturity was extended but the outstanding amount doubled.
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1.5 Bank Financing Without Riba 13
When a loan was not an act of benevolence, but given for the purpose of ﬁnancing, the situation is different. This would be subject to the underlying Islamic ﬁnance principle(s), the creditor is morally not restrained to legally enforce his claim for the repayment in case of a delay by the debtor. However, the majority of Islamic scholars would maintain that no additional beneﬁts must be claimed by the creditor. If so, the loan contract would involve riba and fall under the Qur’anic prohibition, with severe consequences for the creditor in the hereafter. Hence, interest-bearing bank loans or interest-bearing bank deposits, which can be seen as loans by the depositors to the bank, are not permissible.
Bank Financing Without Riba
If bank loans are permissible, but have to be free of interest in the broadest sense (free of any ﬁnancial beneﬁt for the creditor), then bank ﬁnancing cannot be based on loans. The search for an alternative has resulted in two different solutions which were developed by two different groups of experts: Shariah scholars (jurists) on the one hand and Islamic economists on the other hand (Ayub 2007).
The Jurists’ Approach
The jurists refer to a verse in the Qur’an that explicitly prohibits riba but allows trade. Trade at the time of Prophet Muhammad (pbuh) was a very sophisticated and proﬁt-oriented business, comprising:
- commercial partnerships for risky and capital intensive long-distance trade, such as caravans to Syria, China and Yemen,
- the sale of goods to retail and business customers on a deferred payment basis with a mark-up over the spot price, and
- the pre-ﬁnancing of the production of future trade objects especially in agriculture and crafts.
None of these activities required loan contracts for its ﬁnancing. Instead, they were based on partnership contracts and different types of exchange contracts, which I will not discuss here in this chapter (see Chaps. 5–8).2
- In partnership contracts the parties either pool their ﬁnancial resources, manage a project jointly and share proﬁts or losses of the joint venture, or one party only provides the ﬁnancial resources, the other party manages the project, and both share proﬁts while only the ﬁnancing party has to cover ﬁnancial losses should they occur.
2The following is only a brief summary of the main characteristics of these contracts. More details are provided in subsequent chapters.
14 1 Introduction: The Basics of Islamic Economics and Finance
- Exchange contracts are either rent or sales contracts. One contracting party receives the right to use an object or gets the ownership of the object, while the other party pays the agreed rent or price. It is permissible that the exchange of the object and the payment take place at the same time (spot sale), or that the object is exchanged today for payment in the future (sale with deferred payment), or in special cases under particular conditions that money today is exchanged for objects in the future (forward or manufacturing sales).
In exchange contracts in which the payment precedes the delivery, the ﬁnancing component is obvious. In deferred payment sales, the ﬁnancing component is a mark-up on the spot price which is a legitimate trade proﬁt for the seller and not prohibited riba. The buyer who did not have the money for a spot payment can use the purchased items to generate an income that allows him the payment of the higher deferred purchasing price. This income generation has been facilitated (ﬁnanced) by the deferment of the payment. In a similar way, the ﬁnancing component of a rental contract is that extra amount by which the aggregate value of the future rental payments exceeds the spot price of the rented object.
1.5.2 Substance and Form
It can hardly be denied that the economic or commercial substance of the ﬁnancing component of an exchange contract (sales or rental/leasing contact) is equivalent to the interest in a conventional loan. It is, on the other hand, clear that the legal form of an exchange contract is different from a loan contract. However, the difference is not only in form as the parties of exchange contracts have rights and obligations which are related to the object of exchange. For example, the selling party does not only provide the ﬁnancing through accepting a deferred payment. The seller is also responsible for the proper condition of the object and its agreed delivery terms (Saleh 1986).
This is by no means trivial if the selling party is a bank, which is a ﬁnancial institution and not a trading company. If a bank agrees to a mark-up sale for the ﬁnancing of objects which are requested by a customer, it typically does not have these objects in stock but has to purchase them ﬁrst by itself. The bank must ensure to get the right objects at the right time before they can be sold and delivered to the customer on time. Risks are associated with these intermediary steps, which do not exist in a conventional setting where the bank provides only the ﬁnancing by means of an interest-bearing loan, while all issues related to the required object fall exclusively into the realm of the customer.
Contracts which were developed for traders are not particularly well suited for ﬁnancial institutions, and adjustments and adaptations have to be made to achieve a better ﬁt. If a bank wants to avoid riba in its ﬁnancing business, but views itself as a ﬁnancial institution (like a conventional bank), then the general direction of its “con- tractual engineering” is predetermined. It is the shift of nonﬁnancial risks (i.e. risks emanating from the object of the “ﬁnancing sale”) from the bank to the customer.
1.5.3 The Economists’ Approach
The risk avoidance by riba-free banks is in a sharp contrast to the position of those Islamic economists who were thinking of a fundamental reform of the ﬁnancial system. For them a genuine Islamic system should be based on risk sharing between the ﬁnancier and the ﬁnanced entrepreneur (instead of a risk shifting from the ﬁnancier to the entrepreneur). The appropriate legal form would be partnership contracts with proﬁt and loss sharing (PLS) structures. The Islamic economists discussed the qualities of a PLS economy extensively, and they found that it would be more just and superior to the conventional interest-based system with respect to the efﬁciency of capital allocation, the distribution of income and wealth, and the macroeconomic stability (Saeed 1999; Usmani 2002).
Whatever the merits of these PLS models are, they were never a description of the realities in Muslim countries. While it is frequently argued that risk sharing is the main feature of an Islamic ﬁnancial system, PLS techniques are rarely applied in the ﬁnancing product structures of Islamic banks. The contradiction between these two statements can be resolved if the ﬁrst statement is read as prescriptive and the second statement as descriptive. Risk sharing is the feature of an Islamic ﬁnancial system, but such a system is not yet implemented. The riba-free ﬁnancing tech- niques, which presently dominate the practice of Islamic banks are approved by Shariah scholars, but economists argue that they should be phased out and replaced by PLS modes of ﬁnancing in the future. However, this future may be far ahead. It seems that not only those ﬁnancial instruments which replicate risk-shifting features of conventional ﬁnance are persistent, but even more sophisticated risk-shifting instruments are added to the toolboxes of Islamic banks (Siddiqi 2004). The Islamic ﬁnancing system, instruments and products are depicted in Figs. 1.4 and 1.5 respec- tively, and will be explained from an accounting perspective in subsequent chapters (see Chaps. 5–8).
1.6 Shariah Compliance and Shariah Governance
The achievement of a sound corporate governance is a major challenge even in well- developed markets, and one reason why they are well-developed is that in them this challenge has been met to a reasonable degree. Conversely, failure to recognise or to respond to this challenge may slow the development of emerging markets. Most Islamic ﬁnancial institutions are located in emerging market countries. The banking supervisors of such countries have therefore a key role to play in enforcing good corporate governance in their jurisdictions (Lahsasna 2010). With this in mind, there are a number of reasons why Islamic banks are a special case amongst banks. These may be summarised as follows and each is explained further below:
- the need for Shariah compliance;
- accountability to the Almighty: ethics and social responsibility (in contrast to the
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