HORMUUD UNIVERSITY

Faculty of Economic and Management

Science
Islamic Financial System
Chapter Three
ISLAMIC FINANCE AND BANKING

Prepared By: Abdullahi Dahir Mohamed

Coach Abdullahi Dahir Mohamed Ali 1

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 Introduction
• Islam is a way of life. A verse from the Quran states, “This day I have perfected

your religion for you, completed My favour upon you, and have chosen Islam

as your way of life” (Qur’an 5:3).

• The lexical meaning of the word Islam is ‘submission’

• Actions in Islam can be categorized into two broad categories, namely ‘Ibadaat

and Mu’amalaat.

Coach Abdullahi Dahir Mohamed Ali 3

 Introduction
• ‘Ibadaat – Acts of Worship

Ibadaat are based on the individual’s direct relationship with God. This entails that specific acts of worship
must be directed solely for Allah (God) alone with sincerity. This includes one’s Prayers, Fasting, Pilgrimage etc.

• Mu’amalaat – Interactions with People

This refers to the conduct one has with fellow human beings. This can refer to law, work, marriage, inheritance,
business transactions, partnerships, buying, selling etc. Islamic finance and banking falls under this category.
One must ensure their conduct is in conformity with Shari’ah principles.

• Objective of human life is to please GOD – Almighty Allah via Ibadaat and Mu`amalaat.

Coach Abdullahi Dahir Mohamed Ali 4

 Introduction
• Shari’ah –Islamic Law

Shari’ah is the set of rules which includes and clarifies

obligations, prohibitions, recommended duties, detested
actions, what is lawful and unlawful etc. Therefore it
includes ethics, manners, laws, public life, social life,
economic life, politics etc.

Coach Abdullahi Dahir Mohamed Ali 5

 Introduction
Basis of Islamic Banking and Finance

Shari’ah as the Basis of Islamic Banking and Finance

Coach Abdullahi Dahir Mohamed Ali 6

 Ethics in Islamic Finance and Banking
"Assist one another in righteousness and piety. And do not assist one another in sin and
transgression…" (Qur’an 5:2)

• One objective of Islamic finance and banking is to assist in the spread of economic
prosperity. The other objective is to do this in accordance with Shari’ah principles.

• Among the norms concerning Islamic finance are a free market, where prices are
determined by demand and supply, freedom from manipulation, prevention of hoarding,
profit and loss sharing in partnerships, information efficiency etc.
Among the norms in Islamic finance that we want to elaborate on here
are the following three topics:

1. The Prohibition of Riba (Interest or Usury) – Money is not to be exchanged for money with profit. As
a result of this prohibition, alternative solutions are given which encourage trade and equity
participation.

2. The Prohibition of Gharar (Uncertainty) – This demands transparency in contracts as well as in

buying and selling. Prices should be specified, there should be clarity of the delivery details, quality of
goods, quantity of goods etc. The information should be available to all parties involved and the
outcomes of a contract should be free from ambiguity etc.

3. Sanctity of Contract – Contracts should be fair and agreed upon by both parties. Therefore, the
contract should be free from the elements of Gharar and reach Shari’ah approval in their content.
1. The Prohibition of Riba (Interest or Usury)

Definition of Riba: ‫ال&ربا‬

• Riba in the Arabic language literally means increase. However, according to the specific Shari’ah definition,
it means unlawful increase ‫ لا))زيادة لا))محرمة‬. Under today’s literature and terminologies, riba commonly refers
to interest and usury.

• The Islamic Fiqh Academy which was initiated through the OIC (Organization of the Islamic Conference),
was established to bring scholars from around the world in order to address current issues and concerns.
During the 2000 meeting, the OIC reaffirmed the consensus of the historical prohibition of interest. Riba is
one of the core concerns in Islamic finance. In order to avoid riba, many financial alternatives have been
adopted over the centuries. Although scholars describe rationales as to why riba may be prohibited, the
sole reason for sincere Muslims to refrain from riba is to conform to what the Law Maker has legislated.
 Riba ‫( لا))ربا‬Interest or Usury)

• Riba is strongly prohibited in Islam. The many verses of the Qur’an leave no question in this
regard: “Allah has permitted trade and forbidden riba.” (Qur’an: Surah Al-Baqarah 2:275).
The verses prohibiting riba are located in four Surahs of the Qur’an; Surah Al-Baqarah 2:275-
276, 278-280; Surah Aal Imran 3:130; Surah An-Nisaa 4:161 and; Surah Ar-Room 30:39.

• Riba is further elaborated on in the Prophet’s Sunnah. Numerous hadiths explain the details
surrounding riba. In a hadith narrated by the Prophet’s companion Jaabir: “Allah’s Messenger
cursed the one who accepts riba, the one who gives it, the one who records it and the two
witnesses to it, saying, ‘They are all the same.’” (Collected By Muslim).
 Types of Riba:

• There are two major categories of riba.

• The first category is known as Riba An-Nasee’ah which relates to riba in debt. It increases with
time (e.g. interest on borrowed money). This is the most common type of riba today and it
relates to return of money on money at any rate (fixed or floating, compounded or simple
interest).

• The other category is Riba Al-Fadl which refers to riba in exchange. This type of riba refers to the
six commodities (e.g. Gold) mentioned in the hadith.

It increases with the transaction.

Riba An-Nasee’ah - Riba in Debt
• This form of riba was well known in jahiliyah (pre-Islamic era of ignorance). When the date of maturity
neared for one’s debt, it would be said to him, “pay up, or pay riba (increase)”. Due to deferment in
repaying the debt, the debt would increase. It would continue to accumulate as compounded interest
until it doubles and so on.

• Another practice from the jahiliyah period included the loaning of money with a fixed increase in the
return. For example, one would borrow, 10 gold coins (Dinars) with the condition of returning 12 gold
coins at a future date.

• From the above description, we see how riba an-nasee’ah is equivalent to interest. For example, it
includes the use of credit cards and “interest free” periods, as the date of maturity passes, interest is
incurred. Likewise it is typical of bonds, or loans from conventional banks today which lend money with
the condition to be paid back with an increase of a certain percentage in the future, at a variable or
fixed interest rate.
 Riba Al-Fadl - Riba in Exchange
• Although gold and silver were the real currency at the time, the Prophet described certain
commodities that relate to riba. These commodities are prohibited to exchange, same for same,
unless they are of equal amount, without increase. One hadith states, “Gold with gold, silver
with silver, wheat with wheat, barley with barley, dates with dates, and salt with salt; same
quantity for same quantity, equal for equal; transaction being made hand to hand (i.e. on the
spot payment)” (Muslim).

• Some scholars have stated that these commodities are only limited to the six mentioned. Other
scholars, by making Qiyas (analogy), have stated that it can also include other commodities that
can be weighed, or other food, or specific food which can be stored similar in nature to the six.
 Riba Al-Fadl - Riba in Exchange (cont)

• However, gold and silver are the universal tenders like cash money today. The
remaining four commodities may have been used in a similar fashion to
currency.

• Another hadith mentions, “Do not sell gold for gold unless it is the same
amount for the same amount, and do not make one amount greater than the
other. Do not sell silver for silver unless it is the same amount and do not make
one greater than the other.” (Bukhari and Muslim).
 Riba Al-Fadl - Riba in Exchange (cont)
• The following narration sheds light on this form of riba with the exchange of these types of
commodities. A hadith mentions, “Once Bilal brought Barni (a kind of dates) to the Prophet and the
Prophet asked him, ‘From where have you brought these?’ Bilal replied, ‘I had some inferior type of
dates and exchanged two Sa’s (approximately 6 kilograms) of it for one Sa’ (approximately 3
kilograms) of Barni dates in order to give it to the Prophet to eat.’ Thereupon the Prophet said,
Beware! Beware! This is definitely Riba! Don’t do so, but if you want to buy (a superior kind of
dates), sell the inferior dates for money and then buy the superior kind of dates with the money”
(Bukhari).

• This hadith shows the prohibition of exchanging the same commodity of a different measurement, yet
it also displays the alternative solution. That is to sell the dates, and buy the other dates with the
money.
 Riba rules - summary

• The commentator of Sahih Muslim, Imam Nawavi has summarized these rules in the following way:

• When the underlying ‘Illah of the two goods being exchanged is different, shortfall/excess and delay
both are permissible, e.g. the exchange of gold for wheat or dollars for a car.

• When the commodities of exchange are similar, excess and delay both are prohibited, e.g. gold for
gold or wheat for wheat, dollars for dollars, etc.

• When the commodities of exchange are heterogeneous but the ‘Illah is the same, as in the case of
exchanging gold for silver or US Dollars for Japanese Yen (medium of exchange) or wheat for rice (the
‘Illah being edibility), then xcess/deficiency is allowed, but delay in exchange is not allowed. (Ayub
2007, p.52)
 Wisdom behind the prohibition of riba as put forward by some scholars.

• It goes against mutual cooperation, generosity, and spirit of partnership.

• Acquisition of property by wrongful means and harm to the needy.

• Removal of the possibility for injustice and exploitation.

• Drives the capital-owner away from enterprise and real economic activities that contribute
to the welfare of society (e.g. commerce, manufacturing, construction and so on)

• Money is meant to be a medium of exchange and standard of value for other goods. Riba
violates the entire rationale behind money and diverts money from doing what it is meant
to do.
 2. The Prohibition of Gharar (Uncertainty)

• Gharar has a broad scope and is not limited to one simple definition. For our purposes here,
it relates to excessive uncertainty or ignorance by way of a contract, or the goods involved in
a sale, the price, ownership, possession of goods, deliverability, dates of exchange etc. A
hadith collected by Muslim narrated by Abu Hurairah states, “The Prophet forbade selling by
way of tossing stones to settle a sale (Al-Haasah), and the sale of Gharar.”
 Minor and major Gharar

Minor Gharar

• Gharar has been categorized into two categories, namely major and minor. It is expected that minor
(or trivial) accounts of gharar will exist and for that reason it is tolerated and not given concern.
Such is the case of catching a taxi, there is an element of uncertainty in the price as it rises with the
mileage, yet this is a minor form of uncertainty and is permissible. Another example is buying fruit
without peeling the skin to see inside.

Major Gharar

• Causes for alarm are the major or substantial forms of gharar which are clearly condemned from a
Shari’ah perspective. Major Gharar will be simply referred to as gharar in the rest of the lecture
notes.
Gharar can generally refer to the following:

• Lack of Transparency -The Shari’ah stipulates that transparency must exist in order for contracts to be
legitimate. For example, the terms of the contract must be clear to both parties involved in order to be just
and fair. Under such measures, individuals are protected from fraud, deceit and exploitation.

• Deception - Gharar can also imply deceit.

Once Prophet Mohammad came upon a heap of grain in the market of Madinah and thrust his hand onto it.
His fingers felt dampness. On being asked, the trader replied that rain had fallen upon it. The Prophet
observed, "Why did you not then keep (the wet portion of) it above the dry grain, so that people may see
it? He who deceives, has nothing to do with me” (Muslim). Therefore, relevant information cannot be
withheld.
• Selling what you do not have

Part of Gharar is selling what is not in one’s possession. The common example of this is the
selling of the fish in the ocean which has not been caught yet, or selling vegetables that the
seller is yet to purchase (i.e. they are not in possession or ownership). This can lead to
settlement risk and is therefore a form of gharar. One should therefore catch the fish and then
sell it, or buy the vegetables from a wholesaler, and then sell them to avoid the risk of
uncertainty.

An exception to this rule is a salam contract (Bai’ As-Salam) which relates to farm produce which
has not been harvested yet. Such a contract is paid up-front and an agreed upon amount of
goods (e.g. one ton) must be delivered at a later date when the produce is harvested.
• Ignorance - The buyer should have relevant information about the goods they intend to buy or
the contract they intend to sign. This is why it is important to inspect the goods one is about to
buy. With regards to what the buyer is buying, the buyer should know (for example) the quantity,
the attributes, species etc. Or in the case of a contract, both parties should have a sufficient
understanding of the details and outcome of the contract in order to remove any doubt.

• Unspecified Price - The price of the sale should be stipulated. This is important if the goods are
purchased on credit, in order to avoid disagreement at a later date.

• Unspecified dates - As for the delivery of goods, the price can be delayed or the goods can be
delayed in delivery, yet this should be by mutual consent of the buyer and seller.
• Akin to gambling

Maisir (game of chance) is regarded as gambling because the outcome is unknown and clearly
involves gharar. The practice of Maisir is declared forbidden in Qur’an (2: 219). Therefore, according
to the Shari’ah, such games of chance are to be avoided. An example of this is speculation in short
selling, conventional methods of forwards, futures, options and other derivative transactions where
future delivery of underlying assets is uncertain (and usually settled in cash) as being forms of maisir.

• Although excessive gharar is condemned by the Shari’ah, this does not rule out levels of risk by way
of entrepreneurial risk and risk associated with calamities (such as natural disasters). Systematic risk
and unsystematic risk will be covered in more detail in the following weeks.

• Complexity in Contracts

Undue complexity in contracts or interdependent contracts where two sales are combined in one are
not permitted. (e.g. I will sell you A as such a price, if you sell me B at such a price.)
 3. Sanctity of Contract

Sanctity of Contract

• As excessive gharar is impermissible in Islam, the Shari’ah emphasizes that contracts must
include transparency and honesty. Prices should be specified, there should be clarity of the
delivery details, quality of goods, quantity of goods etc. The information should be available
to all parties involved and the outcomes of a contract should be free of ambiguity.

• When full disclosure is present, both parties eliminate or reduce financial speculation and
undue complexity in contracts (due to gharar). This will include discloser of the risk involved
by providing as much information as possible for buyers or investors.
 3. Sanctity of Contract (cont)
• If two or more parties come together for a partnership (e.g. musharakah), all parties should
be aware of their profit-sharing ratio, underlying assets involved, and other conditions of the
contract.

• The parties involved must mutually agree on the sale or contract, albeit orally or preferably
in written form, without coercion.

• Contracts must be in accordance with Shari’ah principles. Therefore, investments considered

unethical, unlawful (haram), unjust etc, would not be considered. Although riba and gharar
may not be involved, one must make sure that other unlawful practices are not present. For
example, it is prohibited to finance a casino or deal with alcohol etc.
 Case study: Riba & Gharar today
Identify role of Riba & Gharar in:
I. Global Financial Crisis (GFC)
II. European debt crisis (EDC)
III. Other examples?
Questions?
The end of chapter

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