CHAPTER ONE

INTRODUCTION TO ISLAMIC FINANCE

Introduction

Islamic Finance is a form of financial activities that are purely guided and controlled by the strict

adherence to sharia laws. The system does not approve the levying of interest (commonly

referred to as riba or usury) as a form of earning income from its operations but rather is

practiced under the principle of profit/loss sharing, risk sharing as well does not require

indulgence in prohibited activities like gambling, alcohol drinking, prostitution and dealing in

drugs. The risk sharing is provided for by the use of financial methods like murabaha,

mudaraba, ijarah, musharakah, salam and istisna.

Islamic finance recognizes capital as a factor that accelerates production but does not allow the

factor to make a prior or predetermined claim on the productive surplus in the form of interest.

The owner of capital can legitimately share the profits made by the entrepreneur through the

profit sharing method but not predetermined rate of return (interest rate). Similarly, in case of

loss incurred, both parties a have to make an agreement and share the loss equally. Islamic

practice allows the owners of capital to have some share in a surplus which is uncertain. The

owner of capital (rabbul-mal) may 'invest' by allowing an entrepreneur with ideas and expertise

to use the capital for productive purposes and he may share the profits, if any, with the

entrepreneur borrower (mudarib); losses, if any, however, will be borne wholly by the rabbul-

mal (Ariff, 1988).

Thus, the notion of Al-ghurm bil ghurm (no risk no gain) and Al -kharaj bil daman (profit is

recognize with liability) are widely applied in the Islamic banking practice especially in the

contract of mudarabah and musyarakah. This is because, Islam makes a clear distinction between

what is halal (lawful) and what is haram (unlawful) as it encourages the growth of economic

activities. The practice and purpose of Islamic Finance and banking is mainly anchored to four

objectives; Islamic objectives, social objectives, ethical objectives and economic objectives. The

objective of welfare and justice Islamic goals in its dealing with persons or institutions is

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considering them as partners and thus where profit is made it is shared equitably between the

parties and where loss is incurred it is equally shared.

There is no single definition of Islamic Finance but it is widely used today to refer to financial

and commercial activities that respect the principles of Islamic law and jurisprudence, more

commonly referred to as Shari a “. Respect for such principles allows investing and making

profits in accordance with the rules of Muslim law. In general, the products and financial

instruments compatible with the Shari an aim to offer a viable ethical alternative to the

traditional finance tools.

The sources of “Shari a”

The Arabic word “Shari a” literally means “the way”. Through principles and recommendations,

Shari a defines acceptable behavior in all areas of Muslim life. It governs the moral, ethical,

spiritual and social dimension of the private and public life of Muslims, including economic and

commercial activities. Shari a refers to unmodified Islamic law. It is a legal system based on

Muslim ethics, which can be interpreted and developed.

Sharia have two main Sources:

The Quran (the sacred text of Islam which accounts for the message of God as revealed to the

Prophet Muhammad) and the Hadith (the Sunna text bodies, expressions, teachings and actions

of the Prophet), these two sources constitute the essential basis for determining the conformity of

any action with the rules and purpose of the Shari a. A key role is played by Muslim law scholars

(Scholars) who specialize in Shari a, who interpret the principles that can be applied to modern

financing techniques, while remaining faithful to the spirit of the traditional sources of The

Muslim right. For this purpose, The Islamic finance sector has developed very rapidly in recent

years.

Estimates of the size of this market vary from source to source and are often quickly outdated.

Nevertheless, the rapid development of the industry and its influence on the financial market in

general are now widely recognized. The proliferation of Islamic financial institutions around the

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world, as well as the growing number of conventional banking institutions that now offer

compatible Shari a financing solutions, confirm the rise of the Islamic finance sector.

As regards Europe, the authorities have just taken a very important step in the process of

recognizing Islamic finance by adopting tax and regulatory measures at the end of 2008 aimed at

promoting this financing technique. In a context of current economic and financial crisis

affecting in particular the real estate sector and significantly complicating access to so-called

“conventional” liquidity, the arrival of Islamic banks in Europe can only attract investor’s

interest in this sector Ethical finance.

Functions of sharia board

The Shariah board is a key part of an Islamic financial institution. It has the responsibility for

ensuring that all products and services offered by that institution are compliant with the

principles of Shariah law. Boards are made up of a committee of Islamic scholars and different

institutions can have different boards. An institution’s Shariah board will review and oversee all

new product offerings before they are launched. It can also be asked to deliver judgments on

individual cases referred to it, such as whether a specific customer’s business proposals are

Shariah-compliant.

The demand for Shariah-compliant financial services is growing rapidly and the Shariah board

can also play an important role in helping to develop new financial instruments and products to

help the institution to adapt to new developments, industry trends, and customers’ requirements.

The ability of scholars to make pronouncements using their own expertise and based on Shariah,

highlights the fact that Islamic finance remains innovative and able to evolve, while crucially

remaining within the bounds of core principles.

Historical Development of Islamic Finance

The Islamic finance is as old as the Islamic religion, with its principles derived from the Qur’an,

according to (Mohammed Naveed). Its rapid growth, remodeling and modernization took place

in the AD 1970 after the Yom Kippur War and the oil crisis of 1973. The concept of Islamic

finance took shape between 8th and 12th Century after the prophet. During this period, the

economy as was driven by the monetary policy of the period was based on the widely circulated

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currency commonly referred to as the gold dinar, and it tied together regions that were previously

economically independent.

It was in the 19th century that Muslims came to know and understand that the current system of

banking and economic finance were based on riba which is not recognized under Islam financial

principles and is categorically forbidden in all its shapes whether commercial or non-

commercial; and there should be an alternate system where its operations, products and services

conforms to the principles of Shariah (Ali, 2015). For that reason, the Islamic banks began

thriving in the middle of 1970s. Islamic bank have undergone into three phase of development.

Pre Islamic Era

Before the coming of Islam, banking activities has begun in the Arab but its operation has the

element of charging interest, riba. Meccan of that time used the money either giving it to another

party to be traded through alQirad or mudarabah and the profits is shared by both party or

lending the money to gain benefits which is considered as riba (Mohammad & et. al, 2013).

However, the coming of Islam has done away with all activities that involve riba, however, this

prohibition did not prevent the development of trade that took place either nationally or

internationally (Sudin, 1996) cited in (Mohammad & et. al, 2013) and the origin of Islamic

finance dates back to the dawn of Islam 1,400 years ago (Ajagbe & Brimah, 2013).

Prophet Muhammad before the time of his prophet hood had applied the concept of trust. Due to

his noble conducts such as honesty and integrity, he was given the authority to be in charge of

the wealth of the Arabs (Hamoud, 1985) cited in (Mohammad & et. al, 2013). Apart from that,

during the time of the Prophet there was also a man by the name al-Zubayr alAwwam who took

the role as a bank, and kept the deposits for other people. However, this form of money keeping

was modified by him to loans. Abd Allah bin Al-Zubayr, the son of Al- Zubayr narrated that

when people brought their money to be kept by his father, he will tell that person that the money

is being borrowed, instead of being deposited, as his father was worried that he might lose the

money.

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Prohibitions in Islamic Finance System

1. The interest (Riba)

The prohibition of riba is a fundamental rule of Islam. The Shari a considers money as a simple means of exchange. Consequently, money alone cannot be the object of a contract or used as a means of making a profit. This requirement prohibits the collection of any interest in return for the making available of a sum of money. Under Shari a, the collection and receipt of interest (fixed or variable) is strictly prohibited and any obligation to pay interest is deemed void.

2. The Uncertainty (Gharar)

In Muslim law, contracts containing elements of uncertainty are deemed to be void. A contract not affected by Gharar is a contract in which all fundamental terms (such as price, subject matter, identity of parties and deadlines for execution) are clearly defined on the day of its conclusion. This rule is rigorously applied by the scholars. It is thus rare to provide for suspense conditions relating to the characteristic elements of the contract in the Islamic financing documents. The scholars also strongly encourage the satisfaction of all preconditions before the contract is signed.

3. Speculation (Maisir)

Operations which are based on pure speculation in order to make a profit are illegal (haram) and therefore null in Muslim law. This principle notably closes Islamic investor’s access to the market of derivatives as a source of profit primarily and prevents them from participating in the speculative trading of securities of companies. There is, however, a clear distinction between pure speculation and speculative activity in the sense of not certain but carried out in an “entrepreneurial” way, which is perfectly lawful insofar as it is at the service of creation Or investment in a business.

4. Unfair Enrichment / Unfair Exploitation

Contracts in which one of the parties unfairly exploits or otherwise unfairly perceives a gain to the other party is also deemed void. Indeed, according to Shari a principles, a Muslim must generate profit only from transactions or activities in which he invests and on condition that he shares the risks (this rule refers to the “three p principle”: sharing of losses and profits).

Sharing is not necessarily egalitarian, but it must be determined according to an agreed-upon allocation key. Under this rule, a financial donor is formally prohibited from making a financial profit resulting from late payment penalties paid by a debtor in default of payment. On the other hand, it is permissible (and accepted by a number of scholars) for a lender to impose the payment of penalties for delay, since this is an incentive for prompt payment.

However, late payment penalties collected by the financier may be retained by the financier only to the extent that they correspond to the sum of the costs actually incurred by him as a result of the late payment. Any amount not corresponding to such expenses shall be distributed to

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charities. The late payment penalties collected by the financier may be retained by the financier only to the extent that they correspond to the sum of the costs which he actually incurred as a result of the late payment.

Any amount not corresponding to such expenses shall be distributed to charities. The late payment penalties collected by the financier may be retained by the financier only to the extent that they correspond to the sum of the costs which he actually incurred as a result of the late payment. Any amount not corresponding to such expenses shall be distributed to charities.

5. Financing / Ethical Investments

Islamic financing cannot have as its object an investment in an activity prohibited by Shari a. No investment can therefore be made by an Islamic financier when dealing with haram products or illicit activities such as alcohol, armament, pig meat, pornography or games of chance. Examining the compatibility of investments and financing with Shari a can sometimes be complex (eg investment in a hotel selling alcohol).

6. The Hoarding

To the extent that the Shari a considers money as a simple means of exchange of no intrinsic value, hoarding is strongly discouraged or even condemned. A Muslim can accumulate legitimately acquired wealth, but he must be careful to spend or invest that wealth wisely. When a Muslim has an annual income greater than a certain amount, he is obliged to return a part of it to a defined category of the population including especially the needy. It thus conforms to the obligation to pay zakat, one of the five pillars of Islam. Beyond these prohibitions,  Islamic Finance must be a driving force for the economy and must therefore actively participate in the creation of added value. It must not be confined to a money-making role!

Islamic Finance prohibitions

The following activities are prohibited:

Charging and receiving interest (riba). The idea of a lender making a straight interest charge, irrespective of how the underlying assets fare, transgresses the concepts of risk sharing, partnership and justice. It represents the money itself being used to make money. It also prohibits investment in companies that have too much borrowing (typically defined as having debt totalling more than 33% of the firm’s average stock market value over the last 12 months).

Investments in businesses dealing with alcohol, gambling, drugs, pork, pornography or anything else that the Shariah considers unlawful or undesirable (haram).

Uncertainty, where transactions involve speculation, or extreme risk. This is seen as being akin to gambling. This prohibition, for example, would rule out speculating on the futures and options markets. Mutual insurance (which relates to uncertainty) is permitted if it is related to reasonable, unavoidable business risk. It is based upon the principle of shared responsibility for shared financial security, and that members contribute to a mutual fund, not for profit, but in case one of the members suffers misfortune.

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Uncertainty about the subject matter and terms of contracts – this includes a prohibition on selling something that one does not own. There are special financial techniques available for contracting to manufacture a product for a customer. This is necessary because the product does not exist, and therefore cannot be owned, before it is made. A manufacturer can promise to produce a specific product under certain agreed specifications at a determined price and on a fixed date. Specifically, in this case, the risk taken is by a bank which would commission the manufacture and sell the goods on to a customer at a reasonable profit for undertaking this risk. Once again the bank is exposed to considerable risk. Avoiding contractual risk in this way, means that transactions have to be explicitly defined from the outset. Therefore, complex derivative instruments and conventional short sales or sales on margin are prohibited under Islamic finance.

what is permitted in Islamic Finance

As mentioned above, the receipt of interest is not allowed under Shariah. Therefore, when Islamic banks provide finance they must earn their profits by other means. This can be through a profit-share relating to the assets in which the finance is invested, or can be via a fee earned by the bank for services provided. The essential feature of Shariah is that when commercial loans are made, the lender must share in the risk. If this is not so then any amount received over the principal of the loan will be regarded as interest. There are a number of Islamic financial instruments mentioned in the Financial Management syllabus and which can provide Shariah-compliant finance:

Murabaha is a form of trade credit for asset acquisition that avoids the payment of interest. Instead, the bank buys the item and then sells it on to the customer on a deferred basis at a price that includes an agreed mark-up for profit. The mark-up is fixed in advance and cannot be increased, even if the client does not take the goods within the time agreed in the contract. Payment can be made by instalments. The bank is thus exposed to business risk because if its customer does not take the goods, no increase in the mark- up is allowed and the goods, belonging to the bank, might fall in value.

Ijara is a lease finance agreement whereby the bank buys an item for a customer and then leases it back over a specific period at an agreed amount. Ownership of the asset remains with the lessor bank, which will seek to recover the capital cost of the equipment plus a profit margin out of the rentals payable.

Mudaraba is essentially like equity finance in which the bank and the customer share any profits. The bank will provide the capital, and the borrower, using their expertise and knowledge, will invest the capital. Profits will be shared according to the finance agreement, but as with equity finance there is no certainty that there will ever be any profits, nor is there certainty that the capital will ever be recovered. This exposes the bank to considerable investment risk. In practice, most Islamic banks use this is as a form of investment product on the liability side of their statement of financial position, whereby the investor or customer (as provider of capital) deposits funds with the bank, and it is the bank that acts as an investment manager (managing the funds).

Musharaka is a joint venture or investment partnership between two parties. Both parties provide capital towards the financing of projects and both parties share the profits in

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agreed proportions. This allows both parties to be rewarded for their supply of capital and managerial skills. Losses would normally be shared on the basis of the equity originally contributed to the venture. Because both parties are closely involved with the ongoing project management, banks do not often use Musharaka transactions as they prefer to be more ‘hands off’.

The difference between interest based financing and Musharakah:

Interest based financing Musharakah

1. A fixed rate of return on a loan advanced by the financier is predetermined irrespective of the profit earned or loss suffered by the debtor.

Musharakah does not envisage a fixed rate of return. The return is based on the actual profit earned by the joint venture.

2. The financier cannot suffer loss. The financier can suffer loss, if the joint venture fails to produce fruits.

3. Results in injustice either to the creditor or to the debtor. If the debtor suffers a loss, it is unjust on the part of the creditor to claim a fixed rate of profit. Also if the debtor earns a very high rate of profit, it is injustice to the creditor to give him only small proportion of the profit leaving the rest for the debtor.

The returns of the creditor are tied up with the actual profits accrued through the enterprise. The greater the profits of the enterprise, the higher the rate of return to the creditor. If the enterprise earns enormous profits, all of it cannot be secured by the debtor exclusively but will be shared by common people e.g. Depositors in the bank.

Sukuk is debt finance. A conventional, non-Islamic loan note is a simple debt, and the debt holder's return for providing capital to the bond issuer takes the form of interest. Islamic bonds, or sukuk, cannot bear interest. So that the sukuk are Shariah-compliant, the sukuk holders must have a proprietary interest in the assets which are being financed. The sukuk holders’ return for providing finance is a share of the income generated by the assets. Most sukuk, are ‘asset-based’, not ‘asset-backed’, giving investors ownership of the cash flows but not of the assets themselves. Asset-based is obviously more risky than asset backed in the event of a default.

Difference between Musharakah and Mudarabah

Musharakah Mudarabah

1. All partners invest. Only Rab-ul-Maal invests.

2. All partners participate in the management of the business and can work for it.

Rab-ul-maal has no right to participate in the management which is carried out by the Mudarib only.

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3. All partners share the loss to the extent of the ratio of their investment.

Only Rab-ul-maal suffers loss because the Mudarib does not invest anything. However this is subject to a condition that the Mudarib has worked with due diligence.

4. The liability of the partners is normally unlimited. If the liabilities of business exceed its assets and the business goes in liquidation, all the exceeding liabilities shall be borne pro rata by all partners. But if the partners agree that no partner shall incur any debt during the course of business, then the exceeding liabilities shall be borne by that partner alone who has incurred a debt on the business in violation of the aforesaid condition.

The liability of Rab-ul-maal is limited to his investment unless he has permitted the Mudarib to incur debts on his behalf.

5. As soon as the partners mix up their capital in a joint pool, all the assets become jointly owned by all of them according to the proportion of their respective investment. All partners benefit from the appreciation in the value of the assets even if profit has not accrued through sales.

The goods purchased by the Mudarib are solely owned by Rab-ul-maal and the Mudarib can earn his share in the profit only in case he sells the goods profitably.

Reasons for the rise of Islamic Finance

From the description above, the Islamic system of finance has been existing for pretty long

period of time, but the recent growth since late 20th C can be attributed to the following drivers.

1. Projections of High growth. It is believe that Islamic banking and finance is the next big

thing in town and so most people tend to find it more interesting to be part of Islamic

Finance, especially the conventional financial institution who see this as an opportunity

to increase customer base.

2. High Demand from the Muslim community . The Muslim population is rapidly

growing across the world, and since they want a strict adherence to Sharia law, the

Islamic finance best suits them.

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3. One Village of financial markets . The world is now one big marketplace and the

Muslim population is one major participant. Thus to satisfy their needs and wants, there

are increasing focus on Islamic finance.

4. The Gulf Influence. That the Gulf countries have remained to dominate the majority of

world’s oil markets, and hence they believe in trading according to the sharia law and

hence want Islamic finance to be practiced in their dealings.

Challenges faced in Islamic Finance

The recent growth in Islamic Finance and banking has faced a lot of criticism and challenges on

the following basis:

1. Imitation of conventional finance. Those who criticize this concept have put forward

their arguments that the recent growth in the financial world has seen the Islamic finance

borrow a lot from the conventional practices to the point of losing their focus of its

practice and purpose. The basic philosophy of Islamic practice has been undermined

making the Islamic Finance a cosmetic of the conventional finance.

2. Social responsibility and emphasis . That Islamic banks initially, were supposed to

practice new financial policies and to explore new channels of gaining returns" to

encourage development and improve the living standard Small and Medium sized traders.

However, very few of the Islamic banks have been able to achieve this purely.

3. Fund mingling . The proponents of Islamic banking had called for keeping distinct and

separation of accounts for various types of fund deposits, however, this has really failed

and there is quite a mix up in it’ entire accounts.

4. Lack of Shariah uniformity . Differences between management committees and boards

on what should be part of the shariah compliance usually give birth to "doubts in the

minds of clients" over whether a certain bank is truly shariah compliant, and should be

given their business.

5. Late payments and defaults. There is a serious challenge on late payment, and high rate

of defaults, since some people take advantage of every dilatory legal and religious device.

In most Islamic countries, various forms of penalties and late fees have been established,

only to backfire and or be considered unenforceable. Late repayment fees in particular

have been likened to riba. As a result, `debtors know that they can pay Islamic banks last

since they run no loss

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CONCLUSION

As a conclusion, modern Islamic banks have undergone three stages of development. It’s starting

with the argument regarding the practice of riba in the conventional banks in the early 20 thC.

During that time, a lot of studies and writings on the interest free banking. Next, the emergence

and establishment of Islamic banks begin in 1940s. This stage involved tremendous development

at both the intellectual and implementation levels. The early banks became pillars for the

continued development of the Islamic financial system. During the year of 1970s, there are a lot

of developments of Islamic banks around the world and until now Islamic banks had shown a

very positive growth. Islamic banking is steadily moving into an increasing number of

conventional financial systems. It is expanding not only in nations with majority Muslim

populations, but also in other countries where Muslims are a minority, such as the United

Kingdom or Japan. Similarly, countries like India, the Kyrgyz Republic, and Syria have recently

granted, or are considering granting, licenses for Islamic banking activities (Sole, 2007)

CHAPTER TWO

FINANCIAL VIEWS

The Capitalist view

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In order to understand the Islamic point of view fully, it would be better to have a look at the

system of the distribution of wealth that is obtained under the capitalist economy. This theory

can be briefly stated like this: wealth should be distributed only over those who have taken a part

in producing it, and who are described in the terminology of economics as the factors of

production. According to the Capitalistic economics, these factors are four:-

1. Capital: which has been defined as "the produced meafns of production" - that is to say, a

commodity which has already undergone one process of human production, and is again being

used as a means of another process of production. 2. Labour: that is to say, any exertion on the

part of man.

3. Land: which has been defined as ''natural resources'' (that is to say, those things which

are being used as means of production without having previously undergone any process of

human production).

4. Entrepreneur, or Organization: The fourth factor that brings together the other three

factors, exploits them and bears the risk of profit and loss in production.

Under the Capitalist economy, the wealth produced by the co-operation of these four factors is

distributed over these very four factors as follows: one share is given to Capital in the shape of

interest, the second share to Labor in the shape of wages, the third share to Land in the shape of

rent (or revenue), and the fourth share (or the residue) is reserved for the Entrepreneur in the

shape of profit.

THE SOCIALIST VIEW

On the other hand under the Socialist economy, capital and land instead of being private

property, are considered to be national or collective property. So, the question of interest or rent

(or revenue) does not arise at all under the philosophy of this system. Under the Socialist system,

the entrepreneur too is not an individual but the state itself. So profit as well is out of the

questionf here - at least in theory. Now, there remains only one factor namely labor. And labor

alone is considered to have a right to wealth under the Socialist system, which it gets in the shape

of "Wages".

THE ISLAMIC VIEW

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The Islamic system of the distribution wealth is different from both. From the Islamic point of

view, there are two kinds of people who have a right to wealth:

1. Those who have a primary right that is to say, those who have a right to wealth directly in

consequence of participation in the process of production. In other words, it is those very

"factors of production" which have taken a part in the process of producing some kind of

wealth.

2. Those who have a secondary right, that is to say, those who have not taken a direct part in

the process of production, but it has been enjoined upon the producers to make them cosharers

in their wealth.

Let it be made clear that we are here concerned with the basic philosophy or theory of socialism,

and not with its present practice, for the actual practice in socialist countries is quite different

from this theory.

ISLAMIC THEORY

Those who have a primary right to wealth

As indicated above, the primary right to wealth is enjoyed by "the factors of production." But

"the factors of production'' are not specified or technically defined, nor is their share in wealth

determined in exactly the same way as is done under the Capitalist system of economy. In fact,

the two ways are quite distinct. From the Islamic point of view, the actual factors of production

are three instead of being four:-

1. Capital: That is, those means of production which cannot be used in the process of

production until and unless during this process they are either wholly consumed or completely

altered in form, and which, therefore, cannot be let or leased (for example, liquid money or

food stuff etc.)

2. Land: That is, those means of production, which are so, used in the process of production

that their original and external form remains unaltered, and which can hence be let or leased

(for example, lands, houses, machines etc.).

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3. Labor: That is, human exertion, whether of the bodily organs or of the mind or of the

heart. This exertion thus includes organization and planning too. Whatever "wealth" is

produced by the combined action of these three factors would be primarily distributed over

these three in this manner: one share of it would go to Capital in the form of profit (and not in

the form of interest); the second share would go to Land in the form of rent, and the third share

would be given to Labor in the form of wages.

Socialism and Islam

As we said, the Islamic system of the distribution of wealth is different from Socialism and

Capitalism both. The distinction between the Islamic economy and the Socialist economy is quite

clear. Since Socialism does not admit the idea of private property, wealth under the Socialist

system is distributedonly in the form of wages. On the contrary, according to the Islamic

principles of the distribution of wealth, which we have outlined above, all the things that exist in

the universe are in principle the property of Allah Himself. Then, the larger part of these things is

that which He has given equally to all men as a common trust. It includes fire, water, earth, air,

light, wild grass, hunting, fishing, mines, un-owned and un-cultivated lands etc., which are not

the property of any individual, but a common trust. Every human being is the beneficiary of this

trust, and is equally entitled to its use.

On the other hand, there are certain things where the right to private property must be recognized

if only for the simple reason that without such a recognition it would not be possible to establish

the practicable and natural system of economy to which we have alluded while discussing the

first object of the distribution of wealth. If the Socialist system is adopted and all capital and all

land are totally surrendered to the state, the ultimate result can only be this: we would be

liquidating a large number of smaller Capitalists, and putting the huge resources of national

wealth at the disposal of a single big Capitalist - the state, which can deal with this reservoir of

wealth quite arbitrarily, thus, leads to the worst form of the concentration of wealth. Moreover, it

produces another great evil. Since Socialism deprives human labor of its natural right to

individual choice and control, compulsion and force becomes indispensable in order to make use

of this labor, which has a detrimental effect on its efficiency as well as on its mental health. All

this goes to show that the Socialist system injures two out of the three objects of the Islamic

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theory of the distribution of wealth namely, the establishment of a natural system of economy,

and securing for everyone what rightfully belongs to him.

These being the manifold evils inherent in the unnatural system of the Socialist economy, Islam

has not chosen to put an end to private property altogether, but has rather recognized the right to

private property in those things of thephysical universe which are not held as a common trust.

Islam has, thus, given a separate status to Capital and to Land, and has at the same time made use

of the natural law of "supply and demand" too in a healthy form. Hence Islam does not distribute

wealth merely in the form of wages, as does Socialism, but in the form of profit and rent as well.

But, along with it, Islam has also put an interdiction on the category of' 'Interest'', and prescribed

a long list of the people who have a secondary right to wealth. It has thus eradicated the great

evil of the concentration of wealth, which is an essential characteristic inherent in Capitalism, an

evil, which Socialism claims to remedy. This is the fundamental distinction of the Islamic view

of the distribution of wealth, which sets it apart from Socialism.

Islam and Capitalism

It is equally essential to understand fully the difference that exists between the Islamic view of

the distribution of wealth and the Capitalist point of view. This distinction being rather subtle

and complicated, we will have to discuss it in greater detail. By comparing and contrasting the

brief outlines of the Islamic and the Capitalist systems of the distribution of wealth, we arrive at

the following differences between the two:-

1. The entrepreneur, as a regular factor, has been excluded from the list of the factors of

production, and only three factors have been recognized, instead of four. But this does not

imply that the very existence of the entrepreneur has been denied. What it does mean is just

that the entrepreneur is not an independent factor, but is included in any one of the three

factors.

2. It is not "interest" but "profit" that has been considered as the "reward" for Capital.

3. The factors of production have been defined in a different manner. Capitalism defines'

'Capital'' as "the produced means of production." Hence, Capital is supposed to include

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machinery etc. as well, beside money and foodstuff. But the definition of "Capital" that we

have presented while discussing the Islamic view of the distribution of wealth, includes only

those things which cannot be utilized without their being wholly consumed, or, in other

words, which cannot be let or leased - for example, money. Machinery is to be excluded

from "Capital", according to this definition.

4. In the same way, ―land'' has been defined in a more general way. That is to say, all those

things have been brought under this head, which do not have to be wholly consumed in order

to be used. Hence, machinery too falls under this category.

5. The definition of Labor too has been generalized so as to include mental labor and planning.

Let us now go into the details of this discussion. Under the Capitalist system, the most important

characteristic of the entrepreneur (which entitles him to "profit") is supposed to be that he bears

the risk of profit and loss in his business. That is to say, from the Capitalist point of view,

―profit'' is a kind of reward for his courage to enter into a commercial venture where he alone

will have to bear the burden of a possible loss, while the other three factors of production will

remain immune from loss, for Capital would get the stipulated interest, Land the stipulated rent

and Labor the stipulated wages.

On the other hand, the Islamic point of view insists that the ability to take the risk of a loss

should, in reality, inherent with Capital itself, and that no other factor should be made to bear the

burden of this risk. Consequently, the Capitalist, in so far as he takes the risk, is an entrepreneur

too, and the mawho is an entrepreneur is a Capitalist as well. Now, there are three ways in which

Capital can be invested in a business venture:-

1. Private business: The man who invests Capital may himself run the business without the

help of any partners or shareholders. In this case the return which he gets may be called

"profit" from the legal or popular point of view; but, in economic terms, this "reward" would

be made up of (1) "profit", in as much as Capital has been invested, and (2) "wages", as

earnings of management.

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2. Partnership: The second form of investment is that several persons may jointly invest

capital, jointly manage the business and jointly bear the risk of profit and loss. In the

terminology of the Fiqh, such a venture is called "Shirkat-ul-Aqd" or Partnership in contract.

According to the terminology of economics, in this case too all the partners will be entitled to

profit in so far as they have invested capital and also entitled to "wages" in so far as they have

taken part in the management of the business. Islam has sanctioned this form of business

organization too. This form was quite common before the time of the Holy .Prophet until

he permitted people to retain it, and since then there has been a consensus of opinion on its

permissibility.

Co-operation of Capital and Organization (Mudarabah): The third form of investment is

that one person may invest Capital while another may manage the business, and each may have

a share in the profit. In the terminology of Fiqh, it is called "Mudarabah". According to the

terminology of economics, in this case, the person who invests his capital ("Rabb-ulMal") will

get his share in the form of "profit", while the person who has actually managed the business

will get it in the form of "wages". But if the person who has been managing the business

("Mudarib") eventually suffers a loss in the business, his labor will go wasted just as the capital

of the investor would go wasted. This form of business organization too is permissible in

Islam. The Holy Prophet himself has made such an agreement with Hazrat Khadijah before

their marriage. Since then there has been a complete consensus of opinion on this too among

the jurists of Islam.

Money Lending Business

The fourth form of investing Capital, which has ever since been practiced in non-Islamic

societies is the money-lending business. That is to say, one person lends out capital in the form

of a debt, and a second person puts in his labor; if there is a loss it has to be borne by labor, but,

profit or loss, interest does accrue to Capital in any case. Islam has interdicted this form of

investment.

“O, believers, fear Allah, and give up what is still due to you from the interest (usury), if you are

true believers. (2:278) The Holy Quran also says: “If you do not do so, then take notice of war

from Allah and His Messenger. But, if you repent, you can have your principal. Neither should

you commit injustice nor should you be subjected to it.” (2:279)

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In these two verses, the phrases ''what is still due to you from the interest" and "you shall have

the principal" makes it quite explicit that Allah does not condone the least quantity of interest,

that "giving up the interest" implies that the creditor should get back only the principal. Thus,

one can clearly see that Islam considers every rate of interest (except zero%) to be totally

inadmissible. In the pre-Islamic period, certain Arab tribes used to carry on their trade with the

help of money borrowed on the basis of interest from other tribes. Islam puts an end to such

transactions altogether. Ibn Juraij says:

CHAPTER THREE

ISLAMIC FINANCIAL PRODUCTS

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Introduction

Islamic financial products or sharia compliant products are financial services that meet

requirements of the Shariah, or Islamic. While they are designed with Islamic religious

requirement, these products are not restricted to Muslims only.

Principles of Islamic Finance

These products conform to Islamic law and principles. Laws that are applicable are as follows:

i. Ban on Interest (Riba): In conventional forms of finance, a distinction is made between

acceptable interest and usurious interest (i.e., excessive rates of interest). In contrast,

under Islamic law, any level of interest is usurious and is prohibited. Some question how

lenders can profit from financial transactions under Islamic law. Take for instance, in a

real estate setting, SCF takes the form of leasing, as opposed to loans. Instead of

borrowing money, the bank obtains the property and leases it to the shariah-compliant

investor, who pays rent instead of interest.

ii. Ban on Uncertainty: Uncertainty in contractual terms and conditions is not allowed,

unless all of the terms and conditions of the risks are clearly understood by all parties of a

financial transaction. This condition may help eliminate most of the speculative

transactions which involve excessive uncertainty (Gharar).

iii. Risk-sharing and Profit-sharing: Parties involved in a financial transaction must share

both the associated risks and profits. Earnings from profits or returns from assets are

permitted, so long as the business risks are shared by the lender and the borrower. This

will help ensure that the lessor also shares a part of the risks in order to be able to get a

share of the returns. Once the financier acquires ownership and possession of the goods

for sale or lease, he/she bears the risks.

iv. Ethical Investments That Enhance Society: Investment in industries that are prohibited by

the Qur’an, such as alcohol, pornography, gambling, and pork-based products, are

discouraged.

v. Asset-backing: Each financial transaction must be tied to a “tangible, identifiable

underlying asset.” The debt cannot be sold, and thus the risk associated with it cannot be

transferred to someone else; it must be borne by the creditor himself. According to this

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condition a transaction must be a genuine trade transaction, and the fact that the creditor

cannot transfer the risk to someone else by selling off the debt, will also help eliminate

speculative and derivative transactions, as well as prevent the debt from rising far above

the size of the real economy.

Islamic Financial Products

These products are not new to the market. Their operations slightly differ to from conventional

financial products. Just like in conventional products, Islamic financial products can be broadly

categorized into banking and non-banking financial products. Some of the common grouping of

Islamic financial products are:

1. Deposit Product

2. Investment Product

3. Financing product

4. Insurance Product

Deposit Product

Wadiah

In Wadiah Bank is seen as keeper of people’s money. just like normal banking system where

depositor keeps his fund with the bank and demands them inform of withdrawals when need

arise either partly or whole. Just like in conventional banking products the following accounts

are held by an Islamic bank client:

a) Current Account

The customer will deposit in the Bank's custody based on agreed conditions. The Bank

can use the fund in accordance with the Shariah principles. However, the bank also

charges certain fee for maintaining the account. Apart from the cheque issue to its

customers, the bank renders such usual services connected with current account services

like ATM cards, Standing Order etc.

b) Saving Account

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This account is similar with that of conventional markets. The bank accepts deposits from

customers willing to save theirs funds. The bank seeks approval to use the deposits and

may reward the customer with some portion of profits realised. Depositors use pass book

in operating such an account, and may withdraw a part or the whole of their balance at

any time they wish to do so without any hindrance from the bank.

Jibah

Its token given by a debtor voluntarily in return of a loan. These loans can either be guaranteed

or non-guaranteed. They most common example of Islamic loan products are:

a) Hiwala: This is the contract where a debtor of a bank or investment company

transfered his obligation to a third party. If the creditor accepts it and the third

acknowledge, then the first debtor is cleared from any obligation against the debt.

This transfer is laterally without any interest, is use by Islamic financial institutions to

remit money between people.

b) Kafala: A third party accepts an existing obligation and becomes responsible for

fulfilling someone’s liability. This product is known as surety or guaranty in

conventional finance product.

c) Rahn (Mortgage): It is property pledged against an obligation. A customer can

extend collateral in order to secure a financial liability. The mortgaged item must be

worth of value. If the time stipulated while giving a debit on security expires, the debt

can be recovered from mortgage property.

Investment Product

Debt-financing is very common in the modern world. Islamic finance prohibits interest-based

borrowing and lending. This does not mean that you must buy everything on a cash basis

because the money might not be there always. Islamic banking deals with real assets and you can

thus not trade a debt because it creates room for speculation. An Islamic bank buys a property for

a customer and can then sell it on an instalment basis. The financial institution will remain the

owner of the home until the customer pays all the instalments. Below are the major investment

products offered by Islamic bakers.

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Murabahah

This is a cost-plus product where a buyer makes deferred payment to the seller which is usually a

bank. The cost of goods is declared with a margin of profit added to the cost. A bank will buy

the product and add its profit to the buyer. This product differs with that of conventional market,

because in conventional market the actual price of the items might not be known to client and the

mode of payment is compounding. Similarly, if the client default payment in one instalment, he

will be penalized for the rest of remaining payments. While he is unable to pay his debt in a

stipulate period, he could be shift to another period for a higher price.

Mudarabah –profit sharing: Its contract between one party providing 100% capital and the

other one specialized skill and manage investment project. The profit is shared at predetermined

ratio

Wakafah-power of attorney: It happens when the investor appoints another person to undertake

transaction of his behalf. Power of attorney is written authorization to represent or act on behalf

of another in private life, business or some other legal matters.

Musaramah: Its negotiation of selling price between two parties by either seller or ask price

while seller may not have full knowledge of the cost of item being negotiated. They are under no

obligation to reveal this cost as part of negotiation process.

Sukuk: Sukuk is the financial certificates which is commonly refers to the Islamic equivalent of

bonds. Sukuk are designed to comply with the investment principles of Islamic law to avoid

charging or paying of interest.It is generally done by involving a tangible asset in the investment,

by giving partial ownership of a property built by the company to the bond owner. The sukuk

owner is then able to collect his profit.

Sukuk differ from conventional bond in the following ways:

a) Sukuk pricing is based on the worth value of the assets they covered. While bond

is priced based on credit rating.

b) Selling of Sukuk means the selling of ownership of the asset while bonds sales

means selling of debt.

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c) Sukuk show that the asset is owned by the holder. While Bonds show an

obligation of debt.

d) Assets that sukuk covered are Shariah compliant, that is, cannot be covered in any

asset that violates terms and condition of Islam like alcohol industry. While bonds

may be backed with any assets that or services that are against Islam.

e) Sukuk can increase in value when the assets increase. While Bond generates fixed

interest, which amounted to Riba.

Financing product

Musharakah –joint venture: Its relationship between two parties that contribute capital to

business and share profit and loss in pro rata. The profit is shared in already agreed ratios the loss

is strictly supported in capital proportion

Ijarah –lease or rent: Refers to selling of benefits of use or service for a fixed price. Under this

the bank make it available to customer the use of asset, items such as plats and equipment and

motor vehicles at fixed income.

Quid Hassan-good loan: Its loan extended on Goodwill basis with the debtor only required to

repay the amount borrowed. However, the debtor can pay amount higher than principal amount

as appreciation.

Salam: Salam are forward Contract where a client or bank pay the agreed price of a given

commodity in advance to be delivered to him at a given future date. There are two types of

forward contracts. All these types of forward contract differ of conventional forward, as there is

no hedge

a) Salam Bai - Here the bank supplies specific amount of goods to client at future date

with price paid upfront at the time of the contract

b) Istisna - allows an Islamic financial or buyer to purchase items under construction and

will be delivered after it have been finished in the future date.

Insurance Product

Takaful is the alternative for insurance in Conventional insurance.

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Takaful

Takaful can be regarded as an Islamic insurance, where parts help cash into a pooling framework

with a specific end goal to ensure one another against misfortune or harm. Takaful-marked

insurance is focused around Sharia, Islamic religious law, and clarifies how it is the obligation of

people to collaborate and ensure one another. As the Islamic Finance does not allow for using

gambling and uncertainty, takaful has in this way developed to address the requirement for an

Islamic protection contract. It can be extensively contrasted with helpful protection conspires in

customary fund. Just like in conventional insurance, Takaful can broadly be grouped into two:

a) Long Term Takaful – This is insurance offered to cover against life related risks.

b) Short term Takaful products – This is insurance offered to cover against non-life

related risks.

Insurance Models

Just as in conventional assurance product, takaful follow two basic operational models the

agency model and the leasing model.

a) Wakala: Wakala is the agency contract which is used widely in Islamic Finance. The

applications ranging from brokerages services in permissible activities, like certain

stocks, as well as to be the agent in a Murabaha transaction. The client, who wants to be

financed, acts as agent of the bank to acquire the asset, then sold to him on credit

instalments. Agents can be compensated for their assignment with a fixed, variable or

performance model, which is frequently used to influence pay outs and cash flows in

financial engineering.

b) Ijara: Ijara/lease literally means reward or remuneration. It means a situation where a

party to a contract sells to the other for temporary enjoyment any property movable other

than ships and animals in return for a price can be regard as al-ijarah.

Conclusion

Islamic Finance market is becoming boom since the 2008 Economic crisis, banks and other

financial institution gradually open door to the Islamic Finance product vis-as-vis with that of

conventional market. Therefore, to study the products and their benefits is imperative for any

Muslim in order to select the fit for his financial activities.

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CHAPTER FOUR

SECURITIZATION

Introduction

Securitization means issuing certificates of ownership against an investment pool or business

enterprise. This chapter discusses the issues, problems and rules in issuing such certificates with

respect to the "nature" of investment pool. Basic guidelines are also provided on the negotiability

and sale of these certificates in the secondary markets.

Securitization of Musharakah

Musharakah is a mode of financing which can be securitized easily, especially, in the case of big

projects where huge amounts are required which a limited number of people cannot afford to

subscribe. Every subscriber can be given a Musharakah certificate, which represents his

proportionate ownership in the assets of the Musharakah, and after the project is started by

acquiring substantial non-liquid assets, these Musharakah certificates can be treated as negotiable

instruments and can be bought and sold in the secondary market. However, trading in these

certificates is not allowed when all the assets of the Musharakah are still in liquid form (i.e. in

the shape of cash or receivables or advances due from others).

For proper understanding of this point, it must be noted that subscribing to a Musharakah is

different from advancing a loan. A bond issued to evidence a loan has nothing to do with the

actual business undertaken with the borrowed money. The bond stands for a loan repayable to

the holder in any case, and mostly with interest. The Musharakah certificate, on the contrary,

represents the direct pro rata ownership of the holder in the assets of the project. If all the assets

of the joint project are in liquid form, the certificate will represent a certain proportion of money

owned by the project. For example, one hundred certificates, having a value of Rs. one million

each, have been issued. It means that the total worth of the project is Rs. 100 million. If nothing

has been purchased by this money, every certificate will represent Rs. one million. In this case,

this certificate cannot be sold in the market except at par value, because if one certificate is sold

for more than Rs.one million, it will mean that Rs. one million are being sold in exchange for

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more than Rs. one million, which is not allowed in Shariah, because where money is exchanged

for money, both must be equal. Any excess at either side is Riba.

However, when the subscribed money is employed in purchasing non-liquid assets like land,

building, machinery, raw material, furniture etc. the Musharakah certificates will represent the

holders' proportionate ownership in these assets. Thus, in the above example, one certificate will

stand for one hundredth share in these assets. In this case it will be allowed by the Shariah to sell

these certificates in the secondary market for any price agreed upon between the parties which

may be more than the face value of the certificate. Since the subject matter of the sale is a share

in the tangible assets and not in money alone, therefore the certificate may be taken as any other

commodity which can be sold with profit or at a loss.

In most cases, the assets of the project are a mixture of liquid and non-liquid assets. This comes

to happen when the working partner has converted a part of the subscribed money into fixed

assets or raw material, while rest of the money is still liquid. Or, the project, after converting all

its money into non-liquid assets may have sold some of them and has acquired their sale

proceeds in the form of money. In some cases the price of its sales may have become due on its

customers but may have not yet been received. These receivable amounts, being a debt, are also

treated as liquid money. The question arises about the rule of Shariah in a situation where the

assets of the project are a mixture of liquid and non-liquid assets, whether the Musharakah

certificates of such a project can be traded in? The opinions of the contemporary Muslim jurists

are different on this point.

According to the traditional Shafi School, this type of certificate cannot be sold. Their classic

view is that whenever there is a combination of liquid and non-liquid assets, it cannot be sold

unless the non-liquid part of the business is separated and sold independently. The Hanafi school,

however, is of the opinion that whenever there is a combination of liquid and non-liquid assets, it

can be sold and purchased for an amount greater than the amount of liquid assets in combination,

in which case money will be taken as sold at an equal amount and the excess will be taken as the

price of the non-liquid assets owned by the business. Suppose, the Musharakah project contains

40% non-liquid assets i.e. machinery, fixtures etc and 60% liquid assets, i.e. cash and

receivables. Now, each Musharakah certificate having the face value of ksh.100/- represents Rs.

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60/- worth of liquid assets, and ksh.40/- worth of non-liquid assets. This certificate may be sold

at any price more than ksh.60.

If it is sold at ksh. 110/- it will mean that ksh. 60 of the price are against ksh. 60/- contained in

the certificate and ksh.50/- is against the proportionate share in the non-liquid assets. But it will

never be allowed to sell the certificate for a price of ksh.60/- or less, because in the case of ksh.

60/- it will not set off the amount of ksh. 60, let alone the other assets. According to the Hanafi

view, no specific proportion of non-liquid assets in the whole is prescribed. Therefore, even if

the non-liquid assets represent less than 50% in the whole, its trading according to the above

formula is allowed. However, most of the contemporary scholars, including those of Shafi

School, have allowed trading in the units of the whole only if the non-liquid assets of the

business are more than 50%. Therefore, for a valid trading of the Musharakah certificates

acceptable to all schools, it is necessary that the portfolio of Musharakah consists of non-liquid

assets valuing more than 50% of its total worth. However, if Hanafi view is adopted, trading will

be allowed even if the non-liquid assets are less than 50% but the size of the non-liquid assets

should not be negligible.

Securitization of Murabahah

Murabahah is a transaction, which cannot be securitized for creating a negotiable instrument to

be sold and purchased in secondary market. The reason is obvious. If the purchaser/client in a

Murabahah transaction signs a paper to evidence his indebtedness towards the seller/financier,

the paper will represent a monetary debt receivable from him. In other words, it represents

money payable by him. Therefore transfer of this paper to a third party will mean transfer of

money. It has already been explained that where money is exchanged for money (in the same

currency) the transfer must be at par value. It cannot be sold or purchased at a lower or a higher

price. Therefore, the paper representing a monetary obligation arising out of a Murabahah

transaction cannot create a negotiable instrument. If the paper is transferred, it must be at par

value. However, if there is a mixed portfolio consisting of a number of transactions like

Musharakah, leasing and Murabahah, then this portfolio may issue negotiable certificates subject

to certain conditions.

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Securitization of Ijarah

The arrangement of Ijarah has a good potential of securitization, which may help create a

secondary market for the financiers on the basis of Ijarah. Since the lessor in Ijarah owns the

leased assets, he can sell the asset, in whole or in part, to a third party who may purchase it and

may replace the seller in the rights and obligations of the lessor with regard to the purchased part

of the asset. Therefore, if the lessor, after entering into Ijarah, wishes to recover his cost of

purchase of the asset with a profit thereon, he can sell the leased asset wholly or partly either to

one party or to a number of individuals. In the latter case, the purchase of a proportion of the

asset by each individual may be evidenced by a certificate, which may be called 'Ijarah

certificate'.

This certificate will represent the holder's proportionate ownership in the leased asset and he will

assume the rights and obligations of the owner/lessor to that extent. Since the assets is already

leased to the lessee, lease will continue with the new owners, each one of the holders of this

certificate will have the right to enjoy a part of the rent according to his proportion of ownership

in the asset. Similarly he will also assume the obligations of the lessor to the extent of his

ownership. Therefore, in the case of total destruction of the asset, he will suffer the loss to the

extent of his ownership. These certificates, being an evidence of proportionate ownership in a

tangible asset, can be negotiated and traded freely in the market and can serve as an instrument

easily convertible into cash. Thus they may help in solving the problems of liquidity

management faced by the Islamic banks and financial institutions.

It should be remembered, however, that the certificate must represent ownership of an undivided

part of the asset with all its rights and obligations. Misunderstanding this basic concept, some

quarters tried to issue Ijarah certificates representing the holder's right to claim certain amount of

the rental only without assigning to him any kind of ownership in the asset. It means that the

holder of such a certificate has no relation with the leased asset at all. His only right is to share

the rentals received from the lessee. This type of securitization is not allowed in Shariah. As

explained earlier in this chapter, the rent after being due is a debt payable by the lessee. The debt

or any security representing debt only is not a negotiable instrument in Shariah, because trading

in such an instrument amounts to trade in money or in monetary obligation which is not allowed,

except on the basis of equality, and if the equality of value is observed while trading in such

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instruments, the very purpose of securitization is defeated. Therefore, this type of Ijarah

certificates cannot serve the purpose of creating a secondary market. It is, therefore, necessary

that the Ijarah certificates are designed to represent real ownership of the leased assets, and not

only a right to receive rent.

Islamic Investment Fund

The term 'Islamic Investment Fund' means a joint pool wherein the investors contribute their

surplus money for the purpose of its investment to earn halalprofit in strict conformity with the

precepts of Islamic Shariah. The subscribers of the Fund may receive a document certifying their

subscription and entitling them to the pro-rata profit actually earned by the Fund. These

documents may be called 'certificates', 'units', 'shares' or may be given any other name, but their

validity in terms of Shariah, will always be subject to two basic conditions:

1. Instead of a fixed return tied up with their face value, they must carry a pro-rata profit

actually earned by the Fund. Therefore, neither the principal nor a rate of profit (tied up with

the principal) can be guaranteed. The subscribers must enter into the fund with a clear

understanding that the return on their subscription is tied up with the actual profit earned or

loss suffered by the Fund. If the Fund earns huge profits, the return on their subscription will

increase to that proportion. However, in case the Fund suffers loss, they will have to share it

also, unless the loss is caused by the negligence or mismanagement, in which case the

management, and not the Fund, will be liable to compensate it.

2. The amounts so pooled together must be invested in a business acceptable to Shariah. It

means that not only the channels of investment, but also the terms agreed with them must

conform to the Islamic principles.

Keeping these basic requisites in view, the Islamic Investment Funds may accommodate a

variety of modes of investment, which are discussed here briefly.

Equity Fund

In an equity or mutual fund (unit trust) the amounts are invested in the shares of joint stock

companies. The profits are mainly derived through the capital gains by purchasing the shares and

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selling them when their prices are increased. Profits are also earned through dividends distributed

by the relevant companies. From this angle, dealing in equity shares can be acceptable in Shariah

subject to the following conditions:

1. The main business of the company does not violate Shariah. Therefore, it is not

permissible to acquire the shares of the companies providing financial services on

interest, like conventional banks, insurance companies, or the companies involved in

some other business not approved by the Shariah, e.g. companies manufacturing,

selling or offering liquor, pork, haram meat, or involved in gambling, night club

activities, pornography, prostitution, or involved in the business of hire purchase or

interest etc.

2. If the main business of these companies is halal, like automobiles, textile, etc. but

they deposit their surplus amounts in an interest-bearing account or borrow money on

interest, the shareholder must express his disapproval against such dealings, preferably

by raising his voice against such activities in the annual general meeting of the

company.

3. If some income from interest-bearing accounts or non-Halal activities is included

in the income of the company, the proportion of such income should not exceed 5% of

the total income. If it exceeds 5%, it is not permissible to invest in that company.

However, if it does not exceed 5%, it must be given in charity, and must not be retained

by him. For example, if 5% of the whole income of a company has come out of

interest-bearing deposits, 5% of the dividend must be given in charity. Moreover, the

company‘s total short term and long term investment in non-permissible business

should not exceed 30% of the company‘s total market capitalization.

4. The leverage or debt to equity ratio of the company should not exceed 30%. To explain

the rationale behind this condition, it should be kept in mind that, such companies

sometimes borrow money from financial institutions that are mostly based on interest.

Here again the aforementioned principle applies i.e. if a shareholder is not personally

agreeable to such borrowings, but has been overruled by the majority, these borrowing

transactions cannot be attributed to him. Moreover, even though according to the

principles of Islamic jurisprudence, borrowing on interest is a grave and sinful act, for

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which the borrower is responsible in the Hereafter; but, this sinful act does not render

the whole business of the borrower as Haram(impermissible). It is explained in the

conventional books of

Islamic jurisprudence that the contract of loan is among those, that are called Uqood

Ghair Muawadha‖ (Non compensatory contracts), therefore, no void condition such as

condition of interest can be stipulated. However, if such a condition has been

stipulated, the condition itself is void, but it will not invalidate the contract. Since, the

contract remains valid despite of void condition, the borrowed amount would be

permissible to use and it would be recognized as owned by the borrower. Hence,

anything purchased in exchange for that money would not be unlawful.

5. The shares of a company are negotiable only if the company owns some illiquid assets.

If all the assets of a company are in liquid form, i.e. in the form of money they cannot

be purchased or sold except at par value, because in this case the share represents

money only and the money cannot be traded in except at par. What should be the exact

proportion of illiquid assets of a company for warranting the negotiability of its shares?

The contemporary scholars have different views about this question. Some scholars are

of the view that the ratio of illiquid assets must be 51% in the least. They argue that if

such assets are less than 50%, then most of the assets are in liquid form, and therefore,

all its assets should be treated as liquid on the basis of the juristic principle:

Share Market Business

Is share market business allowed in Islam

Today, in this sense, we need to analyze the selling and purchasing the stock certificate which is

the base of the stock exchange.

1. To be a shareholder of a company which is working on business licit to be produced and put

into market. This is without any doubt is allowable. The buyer becomes a partner of that

company in accordance with the percentage of his shares, and takes part in its profit and loss, and

he is entitled to sell his shares whenever he wishes.  (The number of such companies is quite

much.)

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2. Buying and selling a share that  gains or losses price in a way free from the economical value

it belongs in the intend of  appreciating  the present money or keeping its charge or making

money by seeking profit. The dealings in the stock market are in the second form. Investing on

the exchange market in this sense, though not completely, it is similar to playing gamble or

lottery. It causes the shares to be more precious or cheaper than they are. The people earn or loss

money without any sound contribution to the economy and production of the country.

Indeed majority of the scholars of Islam arrived at a consensus, though some contemporary

scholars claim otherwise, the stock market and shares two important Islamic problems of today

are permissible in Islam. However, the company whose shares we want to purchase should not

have any hand in producing alcohol or pork meat which is forbidden in Islam. Whether it is

permitted buying and selling shares from Stock Exchange, we can determine it by analyzing the

following conditions.

It is banned to purchase the shares of the companies obviously conducting interest

proceedings such as banks, bankers, usuary institutions.

It is the same decree for the companies working on the production, selling and buying of

the Islamic-banned-things like vine, beer and so forth.

Also, it is vetoed in Islam to buy shares from the companies that are selling at interest the

goods of which we have share, and then mixing that profit with the other goods.

Though the commodity the share of which we have is allowable, if the Muslim people

who are the owner of the company whose shares we have are engaged in disallowed

dealings, we are proscribed to get any share from that company. Because if we buy

anything from them, then we would support them indirectly which is called “cooperation

in sin” in Quran. And that cooperation is not permitted in our holy book.

Buying any share from the Christian or Jewish-owned companies is abominable even if

there may not be any other drawback. When the Islamic law books observed, it can be

come into such a conclusion that it is not allowed to buy any share from communist,

mason or atheist dominated companies. 

It must be known about what is the percentage of the bought share compared to the whole

company.

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There must be asset. Buying the shares of an institution like Credit Company is

prohibited in Islam.

It is permissible to buy participation shares from the share owner of a company which is

essentially licit but is not being run in accordance with Islamic rules so that you can

receive what he owes you. But you must sell those share certificates as soon as possible.

And if you make any profit out of that trading; you must give it either to the poor or to

the service of public.

It is unanimously licit to buy from the companies that have no relation with what is

impermissible, the Muslim people constitute the majority, declare obviously the share to

the sold stock certificate of the company which is subject to be sold, enable the people

whenever they intend to give up the partnership.  And these Muslim Businessmen are

extremely important for Islamic enterprises and licit capital. Because participation shares

are the most crucial alternative for the interest which is one of the greatest major sins in

Islam, the sharpest way of finding management and investment capital. If the Muslim

people succeed putting this into practice by keeping it far from interest, they can be a

means for coming about great operational managements and eradicating the interest.

The majority deserves to be treated as the whole thing.

Some other scholars are of the view that even if the illiquid asset of a company is 33%, its shares

can be treated as negotiable. The basis of this view is a well-known. Hadith that means one third

is big or abundant‖ (Tirmizy). They say that according to the Hadith one-third illiquid assets will

be considered as sufficient or abundant for this purpose. The third view (of the scholars of the

sub-continent of Pakistan and India) is based on the Hanafi jurisprudence. The principle of the

Hanafi School is that whenever an asset is a combination of liquid and illiquid assets, it can be

negotiable irrespective of the proportion of its liquid part. However, this principle is subject to

two conditions:

1. The illiquid part of the combination must not be in insignificant quantity. It means that it

should be in a considerable proportion.

2. The price of the combination should be more than the value of the liquid amount

contained therein. For example, if a share of 100 dollars represents 75 dollars, plus some fixed

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assets, the price of the share must be more than 75 dollars. In this case, if the price of the share is

fixed at 105, it will mean that 75 dollars are in exchange of 75 dollars owned by the share and

the balance of 30 dollars is in exchange of the fixed assets. Conversely, if the price of that share

is fixed at 70 dollars, it will not be allowed, because the 75 dollars owned by the share are in this

case against an amount which is less than 75. This kind of exchange falls within the definition of

'riba' and is not allowed. Similarly, if the price of the share, in the above example, is fixed at 75

dollars, it will not be permissible, because if we presume that 75 dollars of the price are against

75 dollars owned by the share, no part of the price can be attributed to the fixed assets owned by

the share. Therefore, some part of the price (75 dollars) must be presumed to be in exchange of

the fixed assets of the share. In this case, the remaining amount will not be adequate for being

the price of 75 dollars. For this reason the transaction will not be valid. However, in practical

terms, this is merely a theoretical possibility, because it is difficult to imagine a situation where

the price of a share goes lower than its liquid assets.

Among the three different views mentioned above, the most conservative view is the first one.

Therefore, nowadays that has been adopted by the majority of Shariah boards of Islamic mutual

funds or in screening of the Islamic stocks methodology.

Subject to aforesaid conditions, the purchase and sale of shares is permissible in Shariah. An

Islamic Equity Fund can be established on this basis. The subscribers to the Fund will be treated

in shariah as partners inter see. All the subscription amounts will form a joint pool and will be

invested in purchasing the shares of different companies. The profits can accrue either through

dividend distributed by the relevant companies or through the appreciation in the prices of the

shares. In the first case i.e. where the profits are earned through dividends, a certain proportion

of the dividend, which corresponds to the proportion of interest earned by the company, must be

given in charity. The contemporary Islamic Funds have termed this process as 'purification'.

Some scholars are of the view that even in the case of capital gains, the process of 'purification'

is necessary, because the market price of the share may reflect an element of interest included in

the assets of the company. The method of purification adopted by Dow Jones Islamic market

Index and Islmiqstocks.com are in favour of this view.

As we have discussed above for the negotiability of the share, it is essential for the share or

securities that they represent more than 55% illiquid assets. If a mutual fund has 10% cash and

90% shares, we shall have to see how much of these shares represent fixed assets. Fixed assets

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include land, equipment, and machinery and leased assets. If these shares represent more than

55% of fixed or illiquid assets, such shares or Musharkah certificates of mutual fund can be

negotiated at other than par value as well.

Sale of option short sale, future sale and forward sale where some principles of Shariah are

lacking are not permissible.

Islamic Stocks

Stocks need to obey a Sharia screening to qualify for being halal (Sharia-compliant). Indices for

Islamic stocks are tracked on many exchanges. The issue of speculation is discussed from a

Sharia perspective. Speculation is different from gambling; although it is permissible, it can

become a major source of bubbles and crashes in stock markets. The chapter analyzes stock

yields, stock valuation, stock price forecasting, fundamental and technical analysis, efficiency

hypotheses of stock markets, the evaluation of companies, and the mechanics of trading.

Islamic finance emphasizes risk-sharing. Interest-based loans are strictly forbidden. Although

lending is perfectly legitimate, it has to be free of interest. Consequently, traditional lending by

the banking system has no significant role to play in Islamic finance. The stock market is the best

fit for Islamic finance and promotes risk-sharing. It enables people to direct saving to investment,

and stockholders earn a profit (dividend) and not interest. The stock market enhances economic

growth and employment, and reduces financial instability that follows from traditional lending.

The stock market was a historical necessity that enables banks and investors to overcome

constraints on saving and investment.

How Islamic Finance can boost infrastructure development

We know that expanding infrastructure investment in economic and social services is an

effective way both to promote inclusive growth and to foster local resilience to global shocks. In

particular, investment in quality, sustainable infrastructure helps finance the transition towards a

low-carbon, more environmentally friendly economic model. This happens notably in the

renewable energy and low-emission transport sectors. Given the scale of resources needed to

address the infrastructure investment gap, mobilizing the private sector for this goal has become

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imperative, especially in countries where financial transactions in banking and capital markets

follow Islamic law (or shariah) principles.

The conventions of Islamic finance are particularly suitable for infrastructure development. They

define an asset-oriented system of ethical financial intermediation built on the principles of risk-

sharing in lawful activities (halal) rather than rent-seeking gains. This “entrepreneurial”

approach by investors requires a high degree of transparency and creates incentives to monitor

projects more carefully, which, in turn, strengthen the efficiency in building and operating

infrastructure.

In some countries, Islamic finance already accounts for more than half of total financial assets.

The potential for growth of this form of finance is, nonetheless, considerable, given that its

penetration rate in large economies, such as Indonesia and Turkey, is still below 20 percent.

Moreover, even though most Islamic finance assets are in the banking sector, the scope of

adoption of these instruments by asset managers, i.e., pension funds and other long-term

institutional investors is quite relevant, including in countries where demand for Islamic finance

may not derive from religious motives. The issuance of Islamic bonds (sukuk) by Hong Kong

SAR, Luxembourg, South Africa, and the United Kingdom is one example.

We also highlighted that the asset-backed, ring-fenced, and project-specific nature of Islamic

finance structures and their emphasis on sharing risks make them a natural fit for public-private

partnerships in the infrastructure space. Islamic finance can be flexible, as reflected in the wide

variety of structures that are available to those who want to finance equipment purchases and

build assets with clearly specified risk-sharing provisions and those ready to lease these assets

upon completion and pay for their use. These contracts can be transformed into marketable credit

instruments (e.g., notes) linked to specific assets (sukuk), which enable shariah-compliant

financing of assets throughout their life cycles, independently of whether they are on the

government balance sheet or not. It is noteworthy that some Islamic finance investors (banks,

sovereign wealth funds, and other asset managers) harbour large pools of liquidity that can be

channelled to these Islamic infrastructure investments with low risks.

Scaling up Islamic finance in response to growing investor demand still requires overcoming

important legal, regulatory, and institutional challenges, such as insufficient standardization of

contracts and the cost of structuring and executing Islamic infrastructure financing. Indeed,

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inconsistent ruling on shariah compliance of Islamic contracts continues to complicate the

structuring of sukuk.

CHAPTER FIVE

ISLAMIC LAW OF CONTRACT

Introduction of Islamic Law

Islamic law in Arabic known as shariah. The basic principles or the guiding principles of

Islamic law are derived from the religious book of Muslims known as the Quran and Hadis. The

Quran was revealed to Prophet Muhammad (the last prophet in this world) through the angel

Jibril and Hadis is defined as ‘the sayings, deeds, and tacit approval of acts of his companions.’

In other words, hadis is the interpretation and practice of the Quran by Prophet Muhammad. He

practiced his whole life based on Quranic guidance and injunctions and asked his companions to

follow him as he follows the Quran, to write down his deeds and sayings if necessary. The

companions wrote down the important lectures and instructions given by Prophet Muhammad

and his deeds during his life time.

Islamic Law of Contract

i. Origin and Development of the Islamic Law of Contract

It is to be noted that the Islamic legal system did not develop and progress for a long time that

is, for the last 600 years in most of the Muslim countries which were occupied and ruled by the

British Empire. Before, the English rulers ruled the Muslims countries for almost 200 years,

the Islamic law was applied in Muslim countries in the informal courts to give decisions on

disputes submitted to the courts. England started ruling the Muslim countries from the 16 th

century. The English rulers applied the English law, which they brought from England, in the

Muslim countries instead of the Islamic law.

Therefore, the Islamic legal system could not develop in a systematic way as the common law

and the civil law system have been developed by refinement and amendment process from time

to time. Even today, all the Muslim countries which were colonized by England are applying the

English contract law principles in their pursuit of their daily business transactions. This has been

the main reason until today that the Islamic law of contract is not applied in the Muslim

countries and for this particular single reason the Islamic contract law cannot be developed to

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meet the standard of business transactions in the present era. However, Muslims are now

conducting researches on the Islamic legal system which had been basically applied around 600

years ago in different Muslim countries when commerce did not progress tremendously as in the

present time. Nonetheless, research works on the Islamic legal system are producing a lot of

prosperous interest-free transactions which are currently being applied in the Islamic banks.

ii. Some Salient Features of Islamic Law of Contract

A contract is an agreement which is enforceable by law and only legal agreements are contracts

whereas illegal agreements are not contracts. To draft a valid contract there must be some basic

legally enforceable elements which are basically similar and applicable either in the Islamic law

of contract or the English law.As mentioned above, these elements are:

a. An offer (Ijab);

b. An acceptance (qabul);

c. A free consent;

d. An intention to create a legally binding relationship;

e. The objective and consideration of the contract should be legal;

f. A certainty of legitimate performance,

g. A capacity (ahliyah)

h. A formality.

i. A consideration;

a) Offer ( Ijab )

When someone wants to make a contract, he has to make a proposal to the other person to

obtain his consent to the act or abstinence. This is known as an offer. For example, if A wants

to sell something to B, it is required that A has first to make an offer to B that A wants to sell a

particular thing for a certain price, whether B is willing to buy or not. Thus, making an offer to

another party is an element of a contract in the Islamic law.

Kinds of offer

There are three kinds of offer in the Islamic law of contract. They are:

i. Verbal offer (kalam)

ii. Offer by conduct (‘amal)

iii. Offer in writing (kitabah)

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Verbal offer ( kalam )

An offer can be verbal in which it is expressed in words to sell something to someone else and

is not written down. A verbal offer is acceptable in Islam from which an acceptance is good for

an immediate sale. However, when the sale will take place in a future time, it is recommended

that the terms of the offer and the acceptance should be written down concisely so that no

disagreement can arise later due to ambiguity. A classical Islamic jurist said that the verbal

words for an offer should be in the past or the present tense but not in the future tense, because

the offer should have an immediate effect to the offeree.If someone says: “I will offer to sell

my car in future for Kes 1000,000 then the offeree says “I will accept it to buy it in future”. Do

the expressions here make good offer and acceptance? In fact no offer has been made yet so

there cannot be an acceptance at the present time.

Offer by conduct ( amal )

An offer can be made by conduct, that is, without any verbal words or gestures being

exchanged or expressed. For example, seller X is selling rice from a pile of rice. The price per

kilogram is written on top of the pile at Kes 150 per kilogram. Buyer Y gives Kes 300 to the

seller and the seller gives the buyer 2 kilograms of rice. Here no verbal communication is made

between the offerer and the offeree. The offer and acceptance has been concluded by conduct.

Offer and acceptance by conduct is recognized in the Islamic law of contract.

Offer in writing ( kitabah )

An offer can be made in writing to potential customers. It is the best way of making a contract

as the terms of offer and acceptance are in writing and signed by the parties in which case if

any dispute arises later, it can be resolved by referring to the written terms of the agreement.

Invitation to treat ( Al-Muasah )

In the Islamic law of contract, an invitation to treat is known as al-muasah. An invitation to

treat is not an offer. It is merely an invitation to make an offer to buy something. There are

different types of invitation to treat in the English common law which are recognized in the

Islamic contract law as al-muasah. Different types of invitation to treat are as follows:

a) Displaying of goods in shop,

b) Advertisement,

c) Reply to inquiry,

d) Auction sale

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e) Tender

b) Acceptance ( qabul )

In the Islamic law of contract, acceptance is known as qabul. When an offer is accepted by the

offeree, it is said that an acceptance has been made. When there is an effective acceptance, an

agreement is made between the parties which become legally binding for them. An acceptance

can be verbal, by conduct or in writing as stated earlier. Under the Islamic law, in order to

effect a contract the offer must be accepted by the offeree and the acceptance must be in the

same meeting (majlis) not later. The Islamic law of contract emphasizes on an immediate

acceptance of an offer to make a valid contract.

However, it seems that such requirement of an immediate acceptance of an offer in the same

meeting between the offerer and offeree may not be plausible in the modern business world as

businessmen need time to think about the possibility and viability of making a contract and to

finally decide positively. Under the Islamic law of contract there must be a consideration in a

contract. If there is no consideration, the agreement will not be valid as it is not enforceable by

law. A consideration needs not be adequate as an inadequate consideration is enough to

validate a contract as long as the parties give consent freely to the agreement upon which they

are satisfied. If a contract is not caused by a misrepresentation, fraud, coercion, undue

influence and other attendant legal ambiguities then the contract is valid even though its

consideration is not adequate.

For example;

A sells his car to B for Kes 500,000 while the market value of the car is Kes 1,000,000. If A

sells the car with a free consent and he is not forced by someone to sell the car or he is not

unduly influenced to sell the car and if he is satisfied with the price, we can say that the

contract will not be invalid due to a merely inadequate consideration. However, there are

exceptions to this general rule as under certain circumstances a contract might be valid without

consideration.

For example,

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A husband leaves a wife to stay in another country and promises to pay her every month an

amount of Kes 200,000 for the maintenance of wife and children’s educational cost. Such a

promise which the wife accepts is enforceable against the husband if he fails to pay the money

due every month. Here, without consideration an acceptance is valid as in the Islamic religion

where a husband has a legal duty to provide maintenance cost for his wife as well as his

children and educational cost for his children unless he has formally divorced his wife.

A gift offered to a friend makes a valid contract between them as long as no fraud, coercion or

mistake is involved. A gift is usually given as a social practice or as a token of love, or to help

someone. A gift makes a valid contract when offered to and accepted by the other party and

may not be taken back saying that there was no consideration. However, an issue may arise

whether a promise to offer a gift which has been accepted by the other person is enforceable

under the Islamic contract law. The answer is no because there is a lack of consideration.

Communication of acceptance

An acceptance must be communicated to the offeree to form an effective acceptance. The

communication of acceptance is complete the moment it comes to the knowledge of the

offeree. If the acceptance does not come to the knowledge of the offeree, it would not be an

effective acceptance and no contract will be formed. This is the majority view of the classical

Muslim jurists who are also of the opinion that when an offer is made to a person who is not

present near the offeror, the majlis (meeting) will continue until the offeree receives the offer.

For example, if the offer is sent by a letter through the post office, the majlis will continue until

the offeree receives the letter and he will be given some time to accept the offer, but not for

long. Examples of communication of acceptance and revocation of acceptance are as follows:

Example 1:

B accepts the offer by sending a letter through the post office to the offeror A. Here, the

acceptance is complete against B, when A receives the letter. Therefore, if B wants to revoke

the acceptance, he must revoke it before it comes to the knowledge of A and not afterwards.

The acceptance comes to the knowledge of A when he receives the letter and the agreement is

complete and enforceable. When the acceptance comes to the knowledge of the offerer, the

offeree cannot revoke the acceptance.

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However, in English law, A (offerer) needs not to receive the acceptance letter. A contract is

concluded the moment when the offeree (B) posts the acceptance letter, no matter whether the

offerer (A) receives the letter or not. This is known as ‘postal rule’ which is an exception to the

general rule that the offerer (A) must receive the acceptance to conclude a binding contract. It

is to be noted that the general rule of acceptance is applicable only in instantaneous mode of

communication of acceptance such as face to face acceptance, acceptance by telephone, fax, e-

mail etc.

Meeting ( Majlis )

Under the Islamic law, it is emphasized that an offer and an acceptance should take place in

one meeting (majlis). This is to ensure that the offer is accepted before it lapses. As long as the

meeting continues, majlis does exist and the offer can be accepted before the meeting ends.

However, the problem with this condition of acceptance is that it does not allow the offeree

enough time to think about the offer, whether the terms of the offer are reasonable, whether he

will be able to make profit out of it or not. Another important point is that it hinders bargaining

on the price between the seller and the buyer as it does not give extra time for a second or a

third meeting or to accept later.

In a commercial contract sometimes extra time is needed to finalize the terms of the contract

and to fix suitable price through bargaining. The requirement of simultaneous offer and

acceptance at the same majlis (meeting), thus, creates some problems to a business transaction

in terms of making a wise decision in a time frame constraint. It is therefore highly

recommended that the Muslim scholars should view the ridiculously time constraint concept of

acceptance of offer in the same majlis whereby if the offeree fails to accept the offer in the

same majlis (meeting) in the time allocated, the offer will automatically become void and

unenforceable once the time limit has lapsed. This legal anomaly should be reviewed for the

interest of legitimate execution of business transactions in the Muslim community currently

prevailing when business has exponentially expanded.

c) Free consent

For a contract to be valid, the agreement must be made by a free consent of the parties in the

contract. A free consent of parties is also known as consensus of parties without any form of

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coercion, either directly or indirectly. If the contract is caused by a coercion or a fraud or undue

influence, it would be a voidable contract. Hence, the contract must be based on free consent

from both parties. A free consent of parties is very important in the discharge and execution of

the Islamic contract law.

In a hadith the Prophet (pbuh) said: “Verily trade is based on a mutual consent”. Regarding a

free consent Allah swt says in the Quran: “O ye who believe, squander not your wealth among

yourselves in worthless dealings, but let there be trade by mutual consent…” In this verse Allah

(the Creator) emphasizes on the importance of executing a trade contract by a mutual consent.

Thus, it is a fundamental principle in the Islamic law of contract that both parties must

demonstrate a free consent while conducting a transaction. The proof of a free consent between

the offeror and the offeree is very significant and highly required as the essence of the Islamic

contract law aqd.

d) Intention to create legal relation

Under the lslamic law of contract, an intention to create a legal relationship is significant. If there

is a lack of intention to create a legal relationship, the agreement may not, in all probabilities, be

enforceable by one. However, the party that claims that there is a lack of intention to create the

legal relationship has to prove beyond a shadow of doubt of its tangible existence. Usually, the

agreement which has a consideration is regarded as having an intention to create a legal

relationship between the parties. Business contracts are usually considered as having the

intention to create a legal relationship in one way or another. Some social agreements may lack

the intention to create a legal relationship and it depends on the case by case basis and

circumstances of the agreement. For example, A is a friend of B and A promises to give qard al-

hasan (interest-free loan) to B for an amount of $2,000, but later refuses to conclude the deal.

Here, the contract may not be enforceable due to a lack of consideration. This is an example of a

social contract where there is a lack of intention to create a legal relationship between the parties.

e) The objective and consideration should be legal

It is important under the Islamic law of contract that the objective of a contract should be

lawful and legally binding otherwise the contract will be invalid and not enforceable by law. If

the objective of a contract is to perform some form of illegal act or immoral acts, then the

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contract will be invalid. Similarly, the consideration or a subject matter of the contract should

be legal, legitimate and lawful because if any of these elements is absent, the contract will be

invalid. For example, if the subject matter of a contract is haram (prohibited) in Islam, then the

contract will be illegal and not enforceable by law due to the nature of the spirit of the contract

which may be against the grain of judicial prudence and justice. Hence, a contract to sell pig

meat or dangerous drugs, such as, heroin or different types of wine etc., is legally considered as

invalid because to from a valid contract under the Islamic law of contract, the objective and

consideration must be lawful and must fall within the ambit of legal enforceability.

f) Certainty

Under the Islamic law of contract, the terms of an agreement must be definite, clearly defined

and unambiguous. The terms must be expressed or clearly and precisely written down so that

no element of uncertainty can be presumed in the contract. If the terms or subject matter is

uncertain and ambiguous, the contract will become void. A term in the contract is considered

uncertain if it is not very clear to be understood. For example, company X has agreed to buy

100 tons of rice from company Y for an agreed price. This agreement may become void due to

an uncertainty as it does not mention what type of rice to be delivered, the time frame within

which the goods must be delivered as well as the quantity of rice if it is be delivered on a

partial basis and the terms of payment involved thereupon. This example can be considered as

quite crucial as there are different types of rice with the same name in which case the sample of

the rice should be clearly spelled out to be made available before delivery and other pertinent

matters to be clearly itemized and specified in order to avoid elements of uncertainty in the

contract.

g) Capacity (ahliyyah)

Under the Shariah (Islamic) contract law, capacity is known as ahliyyah. Capacity is the ability

to make a contract under a fully sane physical condition with a healthy mental awareness. Not

every person can make a legal contract, such as, a minor, an insane person and any person

incapable of making a decision due to physical and mental defect, etc. Under the Malaysian

Contract Act 1950 and Age of Majority Act (Malaysia), a person must be eighteen years of age

before he can make a valid legal contract which is basically similar to the contract law of the

UK. Under the Islamic contract law, the age of majority is fifteen years. This is known as

bulug (puberty) of a man or woman.

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Thus, IFLA 1984 prohibits early marriage for boys and girls because an early marriage of boys

and girls most of the times creates social problems, such as, they cannot maintain friendly

conjugal life resulting in divorce later on. For the non-Muslims in Malaysia, there is a different

statute for marriage known as the Law Reform (Marriage and Divorce) Act 1976 (LRMDA

1976). This statute is not applicable on Muslims in Malaysia. Under this statute the minimum

age for solemnizing a marriage for both man and woman is 18 years. However, a woman who

has attained her 16 years, can solemnize marriage after obtaining an authorization license

granted by the Chief Minister of a state.

h) Formality

Formality means the writing and signature requirement of a contract and the contract might be

required to be witnessed by others. The Islamic law of contract emphasizes on writing down the

terms of a contract which is to avoid a dispute between the parties as one or more parties may,

after long period of time, forget what they had actually decided or agreed upon. However, under

the Islamic law of contract, an oral contract is valid if it can be proven by reliable and capable

witnesses. In a conventional law, an oral contract is also valid but the conventional law

encourages people to write down the terms of the contract in all contracts if possible.

Nonetheless, some contracts should be in writing because of the nature of contract.

Marriage contract, transfer of real property, etc., must be in writing and signed by the parties

involved. There are parliamentary laws in many countries that stipulate to write down some

contracts and the law provides that if the parties do not write down the contract and duly sign it,

the contract would be considered as invalid. As mentioned above, the Quran requires people to

write down a loan contract in Surah (Chapter) 2, Verse 282. This verse also requires witnesses

to testify the contract when any dispute arises out of this contract. It is easier to prove a contract

when the terms are in writing.

f) Consideration

The concept of consideration implies the bargain, or value given in return for value received.

Islamic law, unlike common law, does not require consideration. A contract in Saudi Arabia is a

bond between the parties and God, hence, the element of consideration is deemed superfluous

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CHAPTER SIX

ISLAMIC INVESTMENTS.

Corporate Governance for the Islamic Financial Institution;

Shari a perspective / supervisory board,

Islamic Finance Principles,

Financial Views,

Comparison between convectional finance and Islamic Finance

Islamic Finance Institution in Kenya and their Supervisory board.

Definition of Islamic Investments

They can be referred to as unique forms of socially responsible investments under the Islamic

law which cuts across both the institutional and individual investors. Islamic Investments starts

with the Sharia Board. Shari a Means “the way” or may refer to the unmodified Islamic law. It is

a legal system based on Muslim’s ethics, which can be interpreted and developed. This is done

by the ‘Shari a Supervisory Board’ (SSB). This is a group of Islamic scholars (jurists) that

vets investment products for compliance with Islamic Law and conducts ongoing due

diligence of them. Their Sources for interpretation follow a hierarchy of authority as follows;

i. The Quran, it is believed by Muslims to be the words of Allah verbatim as revealed to his

prophet Muhammad in the seventh century;

ii. The Sunnah, these are rules from the prophet's sayings (Hadiths) and actions;

They may from time to time rely on the following below;

i. Qiyas, which are scholarly legal deductions; and

ii. Ijma, the consensus of scholars on a particular issue.

Types of investments:

i. Profit/risk sharing partnership contracts such as Musharaka and Mudaraba, and

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ii. Predictable/fixed return structure such as Murabaha, ijara, istisna, Salam and Sukuk.

Prohibited investments

Sharia law prohibits investments in certain products which are known as haram activities. These

are conventional baking, insurance, gambling (ghimar), alcohol, pork, adult entertainment and

arms and weapon (not all school of thoughts prohibit investment in weaponry production).

Therefore, as long as the activities of the trader do not fall within the above mentioned prohibited

categories of investment they are considered as halal.

Corporate Governances for Islamic Financial institutions

Corporate governance is a set of promises made by a corporation, and those that make the

decisions for a corporation, to the corporation’s stakeholders. Corporate governance has been at

the forefront of discussions of the financial services industry for decades. It can be viewed as a

system of law, contracts, and social norms that govern the structure by which corporations make

decisions. Corporate governance is a defining feature in any organizations where the decision

makers, typically directors, are bifurcated from actual ownership of the corporation. At its core,

corporate governance is a set of promises made by a corporation, and those that make the

decisions for a corporation, to the corporation’s stakeholders. It can be viewed as a system of

law, contracts, and social norms that govern the structure by which corporations make decisions.

Corporate governance is a defining feature in organizations where the decision makers, typically

directors, are bifurcated from actual ownership of the corporation Major failures in the business

world, from Enron to Lehman Brothers, have been characterized as, among other things, failures

of corporate governance.

Corporate Governance Challenges Specific to Islamic Financial Institutions

Islamic Financial Institutions (IFIs) are well suited to adopt and implement good corporate

governance standards. The basic tenets of good corporate governance significantly overlap with

principles that guide Islamic. Zakat is a form of alms-giving that is required by the Quran as one

of the Five Pillars of Islam. A fatwa is essentially a legal opinion issued by a qualified scholar on

a question of Islamic Law. Despite the obvious synergies between corporate governance and

Islamic principles, robust corporate governance practices have not gained a strong foothold in

IFIs. The unique structure of Islamic finance and the desire to be competitive on an international

47

scale while still preserving Sharia principles creates unique corporate governance challenges for

IFIs that the industry is in the process of navigating.

Good corporate governance needs mechanisms in place to ensure compliance with the principles

expressed through regulatory action and corporate charters. Improving corporate governance in

Islamic Financial Institutions (IFI) is an “indispensable” measure that must be taken for the

industry to continue to grow and remain competitive. Therefore, corporate governance is key for

IFI’s as they expand and seek to compete with conventional finance beyond the Islamic world.

Sharia supervisory board (SSB) are responsible to make sure that the investment product devised

by the banks complies with the principles of Sharia law.

There is also the Islamic Financial Services Board (IFSB) established in Malaysia to advice on

the management of financial institutions. Accounting and Auditing Organization of for Islamic

Financial Institutions (AAOIF) based in Bahrain is responsible for development of accounting,

auditing of the Sharia standards. The AAOIF standards are largely based on the international

financial reporting standards (IFRS).

Purposes of Corporate Governance

Ensuring the basis for an effective corporate governance frame-

The corporate governance framework should promote transparent and efficient markets, be

consistent with the rule of law and clearly articulate the division of responsibilities among

different supervisory, regulatory and enforcement authorities.

The rights of shareholders and key ownership functions:

The corporate governance framework should protect and facilitate the exercise of shareholders’

rights.

The equitable treatment of shareholders:

The corporate governance framework should ensure the equitable treatment of all shareholders,

including minority and foreign shareholders. All shareholders should have the opportunity to

obtain effective redress for violation of their rights.

The role of stakeholders in corporate governance:

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The corporate governance framework should recognize the rights of stakeholders established by

law or through mutual agreements and encourage active cooperation between corporations and

stakeholders in creating wealth, jobs, and the sustainability of financially sound enterprises.

Disclosure and transparency:

The corporate governance framework should ensure that timely and accurate disclosure is made

on all material matters regarding the corporation, including the financial situation,

Performance, ownership, and governance of the company.

The responsibilities of the board:

The corporate governance framework should ensure the strategic guidance of the company, the

effective monitoring of management by the board, and the board’s accountability to the company

and the shareholders.

Shari a Perspective

Shari'ah literally means "way" or "path". Technically, it refers to the law of Islam. It is a set of

injunctions derived from two primary Sources of Islamic law, namely Qur'an and Sunnah (the

sayings and example set by the Prophet Muhammad (peace be upon Him). Key features of

Islamic Financial Institutions are the Sharia Supervisory Board - the “SSB”. The SSB is separate

from the Board of Directors for the Islamic Financial Institutions (IFI), but works with the Board

to ensure the IFI is complying with Islamic law. The members of the SSB to be effective, they

must be both Sharia scholars and financial experts.

Unfortunately, this is not a common pairing of expertise. Sharia scholars with the requisite

financial knowledge are in high demand and as a result many scholars sit on the boards of

multiple institutions. This presents concerns about the independence and potential conflicts of

SSB members, as they are able to obtain crucial proprietary financial information from multiple

institutions. The SSB covers five main areas;

i. Ensuring compliance with overall Islamic banking fundamentals,

ii. Certifying permissible financial instruments through fatwas,

iii. Verifying that transactions comply with issued fatwas, calculating and paying zakat,

iv. Disposing of non-Sharia compliant earnings, and

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v. Advising on the distribution of income or expenses among shareholders and investment

account holders.

Islamic Financial Principles

Islamic financing principles forbids the lender to realize a financial profit resulting from late

payment penalties paid by a debtor in default of payment. On the other hand, it is permissible for

a lender to impose the payment of penalties for delay, since this is an incentive for prompt

payment. However, late payment penalties collected by the financier may be retained by the

financier only to the extent that they correspond to the sum of the costs actually incurred by him

as a result of the late payment. Any amount not corresponding to such expenses shall be

distributed to charities. Let’s have look at the basic Islamic financing principles that must be in

your mind as business entrepreneur.

Principles of Islamic Finance.

1) Financing / Ethical Investments

Islamic financing cannot have an investment in an activity prohibited by Shari a. No investment

can therefore be made by an Islamic financier when dealing with haram products or illicit

activities such as alcohol, armament, pig meat, pornography or games of chance.

2) The hoarding

To the extent that the Shari a considers money as a simple means of exchange of no intrinsic

value, hoarding is strongly discouraged or even condemned. A Muslim can accumulate

legitimately acquired wealth, but he must be careful to spend or invest that wealth wisely. When

a Muslim has an annual income greater than a certain amount, he is obliged to return a part of it

to a defined category of the population including especially the needy. It thus conforms to the

obligation to pay zakat, one of the five pillars of Islam.

3) Overview

The structure of the Islamic investment fund must be in conformity with the Shari a. This implies

that the investment objectives themselves must be compatible with the Shari a principles

(investment in the strict sense, the underlying investment criteria and the terms and conditions of

such investments and the treatment of investors).

4) The fund structure

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In order to set up an Islamic investment fund, it is essential to ensure that the structure,

management and investments made by the fund are themselves compatible with the Shari a. For

example, a Shari a-compliant investment fund must be set up and managed either on the basis of

a Moudaraba (described above) or under a wakala agreement (also described below). Under a

wakala agreement (mandate agreement), the person or entity responsible for making the

investments (the wakil) acts as an agent on behalf of the investment fund and, indirectly,

investors.

As in the case of a Mudaraba, wakil invests the investor’s funds on behalf of the investor. The

wakil can then be remunerated on the basis of fixed fees or according to an indexed amount on

the performance of the invested funds, or also according to a system combining these two

methods of remuneration. The asset management contract, whether concluded in the form of a

wakala or a Mudaraba, must in principle mention the obligation of the investment manager.

5) The Fund’s investment objectives and investments

The Shari a Compliance Committee is responsible for defining investment criteria for

investments made by the Fund. As a rule, companies operating in haram sectors are not

considered acceptable investments for an Islamic fund. However, the committee of each

investment fund remains of course free to express its own opinion as to the compatibility or

otherwise of the activity of such enterprises with the principles of Shari a.

6) The terms of investment and the treatment of investors

The Shari a principles requires equal treatment of all investors. According to some scholars,

equal treatment of investors in an investment fund can only be effective if it is offered to each

investor to acquire the same class of units (thus allowing each holder to own of the same rights).

However, this analysis is not universally accepted and some scholars argue that the issuance by

the same company of several forms of shares giving rise to different rights is in accordance with

the Shari a. Investors, in spite of the heterogeneity of their portfolio of securities, must therefore

be treated on an equal footing. However, it is recognized that each investor must be treated

equally, in particular in terms of dividends, return on investment, subscription price, repayment

of the redemption price and voting rights.

7) Financial ratios

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In order to determine whether a company that is the subject of an investment is compatible with

the Shari a, scholars examine the financial resources from which the company derives its income.

The transactions generating interest are prohibited by Shari a. However, to the extent that any

company is in one way or another indebted, it is generally considered that a certain debt ratio is

acceptable. Based on a market practice and a contemporary fatwa issued by the Shari a Board of

the Dow Jones, it is recognized that a company’s debt / equity ratio cannot exceed 33%.

The very principle of interest being haram, it should not be permissible for a society to be haram,

Islamic or non-Islamic financing of securities that may generate interest. Despite this, it is

generally accepted that a company may invest up to one third of its market value in interest

bearing securities. It is also recognized that investments in derivatives (futures and options) are

prohibited insofar as such instruments intrinsically involve speculative aspects and are therefore

considered to contain an element of gharar. According to the same reasoning, short selling is also

incompatible with Shari a principles.

8) Current developments

A wide variety of Islamic structured funds have developed in very diverse forms and in many

jurisdictions. In many cases, Islamic funds are set up alongside pre-existing conventional funds,

which invest in a wider range of assets. Such a structure allows managers the flexibility to

exploit existing opportunities in different market sectors. If Islamic investors are always looking

for investment opportunities in line with the Shari a, the structures in place tend naturally

towards more diversification and sophistication.

Comparison between Conventional Finance and Islamic Finance

Islamic Banking can be described as a system of banking that adheres to the principles of

Sharia i.e. The Islamic Law. It’s therefore a financial system which identifies itself with the

spirit of Sharia (The Islamic Law), as laid down by the Holy Qur'an and Sunnah (the

practices of Prophet Mohammed).

Conventional banking on the other hand is a financial system where, lenders lend to

borrowers to make a profit from interest charged on the principal amount. Borrowers, pay for

property loans an interest on the outstanding principal amount. This is therefore, a type of

finance that gives loans to clients without taking a trading position, hence faced with credit

risk which can be shifted to a third party. An example of risk shifting in the conventional

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credit market is using derivatives instruments such as a credit default swap (Mizanur

Rahman, 2014:63).

However, under the Islamic Finance this is not allowed under the prohibition of interest and

gambling. If an enterprise is financed by debt with an obligation to pay interest, the risk of

the business is not being shared fairly. Instead, Islamic finance requires that finance is

provided on the principle of profit and loss sharing. Under shariah law finance can be

provided through several types of contract. Each type specifies how risk is shared between

the enterprise and the supplier of finance.

Conventional banks accept deposits on the basis of loan for all types of deposit accounts

including Term Deposit, Savings and Currents accounts. Interest based returns are provided

for the Savings accounts and Term Deposits, whereas Current Accounts may offer free

banking facilities. In addition to this, conventional bank invests the deposits in non-shariah

compliant avenues and subsequently earns non-shariah compliant returns.

Islamic Banks offers deposit products based on the following structures:

1. Qard – Current accounts are offered under this contract where the risk of the funds lies

with the bank and no added benefits are provided to the client solely based on this facility.

However, clients may be allowed to avail those facilities which are offered across the board.

2. Mudarabah – a type of partnership where client funds are invested in various businesses

and returns are shared between the bank and client as per the agreed profit sharing ratio

whereas, the loss is shared as per the investment ratio. Term Deposit and Savings Accounts

are offered on the basis of Mudarabah.

Islamic Financial Institution in Kenya

Kenya was the first country in the East and Central African region to introduce Islamic banking

in the year 2007. In this short period, two banks were licensed to exclusively offer Shari’ah-

compliant products with many other conventional banks establishing a window specifically for

Shari’ah-compliant products. Records show that for the short period of existence, Islamic

banking in Kenya has shown very commendable performance commanding combined market

share of the banking sector in terms of gross assets of 0.8%.

Currently, there are two Islamic banks operating in Kenya i.e. Gulf African and First Community

Bank with a loan portfolio of over 4.9 billion shillings, deposits totaling 7.5 billion shillings and

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27270 deposit accounts. Other banks which offer shari’ah complaint products and services

include Dubai Bank, Kenya Commercial Bank Ltd and Barclays Bank Ltd. (Kinyanjui, 2013)

The Barclays bank of Kenya via their “La riba bank Account” served as a model of introducing

the Islamic Finance Services. Later several banks jumped in to provide Islamic banking services

through sections or windows. These include but not limited to KCB, Chase bank of Kenya now

SBM. NIC bank of Kenya and National Bank of Kenya now under KCB management .However,

the Islamic community in Kenya felt that it’s important to have 100% Islamic banks. The “La

Riba Bank account” was to provide Islamic Finance and Banking services for Kenya’s 8

million Muslims who represent 25% of the population.

In Kenya, there are fully-fledged Islamic banks that solely offer Shari’ah-compliant products;

and main stream banks that provide products that are tailored to be in compliance with Islamic

law. Examples of such banks targeting lower income and special customers are Jamii Bora Bank,

which has carved a niche for itself not only by tailoring its banking services mainly to low-

income customers but by also venturing into mortgage financing for low-income housing, and

two fully-fledged Islamic banks; First Community Bank and Gulf African Bank, that have

succeeded in bringing Sharia-compliant banking services to Kenya. (KBA, 2013). They operate

on the economic law of Islam which has the basis of the following contracts and are 100%

shariah;

Murabaha - This is a sale contract.

Mudaraba - it’s simply part financing.

Musharika - it’s a partnership.

Ijara - its rental or lease.

Istinaa -sale yet to exist property.

Salam- sale yet to exist agricultural goods.

Banks in Kenya under Islamic Finance.

Kenyan financial legislation and rules / regulations are not clear on Islamic banking .However,

there are various lending institutions that are serving the Islamic community in Kenya. These

includes;

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First Community Bank of Kenya

Gulf African Bank of kenya

Middle East Bank of kenya

Dubai Bank of kenya

Bank of India kenya

Bank of Baroda kenya.

Supervisory Board of Islamic Finance Institution in Kenya

According to Wako, Kamaria and Kimani (2014), Islamic banks in most countries are put under

the supervision of the central bank of the country and are given the same treatment given to

conventional banks. With only a few instances where special Islamic banking legislation are

approved to define a new relationship between Islamic banks and the central bank.

This position is supported by Azizul, (1999) who believes that most Islamic banks in the

contemporary world operate in a mixed environment in which interest based banks function side

by side with Islamic banks. The central banks subject Islamic banks to the same controls,

conditions, and regulations that they apply to interest-based banks. Azizul, (1999) notes that

there are certain factors such as lack of understanding of the correct nature of Islamic financing

techniques, however, that requires that Islamic banks be treated on a different footing.

The supervisory board of the Islamic Finance Institution is the Shariah Supervisory Board

(SSB).This is chaired by Prof. Badamana. Prof. Badamana is currently the Chairman,

Department of Animal Production at the University of Nairobi. He has also been the Director of

World Assembly of Muslim Youth – East Africa and has taught Islamic law at the University of

Nairobi Department of Philosophy and Religious studies. Other members are;

Dr. Mohamed Mohamud Ali

Dr. Ali lectures Islamic Economics and Finance at the Thika Islamic College (Proposed Umma

University). He is an advisory board member of Bayan Center of Islamic Financial Engineering,

an international institution established as one of the supporting institutions for Islamic Finance

industry and based in Khartoum, Sudan

Dr. Mwanakombo M.H. Noordin

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Dr. Noordin currently works as the Director of Moi University Coast Campus. She is in charge

of coordinating all campus operations, administrative and academic programmes. She is a senior

lecturer at Moi University where she teaches Kiswahili language and literature.

Dr. Abdulkadir Hashim

Dr. Hashim is currently a Lecturer in the Department of Philosophy and Religious Studies at

University of Nairobi. He has extensive experience in Sharia law and has served as the Muslim

Chaplain at the University of Nairobi, Head of Department of Sharia at Zanzibar University, and

as a lecturer in various universities in Kenya and Zanzibar.

Mohamud Mohamed Omar ( Shariah Coordinator)

He is a Shariah practitioner who comes with a solid academic background in Islamic Finance.

Omar is a Certified Islamic Finance Executive from Ethica Institute of Islamic Finance (CIFE)

from Dubai. . He is also a CPA (K) finalist.

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CHAPTER SEVEN

TAKAFUL (ISLAMIC INSURANCE)

Introduction

Islamic insurance also commonly known as takaful is a type of insurance that is based on the

principles of co-operation as well as mutuality in cooperating the features of solidarity, shared

responsibility, common interest and also joint indemnity. There exists a similarity between

insurance and the contract of kafalah i.e. guarantee and thus this makes takaful acquire its name

of Islamic insurance.

Definition of takaful.

Takaful, i.e. Islamic insurance is derived from the word “kafalah” that is Arabic which means

guarantee of each other. Takaful is based on the principle of taawul i.e. brotherhood as well as

tabarru i.e, donation. In takaful the risk of losses is shared cooperatively and willingly by

members who act as guarantors against the losses and damages.

Takaful is a typical example of how the privileged in the society come together to help the less

privileged in order that equity may be maintained among the members in the society and also in

order that those that are suffering or had suffered misfortune previously may be helped. Its main

aim is not to make profits but rather for the individuals who have more to redistribute to their

counterparts who have less.

For a good takaful system to be in place, there exists some elements that must be considered, i.e.

i. All activities of takaful must be in line with Shari ’a. These are sharing of risk, ownership

coincidence, policyholders participation in the management activities and avoidance of either

receiving or giving interest on any money i.e. riba.

ii. All takaful businesses should be carried out with transparency, honesty, good faith,

consistency, fairness as well as truthfulness

iii. Any takaful contract must be between individuals of sound mind and with the knowledge on

what is contained in the contract.

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iv. Activities regarding takaful must be haram free, i.e. they should not contain any element that

is forbidden.

v. All takaful members must adhere to the principle of sincerity i.e. neaa and also takaful

principles which are collectively sharing of risk among the members and also mutual

assistance among the members.

Gambling and Insurance

Gambling is very different from insurance. The following are some of the distinct features

between gambling and insurance

1. In gambling there is a chance of either winning or losing by creating that chance of loss

while in insurance it a risk already exists and by entering into an insurance contract a party is

trying to minimize the effects with regards to finance that may occur due to that risk.

2. Gambling encourages conflict, hatred as well as ruin among the members involved in it while

insurance on the other hand encourages unity among the members in that one’s an individual

enters into an insurance contract, the possibility of his or her dependents languishing in

poverty is minimized if they were the bread winners as they are covered in the insurance

contract. An insurance contract ensures that the dependents are well taken care of once the

individual is gone or not able to take care of them.

3. In gambling the aim of the parties is to win a certain amount of money and under no any

circumstance are they compensated when they incur a loss. Insurance on the other hand has

the aim of compensation in case one incurs a loss from the covered policies i.e. insurance

mainly deals with restoring one to their normal position in case they suffer a loss

4. In gambling situation there must be a win and a loss in that one party must win while the

other loses. Insurance on the other hand the risk covered may not occur though the party

inured must continue paying premiums during that period as per the contract in order to be

covered from the risk during the entire period.

5. In the case of gambling, if one wins they are restored back to their normal position plus they

get an additional extra amount from the party who has lost while in insurance the insured

party is never compensated his or her premium and is only restored back to the normal

position in case a loss occurs, there is no making of profits in insurance.

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Basis and Principles of Takaful

The following are the underlying principles of takaful;

i. Liabilities are spread with regards to the community’s pooling system while losses are

divided between the community members

ii. Uncertainty is eradicated with regards to compensation and subscription

iii. There is co-operation amongst the policy holders which is for their own good.

iv. Each and every policyholder gives part of their contributions as donations to help the less

privileged in the society.

v. It does not aim to exploit one at the expense of others.

Reasons why conventional insurance is not suitable to Muslim

Insurance has been used as risk mitigation especially on any financial loss since the time of

merchants. The concept was to pool resources together and works with law of large numbers to

compensate the unfortunate in the pool. However this is not different from the principle behind

the Islamic insurance (takaful). However there are key distinguishing features between the

conventional insurance and the Islamic insurance which includes

1. There is usually high uncertainty (gharar) in the conventional insurance contracts the prophet

prohibited gharar in any Muslim transaction therefore there is no uncertainty in takaful

contract;

2. The element of Gambling (maysir) is evident in the conventional insurance i.e high

uncertainty about the future outcomes. Maysir is prohibited in quarun and sunna and should

not be in takaful contracts

3. The conventional insurance companies invest heavily on financial market which involves

Interest (riba) Muhammad prohibited issuance of usury (riba);

4. Conventional insurance are owned by shareholders and their major duty is to maximize

shareholders wealth while takaful interest is on the policyholder.

The major difference between Takaful and conventional insurance is in the risk assessment and

handling together with management of takaful fund. In addition the relationship between the

takafu operator and the participant. The policy holder benefit solely in case of profits in the

takafu funds.

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How does Takaful Work

Takafu is based on a mutual guarantee and brotherhood, the participants (policyholders)

contribute voluntarily to guarantee each other by making contributions to a mutual fund. The

mutual fund collected becomes the takafu fund. Usually different people are faced with different

classes and degrees of risky so every participants will contribute based on the risk they want to

be covered against. Also in addition the financial capability of the participant. Just like

conventional insurance the takafu contract gives the nature of the risk and term period of the

cover.

The funds contributed by the participants is administered and managed by takafu operator and

charges an agreed amount to cover the cost incurred which include marketing underwriting

servicing and claim management. Participants claims are usually paid from the member

contributions and remaining surpluses generally after reserving for the future anticipated claims

the remaining amount belongs to participant who make the fund and not the takafu operator and

should be distributed to the participants as cash dividends or a subside in future contributions. 

Operating Principles

Takaful is a sharia compliant so Islamic insurance company should operate under the following

principles:

1. Should operate under Islamic co-operative and brotherhood principles

2. Commission to reinsurer should be received from Islamic insurer and vice versa.

3. There should be two separates fund in insurance company, the participants and the

shareholders fund.

The participants' Fund

1. The assets of the policyholders' fund consist of:

i. Participants contribution to the takafu fund

ii. The profits from the investments allocated to the participants by the board of directors.

iii. Salvages and recoveries

iv. Consultancy and other receipts.

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2. The claims made to the participants, money paid to the reinsurer, amount reserved for

anticipated claims, administrative expenses, etc., all this are met by policyholder except

investment expenses.

3. The surplus is the balance remaining at the policyholders fund at the end of the year, this

may be allocated all of it or proportion of it special reserves and the remaining will be

distributed to the participants. When the policyholders' funds are insufficient to meet their

expenses, the deficit is funded from the shareholders' fund.

4. The shareholders undertake to discharge all the contractual liabilities of the policyholders'

fund, but this liability does not exceed their equity in the company.

The Shareholders' Fund

1. The assets of the shareholders' fund consist of:

i. Reserves allocated to the shareholders and the share

ii. Investment profit from the share capital and shareholders reserves

iii. Proportion of investment profit from the policyholders funds and other technical reserves

attributed to them

iv. Miscellaneous receipts

2. The investment administrative expenses at department of investment comes from

shareholders fund

3. The balance of the shareholders' surplus, if any, is distributed among them.

Investment of Funds

The investment made the company should be sharia compliant and should be invested in profit

loss sharing basis

TAKAFUL MODELS

There are four main types of takaful models used by takaful insurance namely

Wakala model

Mudaraba model

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Hybrid model

Waqf model

Wakala Model

The contractual arrangement is based on the wakala model, the agent. The agent of the takaful

gets a fixed fee irrespective of the performance of the takaful even if the takaful makes a loss the

agent is still entitled to his fee. The participants are the policy holders and the takaful operator’s

acts as the agent of the participants. The agent does two major activities the first one is to

manage the contributions of the participants, manage the takaful policies and settlement of

claims. The second activity for the agent is to invest a section of the takaful fund in sharia

compliance activities.

Takaful fund is initially divided into initially divided into personal special account and personal

account. The personal special account is used to manage the liquidity for any arising claim that is

the claims are paid from that account. The personal account is where the agent now takes the

money for investment in the sharia compliant business activities. The personal special account

minus claims and operational expenses the remaining amount goes to the surplus account. The

investment amount plus profit minus investment expenses goes to the surplus account. In short

the excess amount in personal special account and the excess in personal account goes to the

surplus account as the profit of the takaful fund which is shared among the participants in ratio of

their contribution.

Mudaraba Model

The contractual arrangement is based on the mudaraba basis. The participants are the (rabal

amaal) and the takaful operators are the (mudaribs). There is only profit sharing on this model, if

the takafu fund makes a profit the profit is shared as agreed in a pre-arranged ratio however if a

loss is made the mudarib doesn’t share in it however he too will not receive anything. The agent

does two major activities the first one is to manage the contributions of the participants, manage

the takaful policies and settlement of claims. The second activity for the agent is to invest the

section of the takaful fund in sharia compliance business activities.

Takaful fund is initially divided into initially divided into personal special account (PSA) and

personal account (PA). The personal special account is used to manage the liquidity for any

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arising claim that is the claims are paid from this account. The personal account is where the

agent now takes the money for investment in the sharia compliant business activities. The

personal special account minus claims and operational expenses the remaining amount goes to

the surplus account. The investment amount plus profit minus investment expenses goes to the

surplus account. In short the excess amount in personal special account and the excess amount in

personal account goes to the surplus account as the profit of the takaful fund which is shared

between the takafu operator and the participants according to a predetermined ratio.

Hybrid Model

If more than one structure is used to structure the takafu that is generally the wakala and

mudaraba contracts are used. The takaful operator acts as the agent and receives a fixed fee on

the wakala part. However the investments are made on mudaraba basis and the agent is also

entitled to profit-sharing as in mudaraba model.

Waqf Model

However some opponent of the first three argued that the three models are not Shari ‘a compliant

since the premium paid is not tabarru as claimed by the takaful companies. Some scholars argue

that the premium contributed by the participants can no way qualify to be donations since an

Islamic donation is given without the expectation of a claim from it. This lead to the

development of another fourth model called the waqf. In this model it works the same as the

mudaraba or wakala however the profit is reinvested back in case of surplus. This is considered a

better Islamic model since the premium qualifies to be tabarru because no one claims the profit.

Types of Takaful

Takaful plans are of two types, i.e.

a) Family takaful plan

b) General takaful plan

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Family Takaful plan: In family plan there exists three forms which are individual, mortgage as

well as medical takaful plans.

Individual takaful plan: In the individual plan, it can be said that to be more of a long term

investment and saving plan by individuals. The investment and saving plan has a maturity period

that is fixed in the future. It can also be said to be similar to an insurance plan that has a term life

though the only difference is its mechanism as well as the transaction structure.

The main purpose of the individual takaful plan is to;

Inspire individuals to regularly save

Earn as well as share profits that are as a result of investing in products that are Shari ‘a

compliant

Paying the benefits of takaful to the intended beneficiaries should an individual die

before the actual maturity date of their plan or in some circumstances when an individual

becomes disabled.

According to this plan, the family members and beneficiaries automatically becomes entitled to

the following should an individual be deceased before the term plan actually ends. The

individuals total contribution that was paid up to the time of his or her timely death as well as the

share profits earned as a result of investment. The remaining amount of the takaful installment as

is stated under the plan and is calculated from the individual’s date of death. The benefits are

paid separately from tabarru fund. If an individual lives up to the maturity of the takaful plan, he

is entitled to the following benefits;

The amount of contributions in whole that was contributed by the individual as well as

the share profits that was gained as a result of investments

Any excess tabarru funds that was allocated to the individual’s account

Should the individual participant be forced to pull out from the takaful plan before the

actual maturity date he is entitled to the amount of contributions he has contributed up to

the time of his withdrawal plus the share profits credited to his account as a result of

investment. However the amount relinquished as tabarru is never refunded.

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Mortgage takaful

This can be described as family plan that acts to offset the individual policyholder’s house

financing in case the individual dies or becomes permanently disabled. In many occasions the

policyholder is only required to pay a contribution for this plan only once. The amount to be paid

by the policy holder depends on certain factors such as profit rate, age of the policy holder, time

in which protection is valid and also protection amount that is bought by the policy holder. In a

situation whereby the policyholder sells his house or converts his financing before actual expiry

of the plan term, he is entitled to a refund of his contribution for the takaful period that is

unexpired.

Medical/Health takaful

This takaful plan is inclusive of private treatment cost e.g. admission cost in the hospital plus the

amount paid to the doctor for care of the patient. Should an individual have an accident or be

suffering from certain diseases, the cover could be separate or in some cases act as an additional

contract to a basic family takaful plan.

General Takaful.

This plan can be defined as contract that guarantees jointly and also compensates the participants

in case of occurrence of a loss that is defined. These plans are short term in nature, i.e. one year

or below and they cover individual persons, commercial entities and also real as well as personal

property. Some of the schemes offered under general takaful include motor takaful, fire takaful

and also marine takaful.

Differences between Takaful and Conventional Insurance

The Islamic jurists have overwhelmingly agreed that the contracts of conventional insurances

unacceptable to Muslim. The reason is that they are not Shari ‘a compliant due to the following

reasons:

1. There is element of uncertainty (gharar) in the conventional insurance contracts.

2. Theory of interest is a key feature in life insurance policies whereas Islamic insurance basis

is on tabarru in which a portion of contribution made by the participants are considered to be

donations, hence the policy holders are called the participants.

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3. The conventional insurance are considered to have excessive uncertainty(maysir)

4. Takaful is sharia compliant as it is based on mutual guarantee, social solidarity co-operation

and trusteeship is the key driver of takaful.

The Key Differences

1. The contracts in conventional insurance contracts the insured exchanges certainty with

uncertainty by paying a known premium to insurer for losses that can occur in case the

insured event happen which depends on chance. The Islamic insurance all participants are

involved by sharing the risks and the risk is not transferred to the insurer.

2. The main agenda for Conventional insurance companies is to make profit are motivated by

the desire for profit, whereas Islamic insurance companies not to make profit but for social

welfares, the shareholders will not share the profits proceeds made from the business but will

get a fee for rendering the services but can share the investment returns managed by them in

cases of mudaraba model.

3. In the normal insurance companies the policy holders do not have any right to participate in

voting during election of the directors unless they are shareholders of the same company

neither can they have access to companies annual accounts. In contrast Islamic insurance

companies all the above mentioned are accessible to participants with a stipulated

contribution.

4. In cases of Islamic insurance, upon the death of the assured person the beneficiary gets the

total premium contribution, the dividends bonuses and a profit share made from the paid

premiums in addition donation from the tabarru kitty which is a contribution to the needy and

less fortunate in the society. In cases of the insured surviving to the end of the policy term all

the contributed premium amount, profit share made from the investments of contributed

premiums dividends and the bonuses with regards to the company policy. In a conventional

life insurance policy, the agent's payments are paid out of the insured's paid premiums,

whereas in the Islamic model, the agents work for the company and thus are paid by the

company.

5. The policy holder is generally paid the sum assured if he/she survives to the end of policy

terms in the conventional insurance however if he dies before the term then the sum assured

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is paid to the nominated beneficiaries who can be anybody but in the takaful the sum assured

goes to the heir in conformity of Mirth or Wasiyyah principle.

Co-operative Insurance

This concept is acceptable in Islam because;

1. There is active co-operation between the policy holders for their own good.

2. Each and every policy holder generally pays their subscriptions to help the needy.

3. The concept spreads liability among the community through a pooling system.

4. It does not aim at deriving undue advantage for one at the cost of other individuals;

5. The element of uncertainty is eliminated as far as determination of the premiums

is concerned.

An Islamic co-operative insurance contract should embody the following conditions:

1. The company functions according to Islamic co-operative principles.

2. The policyholders have the right to participate in surplus profits and are liable to contribute

additional amounts if their subscriptions are not sufficient to meet all the losses. However, it

is preferable for such losses to be written off against future surpluses. Shareholders are not

entitled to any of the underwriting profits generated by the insurance operations. But, as

mudarib (agents), they are entitled to receive a proportion of the profits from the investment

of insurance funds, plus, of course, all the profits on the investment of their own capital and

any other funds and reserves attributable to them.

3. The company will strictly follow Islamic laws in the matter of investment and will not

indulge in the practice of usury.

4. Policyholders are represented on the Board of Directors and have a right to scrutinize

its accounts.

Retakaful or Reinsurance

Mostly, the insurance risks scale is great for one insurer to manage carry safely. Due to these

factors, firms use reinsurance to reduce their own peril exposure. Reinsurance refers to insurers

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insuring a risk again with another insurance company, which in turns allows the insurance

industry to reduce it losses, minimizing the impact of claims.

Many insurance companies spread their risks among other insurance companies that is

reinsurance companies. Sharia must be conformed to by all Islamic companies entering into the

reinsurance contract. Currently, the capacity of retakaful has become minimal and decrease of

firms in the market has become a major challenge and an opportunity too. The main challenge

includes having a big adequate takaful market to proof retakaful business. In addition, there is a

major whole world need for efficient retakaful operators to help the development and expansion

of insurance/ takaful business. Scholars of Shari ’a have given a chance to takaful operators to

conventionally reinsure when there is no alternative, despite the fact that retakaful is preferred

strongly.

Additionally, conventional reinsurance is different to the clients’ tastes and preference of

searching on Islamic principles cover. The retakaful principles are basically the same with the

takaful principles, and also applies similar principles of Shari ‘a. Islamic reinsurance companies

should be prioritized so as to end connections with commercialized conventional reinsurance

companies as fast as possible.

Shari ‘a Authenticity

Shaikh Yusuf Talal DeLorenzo, believes that a financial service or product can be confirmed as

Shari ‘a compliant by a qualified Shari ‘a regulatory board, and that product's originality is

doubtful. This means then, it is then the duty of the investor or the client to decide on his or her

own that the product is in accordance with the principles Shari ‘a.

Shari ‘a Supervisory Board [Religious Board]

The responsibility of the Board includes the review of the takaful / retakaful operations, zakat

payments calculations, ensure bank guidance especially on social role, development supervision

of Islamic insurance services and products, auditing Shari ‘a to ensure products are in line with

policies and access the Shari ‘a adherence of these products and the overall investments.

Islamic financial institutions should always comply with the best practices of their rules and

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guidelines since there is an extra layer of coordination in terms of religious regulatory boards

which includes functions in consultative and regulations. 

The financial institution is therefore expected to establish a fully organized procedures and

policies to guarantee that there is no any form of business activity is conducted and has not

certified and approved previously by the regulatory religious board. Hence the management

should often to the board that all the actual investments activities conducted by the institution are

in accordance with the advanced approved policies by religious board. 

Products and services offered by the Islamic financial institutions should be in line with the

Islamic principles and must be regulated and governed fully by a religious board which act as

an independent Shari ‘a Supervisory Board comprised of scholars of Shari ‘a with expertise

knowledge of transacting Islamic laws , fiqh al mu`amalat, and special skills and knowledge of

finance, economics and modern business. The decision-making idea is important in the sense

that Shari ‘a Supervisory Boards plays a major role of ensuring that that decisions are not made

by only one party , and basically that different difficult finance issues receive adequate and

efficient consideration by a large number of fully qualified personnel . 

Status of Takaful

In conclusion, as Islamic finance daily continues to grow, other products such as pensions, health

care, education, marriage and health Takaful plans. In addition, there is a big area for mortgage

Takaful. Basically, Islamic principles will always emphasis in Takaful on the economic, ethical,

moral and social dimensions, to enhance and focus on equality and fairness for the wellbeing of

the society. Globally, insurance has raised and become a necessity to all sorts of trade and

industry. Life assurance becoming most effective way for encouraging and mobilizing savings,

for creation of capital as well as long-term investment, old age provision and bereavement.

In western regions, insurance sector has become the biggest single contributor of income to the

financial sector and capital market. Basically, commercial banks and insurance firms now have

formed international alliances especially for mutual benefit. Demand has drastically increased for

a Sharia’-compliant insurance system. Nowadays, Islamic countries have low demand for

insurance since Muslims still believe that insurance is un-Islamic. Therefore, the growth of

Islamic insurance, demands that there is extensive awareness of the Muslim public at large,

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development and acquisition of resources and expertise, a stable legal framework , ethical

practices, review and development of brand new Shari ‘a-compliant instruments, international

accounting standards and new arrangements for retakaful

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