PRINCIPLES OF ISLAMIC FINANCE, INVESTMENT AND BANKING
by Zulkiply Harun

The guiding principles for an Islamic financial system is a set of rules and laws, collectively referred to as shariah, guiding economic, social, political, and cultural aspects of Islamic societies. Shariah originates from the rules dictated by the Quran and its practices, and explanations rendered (more commonly known as Sunnah) by the Prophet Muhammad. Further elaboration of the rules is provided by scholars in Islamic jurisprudence within the framework of the Quran and Sunnah. In a sense, the combination of law and finance in Islam is inevitable.

Islamic law, by its nature, is resilient enough to accommodate modern financing modes and institutions with great ease. Rather, it can be, perhaps, said, that Islam is not a rigid methodology which insists that certain specific directions be taken to reach a destination, but a framework which provides directional guidance when directions for certain types of activities have not been documented yet, or those that are already documented need to be reengineered to suit changing scenarios.

Islam, however, expects that the principles it enshrines are not breached while redefining, reengineering and adopting the same in practice.

Whereas the conventional financial system focuses primarily on the economic and financial aspects of transactions through the maximization of returns, the Islamic system places equal emphasis on the ethical, moral, social, and religious dimensions, to enhance equality and fairness for the good of society as a whole. The system can be fully appreciated only in the context of Islam's teachings on the work ethic, wealth distribution, social and economic justice, and the role of the state.

Undoubtedly, prohibiting the receipt and payment of interest is the nucleus of the system, but it is supported by other principles of Islamic doctrine advocating risk sharing, individuals' rights and duties, property rights, and the sanctity of contracts. Similarly, the Islamic financial system is not limited to banking but covers capital formation, capital markets, and all types of financial intermediation.

A quick summary of the well-known principles of Islamic Finance and the wisdom inherent in them will be in order, here :

Making Money from Money is not Permissible

One of the wrong presumptions on which all theories of interest are based is that money is a commodity. It is, therefore, argued that just as a merchant can sell his commodity for a higher price than his cost, he can also sell his money for a higher price than its face value, or just as he can lease his property and can charge a rent against it, he can also lend his money and can claim interest thereupon. Islamic principles, however, do not subscribe to this presumption. Money and commodity have different characteristics and, therefore, they are treated differently.

The basic points of difference between money and commodity

(a) Money has no intrinsic utility. It cannot be utilized in direct fulfillment of human needs. It can only be used for acquiring some goods or services. A commodity, on the other hand, has intrinsic utility and can be utilized directly without exchanging it for some other thing.

(b) Commodities can be of different qualities while money has no quality except that it is a measure of value or a medium of exchange. Therefore, all the units of money of the same denomination, are hundred per cent equal to each other. An old and dirty note of RM100 has the same value as a brand new note of RM100.

(c) In commodities, the transactions of sale and purchase are effected on an identified particular commodity. If A has purchased a particular car by pin-pointing it, and seller has agreed, he deserves to receive the same car. The seller cannot compel him to take the delivery of another car, though of the same type or quality.

Money, on the contrary, cannot be pin-pointed in a transaction of exchange. If A has purchased a commodity from B by showing him a particular note of SR.100 he can still pay him another note of the same denomination.

Based on these basic differences, Islamic Shar'iah has treated money differently from commodities, especially on two scores:

Firstly, money (of the same denomination) is not held to be the subject-matter of trade, like other commodities. Its use has been restricted to its basic purpose i.e. to act as a medium of exchange and a measure of value.

Secondly, if for exceptional reasons, money has to be exchanged for money or it is borrowed, the payment on both sides must be equal, so that it is not used for the purpose it is not meant for i.e. trade in money itself.

In short, money is treated as "potential" capital. It becomes actual capital only when it joins hands with other resources to undertake a productive activity. Islam recognizes the time value of money, but only when it acts as capital, not when it is "potential" capital.

It is pertinent to quote herein the following, which vindicate the Islamic viewpoint concerning the nature of money:

During the horrible depression of 1930s, an "Economic Crisis Committee" was formed by Southampton Chamber of Commerce in January 1933. The Committee consisted of ten members headed by Mr. E. Dennis Mundy. In its report the committee had discussed the root causes of the calamitous depression in national and international trade and had suggested different measures to overcome the problem. After discussing the pitfalls of the existing financial system, one of the committee's recommendations was that:
"In order to ensure that money performs its true function of operating as a means of exchange and distribution, it is desirable that it should cease to be traded as a commodity."

James Robertson observes in his latest work, Transforming Economic Life in the following words:

"Today's money and finance system is unfair, ecologically destructive and economically inefficient. The money-must-grow imperative drives production (and thus consumption) to higher than necessary levels. It skews economic effort towards money out of money, and against providing real services and goods…
…(It) also results in a massive world-wide diversion of effort away from providing useful goods and services, into making money out of money. At least 95% of the billions of dollars transferred daily around the world are for purely financial transactions, unlinked to transactions in the real economy."

Prohibition of Interest:

The most famous principle of Islamic Finance is the prohibition of usury or interest (Riba in Arabic). There is a consensus among the scholars that even the interest paid by and to conventional banks is riba. Islam does not recognize loans as income-generating transactions. They are meant only for those lenders who do not intend to earn a worldly return through them. They, instead, lend their money either on humanitarian grounds to achieve a reward in the Hereafter, or merely to save their money through a safer hand. So far as investment is concerned, there are several other modes of investment like partnership etc. that may be used for that purpose. The transactions of loan are not meant for earning income.

The basic philosophy underlying this scheme is that the one who is offering his money to another person has to decide whether:

(a) He is lending money to him as a sympathetic act or

(b) He is lending money to the borrower, so that his principal may be saved or

(c) He is advancing his money to share the profits of the borrower.

In the former two cases (a) and (b) he is not entitled to claim any additional amount over and above the principal, because in case (a) he has offered financial assistance to the borrower on humanitarian grounds or any other sympathetic considerations, and in case (b) his sole purpose is to save his money and not to earn any extra income.

However, if his intention is to share the profits of the borrower, as in case (c), he shall have to share his loss also, if he suffers a loss. In this case, his objective cannot be served by a transaction of loan. He will have to undertake a joint venture with the opposite party, whereby both of them will have a joint stake in the business and will share its outcome on fair basis.

Conversely, if the intent of sharing the profit of the borrower is designed on the basis of an interest-based loan, it will mean that the financier wants to ensure his own profit, while he leaves the profit of the borrower at the mercy of the actual outcome of the business. There may be a situation where the business of the borrower totally fails. In this situation he will not only bear the whole loss of the business, but he also will have to pay interest to the lender, meaning thereby that the profit or interest of the financier is guaranteed at the price of the destructive loss of the borrower, which is obviously a glaring injustice.

On the other hand, if the business of the borrower earns huge profits, the financier should have shared in the profit in reasonable proportion, but in an interest-based system, the profit of the financier is restricted to a fixed rate of return which is governed by the forces of supply and demand of money and not on the actual profits produced on the ground. This rate of interest may be much less than the reasonable proportion a financier might have deserved, had it been a joint venture. In this case the borrower secures the major part of the profit, while the financier gets much less than deserved by his input in the business, which is another form of injustice.

Thus, financing a business on the basis of interest creates an unbalanced atmosphere, which has the potential of bringing injustice to either of the two parties in different situations. That is the wisdom for which the Shar'iah did not approve an interest-based loan as a form of financing.

Once interest is banned, the role of "loans" in commercial activities becomes very limited, and the whole financing structure turns out to be equity-based and backed by real assets. In order to limit the use of loans, the Shar'iah has permitted to borrow money only in cases of dire need, and has discouraged the practice of incurring debts for living beyond one's means or to grow one's wealth.

It should be the last thing to be resorted to in the course of economic activities. This is one of the reasons for which interest has been prohibited, because, given the prohibition of interest, no one will be agreeable to advance a loan without a return for unnecessary expenses of the borrower or for his profitable projects. It will leave no room for unnecessary expenses incurred through loans. The profitable ventures, on the other hand, will be designed on the basis of equitable participation and thus the scope of loans will remain restricted to a narrow circle.

Conversely, once interest is allowed, and advancing loans, in itself, becomes a form of profitable trade, the whole economy turns into a debt-oriented economy which not only dominates over the real economic activities and disturbs its natural functions by creating frequent shocks, but also puts the whole mankind under the slavery of debt. It is no secret that all the nations of the world, including the developed countries, are drowned in national and foreign debts to the extent that the amount of payable debts in a large number of countries exceeds their total income. Just to take one example of UK, the household debt in 1963 was less than 30% of total annual income. In 1997, however, the percentage of household debt rose up to more than 100% of the total income. It means that the household debt throughout the country, embracing rich and poor alike, represents more than the entire gross annual incomes of the country. Consumers have borrowed, and made purchases against their future earnings, equivalent to more than the entirety of their annual incomes. Peter Warburton, one of the UK's most respected financial commentators and a past winner of economic forecasting award, has commented on this situation as follows: "The credit and capital markets have grown too rapidly, with too little transparency and accountability. Prepare for an explosion that will rock the western financial system to its foundation."

 Gharar (Uncertainty or Speculation) is Prohibited:

Another significant principle of Islamic finance is the prohibition of transactions involving gharar, or uncertainty. Under this prohibition any transaction entered into should be free from uncertainty and speculation. Contracting parties should have perfect knowledge of the counter values intended to be exchanged as a result of their transactions. Thus, options and futures are considered un-Islamic and so are forward foreign exchange transactions because rates are determined by interest differentials.

We have divulged largely on how risk is defined under conventional finance. Under that definition, gharar will have to be defined as something that exposes one of the parties to risk. The presence of gharar leads to risk. An insurance company, which insures a car, is taking on risk, because it does not know how much the individual who has insured his car will pay. Similarly, if someone sells a car without the buyer knowing about its weak engine the buyer is exposed to risk of loss. This is gharar at work.

 The unfair element of risk, which is attached with gharar, is the reason why it is disallowed. As we mentioned earlier that entrepreneurial activity has been encouraged in Islam and risk is an intrinsic component of business. However, Islam lays down principles of fair and transparent business. Contracts should be fair and transparent.

 Gharar extends to all forms of contract: employment, marriage, etc. A verse from the Qur'an, which propagates this principle of fair business, is:

"O believers! do not devour one another's property by unlawful ways; instead do business amongst you by mutual consent". (Chapter 4: Verse 29)

Some good examples of sale transaction which include gharar are :

• Selling goods that the seller is unable to deliver
• Selling known or unknown goods against an unknown price, such as selling the contents of a sealed box
• Selling goods without proper description, such as a shop owner selling clothes with unspecified sizes
• Selling goods without specifying the price, such as selling at the 'going price'
• Making a contract conditional on an unknown event that happens at an unspecified time
• Selling goods on the basis of false description
• Selling goods without allowing the buyer to properly examine the goods

In all these examples, we will notice two distinct patterns. There are instances of gharar where there is clear deception on the subject matter by one party and therefore obvious why it has been forbidden. The other are those that have excessive risk.

For instance, forward selling, or selling in advance something that we do not possess is said to have gharar and therefore would be invalid. This is because there might be things that neither of them knows but which are important in a valid sale.

Mutual consent and truthfulness of the parties to a contract is therefore a moral obligation and a basic requirement for a valid contract in Islam. The absence of gharar from transactions will allow both parties to better evaluate the contract and enable them to make better decisions about their participation.

 Investments Should only Support Halal Activities

The Shariah does not permit Muslims to invest in any business or activity that involves the production of items or pursuit of activities the shariah considers haram, or impermissible.

Scholars have devised a set of rules to govern such investments. Some of them are:

1) The main business of the company in which the investment is sought to be made is not in violation of 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, such as those manufacturing, selling or serving liquor, pork, haram meat, or involved in gambling, night club activities, pornography etc.

2) If the main business of the companies is halal, like automobiles, textiles, etc. but they deposit their surplus amounts in a 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 body meeting of the company.

3) If some income from interest-bearing accounts is included in the income of the company, the proportion of such income in the dividend paid to the share-holder 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.

 FUTURE OF ISLAMIC FINANCE

 Harvard has been aware of the promise of Islamic finance and investment for some time. In 1996, the Harvard University Center for Middle Eastern Studies (CMES), in cooperation with the Harvard Law School and Harvard Business School, and with the support of The National Commercial Bank, the Islamic Development Bank, Wellington Management and Goldman Sachs, completed the Harvard Islamic Investment Study.

In response to this need, Harvard CMES, with support from the Islamic Investment Company of the Gulf, Bahrain (IICG), a member of the Dar al-Maal al-Islaami Group, established the Harvard Islamic Finance Information Program (hereafter HIFIP) in December 1995.

Malcolm Burnett, President and CEO of HSBC Bank USA, had highlighted emerging trends and opportunities in the Islamic finance industry and the role HSBC is playing in the area. David Moran, President of Dow Jones Indexes, discussed the reasons for launching the new Dow Jones Islamic Index (DJII), marking the growing importance of Islamic finance in the Untied States and other western markets and reflective of the anticipated progress of the sector as a whole.

All investors seek to maximise the performance of their portfolios. However, in measuring the performance of an investment, one should consider two important criteria, the return one gets from the investment and the variability of the return. In Malaysia, return is often given prominence while very few investors consciously think of how his potential return can vary from the expected. In truth, both should be given equal consideration.

 It is widely accepted fact that an investment which has high but highly variable return is not a very good investment. The reason being that there is a big probability that in the event of an investor needing to sell the shares, its price may be at such a low level that he would incur a loss in doing so. Thus he cannot be certain of obtaining a good return from his share investment.

 This is probably another of the major differences between the Western and local markets. In the West, most people prefer an investment with a slow but steady increase in price. While locally, the preference seems to be for shares which are highly volatile such that there is a possibility that a big profit can be made. ¹⁰

 However, what is often forgotten is that there is an equally great possibility that the shares may go down in price. Our local investors ought to try to emulate the way of investment for a small “boom-and-bust” portfolio is hardly the best investment for a small investor.

Although shares may behave differently relative to the market, it has been discovered that they are fairly consistent in terms of their behaviour. Most shares consistently mirror, magnify or attenuate (reduce) the overall movements of the market.

Awareness of the importance of Islamic banking and finance, as part of a comprehensive approach to Islam, is palpably felt among many economic, financier and civil circles in Malaysia.

Studies delving on the merits of Islamic banking and finance generally converge in their emphasis on the religious and social dimensions of the system, its much needed contribution to the welfare of the masses and the fair and rational utilization of the nation's resources.

Given the entire scenario in Malaysia and taking into account the numerous spiritual and material benefits the Islamic financial system possesses, there is a great prospect that the authorities and the detractors would eventually yield to the pressure of civil society and allow more Islamic banks, based on the principles of Islam, besides the 2 Islamic banks that have been operated successfully in the country, Bank Islam and Bank Muamalat, to be established in the country

Despite the logistical difficulties and challenges, which might appear insurmountable in the eyes of some, once authorized, Islamic finance will entice the overwhelming majority of Malaysians and gradually replace the current system.