16 Feb 2017

Foundations of Islamic Finance

Authored by: James Farn and Kerie Receveur

Foundations of Islamic Finance

The 1960s was a decade of great cultural change in many areas, but perhaps what is less appreciated is it was also the time that ‘Islamic Finance’ began to be considered as being a separate branch of financial activity.

Background

Egypt can perhaps be credited with taking the initial steps in this area of law and business practice, as that it was here in the 1960s, on a very small scale, that the reintroduction of Islamic modes of financing began.

It can be seen as a reintroduction, rather than as a completely new concept, as the role of Islamic law in financial and business matters was far more obvious, and widely accepted in the Middle Ages. The prohibition on lending money at interest (the concept known as ‘usury’ in the West) is found in both the Quran and the Bible, and was widely accepted in Christian society during the period up to the Renaissance. In fact at this point a perceived gulf between the Islamic and non-Islamic systems had not yet developed. Certain types of Islamic financial documents can also be seen to have been regularly used in the Mediterranean and Asia up to the 18th century, including types of agreement such as the Mudarabah, which was a common way to finance the expeditions in and around the Indian Ocean in that period.

Twentieth Century

Despite the developments in Egypt in the 1960s, between 1960 and 1980 there was considerable opposition to the concept of Islamic finance, although there were some landmark developments in those years. One of these was the establishment of the Islamic Development Bank in 1975, which together with the creation of the Dar al-Maal al-Islami and the Al Baraka Groups in the early 1980s, helped demonstrate there was a certain level of support (both in financial and political terms) for bringing Islamic finance to the fore.

Current Position

Today, there are more than 250 Islamic financial institutions which manage over USD200 bn. These institutions are increasingly sophisticated and innovative, and there is much interest in offering Islamic finance instruments comparable to those offered by the conventional banking establishment.

Islamic Legal Principles Relevant to Finance

In a very simplified form, the sources of Islamic law which govern financial activity are the same as those for all other aspects of the life of a Muslim, namely the Quran, the Sunnah and Ijtihad, which together form the Sharia, which is the Islamic law. The Quran is the core of Islamic law and is considered to be the word of God as revealed to Prophet Muhammad (PBUH) over a 23-year period. All other sources of Islamic law derive from it. The Quran was created over 1,400 years ago, and as a result the legal elements contained in it are very detailed on certain aspects such as the laws of inheritance, but only set down principles in outline terms for other concepts such as governance. The literal meaning of the Sunnah, is ‘a path’ and it is the recorded practice of the Prophet, and acts as a guide to ideal practice in the lives of Muslims. It helps to elaborate on the principles which are set out in the Quranic text, and gives guidance on applying them to everyday life. The third key source is Ijtihad. This is an amalgamation of numerous secondary sources and tools. The thread that binds all of these together is that the concerted effort of qualified Muslim jurists or Ijtihad is required in order to interpret the Quran and the Sunnah to situations which are not expressly dealt with in either text.

Secondary Tools

There are a number of secondary tools and sources including:

  • Qiyas which are the application by analogy of the rule for a given situation which is similar to situation not dealt with in the original sources;
  • Ijma which is the scholars’ consensus on a particular issue which helps achieve binding status in the wider Muslim world;
  • Maslaha mursala and istihan which is the seeking of the common good or benefit, in line with Sharia principles;
  • Urf or adah which is custom or habitual practice, i.e. the usual way things are done without breaking any laws.

Fiqh

An another important areas is that of Fiqh, which literally translates as the understanding reached by the scholars. It is important to note that no single scholarly opinion is binding in and of itself, but in the general nature of things, certain scholars will be seen as having more weight when dealing with certain issues, and their opinions are consequently given more credence. There are two concepts that fall under Fiqh and figure prominently in the discussion of the part Sharia boards play in Islamic financial practice. A fatwa is not binding, as it is the opinion of a scholar on a matter of Islamic law. On the other hand, a qada is a judgement issued by an Islamic scholar who is sitting as a judge in a dispute governed by Islamic law, and this will be binding on the participants. Sharia boards give fatwas not qadas. Islamic finance falls under a particular part of Fiqh, called Fiqh al-mu’amalat (which translates as the Fiqh of commercial transactions). Given the fundamental centrality of commerce to early Islamic communities, it is not surprising that a significant proportion of the texts making up the classical compendium on legal rulings in the Islamic sphere are devoted to commercial transactions. As a result there is a great deal of information available to researchers into the origins of Islamic finance. Within Fiqh al-mu’amalat the famous Islamic principle that ‘whatever is not forbidden is permissible’ is used. As commercial practice differs across territories and the generations, it seems only sensible that the scholars’ role is to apply the very general principles set out in the Quran and the Sunnah to the vastly more complex and constantly changing world of modern commercial transactions.

Main Principles Governing Islamic Finance

The prohibition against riba is perhaps the most widely-known of the governing principles which are applicable to Islamic finance. This concept is often translated as ‘usury’ or ‘interest’, but in fact the definition goes much wider and also involves any unjust enrichment on money over time without risk. The wording in the Quran on this particular issue is actually so forceful that it leaves no doubt about the strength of feeling against such practices. Placed against this is the express encouragement of trade which is contained in the Quran, and on which the modern structure of Islamic finance is built. This is an interesting dichotomy. Another key concept which is found at the core of Islamic finance is the pressing need to achieve justice with the aim of avoiding injustice to any party in a transaction. From this key principle, the prohibition of ignorance (or jahala) and the prohibition of speculation and uncertainty (or gharar), also stem. Obviously, it is not possible to remove all uncertainty from commerce and trade, but with Islamic finance it is necessary that any avoidable elements of uncertainty are removed, and the parties involved agree to do business on clearly understood terms. One example of this in practice is that it should be possible to easily know the price of the goods in question. One of the more interesting effects of this is that there is a practice within Islamic finance of setting out the discrete elements of a contract in separate documents. This comes from a hadith which states ‘there should not be two contracts in one’. A party’s obligation in a contract also needs to be easy to understand and to stand on its own, independently, in order to avoid the possibility of jahala. Other prohibitions include those against:

  • Unfair advantage;
  • Deriving income from objects which are forbidden to Muslims (e.g. pork and alcohol).

Islamic finance may appear to be the product of the modern, technological era, but, its underlying principles and background actually go back to the times of the earliest Muslim communities.

(Originally published in the January edition of Emirates Law Business & Practice)

 
 

This article, including any advice, commentary or recommendation herein, is provided on a complimentary basis without consideration of any specific objectives, circumstances or facts. It reflects the views of the writer which may, in some cases, differ from those of the firm, especially in the developing jurisdiction of the UAE.