Definition of Islamic Banking

Prof. Javed Anwar

 Conventional Bankers and Islamic
Banking
• The central principle of Islamic banking, the prohibition
of interest (riba), stems from the following Qur’anic
quotation:
S. 275. Those who eat riba will not stand (on the Day of
Resurrection) except like the standing of a person beaten by
Shaitˆan (Satan) leading him to insanity. That is because they
say: ‘Trading is only like riba’, whereas Allah has permitted
trading and forbidden riba. So whosoever receives an
admonition from his Lord and stops eating riba shall not be
punished for the past; his case is for Allah (to judge); but
whoever returns [to riba], such are the dwellers of the Fire –
they will abide therein.
The Qur’an – Al-Baqarah S. 275–281
 Conventional Bankers and Islamic
Banking
• Technically, riba refers to the addition in the
amount of the principal of a loan according to
the time for which it is loaned and the amount
of the loan.
• The term riba, in Islamic law (the Sharia’a),
means an addition, however slight, over and
above the principal.
 Conventional Bankers and Islamic
Banking
• According to the Federal Sharia’a Court of
Pakistan, this means that the concept
– covers both usury and interest;
– is not restricted to doubled and redoubled interest;
– applies to all forms of interest, whether large or
small, simple or compound, doubled or redoubled.
• Therefore, the Islamic injunction is not only
against exorbitant or excessive interest, but
also against a minimal rate of interest.
SIX KEY ISLAMIC BANKING PRINCIPLES
• predetermined loan repayments as interest (riba)
is prohibited;
• profit and loss sharing is at the heart of the
Islamic system;
• making money out of money is unacceptable: all
financial transactions must be asset-backed;
• speculative behaviour is prohibited;
• only Sharia’a-approved contracts are acceptable;
• contracts are sacred.
SIX KEY ISLAMIC BANKING PRINCIPLES
• Predetermined Payments are Prohibited
• Any predetermined payment over and above
the actual amount of principal is prohibited.
• Islam allows only one kind of loan and that is
qard al hassan (literally meaning good loan),
whereby the lender does not charge any
interest or additional amount over the money
lent.
SIX KEY ISLAMIC BANKING PRINCIPLES
• Predetermined Payments are Prohibited
• Traditional Muslim Jurists have construed this
principle so strictly that, according to one
Islamic scholar:
– the prohibition applies to any advantage or benefits
that the lender might secure out of the qard (loan)
such as riding the borrower’s mule, eating at his
table or even taking advantage of the shade of his
wall.
SIX KEY ISLAMIC BANKING PRINCIPLES
• Profit and Loss Sharing
– The principle here is that the lender must share in
the profits or losses arising out of the enterprise for
which the money was lent.
– Islamic finance is based on the belief that the
provider of capital and the user of capital should
equally share the risk of business ventures,
whether those are industries, service companies or
simple trade deals.
SIX KEY ISLAMIC BANKING PRINCIPLES
• Profit and Loss Sharing
– Translated into banking terms, the depositor, the
bank and the borrower should all share the risks
and the rewards of financing business ventures.
– This is unlike the interest-based commercial
banking system, where all the pressure is on the
borrower who must pay back the loan, with the
agreed interest, regardless of the success or failure
of his venture.
SIX KEY ISLAMIC BANKING PRINCIPLES
• Profit and Loss Sharing
– The central principle is that under any Islamic
financing arrangement the financier is only entitled
to returns if risk is involved. If a return is expected
there must be risk. If there is no relationship
between risk and return, then this financial
arrangement is not permitted Islamically.
SIX KEY ISLAMIC BANKING PRINCIPLES
• Profit and Loss Sharing
– The central principle is that under any Islamic
financing arrangement the financier is only entitled
to returns if risk is involved. If a return is expected
there must be risk. If there is no relationship
between risk and return, then this financial
arrangement is not permitted Islamically.
– Risk Sharing
– Emphasis on Productivity as Compared to Credit-
worthiness.
SIX KEY ISLAMIC BANKING PRINCIPLES
• Making Money Out of Money is Not
Acceptable
– Making money from money is not Islamically
acceptable. Money, in Islam, is only a medium of
exchange, a way of defining the value of a thing. It
has no value in itself, and therefore should not be
allowed to generate more money, via fixed interest
payments, simply by being deposited in a bank or
lent to someone else.
SIX KEY ISLAMIC BANKING PRINCIPLES
• Making Money Out of Money is Not Acceptable
– The human effort – that is, the initiative – and risk
involved in a productive venture become more
important than the money used to finance it. Muslim
Jurists consider money as potential capital rather than
capital, meaning that money becomes capital only
when it is invested in business. Accordingly, money
advanced to a business as a loan is regarded as a debt
of the business and not capital. As such, it is not
entitled to any return (such as interest).
SIX KEY ISLAMIC BANKING PRINCIPLES
• Uncertainty is Prohibited
– Gharar (uncertainty, risk or speculation) is also
prohibited, and so any transaction entered into
should be free from these elements. Contracting
parties should have perfect knowledge of the
counter-values intended to be exchanged as a result
of their transactions.
– In this context the term counter-values is used in
the sense of something being deferred, either the
price paid or the commodity delivered.
SIX KEY ISLAMIC BANKING PRINCIPLES
• Uncertainty is Prohibited
– Deferral of payment is an acceptable form of debt
under Islam, in contrast to predetermined debt in
conventional finance. Also, parties cannot
predetermine a guaranteed profit.
– The rationale behind the prohibition of gharar is the
wish to protect the weak from exploitation.
– Therefore, options and futures, considered to be very
risky, are deemed to be forbidden as are forward
foreign exchange transactions, given that forward
exchange rates are determined by interest rate
differentials.
SIX KEY ISLAMIC BANKING PRINCIPLES
• Only Sharia’a-Approved Contracts are
Acceptable
– Conventional banking is secular in its orientation. In
contrast, in the Islamic system, all economic agents
have to work within the ethical system of Islam.
Islamic banks are no exception. As such, they cannot
finance any project that conflicts with the Islamic
moral value system. For example Islamic banks are not
allowed to finance a wine factory, a casino, a night
club or any other activity prohibited by Islam or known
to be harmful to society.
SIX KEY ISLAMIC BANKING PRINCIPLES
• Sanctity of Contract
– Many verses in the Holy Qur’an encourage trade
and commerce, and the attitude of Islam is that
there should be no impediment to honest and
legitimate trade and business. It is a duty for
Muslims to earn a living, support their families and
give charity to those less fortunate.
SIX KEY ISLAMIC BANKING PRINCIPLES
• Sanctity of Contract
– The basic principles of the law are laid down in the
four root transactions of
• sales (bay): transfer of the ownership or corpus of
property for a consideration;
• hire (Ijara): transfer of the usufruct (right to use) of
property for a consideration;
• gift (hiba): gratuitous transfer of the corpus of property;
• loan (ariyah): gratuitous transfer of the usufruct of
property.
SIX KEY ISLAMIC BANKING PRINCIPLES
• Sanctity of Contract
– These basic principles are then applied to the
various specific transactions of, for example,
pledge, deposit, guarantee, agency, assignment,
land tenancy, waqf foundations (religious or
charitable bodies) and partnerships.
 DEFINITION OF ASYMMETRIC
INFORMATION
• Asymmetric information can be defined as information
that is known to one party in a transaction but not to the
other. The classical argument is that some sellers with
inside information about the quality of an asset will be
unwilling to accept the terms offered by a less informed
buyer. This may cause the market to break down, or at
least force the sale of an asset at a price lower than it
would command if all buyers and sellers had full
information.
• This is known as the lemon market problem in
valuation, with the term lemon referring to a poor
quality item, company or borrower.
 DEFINITION OF ASYMMETRIC
INFORMATION
This concept has been applied to both equity and
debt finance as follows:
• For equity finance, shareholders demand a
premium to purchase shares of relatively good
firms to offset the losses arising from funding
lemons. This premium raises the cost of new
equity finance faced by managers of relatively
high-quality firms above the opportunity cost of
internal finance faced by existing shareholders.
 DEFINITION OF ASYMMETRIC
INFORMATION
This concept has been applied to both equity and
debt finance as follows:
• In debt markets, a borrower who takes out a
loan usually has better information about the
potential returns and risk associated with the
investment projects for which the funds are
earmarked. The lender on the other side does
not have sufficient information concerning the
borrower.
 DEFINITION OF ASYMMETRIC
INFORMATION
Lack of sufficient information creates problems
before and after the transaction is entered into,
which is potentially a major problem with
Islamic profit-sharing financial contracts.

The presence of asymmetric information

normally leads to adverse selection and moral
hazard problems.
 DEFINITION OF ASYMMETRIC
INFORMATION
• Adverse Selection
• Adverse selection refers to a situation in which sellers
have relevant information that buyers lack (or vice
versa) about some aspect of product quality.
• The term refers to the problem created by asymmetric
information before the transaction occurs. It occurs
when the potential borrowers are the ones most likely
to produce an undesirable (adverse) outcome.
• Bad credit risks are the ones who most actively seek out
a loan and are thus most likely to be selected. This is
potentially problematic with Islamic profit-sharing
financial contracts.
 DEFINITION OF ASYMMETRIC
INFORMATION
• Moral Hazard
– Moral hazard is the consequence of asymmetric
information after the transaction occurs. The
lender runs the risk that the borrower will engage
in activities that are undesirable from the lender’s
point of view because they make it less likely that
the borrower will repay the loan.
 DEFINITION OF ASYMMETRIC
INFORMATION
• Moral Hazard
• The conventional debt contract is a contractual
agreement by the borrower to pay the lender a
fixed amount of money at periodic intervals.
• But if debt interest payments are not being
made, as under Islamic financing principles,
the moral hazard problem is embedded within
the system.
 RIBA IN THE QUR’AN AND SUNNAH
OR HADITH
There are two major kinds of riba:
• Riba Al-Nasiah:
– Interest on borrowed money.
• Riba Al-Fadl:
– Taking a superior thing of the same kind of goods
by giving more of the same kind of goods of
inferior quality, for example dates of superior
quality for dates of inferior quality.
 RIBA IN THE QUR’AN AND SUNNAH
OR HADITH
• The literal meaning of interest or riba, as it is
used in Arabic, means an excess or increase.
• In the Islamic terminology interest means
effortless profit.
FIVE REASONS FOR THE PROHIBITION
OF RIBA
• Islamic scholars have put forward five reasons
for the prohibition of riba:
– it is unjust;
– it corrupts society;
– it implies improper appropriation of other people’s
property;
– it results in negative economic growth;
– it demeans and diminishes human personality.
FIVE REASONS FOR THE PROHIBITION
OF RIBA
 RIBA is unjust;
• Among the most important reasons that have
been emphasized by most Islamic scholars is
that interest is prohibited because it is unjust
(zulm).
• A contract based on interest involves injustice
to one of the parties, sometimes to the lender
and sometimes to the borrower.
FIVE REASONS FOR THE PROHIBITION
OF RIBA
 Interest Implies Unlawful Appropriation of Other
People’s Property
• The reasoning here is indicated in the Qur’an,
Chapter Four, Surah al-Nisa’, where the Jews are
admonished for ‘taking usury when they were
forbidden it, and of their devouring people’s
wealth by false pretences' (S4: 161).
• Significantly, the Qur’an relates the tendency to
appropriate other people’s wealth without any
justification, to some more serious crimes. In (S9:
34) riba is associated with hoarding and (S4: 29)
seems to put it at par with murder.
FIVE REASONS FOR THE PROHIBITION
OF RIBA
 Interest-Based Systems Result in Negative
Growth
– The fourth reason is implied in the Qur’an’s
declaration that riba is subject to destruction (S2:
276), which means decrease after decrease, a
continuous process of diminishing. That sounds a
little odd as it runs counter to the commonly
observed fact of people growing rich by applying
the power of compound interest.
FIVE REASONS FOR THE PROHIBITION
OF RIBA
 Interest Demeans and Diminishes Human
Personality
– The fifth reason behind the prohibition of riba is
inferred from S2: 275.
– This verse draws a picture of ‘those who devour
usury’ as well as stating the reason why they got
into that pitiable moulded. That reason is their
being trapped into the false economics that equate
trade – the act of selling and buying – with the
practice of charging interest.