These days, banking is a highly influential and ubiquitous sector of modern society. It provides an opportunity to those households with surplus capital to select the best mix of investments in terms of return, tenors, and security along with the opportunities to do businesses and for the governments to finance their respective activities through obtaining surplus funds.
While banking has become essential to the function and development of our society, it comes with a set of issues as well. For example, a key function of conventional banks is to lend money and get it back with compounding interest. And, while the investor is assured of a predetermined rate of interest the methods for many would argue that the conventional banking model leaves a lot to be desired. The operating modes of conventional banking are based on “man-made” principles aimed at maximizing profit (generally without any restriction) and as such do not take into account ethics and morality which in turn creates real life problems for people indulging in conventional banking as their remains no control over the conventional banks as they indulge in legal yet unfair practices to make the borrowers pay more i.e., encouraging credit card holders to make minimum payments so that they could earn compounding interest which interest charges on interest. Following on from the “global financial crisis”, Islamic finance gained greater fraction in the Islamic and non-Islamic world. While its broader acceptance is a fairly recent phenomenon, the tenets underlying Islamic Banking & Finance are not new. Indeed, the practice dates back to the newly Islamic era that emerged some 1,400 years ago.
What is Islamic Finance
Islamic finance is governed by Shariah principles which are derived from the Quran, Hadiths and Sunnah (teachings of Prophet Muhammad PBUH).
Islamic finance refers to the methods for conducting business, banking, and finance transactions in accordance with Shariah principles. If banking or financial institutions are not governed by Shariah principles, they cannot be called Islamic banks and/or Islamic financial institutions. The Islamic way of banking differs from conventional banking on many fronts. It adheres to certain aspects of social, moral, and economic values that are engrained in Shariah principles and the religion itself. One key difference between conventional banking is that conventional banking does not involve itself in trade and business and the depositors get a fixed rate regardless of the bank’s profitability, thus, insulating them from the bank’s true performance. Whereas, Islamic banking actively participates in trade and production, in which, the profit is shared with the depositors and higher the profit earned by the bank, the higher the depositors’ income is set.
To that end, conventional banking prices money and is based on fixed return on both sides of the balance sheet, whereas, Islamic banking is based on profit & loss sharing on deposits side, on profit & loss sharing, or profit on assets side. The stated objective of Islamic banking/finance is to create real wealth in society, leading to a state of economic well-being through its goods and services.
Islamic Banking in Sultanate of Oman
Islamic banking in Oman is governed by the ”Islamic Banking Regulatory Framework” issued by the Central Bank of Oman in 2012. This framework provides the rules for regulating the operations of Islamic banks and Islamic windows operating in Oman. Islamic banking in Oman differs from other jurisdictions as it follows more stringent rules provided of Audit and Accounting Organization for Islamic Finance Institutions of Bahrain which take a conservative approach when dealing with Shariah rules. This is evident from the fact that Islamic Banking Regulatory Framework prohibits Tawaruk transactions in Oman, which are allowed in other jurisdictions such as in Malaysia and United Arab Emirates. Tawaruk or as commonly known as Commodity Murabaha is seen to have an element of Riba by some scholars and hence, has been deemed as Un-Islamic by Audit and Accounting Organization for Islamic Finance Institutions.
Key factors that distinguish Islamic Banking from Conventional Banking
Following are the key factors that distinguish Islamic banking and finance from its conventional counterpart:
– Riba- Interest/ Usury
– Gharar’- Uncertainty/ Deception
– Maisir’- Gambling/ Speculation
– Prohibited-Activities/ Commodities
The word “Riba” means excess, increase, or addition which when correctly interpreted according to Shariah terminology, implies that there is excess compensation without due consideration, such as:
– Rolling-over a term loan with an increase over and above the principle amount and thereby earning interest
– Periodic payment of increase, principle payment at maturity or rescheduling with new increase
– Allowing additional time against additional amount in deferred payment sale
Why is Riba considered “haram”? It can be explained by way of the following quotation. Referring to the practice of ‘Riba’ back in 2000 at the G8 Summit, the Nigerian President commented: “All that we had borrowed up to 1985 or 1986 was around $5 billion and we have paid about $16 billion yet we are still being told that we owe about $28 billion. That $28 billion came about because of the injustice in the foreign creditors› interest rates. If you ask me what the worst thing in the world is, I will say it is compound interest.”
“Gharar” means delusion, risk, or uncertainty – i.e., an ambiguous situation that has the potential to create a disagreement or dispute once the details/facts are known.
Examples that could be considered Gharar are: a sale of fish which are still in the sea, sale of unborn animals, or sale of birds in the air.
Maisir / Qimar (Gambling)
Gambling is strictly prohibited due to the inherent aspect of uncertainty and chance. Prize bonds and lotteries are modern day examples that fall under the category of Qimar.
Prohibited Activities / Commodities
Certain types of transactions are prohibited in Islamic Banking and Finance, including:
– Transactions where the parties involved are not competent to contract
– Sale of something non-existing or weak existence
– Sale of something which is not easily deliverable
– Sale of debt to someone other than the debtor
– Sale with Jahalah’ (subject matter or price or time is unknown)
– Sale with two different prices
– Contingent & future sales
– Sale before taking possession
– Sale with Haram’ money or consideration
– Hording (sale containing harm to the society)
– Sale of Haram’ or ‘Najis’ subject matter
– Sale of grabs to the producer of wine
– Sale with wrong condition
– Combining a sale with a loan
Kinds of Islamic Contracts
Essentially there are two kinds of Islamic Financial Contracts i.e. Commutative and Non-Commutative. Commutative (Uqood Muawadha): Contracts that include exchange of counter value by both the transacting parties, such as a contract of sale and Ijara and Non-Commutative are non-compensatory contracts where the donor, donates his property without consideration e.g. Qard-e-Hasan, Aariya, Hiba etc.
The Islamic Contract essentially has the following four (4) elements for it to be valid:
– Contract (Aqd – );
– Subject matter (Mabee’e – )
– Price (Thaman – )
– Possession (Qabdh – )
A contract is a combination of offer and acceptance in a manner that results in the desired consequence (transfer of ownership) in the subject matter. The following elements are required to form a valid contract under Sharia rules:
– Offer and Acceptance (Ijab-wa-Qabool) can be:
– Explicit (Oral or Written)
– Implied (Hukmi)
– Buyer and Seller (Muta’aquedan) must be:
– Sale Contract must be:
– Immediate (Exceptions)
The thing that is being sold and purchased by the parties under any Islamic contract is the “subject matter” of that contract. As relates to the subject matter in an Islamic contract, it must be:
– Existing (Exception of Salam & Istisna’)
– Valuable (in the eyes of Shariah)
– Specified and Quantified
Additionally, the seller must have title/ownership and possession. Further, delivery of the subject matter must be certain and non-contingent.
The price in any Islamic contract must be certain, quantified, specified and should be “valuable” in the eyes of Shariah.
Fundamental Contracts in Islamic Banking and Finance
Some of the major Islamic banking products that are offered to customers are:
– Mudaraba (direct equity participation)
– Musharaka (partnerships/joint ventures)
– Murabaha (cost plus profit mark-up)
– Ijarah (leasing)
– Sukuk (Islamic bonds)
– Istisna & Salam (long & short term project financing)
Mudaraba is an investment contract in which one party (Rabul-Mal) contributes capital while the other party (Mudarib), makes efforts to generate a profit from such contribution. In the banking context, it is a contract in which the capital is provided by the depositor/fund provider and the bank acts as the Mudarib with the profits of the Mudaraba then being shared in pre-agreed ratios. Losses (if any), unless caused by negligence or violation in terms of the contract by the Mudarib, are borne by the depositor. Mudaraba is predominantly used by Islamic banks as the vehicle for offering savings accounts to its customers / depositors.
Musharaka means two or more persons commingling either their money or work to earn a profit or appreciation in value and sharing the resulting profit and loss.
Generally, losses in the Musharaka are shared according to the partners’ proportionate share in the Musharaka; however, it is possible for the profit to be shared in any ratio between the parties, if the said persons are active/working partners in the Musharaka arrangement. In case one of the partner(s) is a “sleeping” partner, then the sleeping partner(s) cannot have a profit sharing ratio higher than the share they contributed.
The most common form of Musharaka used by financial institutions is “Diminishing Musharaka”, which is a form of a partnership in which, one of the partners promises to buy the equity share of the other partner in a Musharaka asset over time. Until the title to the Musharaka asset is completely transferred to the other partner, the partner using the asset pays the rent for use of the financial institution’s share in the Musharaka asset.
Murabaha is a sale contract in which a seller sells its goods/assets at cost inclusive of an agreed profit. The sale price may be paid on the spot or deferred to be paid in lump sum, or in installments. Normally in Murabaha, the goods/assets are purchased after a customer requests the bank to purchase the goods/assets in order to sell the same to the customer on Murabaha (cost plus profit) basis on deferred payment to the customer.
Ijarah is leasing of an asset under which a specified permissible benefit, in the form of a usufruct, is obtained for a specified period in return for a rental payment. Islamic Banks commonly use Ijarah Muntahiya Bit Tamleek (MBT), which is a lease that includes a promise from the lessor to transfer the asset to the lessee at the end of the lease term by way of a gift or sale for an agreed price.
Sukuk is an Islamic investment instrument that is asset-backed, structured in accordance with Shariah, and is registered in the name of the holders (Sukuk holders). Accordingly, a Sukuk certificate is a proof of partial ownership or beneficial interest in an asset or enterprise (it is always linked with an underlying asset (tangible or intangible). Sukuk can be either bought from the issuer (primary market) or from its holders (secondary market) either directly, or via intermediaries (brokers).
Invariably, Sukuk funds are raised based on the value of the underlying asset. Any increase or decrease in the value of the underlying asset would be reflected in the value of the Sukuk. Additionally, the return on Sukuk is directly proportionate to the performance of the underlying asset/project.
Istisna is an advance sale of a specific commodity not yet manufactured or constructed/processed. Although the buyer may make progress payments, no advance payment is required. An Istisna is only valid if (1) the price is fixed with the consent of both parties, and (2) the to-be-manufactured commodity’s specifications are fully agreed upon by both buyer and seller/manufacturer.
Salam is an advance sale of specific goods which are to be supplied at a later date and for which advanced payment is required. In contrast to a Murabaha sale where goods are delivered and payment is deferred at a price higher than the spot price, in a Salam transaction, the agreed-upon price is paid in full in advance and the delivery of the goods is deferred.
Wakalah is a contract, whereby the principal appoints the agent to substitute him or perform on behalf of the principal. The principal is called “Aseel / Muwakkil” and the agent is called “Wakeel. The profit/loss earned/sustained is solely of the principal and the agent may take a fixed remuneration against its services. Wakala is commonly used by Islamic Banks for inter-bank lending. اÔ
By: Arsalan T. Buriro
AL ALAWI & CO., ADVOCATES
& LEGAL CONSULTANTS BANKING & FINANCE GROUP