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Foundation of Islamic Finance ISF 1101
TOPIC 2.BASIC PROHIBITIONS AND
BUSINESS ETHICS IN
ECONOMICS AND FINANCE
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TOPIC CONTENT
1.The Basic Prohibitions
2.Islamic Business Ethics andNorms
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1.
The Basic Prohibitions
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Three Basic Prohibitions
Islam does not recognize transactions that have provenillegitimate factors
Three factors/elements identified
interest - riba
excessive ambiguity - Gharar
gambling - Maysir
Lead to contracts to be void/invalid/nullified
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1. Prohibition ofRiba
Literal definition
- excess, increase, expansion, growth
Technical definition
every excess in return of which no reward or equivalent counter-
value is paid
a predetermined excess or surplus over and above the loan received
by creditor conditionally in relation to a specified time period
A forced increase in value in amount being loaned out
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Evidence for Prohibition ofRiba
All jurists agree that riba is prohibited (haram) due to clear prohibitions
Various verses in Quran prohibit riba: al-Rum verse 39, al-Nisa: 161, al-
Imran: 130, al-Baqarah: 275-281. For example:
(2:275) they say, trade is like riba, but Allah has permitted trade
and prohibited riba beware of the war on the part of Allah and HisApostle
Various sunnah on prohibition ofriba, severity of its sin and its form. An
example:
- The Prophet of Allah s.a.w. cursed the receiver and the payer of
riba, the one who records it and the two witnesses to the transaction
and said: they are alike (in guilt)
But, differences on meaning/what constitute riba
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Rationale for Prohibition ofRiba (1)
Rationale/reasons for prohibition ofriba so as to better appreciate wisdom behind
injunction:
1. Element of injustice in financing productive activities
Contract with unequal countervalues
Injustice to debtor obligated to pay interest even if business ventureresults in no profit or loss; certainty of interest obligation vs. uncertainty
of business outcome
Injustice to creditor in event of substantial profits, creditor receives a
return disproportionate to amount of generated profits
2. Element of exploitation in financing consumption The rich is able to generate more wealth without exerting much effort or
contributing to productive activity
Riba assumes money as a commodity, one which the rich has in abundance
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Rationale for Prohibition ofRiba (2)
3. Inconsistent with Islams perspective on debt
Incurring debt is discouraged
Prophet s.a.w. refused to offer salat-ul janazah of a person who died
indebted
Borrowing money should be limited to cases of dire needs To practice moderation in consumption
However, permitting riba enables lending to become a viable
business
Banks motivated to lend as much as possible
Banks exploit mans inherent greed to spend beyond their means
Result in negative repercussions
The outcome is the proliferation of a credit society
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Rationale for Prohibition ofRiba (3)
4. Negative effects of a credit society Easy availability of credit cultivates a materialistic society
-People work harder to repay bank debt
-Banks exercise control over people: become enslaved to banks
Quest for economic development clouds good moral judgment and Islamic
value system
-Greed leads to unethical business practices: degradation of natural
environment (to reduce cost)
-Less emphasis on institution of family leads to social ills
Essentially, Muslims forget their roles as abdand khilafah
Social relations amongst people negatively affected
-Members of society should help each other in times of need
-Riba entails taking advantage of another people
-Breeds hatred, jealousy, ill-will towards the rich
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Rationale for Prohibition ofRiba (4)
5. Negative effects on production
Impediment to healthy economic growth
-Riba-based lending is security-oriented rather than growth oriented
-Lending directed to established businesses
=Creditworthiness and adequate security (collateral)=Potential entrepreneurs without security to pledge are denied credit
Inefficient allocation of resources
-Bank interest return does not vary with actual profits, no incentive to give priority
to ventures with highest profit potential
-Lending based on creditworthiness, not profitability
Discourages innovation
-Interest obligations act as disincentive for experimenting with new, unproven
methods of production, especially for small-scale enterprises and agriculture
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Rationale for Prohibition ofRiba (5)
5. Negative effects on production (continued) Leveraged financing favors large-scale businesses
-Domination of big businesses over smaller entrepreneurs will curtail
competition and in turn will affect product variety and innovation
Anti-productive-Inflexibility: in a loss situation leads to bankruptcies loss of productive
potential and unemployment
Funding not channeled to deserving economic agents
-Utility of certain projects is with reference to criteria other than profitability-E.g. projects that benefit the public, poverty alleviation
Financing of luxurious or wasteful consumption and/or production
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Rationale for Prohibition ofRiba (6)
6. Negative effects on distribution
Disproportionate supply of credit to the already affluent segments of
population since lending is based on creditworthiness
Wealth inequality (in terms of purchasing power) is widened
Rich become richer and poor become poorer
Domination of large enterprises leads to demise of smaller economic units
Lacking collateral and established economic standing, poorer segments of
economy at disadvantage when competing for credit to finance economic
activities
Wealth and income disparities worsen
Transfer of real assets to the lenders
Debt-financing requires collateral in the form of real assets
In event of default, there will be transfer of real assets from borrower to lender
Long run, wealth inequality (in real terms) becomes prevalent
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Types ofRiba
1. Riba al-Qard (Riba al-Dayn- debt)
As being highlighted in Quran, thus also known as riba al-
Quran
Any amount over & above principle on loan or any debt
regardless of cause of debt (debt resulting from loan
contract or from a deferred payment sale)
Common in conventional banking products
1. Loan with interest or other benefits: when there is a predetermined
excess/surplus over the loan received by creditor conditionally in relation to a specifiedtime period
2. Penalty imposed on delinquent debt repayment or default: Jahilliansdoubled the amount of debt outstanding if payment is overdue = riba al-jahiliyyiah
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Types ofRiba
2. Riba al-Bay (sale) Also known as riba al-Sunnah
The Arabs used certain commodities like wheat, barley, dates and salt
(termed as ribawiitems) as medium of exchange to purchase other things,
and as such they were like money
Applies to sale transactions in commodities
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Riba al bay (sale)(1)
Basis for prohibition ofriba in exchange of commodities is based on
hadith of the Prophet on six commodities:
Gold for gold, silver for silver, wheat for wheat, barley for barley, dates for
dates, salt for saltlike for like, equal for equal, and hand-to-hand (spot); if thecommodities differ, then you may sell as you wish, provided that the exchange
is hand-to-hand or a spot transaction.[Muslim]
2 types:
Riba an-nasiah- delay in paying or delivery of one or two sold items
Riba al-fadl- exchanging one ribawi commodity for same commodity but
unequal in amount
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Riba al bay(2)
Summary of rules
Exchange Condition(Amount & Time)
Money1 + Money1 Equality
Hand-to-hand (spot)
Food1 + Food1 Equality
Hand-to-hand (spot)
Money1 + Money2 Hand-to-hand
Food1 + Food2 Hand-to-hand
Money + Food
No conditions
free tradingMoney + Others No conditions free trading
Food + Others No conditions free trading
Others + Others No conditions free trading
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Riba al bay(3)
Interpretation In trading commodities of same group and same kind (gold for
gold), both commodities must be exactly equivalent and prompt in
delivery
In trading commodities of same group but different kind (gold forsilver), promptness of delivery a condition
In trading commodities of diff groups and kind (gold for wheat), no
condition imposed, free trading can exist.
Islam encourages earning of profits from trade but forbids charging of
interest
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Misconceptions about Riba
Several misconceptions about riba and its prohibition,resulting in confusion in its applications
1. Interest-based commercial transactions were invented by modern
day business, thus not covered by riba referred to in the Quran
2. Bank interest is not riba because it is not excessive (usurious)3. Riba should be allowed under dharurah
4. Riba is only relevant to consumption loans, not commercial loans
5. Interest should be allowed because of inflation
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M1a: Modern day interest is not riba
Misconception
Prohibition ofriba was revealed in the last daysof Prophets life
Did notelaborate on interpretation and definition ofriba
Ambiguity in meaning ofriba (area ofmutashabihaat): its prohibition
cannot be extended to modern day banking
Addressing Misconception
Including prohibition ofriba in his last sermon does not mean that prohibition
was only introduced at that time
Emphasizing importance, last sermon was attended by most of his
followers, reiterate prohibition ofriba Prohibition ofriba comes in 5 stages
Other prohibitions were also not given elaborate definitions
E.g. prohibition of pork, liquor, gambling, adultery, etc.
Impacts well known to its immediate audience
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M1b: Modern day interest is not riba
Addressing this Misconception
Mutashabihaat: verses ofQuran which correct meaning is not known clearly to
anybody/ambiguous
E.g. Alif Lam Mim; hand of Allah (3:73)
For these examples, ignorance of correct meaning does not affect the lives of
Muslims because no precept ofShariah is revealed through them
However, riba has substantial affects on well-being - relates to prevalent
economic and social practice
It is not imaginable that Allah would wage war against a practice where thecorrect nature is not known to anybody
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M2: If it is not excessive, it is not riba
Misconception Al-Imran (3:130) - O those who believe, do not eat up ribadoubled and
redoubled
If rate of interest is not excessive (e.g. doubled), then it does not constitute riba,
therefore not prohibited
Addressing this Misconception
Other verses on same subject matter must be studied in relation to each other
Al-Baqarah (2:278)O those who believe fear Allah and give up whatever remains of
riba, if you are believers
Every amount, regardless of magnitude, over and above principal is riba
Quran is a book of guidance, not a book of statutes and legal text Embodies many expressions having persuasive value
Al-Baqarah (2:41)Do not sell My verses for a little price does not imply that one
can sell the verses for a high price
Expression doubled meant to emphasize added severity
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M3: Riba allowed under dharurah
Misconception Doctrine of Necessity under dharurah circumstances, haram is permissible
E.g. It is permissible to consume pork to save ones life from dying of hunger
Addressing this Misconception
Is the necessity real or exaggerated?
Can the necessity be met with by any other permissible means?
At the individual (debtor) level
Is purpose ofriba-based loan to protect an absolute necessity? Have all other permissible
alternatives been exhausted?
At the institutional (creditor) level
Removal ofriba from economy does not imply that financial institutions will have togive charitable (interest-free) loans
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M4a: Ribaallowed for commercial loans
Misconception1. Common practice of riba during time of its prohibition was charging of interest on
consumption loans taken by poor people to finance their basic needs
2. This form of exploitation is not present in production loans whereby in many cases,
debtor is economically well-off
Loans taken by rich businessmen are used to generate profit
3. Basic cause of prohibition ofriba, zulm (injustice), is absent
Addressing this Misconception
1. To say that commercial or productive loans were not in existence then is not accurate
There are evidences to substantiate that practice of interest-based production loans
dated back to much earlier times
A number of al-hadith reporting on the practice ofriba-based commercial loans As early as 2000 B.C. in Babylon, 500 B.C. in Greece, in time of Byzantine emperor Justinian
(527-565 A.D.)
Nature ofQuranic prohibition - includes all forms ofriba regardless of whether or
not prevalent at time of its revelation
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M4b: Ribaallowed for commercial loans
Addressing this Misconception (Continued)
2. Validity of a transaction is not based on financial status of a party
Intrinsic nature of transaction itself should determine its validity
Selling to the poor does not make the profit haram
Similarly for prohibited transactions are haram for both the rich and poor
regardless of their financial status Subjectivity and relativity of financial status
Who will have the authority to determine exact degree of poverty required for exempting
of interest charges?
Consumption loans taken by the poor, Production loans taken by the rich an
erroneous presumption
Consumption of luxurious objects Financing of business by poor entrepreneur
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M4c: Ribaallowed for commercial loans
Addressing this Misconception (Continued)
3. Need to differentiate/understand illatand hikmat Illat Basic feature of the transaction vs Hikmat Wisdom or rationale
behind the prohibition
Application of law depends on illatand not hikmat
Illatof a law is always determinable by hard and fast definition that leaveslittle room for dispute
Zulm (injustice) is relative, ambiguous and subject to manipulation
Rationale for making application of law based on illatand not hikmat
Human reason, despite its wide capabilities, cannot claim to have
unlimited power to reach absolute truth Reason often confused with desires, leading to disguised justice
Thus humans need guidance of divine revelations
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M5: Inflation justifies interest
Misconception Interest represents compensation for erosion ofvalue of money (due to
inflation) during period of borrowing
Loans should be indexed so that there is no injustice to creditor
Addressing this Misconception Rates of interest are not based on rates of inflation, although there may be
correlations
Indexation of loans is problematic due to lack of precise measures of inflation
If surplus on loan amount is only attributable to actual value loss due to
inflation, there will be no commercial incentives to banks Interest is one of causes of inflation
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2. PROHIBITION OF GHARAR
Literally: Deceit, fraud, uncertainty, danger, peril, or hazard that mightlead to destruction or loss
Technically: uncertainty caused by lack of clarity regarding subject
matter or price in a contract of exchange
A sale of a thing which is not present at hand or whose consequences is
not known
Classic examples ofghararsale
Sale of fish still in the sea
Sale of birds in the air
Sale of unborn animals
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Prohibition ofgharar
All jurists agree that ghararshould be avoided in commercial
exchange contracts
Contemporary scholars differentiate between minor and
major gharar
Types ofgharar
1. Gharar yasir (minor or slight)
Can be tolerated and will not invalidate a contract
If exist, contract still valid
2. Gharar fahish (major or excessive)
Not tolerated and may result in contract voidability
If exist, contract is nullify
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Prohibition ofgharar(2)
Rationale for prohibition ofgharar
To ensure full consent and satisfaction of all parties in
a contract
Without full consent, a contract may not be valid
Can only be achieved through certainty, full knowledge, full
disclosure and transparency
Ghararin commercial contracts may lead to injustice,
exploitation and/or enmity among contracting parties
ff k ( h ) d h
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Differences: Risk (Ghurm) and Gharar
Ghurm
(Risk)
Gharar
(Uncertainty)
Permissibilityin Islam
Allowed in Islam, as per Islamiclegal maxim Al ghurmu bilghunmi(no risk no gain)
Prohibited (e.g. selling fish inthe sea, birds in the sky)
Characteristic Inherent in productive economicactivities
Unnecessary, avoidable,intentionally created
Common day
example
Risks of trading, doing business,
making investments
Not stipulating price or product
specification in a sales contract
Effects Encourage entrepreneurial spiritand productivity
Exploitation for self interest,can lead to harm and injustice
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3. Prohibition ofmaysir/qimar
Definition: easily obtaining something without effort;
acquisition of wealth by chance
Applies to all activities where a person wins or losses by
mere chance; a form of gambling
Many direct references in Quran prohibiting gambling, e. g.:
Satan intends to excite enmity and hatred among you with intoxicants and
gambling, and hinder you from remembrance of Allah, and from prayer
(5:90) They ask thee concerning wine and gambling. Say: In them is great sin and
some benefits for people; but the sin is greater than the benefits (4:219)
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Prohibition ofmaysir/qimar
Injustice elements in gambling:
Winner:
-Does not lawfully earn what he has won
-Consume/enjoy others property unlawfully/unjustly
Looser losses his money without a fair compensation
Result in hostility, hatred, enmity
In Islam, contracts involve elements of chance (maysir) are prohibited
Islam encourages one to earn living through honest effort andprohibit injustices
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Concept ofiwad
Definition: equal counter-value
promotes a sense of equity and justice in economic transaction, differentiating
it from riba
Islam permits sale (bay) but prohibits riba
Shariah requires all legitimate exchange to contain iwad Every increase, which is without iwad or equal countervalue, is riba
[ Ibn al-Arabi ]
Components of iwad
1. Risk (ghurm): Market risk - price risk, holding costs, obsolescence2. Work and effort (ikhtiyar): Services or activities that value-add
3. Liability (daman): Product liability borne by seller, in event of defects
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Examples of valid counter-value (iwad)
1. Risk (ghurm) of trade or ownership (daman milkiyyah) TV manufacturer undertakes risk that he might produce TVs that customers do not
like and do not end up buying
TV retailer faces risk of unfavourable market price movements - he might have to
sell his products in stock at a price which is lower than cost or accept inventory
buildup which would eventually be costly
2. Effort (ikhtiyar) expended or expertise rendered TV manufacturer adds value to raw materials that make up a television set by
contributing effort in putting TV set together as well as providing expertise on how
to put a TV set together
3. Liability in event of product defect When TV retailer sells a TV set, he provides a product warranty against defects
In event that a particular TV set is defective, TV retailer will assume liability and
bear some costs
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Is there iwadin conventional banking?
1. Risk (ghurm)Argument
Banks face risk of default on repayment (credit risk)
Counter-argument In event of default, bank has recourse (collateral, punitive
measures by authorities): no equal counter-value, bank always
win
Different from market risk associated with trading
Risk is inherent in trading activity itself
If downside risk materializes (e.g. cannot sell goods at
profit), trader has no contractual or systemic recourse
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Is there iwadin conventional banking?
2. Effort (ikhtiyar)Argument Bank expends effort to act as financial intermediary, evidenced by its costs of
operation (wages, overheads)
Bank charges for, and earns profit from, bringing together deficit and surplus
units
Bank is providing a service
Counter-argument
Banks efforts do not value-add the product itself
If bank is charging for service of matching deficit-surplus units, its return should
not be a function of amount of financing At most, bank can justify fee-based revenue but not interest-based revenue
Bank does not act as agent for both deficit and surplus units but contracts
separately with them
Effort cannot validate an underlying transaction/activity which is prohibited
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Is there iwadin conventional banking?
3. Liability
The product in a conventional loan contract is money
Physical defects in currency do not permanently diminish its value
as legal tender
E.g. a torn or badly-soiled note can be exchanged at central
bank
Therefore, product liability is not relevant
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2.
Islamic Business Ethics and
Norms
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1. Justice and Fair Dealings
Fair dealing with all and keeping a balance Various evidence from al-Quran, e. g., 5: 8 and 4: 135
Equal rights and obligations of every market player:business rules are equally applied
Ensure justice and fair play that result in harmony in the society
Norms and good practices include:
Honesty and gentleness: truthfulness and care for others
Prohibition ofnajash (bidding up price without intention to takedelivery
Prohibition ofkhalabah (misleading marketing): over-projectingquality of commodity
Disclosure, transparency and facilitating inspection: role ofinformation
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IBs are required to adopt transparency, disclosure and
documentation
Lack of transparency may render the transaction to benon-shariah compliant
The Quran requires to write down and take witness inall business transactions
The nature of IBs require full documentation andtransparency between the bank and the clients
Hence, the possibility of IBs to engage in illegalactivities such as money laundering is lesser than CBs
TRANSPARENCY AND DOCUMENTATION
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2. Fulfilling of Covenants and Paying Liabilities
Evidence in the Quran to fulfill covenants (17: 34)
Business and financial contracts result in rights and liabilities ofthe parties; must be fulfilled as per the agreement
Fulfillment of contracts and promises (or unilateral contracts)
Those who do not fulfill their promises: symbol of hypocrites
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3. Mutual Cooperation and Removal of Hardship
Mutual help, solidarity, and joint-indemnification of lossesand harm
No cut throat competition, unethical practices like fraud andforgery
Mentioned in the Quran 5: 2
This forms the basis oftakaful
-Concept ofaqilah (kin or persons of relationship) were validated by theProphet
-Principle of reciprocal compensation and joint responsibility-To enable burden and losses being shared and distributed
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4. Free Marketing and Fair Pricing
Exchange is permitted only when undertaken in permissiblecommodities and according to shariah rules and principles
Islam envisages a free market where fair prices are determinedby the forces of demand and supply
No interference in the free play of functioning of market forces
Price is only fair if it is the outcome of genuinely market forces
Pricing: price of commodity determined by the input andproduction costs, storage, transportation and other costs
Selling goods lower than market price and creates problem for
genuine business is not allowable Interference by authority is not allowed, unless to remove
market anomalies caused by impairing the condition of freecompetition
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5. Freedom from Dharar(Detriment)
Definition: Harm, injury, damage
Saving others from any harm due to a contractbetween 2 parties
Enforcement of rights with a provision that theinformationally disadvantaged party to reverseits position
Regulators are to ensure:
Fair play and justice for all
To take paternal approach to protect traders fromunhealthy practices of any market players
Provide the general public with necessaryinformation about the nature of business activities
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Concluding article
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References
1. Ayub (2008), pp. 43-70
2. Haron and Azmi (2003), pp.
3. Iqbal and Mirakhor (2007)
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