Study on the Sources of Islamic Jurisprudence Finance Essay

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Islamic Finance is dealing in financial matters based on the Islamic Jurisprudence (Shariah), therefore it is important to understand what Islamic Jurisprudence (Shariah) is. The main sources of Islamic Jurisprudence are as follows: For Muslims, the first and foremost ruling for any matter, social, economical, and religious, comes from the Holy Quran followed by the Hadith and the Sunnah of the Prophet Muhammad (p.b.u.h). If the matter is not clarified within the mentioned, Shariah allows the use of Ijma, Qiyas and Ijtihad. With regards to financial matters, the rulings are mentioned clearly in the Quran and the Sunnah. Principles of Islamic Finance As already mentioned, the Holy Quran does not only act as guidance for the religious issues but also for the working of an individual’s daily life. A Muslim is obliged to follow the commandments that are laid down in the Holy Quran and also by the Prophet Muhammad (p.b.u.h). Financial issues are considered one of the more important issues that the Islamic Jurisprudence controls in order to maintain a more equitable society (Gait and Worthington, 2007). According to Gait and Worthington (2007), many scholars have studied the Islamic finance in great depth and have generally established that the fundamental principles of Islamic Finance (based on Shariah) are (a) the prohibition of Riba (excess amount on the principle lent) and the elimination of debt based financing, (b) the prohibition of Gharar (uncertainty, risk and hazard) therefore elimination of asymmetric information in contracts, (c) The prohibition of financing or investing in activities deemed sinful and socially irresponsible for example, gambling and alcohol, (d) the sharing of risk between the owners of the business and the sharing of profit and losses (this is considered to be an important part of Islamic Finance and hence will be looked at in detail later on in the essay), (e) there should be materiality and the transaction needs to be real and (f) justice should be maintained and it has to be made sure that exploitation does take place due to the transaction (Gait and Worthington, 2007). Prohibition of Riba (Interest) There are various different definitions that are given for the term Riba. According to Al Jarhi and Iqbal (2001) Riba is an Arabic word meaning any increase in the amount of loan that a debtor has to pay to a lender.

Metwally (2006) on the other hand related Riba to usury. According to Usmani (2002: p.6) Riba means excess, increase or addition and as interpreted by the Shariah, it implies any excess compensation without due consideration. Nonetheless, Riba has been clearly prohibited in the Quran and the Sunnah. Following are some of the commandments worth mentioning: “Those who devour usury will not stand except as stands one whom The Evil One by his touch hath driven to madness. That is because they say: Trade is like usury.

But Allah hath permitted trade and forbidden usury” (Quran: 2:275). “O Ye who believe! Fear Allah and give up what remains of your demand for usury, if Ye are indeed believers. If Ye do it not, take notice of war from Allah and His Apostle. But if Ye turn back, Ye shall have your capital sums: Deal not unjustly and Ye shall not be dealt with unjustly”. (Quran: 2:278-279). “That which you give in usury in order that it may increase in other people’s property has no increase with Allah; but that which you give in charity, seeking Allah’s countenance, has increase manifold.

Allah is He Who created you and then sustained you, then causes you to die, then gives life for you again. Is there any of your (so called) partners (of Allah) that does aught of that? Praised and exalted be He above what they associate with him. Corruption does appear on land and sea because of (the evil) which men’s hands have done, that He may make them taste a part of that which they have done, in order that they may return”. (Quran: 30: 38-41) With regards to Hadith, Muslim narrated on the authority of Abu Said Al Khudriy; the Messenger of God (p.b.u.h) said: “Gold for gold, silver for silver, wheat for wheat, barley for barley, dates for dates, and salt for salt; like for like, hand to hand, in equal amounts; and any increase is Riba”. The above mentioned commandments clearly declare Riba as unlawful and hence prohibited. Although the reasons for the prohibition of riba are not clear, scholars have provided numerous reasons as to why riba is declared as unlawful by the Shariah. According to Sarker (1999), riba creates injustice between the borrower and the lender where the lender is clearly at an advantage.

The lender does not only get a positive and fixed rate of return, but also no share in the risk which then completely becomes a burden for the borrower. Another reason why riba is forbidden is because Shariah does not allow making money from money as it is a medium of exchange (Gait and Worthington, 2007). Furthermore, riba not only creates hardships for the borrower who has to make additional payments as well as return the original principle amount borrowed, it is in a way unfair for the lender as well who is entitled to a fixed return even though the profits made by the borrower are far greater (Iqbal and Molyneux, 2005). It has to be noted however, that Islam is not the only religion that forbidden riba (interest). The Torah (Holy Book for Jews) and the Bible have forbidden dealings based on interest (Gait and Worthington, 2007). Following are a few verses translated from the Hebrew Bible prohibiting interest (Cohen and Meislin, 1964: p 250-251) “Exodus XXII: 25-27 25. If thou lend money to any of My people, even to the poor with thee, thou shalt not be to him as a creditor; neither shall ye lay upon him interest. 26. If thou at all take thy neighbour’s garment to pledge, thou shalt restore it unto him by that the sun goeth down; 27. for that is his only covering, it is his garment for his skin; wherein shall he sleep? and it shall come to pass, when he crieth unto Me, that I will hear; for I am gracious”. ” Leviticus XXV: 35-37 35. And if thy brother be waxen poor, and his means fail with thee; then thou shalt uphold him: as a stranger and a settler shall he live with thee. 36. Take thou no interest of him or increase; but fear thy God; that thy brother may live with thee. 37. Thou shalt not give him thy money upon interest, nor give him thy victuals for increase”. Deuteronomy XXIII: 19-20 19. “Thou shalt not lend upon interest to thy brother: interest of money, interest of victuals, interest of anything that is lent upon interest. 20. Unto a foreigner thou mayest lend upon interest; but unto thy brother thou shalt not lend upon interest; that the Lord thy God may bless thee in all that thou puttest thy hand unto, in the land whither thou goest in to possess it”. Gamoran (1971) based on the above verses argues that the law prohibiting interest was applicable to Israelites. The Prohibition of Gharar Gharar is generally translated as risk, hazard or uncertainty (Gait and Worthington, 2007). According to Professor Mustafa Al Zarqa (cited by Gamal, 2000), Gharar “is a sale of probable items whose existence and characteristics are not certain, due to the risky nature which makes the trade similar to gambling” (Gamal, 2000: p 7). Uncertainty can also be caused due to asymmetric information especially in case of a contract. Since Shariah believes in the fair dealing between the two parties and as uncertainty leads to injustice, if such uncertainty is not declared, it will be considered unlawful (Omar and Haq, 1996). Gamal (2000) also argues that sale of any item for which the existence and characteristics are risky or uncertain, will also be defined as Gharar, as this uncertain nature will make the trade similar to gambling. According to a Hadith narrated by Ahmad and Ibn Majah on the authority of Abu Said Al Khudriy: “Muhammad has forbidden the purchase of the unborn animal in its mother’s womb, the sale of milk in the udder without measurement, the purchase of spoils of war prior to their distribution, the purchase of charities prior to their receipt and the purchase of the catch of a diver”. Gamal (2000) states in this regard, that since the sale of fish that has not actually been caught, or an unborn calf (as mentioned in the Hadith) account for uncertainty and hence it is in the best interest of the contracting parties to be sure of the nature and characteristics of what is being traded. In conventional banking, two areas where Gharar is said to be applied is the insurance and financial derivatives. In insurance contracts, a premium needs to be paid regularly to secure against something that is uncertain. In this case, it is possible that the insurance company keeps receiving premium if nothing happens or the insurance company might end up paying a huge amount of money possibly after receiving the first premium (Gamal 2000). Prohibition of gambling and games of chance (Maysir) Maysir, also known as gambling and other games of chance by many jurists, is another form of transaction that is explicitly forbidden in the Holy Quran. Iqbal and Molyneux (2005:p 15) provide the following evidence from the Holy Quran regarding Maysir: “O, you who believe! Intoxicants (all kinds of alcoholic drinks), and gambling, and Al Ansab (animals that are sacrificed in the name of idols on their altars) and Al Azlam (arrows thrown for seeking luck or decision) are an abomination of Satan’s handiwork. So avoid that (abomination) in order that you may be successful” (Holy Quran 5:90). Although the rules of shariah are accepted by Muslims without any questions with regards to why something is forbidden, Iqbal and Molyneux (2005) provide some reasoning as to why games of chance and gambling are forbidden. They argue that such activities are associated with high risk in that a person can either gain a lot by sacrificing very little as well as lose everything.

This according to Iqbal and Molyneux leads to financial and societal problems and these activities do not generally add to the wealth of the society. Prohibition of investing in activities that are considered sinful Like gambling, the Shariah law does not allow an individual to invest in activities that are considered to be sinful or harmful to the society. Such activities can be investing in alcohol, pork or drugs which are considered to be forbidden for consumption by the Islamic Doctrine (Gait and Worthington, 2007). Accordingly Lewis and Algaoud (2001) argue that the aim of shariah is to promote ‘ethical’ investments and therefore, any individual or an organisation is not allowed to trade in any commodity or activity that has been declared Haraam (forbidden). As we have seen that Islamic law (Shariah) has forbidden trading based on riba (interest), gharar (uncertainty and hazard), maysir (gambling and other games of chance) and investment in activites and commodities deemed unlawful, it is interesting to see what alternatives Islamic finance and Islamic banks have provided especially to replace riba (interest) which is a common variable that is used to attract investments and savings not only in the western economies but also in many eastern economies as well. A unique feature that is provided by the Islamic finance is the profit and loss sharing system. In theory, this is the main difference in the working of conventional banks and the Islamic banks. Although there are other modes of financing available through Islamic banks, the profit and loss sharing system is considered to be the heart of Islamic banking (Chong and Liu, 2009). ISLAMIC MODES OF FINACE As already mentioned, theoretically, Islamic banks differ from conventional banks in that they are not allowed to trade riba and are based on the profit and loss sharing system. There are two types of contracts that are based on this profit and loss sharing system provided by the Islamic banks: Musharakah (joint venture or full equity partnership) and Mudarabah (profit sharing or partial equity partnership). Musharakah (joint venture or full equity partnership) It is narrated in Hadith Qudsi that “God Almighty has declared that He will become a partner in a business between two Mushariks until they indulge in cheating or breach of trust” (Usmani, 2002) Musharakah is a concept that is based on the profit and loss sharing system.

According to Usmani (2002), the literal meaning of the word musharakah is sharing. Iqbal and Molyneux (2005: p 2) define musharakah as “an arrangement where two or more parties establish a joint commercial enterprise and all contribute capital as well as labour and management as a general rule”. It is quite clear for the definition that in musharakah arrangement, the partners have to provide the capital and the labour as well be involved in the decision making process. Hence in a way all the partners involved in a musharakah arrangement do not only share profits but also the risks associated with the venture. In the context of Islamic banking, musharakah is an agreement between the Islamic bank and the customer who then become partners or a joint venture agreement. The profits and loss that come about from a musharakah setting are shared equally among the parties or on a pre determined ratio (Gait and Worthington, 2007). The Islamic bank can however terminate the joint venture agreement after a certain time period or upon completion of certain conditions (Chong and Liu, 2009). According to Lewis and Algaoud (2001), musharakah contracts can be made in two ways, through permanent contract and a diminishing musharakah. A permanent contract in a musharakah setting that provides an equitable share of the annual profit and losses to its parties or on terms originally agreed. The second type, as Lewis and Algaoud (2001) state, is a musharakah setting that is a diminishing contract.

This diminishing musharakah is generally preferred by Islamic banks as it allows them to reduce their share of the project annually and obtain periodic profits as well, while the share of the joint partner (the banks customer) increases till the point of full ownership. In drawing a musharakah contract, the parties might usually require the help of legal experts in order to avoid riba and Gharar (Gamal, 2000). Mudarabah (profit sharing or partial equity partnership) Mudarabah is a very old form of profit sharing that was used by the tradesmen even at the time when Muhammad (p.b.u.h) was not declared a Prophet. The best example of Mudarabah is the fact that the Prophet Muhammad (p.b.u.h) himself practiced it with Khadija (r.a) almost fifteen years before the establishment of Islam (Adbul Gafoor, 2006). According to Obaidullah (2005), Mudarabah is a setting through which an owner of capital provides finance to fund a specific venture or business that has been indicated by the borrower.

Therefore, in an Islamic bank setting, the bank will provide the entire amount of capital that is needed for the venture, while the expertise, labour and decision making will be provided by the customer (Chong and Liu, 2009). Mudarabah can hence be seen as a silent partner agreement. In another way, an individual may wish to deposit capital in the bank which can then use it to invest in accordance to Mudarabah. Mudarabah differs from musharakah on the profit and loss sharing. Where in musharakah both the profit and the loss are shared by the parties, in a Mudarabah setting or contract, the profits are shared on a pre determined ratio while the loss is completely born by the owner providing the capital (Chong and Liu, 2009; Gait and Worthington, 2007). However it has to be noted that only loss that occurs in the normal working and not due to the negligence of the entrepreneur will be borne fully by the capital owner (Sarwer, 1999: p 4). In a banking setting, the Islamic bank as a provider of finance will face the entire loss. This in a way keeps the banks more disciplined as they have to distinguish between good and bad customers and not involve in deliberate risk taking (Chong and Liu, 2009). This characteristic of Mudarabah has also been recognised by Gamal (2000) who argues that Mudarabah can be a very risky method of financing as the entrepreneur does not invest anything in the business but merely gives his time and skills.

Therefore, the Islamic banks have to carefully analyse the project before the decision regarding investment is made. The two mentioned modes of financing are based on the unique feature of the profit and loss sharing. In Islamic banking and finance, there are other modes of financing that are not particularly based on the same profit and loss sharing basis as musharakah and mudarabah. Murabaha Murabaha is not particularly a mode of finance as musharakah and mudarabah but is more like a sale. In a murabaha setting for the Islamic banks, the customer can ask the bank to buy a good (for example car, machinery etc) on their behalf and agree to pay a profit margin when making the payments to the bank (Gamal, 2000). For this to take place, the customer usually provides the bank with the specification and the prices of the goods that it wants the bank to purchase. The bank on the other hand studies the prices that it has been given and forms conditions of payment. Only when the customer and the bank have agreed on the terms and conditions will the sale take place. The bank will then purchase the goods and then sell it to the customer (Gait and Worthington, 2007). In a murabaha contract, the profit that the bank obtains from the sale of the contract has already been agreed by the customer (Metwally, 2006). Although in the murabaha contract the profit margin may be considered to be a form of interest, the reason why it is not considered so is because the profit is made from the exchange of goods for money rather than money for money (Mills and Presley, 1999). Furthermore, to comply fully with Shariah, in a murabaha contract, goods must be specified clearly, the bank must have ownership of the goods before making the sale, the original cost price must be known by the customer and the customer must also agree on the profit margin which in turn has to be de linked to the repayment period (Gait and Worthington, 2007; Mills and Presley, 1999). However, Saleem (2005) argues that although murabaha is being widely used by the Islamic banks, it is not being done so in compliance with the Shariah rules and regulation. Usmani (2000a) on the other hand states that murabaha has only been allowed by scholars under very strict conditions. If these conditions are not fulfilled, murabaha will not be allowed. Bai Muajjall (deferred payments) Bai Muajjall is somewhat similar to the murabaha but is structured on the basis of deferred payment.

Where the delivery of goods will be immediate, the payment for the goods will be made on a later agreed date either in instalments or lump sum. This price that needs to be paid will be agreed upon at the time of sale and will not include any charge for deferred payments (Chong and Liu, 2009). This kind of sale can be seen as a sale on credit which, as accepted by Islamic scholars, is permissible and does account to riba. This is because the increase in the price is due to deferment of payment and is agreed by the buyer and seller at the point of the sale. However, it the amount of debt increases as a result of deferment, then it would not be allowed (Gamal, 2000). Bai Salam According to Iqbal and Molyneux (2005: p 25), Salam is a contract for sale or purchase of goods at a specified future date with the price of these goods paid in advance at the time of the contracting.

Although as a general rule, the goods that are being purchased or sold must physically exist to avoid Gharar, Bai Salam is one such exception. Gamal (2000: p 17) provides evidence on this from Hadith narrated on the authority of Ibn Abbas: The Messenger of Allah came to Madinah and found its inhabitants entering salam contracts (with the price paid in advance) in fruits for one, two and three years. He said: Whoever enters a salam contract, let him specify a known volume or weight and a known term of deferment. According to Usmani (2000a: p 185-187), the Prophet Muhammad (p.b.u.h) allowed salam contracts on very strict conditions. Therefore, for the salam contract to be permissible, the commodities must not be available at the time of the contract, the quality and the quantity of the goods must be known, the date and the place of delivery must be clearly defined and the full purchase price must be paid at the time of the contract (Gait and Wothington, 2007). Istisna (Manufacturing Contracts) Istisna contracts are a form of manufacturing contracts where one party agrees to produce or manufacture goods which are to be delivered at a future date at a predetermined price (Chong and Liu, 2009). Gamal (2000: p 17) translates Istisna as “commission to manufacture”. It is a relatively new concept in Islamic banking and allows a party to obtain industrial goods on either a full upfront payment or deferred payment for a deferred delivery (Gait and Worthington, 2007). The advantage of istisna is that since the cost price is either prepaid or deferred as instalments, it helps in the creation of the a product at a cheaper price than buying the complete product (Gamal, 2000; Gait and Worthington, 2007). Although the permissibility of Istisna has been adopted through the use of Qiyas (analogy) by the scholars with the permissibility of Bai Salam (Gamal, 2000), the two are different. Istisna involves a commodity that needs manufacturing, the payment can either be lump sum or deferred instalments but the time of delivery could be unknown (Iqbal and Molyneux 2005).

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Study On The Sources Of Islamic Jurisprudence Finance Essay. (2017, Jun 26). Retrieved December 2, 2023 , from

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