Credit crunch: islamic perspective

Chapter II: Islamic contracts

The application of Islamic banking is in contradiction with conventional banking products due to the forbidding of Riba, Gharar and Maysir discussed earlier.

Therefore some techniques or contracts have been created in order to apply Islamic principles in the banking system.

When determining if a particular fund is Shariah compliant, the supervisory board takes into consideration certain core Shariah principles. Such principles include: ban of receipt of interest, avoiding uncertainty and discouraging risky behaviour.

These techniques have been the subject of a lot of literature.

Our main objective is to try to give a brief descriptive overview explaining why they are admitted by the Shariah.

1) Mudaraba^56(*)

It is an arrangement whereby one party or investor possessing capital (rab al maal) advances funds to his partner (mudarib) for trade purposes^57(*).

The benefits of his contract must be shared on a pre-agreed basis between both parties.

The percentage of benefit may differ from contract to contract. However, the determination of each one's part must be imperative.

In the case of loss, the parties who entrusted the others will bear the risk of loss. The other party or the manager of the Mudaraba (the mudarib) is considered to have lost his labour and time.

The mudarib will be charged for the losses incurred as a result of his negligence or breach of the contract terms.

The capital of the Mudaraba cannot be a debt owned by the mudarib for the reason that if it generates benefits, it will be assimilated to Riba.

The mudarib should manage the Mudaraba contract without interference from the investors.

There shouldn't be any time limit for a Mudaraba contract.

This can endanger the plans and the possibility of realising benefits.

The investor cannot request any guarantees from the mudarib.

The profits held will be fixed on a ratio basis not a fixed amount.

In practice, Mudaraba can be used by Islamic banks in two different ways:

The bank while taking money from the client plays the role of mudarib. When making the money at the disposition of other clients, the bank is rab al maal.

Mudaraba is used as a form of participation or trust financing^58(*), often when a number of investors want to pool their resources under the management of a third party.

It can be used to structure funds, syndicate other Islamic finance products or provide a format for a Shariah compliant deposit account.

2) Musharakah

A Musharakah is a joint venture arrangement^59(*). The word in Arabic literally means «participation». This partnership means participating finance in which the bank participates with one of its clients in a commercial industrial operation.

The losses are suffered by all the partners according to their participations. Profits are to be distributed among partners according to a pre-agreed ratio^60(*).

Musharakah can take many forms:

«Musharakah-moufawadah^61(*)»: or universal partnership, in which the profits and losses are equally split.

«Musharakah-inan»:^62(*) each partner is the agent but not the guarantor of the others. This is a Musharakah in which the profits and losses are split according to their participation and are limited to the amount of capital brought by the partners.

«Musharakah al daima» or permanent: in which the bank is a partner or owns a permanent share, it can sell its parts afterwards.

However, the most used form of Musharakah is the «Musharakah al moutanakissa» or «Musharakah moutanakissa bil tamallok »(diminishing musharaka)^63(*) which means a participation in which the borrower would get the whole ownership only after the bank has collected its participation back^64(*).

Each partner is required to contribute to the capital to a certain percentage.

Since all the partners participate in the money the priority for management is not given to anyone. However it can be delegated.

The contract is based on trust. In consequence, no guarantees should be provided.

The profit shares of each partner should be a percentage not a fixed amount.

The Musharakah is used by Islamic banks to finance projects.

It is used to participate in industrial, agricultural projects or services rather than commercial ventures^65(*).

3) Murabaha

Murabaha is a form of cost-plus financing^66(*).

In a Murabaha contract, the financial institution buys the product on request from the client. It sells it back to the client (for cash or instalments). It is evident that the bank will sell the product for a higher price than the one paid originally.

The Murabaha financing mechanism is translated as fixed profit and cost plus profit.

There is no reference to Murabaha in the Quran.

However it was justified by reference to Muslims practices in the prophet time to buy a commodity in a village and sell it in another on for a premeditated profit.

75% of Islamic banking contracts are based on Murabaha. This contract is widely used to help short-term financing to clients to purchase goods with a deferred payment. The basic three elements of Murabaha contracts are:

The price, related costs and benefits should be defined and determined in money.

The subject should be a commodity.

It is very crucial that the sale transaction includes a commercial risk for the buyer of the commodity. If the profit is predetermined it can be assessed as illegitimate Riba^67(*) .

Also some issues had been raised about the legality of premiums for the promise to buy or urboun.^68(*)Is the promise to buy compulsory, is the premium refundable in case of deferment of the contract? The current Islamic scholars think it is not binding which can cause losses for the purported buyer and can be linked to Gharar. Some banks present it as a proof of good intentions and a cost cover in case of non acceptance of the deal.^69(*)

4) Ijarah

The word Ijarah in Arabic refers to rent.

Ijarah is a contract relative to a specific benefit from the ownership of a good or product for a known cost.

There are two kinds of Ijarah:

The first one is «Ijarah»^70(*) or true lease, which represents an exchange transaction, where a benefit of an asset is transferred for a known price but ownership of the asset is not transferred.

The second one is «ijarah wa iqtinaa» ^71(*)or lease and ownership

This is a lease where the lessee derives economic use and achieves the ultimate ownership of the product.

For example a bank accepts to buy or rent a building and leases it back to the client^72(*).

This last contract is used whenever the commodity is leasable (aircraft, ships, real estate) of the lease with lease rentals used to partly pay the price of buying the property.

In this structure, a special purpose vehicle is used to carry the debt and equity portions of the purchase.

The price of the asset together with lease rentals is used to pass money both back to the fund and to repay the initial debt.

The difference with conventional lease to highlight is the risk taken by the lessee.^73(*)

5) Istisnaa

Istisnaa is a form of sale where a commodity is transacted before it comes into existence. It involves ordering a manufacturer to provide a specific commodity for the transaction. Islamic banks enter into a back to back Istisnaa structure which involves two contracts. The first contract is between the Islamic bank and the manufacturer whereby the bank acts as a buyer of the manufactured assets. The second contract is between the client and the Islamic bank whereby the bank acts as the seller of the manufactured assets.

To be Shariah compliant the contract must specify the features of the goods to be produced and the delivery date^74(*).

This type of financing is widely used Islamic project finance.^75(*)

6) The Islamic insurance (Takaful)

Takaful, literally means in Arabic «mutual guarantee».

The instinct of survival and protection has flourished to become a world business: the conventional insurance.

Some Muslims believe that there is no need for Islamic insurance, because in case of catastrophe, Muslims are supposed to help each other. Also, taking protection procedures is challenging the will of God^76(*).

Also they believe that insurance businesses are involved in illegal fields such as alcohol, pork and gambling.

Objections to conventional insurance can be resumed in five facts^77(*):

Insurance includes an element of Gharar or uncertainty concerning the price and the liabilities of the parties. The insurance can create an unlawful disadvantage.

Insurance includes an element of Riba. The premium can be non equivalent as it can be lost without getting any advantages.

The conventional insurance contract is a contract on security which is not defined in Islam.

It is against predestination.

It includes an element of gambling.

Against these objections some people see no problem in the conventional insurance:

Some scholars consider that conventional insurance doesn't include Riba or Gharar.

Others compare the conventional insurance to the custody contract or «Hirasa» in which the custodian receives money to provide security.

For those who compare insurance to gambling, gambling concerns unnecessary risk that the person takes. However, insurance is against risk not under its control.

Opponents of insurance see no value for this argument.

For them there is no contract in Islamic law where the security is the subject matter.

The subject matter may include Riba whereas the party can pay less and get more.

With all these controversial views, an alternative was found in the «Takaful» contract.

In 1985, the Takaful system has been invalidated as a system based on mutual cooperation. The Takaful is a mutual protection in case of casualties.

A Takaful contract company works on the basis of a Mudaraba contract with the manager of the funds being the provider of the Takaful contract or the Takaful Company.

Claims are paid from the premiums paid to the fund.

All the benefits are the property of the policy holders. However, in the case of deficit of funds, losses are covered by all the participants.

A Takaful company serves as a trustee or as a manager on the basis of «Wakala» or Mudaraba contract.

Guaranteeing each other or «Takaful» consists of a pool of funds formed by the collection of a periodic contribution, paid from the participants.

If these funds are not sufficient to cover the losses, an extra-donation or «tabarru» would be claimed from all the participants in the fund.^78(*)

7) Islamic securities

As a result of further activity in the Islamic sector, further innovation of Islamic financial instruments was necessary. In consequence, a new way for borrowers to raise capital was created facilitating the conversion of non tradable assets into liquid securities. We make the difference between Islamic equities and Islamic bonds.

A) Islamic equity

Equity represents shares of capital in conventional finance and the concept of risk sharing is common in Islamic finance. For this reason, the idea of using the existing equity market without developing a new one was perfectly logical. The process followed was that investment in common equity finance was encouraged. However, screening will permit to scan Shariah based stock on a criteria developed by many Islamic scholars who influenced the creation of an Islamic stock index^79(*).

These criteria can be divided between qualitative and qualitative criteria:

Qualitative criteria include the screening of the activity of the funds to check if they are Shariah compliant. Thus any shares in companies which deal with selling alcohol or pork should be banned.

The qualitative criteria concern the respect of an Islamic ratio.

As it was previously detailed, Islam prohibits interest. Therefore, the underlying investment must not pay interest''^80(*).

Another quantitative criterion is the leverage ratio to insure that the debt proportion is at acceptable levels to equity.

According to the Dow Jones Islamic Market Index, the total debt divided by trailing 12 month average capitalization should be 33%^81(*) .

B) Islamic bonds

By definition, conventional bonds uphold interest. Therefore, they cannot be the subject of Shariah compliant investments. An alternative was created: Islamic bonds or «sukuks».

A traditional bond is a loan of money creating a creditor debtor relationship; an Islamic bond represents an ownership stake in an existing asset.

Whereas the trading in conventional bonds realises the transfer of debt, the Islamic bonds is a transfer of benefits of ownership.

The transfer of Islamic bonds can be accomplished via one of the Islamic modes of financing.

The Ijarah contract is widely used in Islamic securitisations as per the below structure for example^82(*):

1. The originator sells an asset to a special purpose vehicle (SPV)

2. The SPV raises financing to purchase the vehicle by issuing an Ijarah sukuk (leasing bonds)

to investors. The amount raised by issuing the sukuk equals the purchase price.

3. The Ijarah sukuk represents an equity interest in the asset.

4. The SPV leases the asset back to the seller. The seller makes periodic lease payments to the SPV which match the SPV's obligation under the Ijarah sukuk.

5. At maturity, the SPV sells the asset back to the originator (ie. the lessee). The sale price covers any liability owed by the SPV to the Ijarah sukuk.

The discussion concerning Islamic securities concerns the idea of giving a guarantee to the investors to pay their principal and benefits. The scholars insist that investors should take risks on the performance of the sukuk and no guarantee related to that matter should be given.

* 56 ^_ Mudaraba is known as a profit losses sharing arrangement.

* 57 ^_ Michael Balir QC abd G A Walker,Markets and Exchanges Law (OUP,2006)11

* 58 ^_ Atif Hanif,'Islamic Finance an Overview'[2008]International Energy Law Review 1.

* 59 ^_ Atif Hanif,'Islamic Finance an Overview'[2008]International Energy Law Review 5.

* 60 ^_ Ibid.

* 61 ^_ Saleh N.A, Unlawful Gain and Legitimate Profit in Islamic law (Cambridge University Press, Cambridge, 1986) 113.

* 62 ^_ Saleh N.A, Unlawful Gain and Legitimate Profit in Islamic law (Cambridge University Press, Cambridge, 1986) 114.

* 63 ^_ Atif Hanif,'Islamic Finance an Overview'[2008]International Energy Law Review 5.

* 64 ^_Saleh N.A, Unlawful Gain and Legitimate Profit in Islamic law (Cambridge University Press, Cambridge, 1986) 114.

* 65 ^{_ _} Atif Hanif,'Islamic Finance an Overview'[2008]International Energy Law Review 5.

The difference should be made between diminishing musharaka and equity financing. In the latter, the insolvent customer could not be treated as a debtor of the capital provider.

* 66 ^_ Michael Balir QC abd G A Walker,Markets and Exchanges Law (OUP,2006)5.

* 67 ^_ Saleh N.A, Unlawful Gain and Legitimate Profit in Islamic law (Cambridge University Press, Cambridge, 1986) 114.

* 68 ^_ Simon Archer and Rifaat Ahmed Abdel Karim, Islamic Finance: Innovation and Growth (Euromoney Books and AAOIFI) 93.

* 69 ^_ ibid

* 70 ^_ Atif Hanif,'Islamic Finance an Overview' [2008]International Energy Law Review 6.

* 71 ^_ Ibid

* 72 ^_ Ibid

* 73 ^_Eloise Walker, Shari'a Finance [27 April 2009, issue 978, 17] Tax Journal .

* 74 ^_ Atif Hanif,'Islamic Finance an Overview' [2008] International Energy Law Review 6.

* 75 ^_ Ibid

* 76 ^_ Muhamad Ayub, Understanding Islamic Finance (2007)418.

* 77 ^_ ibid

* 78 ^_ ibid

* 79 ^_ Michael Blair QC and G A Walker, Markets and Exchanges Law (OUP,2006)8.

* 80 ^_Ibid.

* 81 ^_ Ibid.

* 82 ^_Atif Hanif,'Islamic Finance an Overview' [2008] International Energy Law Review 7.