Objectives of Shari`ah in the Prohibition of Riba *

Implications for Modern Islamic Finance

• Introduction
• Objectives of the Prohibition of Riba
• Implications of the Objectives of the Prohibition of Riba
• Conclusion

Introduction

Islamic finance was revived at the institutional level with the establishment of Islamic banks during the last quarter of the 20th century. Along with the new institutions of Islamic banks, Islamic insurance companies and other Islamic finance companies emerged. Also, new ways of "financing" practices came about. Few classical contracts appeared; they include inter alia, murabahah [1] of the party who orders the purchase, Istisna' [2]backed by a parallel Istisna' and financial lease. These and similar new practices of old contracts raised intensive discussions about Shari`ah's validity for the addition of conditions to or combination of contracts for the sole purpose of transforming them into tools of financing.

The dust of these discussions has not been settled yet, and the raised red flags have not been lowered when at the end of the century a new stream of  fatwas came about tawarruq  [3], sukuk [4], and paid-for guarantee (al-Kafalah bi ajr[5]). This has introduced new dimensions in the 21st century Islamic finance that were considered previously as absolute taboo.

These new dimensions include the provision of cash/ or personal financing to individuals and corporations and the hedging in future commodities and currencies. A closer look at these new fatwas indicates that there is an exerted effort to deal with or mitigate the risks of Islamic financing and to make it match the riba-based finance.

This paper aims at re-visiting, from the angle of modern finance, the Maqasid (objectives) of  Shari`ah with regard to the prohibition of riba (Arabic for interest) and examining the consistency of such fatwas with these objectives. Also, the paper aims at examining whether there are any Shari`ah intrinsic alternatives that satisfy the same finance purposes that the fatwas sought to achieve.

Section II will discuss the implications of the objectives of the prohibition of ribaand delineate the methodological principles of creating new financial products, while preserving the objectives of the prohibition. It will also discuss the nature of Islamic financial intermediation, especially in its institutional form, which is not addressed in the classical jurisprudential (fiqhi) literature.

Finally, this study will offer a few examples of "objective-friendly" modalities of reducing the risk of financing and will attempt to show that all the purposes used to justify some of the controversial fatwas can be achieved by such modalities without taking the risk of violating the objectives or loosing some of the basic characteristics of which Islamic finance stands proud when compared to conventional riba-based finance.

I. Objectives of the Prohibition of Riba

Intrinsically and by its own nature, riba-based financing is purely personal as it solely depends on the integrity (interpreted as ability to pay back) of the borrower and obtained collaterals. This also implies that riba-based financing is not target-oriented or is detached from the objective for which financial means are going to be used. Detachment from the use of funds leads in turn to another problem that arises from the fact that personal financing can be put to any kind of usage regardless of ethical or moral values.

 The assumptive nature of riba -based financing applies not only to assuming an increment but also to assuming a rate of increment that is attributed to the non-able-to-grow asset. Finally, riba-based financing allows for the creation of multiple layers of pure financing on a small base of real market. This means, because of its nature that permits attributing increment to a non-growing asset, it goes even farther from reality to permit pure debt exchanges and transactions so that the size or amount of financing in any society exceeds by many folds the size of real market transactions.

 Of course, one may argue that some of these problems can be tackled by additional means, regulations, and laws. But this is incorrect as any regulations that violate the nature of a transaction are bound to die out because of the market pressure. Additionally, no regulations can cover all potential outcomes of the market forces once one founds the market on unrealistic assumptions. We will approach this section through three subheadings: prohibition of riba , characteristics of Shari`ah-friendly financing contracts, and derivation of the objectives of the prohibition of riba.

Prohibition of Riba

Islam, like other monotheistic religions, condemns and prohibits riba. The prohibition of riba in Islam is given in strong and clear-cut terms. Almighty Allah says in the Qur'an,  

[But Allah has permitted trade and forbidden usury.] (Al-Baqarah 2:275)

[Allah has blighted usury.] (Al-Baqarah 2:276)

[O you who believe, observe your duty to Allah and give up what remains (due to you) from usury if you are (in truth) believers, but if you do it not, take notice of war from Allah and His Messenger.] (Al-Baqarah 2:278-279)

No other sin is prohibited in the Qur'an with a notice of war from Allah and His Messenger! The traditions of Prophet Muhammad (peace and blessings be upon him) contain several statements that condemn riba and consider its practices as one of the gravest sins that invoke a curse or wrath from Allah. In one of the hadiths , the Prophet (peace and blessings be upon him) said,

"The wrath of Allah is on the taker of riba, its giver, its writer, and its two witnesses." (Al Albani, Al-Jami` Al-Sahih, 5089)

Definitions of Riba and interest.

Riba is an Arabic word that means increment or increase. But the Qur'an did not mean any increment as it refers to an increment in a specific transaction: the riba that was common and known among the Arabs and other nations at the time of revelation.

This is why the reference in the Qur'an came to the" riba ". This transaction was done in either of two ways: (1) deferring an already-existing and due debt to a new maturity provided the amount of debt is increased; (2) giving a loan that is due with an increment after a given period of time.

This definition is implied in the Qur'an itself. Almighty Allah says,

[And if you repent, then you shall have your principal; neither shall you make (others) suffer loss, nor shall you be made to suffer loss.] (Al-Baqarah 2:279)

This part of Verse 279 of Surat Al-Baqarah has two important indications: (1) it defines riba as any increment above the principal of a debt or a loan; (2) it describes such an increment as unjust. The exclusion of profit, being an increment in sale, is given in the following verse: [ But Allah has permitted trade ] (Al-Baqarah 2:275).

To be exact, riba is defined with regard to financial transactions [6]as any contractual increment in a loan or debt due to the time element. This is exactly what we know today as interest. Both legally and financially, interest is defined as an increment paid by the debtor to the creditor for granting a loan or for extending the maturity of an existing debt.

Obviously, the Shari`ah does not recognize the legitimacy of this increment. Consequently, once a debt is created (notice that a loan creates a debt), any increment above the principal of the debt is interest, and it is the "prohibited riba " according to the terminology of the Qur'an.

To understand why interest is prohibited, we need to revisit the basic concept of debts. What is a debt? A debt is an interpersonal relation that is a liability on one party and an abstract asset to the other. In real life, by its nature, a debt is not liable to increase or decrease; it is not able to produce increments because it has no intrinsic utility other than being an ingredient of wealth.

In other words, a debt cannot have different values at different times and places unless we create additions in the form of assumptions - that is, by creating a debt market and valuating or assessing debts in relation to time. Additionally, the amount of an increment in a debt is also assumptive; it depends on the conditions and externalities in the imaginary market that we create for debts.

Of course, this may sound astonishing to many of us who are accustomed to talking and hearing about debts' markets and interest all through their lives! Are debts, in fact, able to increase or decrease or to produce increments? And how can this take place except in our imagination? Do we falsely think this to be true and real?

Of course, once a market is created for anything, be it a thin air, there will be a demand and supply for it on speculative grounds, exactly as people exchange indices, in a fantasy-created pure speculation-based index market, though indices are neither real assets nor goods or services! We must remember that Shari`ah recognizes real things and real growth, whether by the nature of a real asset or by the effect of market forces on real assets, goods, or services.

Additionally, all real things or assets that may grow may also loose substance or value, and the owners of such things or assets are exposed to losses exactly by virtue of the same argument that justifies their entitlement to increments. But a debt, among all assets, is not liable to decrease and does not expose its owner to such kind of losses; brush aside the issue of default because every debt can be secured by all kinds of guarantees and collaterals and because the nature of default risk is different from the risk of increase or decrease, which results from natural factors or from the interaction of market forces.

A default risk is fault in the debt itself; it is of the kind of a faulty product or a product that does not maintain its normal characteristics. A defaulted debt is like delivering rotten apple in a sale contract, which is very different from the price risk that affects the owner of the apple. This is why the default risk is compensated by a risk premium over and above interest, which is "the price of money."

It may be argued that a creditor has made a sacrifice and he or she deserves compensation, without which he or she would have not made such a sacrifice. While the idea of a sacrifice is a legitimate one, the basic principles of private ownership prevents allowing any part of the increment of the debtor's property to be deserved by any other person because any growth that may take place in the debtor's property can be deserved only by the owner of the  property.

 Additionally, there are no measuring tools or criteria to estimate the contribution of a loan to increments, especially that an asset is also exposed to declining by the same virtue that it may develop increments. Consequently, a personal loan must remain personal and it deserves thanks, gratitude, and appreciation from the borrower. It may be a reward from Allah, too, but it is not a contributor to creation of value.

Alternative Financing Contracts and Their Characteristics

Notwithstanding the several attempts to encode Shari`ah, the fact is that its bulk remains not coded in the form of articles of law, but its rulings are found in the writings of  Shari`ah specialists through the centuries, as Islam does not establish a religious hierarchy with a law-giving authority. We will study the Shari`ah  alternative financing contracts in an attempt to understand their essential characteristics. We will then find out more about the Islamic financing principles and rationale of the prohibition of riba. It has become known over the last four decades of theorization and practice that Shari`ah  financing contracts are of three major kinds: Sharing-based, sale-based, and lease-based. On the other hand, from a historical point of view, Islamic financing products can be classified into two categories: (1) classical contracts that existed throughout centuries and derived from the practice of the Prophet's community in Madinah; (2) hybrid contracts that developed over the past half century and practiced in contemporary Islamic finance and banking.

Classical financing contracts. Classical writings on Shari'ah, some of which date back to 12 centuries ago, mentioned three  essential sharing-based financing contracts: equity sharing (musharakah )[8], equity sharing with a sleeping partner (mudarabah)[9]and crop-sharing (muzara`h).[10]They also mentioned three sale-based financing contracts: deferred-payment sale (al-bay` al-'ajil), forward sale with cash advance (salam ), and manufacturing financing sale (istisna`). Lastly, classical writings also mentioned leasing (ijarah ) as a form of financial contracting.

Although this paper does not intend to go through the now well-known descriptions and conditions of each of these contracts, one stop is necessary at the deferred-payment sale at a higher-than-the-cash price because it gives a demarcation of interest vis-à-vis financing sale. The permissibility of deferred-payment financing sale is mentioned in no less than the Qur'an itself. Almighty Allah says,

{Those who devour usury will not stand except as stand 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. Those who after receiving direction from their Lord, desist, shall be pardoned for the past; their case is for Allah (to judge); but those who repeat (The offence) are companions of the Fire: They will abide therein (for ever ).] (Al Baqarah 2:275)

Claiming that cash sale is just like interest lending is logically incorrect and exposes the claimant to be ridiculed and accused of foolishness, insanity, or loss of rationale because cash sale is very remote from interest lending and has no similarity to it. What is obviously similar to interest lending is deferred-payment sale at a price that is higher than the cash price. Here the similarity is obvious.[11]

Interestingly, the Qur'an did not ridicule this claim or accuse it of irrationality; this is in spite of the fact that the Qur'an invokes in many instances the rational argument by statements such as [ will they not understand], [So you may understand], [Do you not understand?], and [in order that you may rationalize]. All such verses came in the very chapter 2 of the Qur'an itself .  Other expressions do exist: [Have you no rationale?], [If you have reason], [Don't you reason?], [So that they may have minds to rationalize with]. There are many like verses throughout the entire Noble Book.

This implicitly means that some similarity is acknowledged, but yet the Qur'an quickly directs the attention to the permissibility of the sale that is similar to interest lending and the prohibition of the latter, as if it says that while certain similarity is acknowledged, there are differences that warrant the permissibility of deferred payment, sale-based financing and the prohibition of interest- or lending-based financing.

This is why the overwhelming majority of scholars argue that the permitted sale in this verse, though generalized and applied to any kind of sale, specifically refers to deferred-payment (i.e. financing) sale. This is also supported by bringing in Verse 282 from Surat  Al-Baqarah about the confirmation and documentation of debts immediately after the Verses that deal with the prohibition of interest and permissibility of deferred-payment-sale financing (in Verses 275-281 of the same surah). This is because deferring the payment creates a debt that needs to be documented.

The unavoidable, immediate implication of Verse 275 of Surat Al-Baqarah is that debt-creating financing is permissible and recognized in Shari`ah, while the verse condemns interest-based lending and prohibits any increment on it, thus rendering loan giving a nonprofitable activity and shifting it from business arena to personal spheres. It approves a kind of sale that fulfills the same objectives, including giving a reward for the time value of the sold commodity (rather than the money lent).

In other words, this verse establishes a very important rule that debt-creating financing is an acceptable and rewarding business that, at the same time, prohibits riba. This plainly means that the creation of debts is not a thing that is discouraged or disliked in Shari`ah. It also means that avoidance of creating debts is not an objective of the prohibition of riba.

The similarities between deferred-payment sale at a higher-than-the-cash price and interest lending are apparent. They include the following.

1. The purchaser gets the asset or goods at the time of the contract and pays later.

2. The amount he or she may end up paying is about the same in both transactions.

3. The seller gets compensated for the time span between the contract and the maturity of the debt.

4. A debt is created. But the dissimilarities are not so clear, and the verse did not elaborate on them.

 Hybrid Islamic financing contracts and financial intermediation. The industry of financial intermediation is new to the Islamic Shari`ah .[12] It has been developed in the Western countries over the past four centuries or so. Recognition of financial intermediation as an independent industry is vital to understanding the hybrid financial contracts. Those scholars and researchers who fail to recognize this industry still argue for preferences of sharing over other modes of financing instead of taking such preferences to be decided by players on the basis of market circumstances and forces.

When a merchant sells at a deferred price or lease an asset, he or she is providing financing to the purchaser or the lessee. But if a corporation specializes in getting the savings of those who have them and channeling them to businesses that need them for investment, that is a specialized industry of financial intermediation.

In other words, financial intermediation is a specialty of those who recruit deposits and provide funding, while merchants and producers provide commercial credit from their own resources as they deal with the daily decisions of a production line or the process of buying and selling of goods and services.

Over the last four decades, the role of Islamic financial engineering has been to develop contracts that fit this new industry. Its success or failure can be assessed on the basis of the extent to which new contracts maintain the main characteristics implied by the prohibition of riba and preserve the objectives of this prohibition.

Although assessing how close or far each of these contracts to consistency with the objectives of the prohibition of riba, is outside the limit of the present paper, it must be said that some of the applications of new hybrids amount to pure interest-based rescheduling of debts and are consequently in violation of the basic objectives of the prohibition of riba

 General characteristics of financial products in Shari`ah .

  Islamic financial products are contracts that abide by the axioms and rulings of Shari`ah . The main principles that govern financial contracts in the Islamic law are twofold: (1) The first group of principles is the general principles of contracting that include civil aptitude, consent, and legal permissibility. These are common among all legal systems and societies, though there are variations in their minute details.

For instance, while the Islamic law defines the civil aptitude for financial contracts as age 18 in addition to sanity, some states or countries carry the age limit to 21. (2) The second group of principles is important. It covers a specific Islamic viewpoint and includes moral commitment or ethical foundation, Shari`ah's permissibility, balance, and realism or validity.

To be acceptable from a Shari'ah point of view, a finance product must be morally sound. This is a general human standard that is preached and adopted by the Shari`ah . It means that an Islamic financing institution cannot use its resources to support drugs, alcohol, gambling, porn industry, environmentally harmful products, or any other production or distribution of any material or service that does not have a humanly acceptable, ethical foundation.

In this regard, Islamic financing is very similar to what is known as ethical investment. Yet, the following points will show that Islamic financing is, in fact, more demanding than ethical investment.

The principle of balance requires that the obligations of one party be equivalent to the obligations of  the other , so that there is no excessive load on either party. This principle rules out excessive overcharge, and it stands against the charge of interest, too. As we will discuss later, interest is an obligation on one party against a presumed opportunity cost of another. These obligations are obviously unbalanced.

Lastly, the principle of realism or validity means that all financing contracts must be founded on real - in contrast to presumed or deemed- transactions, exchanges, or things and assets. This principle rules out any contract that is based on pure assumptions. Interest itself is one example, both in its very existence and in its rates; both are assumptive as we will later discuss in more detail.

Another example is trading indices such as DJII or NASDAQ, because an index is a mere mental calculation that does not represent any real ownership. On the other hand, one can own and trade units in an indexed fund because the fund owns shares in companies that are represented in the index.

 What is wrong with interest? This paper argues that understanding the differences between interest-loan-based financing and debt-creating sale financing is extremely essential to comprehend the objectives of the prohibition of riba because these differences elucidate the crucial point of the distinction among seemingly similar transactions.

The basic difference between interest financing and Islamic financing is that interest financing is done in a loan contract; hence it is based on a postulate that a debt may be assigned an increment or may give entitlement to it, while in reality a debt cannot produce any increment.

At the same time, this is very much linked to (or you may call it the counter facet of) the theory of property rights. Property rights give to the owner of an asset the entitlement to all and any increments that may happen in his or her asset and preclude any other person from any claim on increments that may happen in other persons' assets.

In other words, a person whose asset does not produce any increment has no claim to an increment and, consequently, cannot and must not have any entitlement to increments that happen in other persons' assets. This is the ideological foundation of the prohibition that is consistent with the characteristics of realism of Islamic Shari`ah. This is because, in reality, the lender's asset is a debt and a debt is abstract, which, by its nature, cannot create increments.

The implications of accepting the idea that a debt has increments are the following.

1. Gross violation of the principles of private ownership, which requires entitling an asset's owner to all increments that may happen in his or her owned asset. It also requires that no entitlement may be assigned to any other person. Furthermore, because this is based on mere assumption, allowing any entitlement to increments to be assigned to any person other than the owner amounts to a gross disturbance in the property rights and gives room for other violations, too.

2. One needs another unrealistic assumption about the valuation of the increment (the rate of interest) that is to be assigned to an asset (a debt) that does not create increment.[13]This has been done by creating an artificial market for exchanging debts. This market is in fact built on pure speculation and purely speculative market forces, unlike markets of assets, goods, and services; it is therefore very volatile by its nature.

3. Once one allows a debt to have an increment, one will have to allow it to be rescheduled with increment and one will have to allow discounting with a reduction; both these transactions do not create or add value in the economy.

4. One will have to allow other transactions on debts, including exchanging them through interbank transactions and a whole set of pure financial or monetary transactions that do not essentially add value but only transfer wealth from one person to another. Shari`ah takes a close look at these transactions and finds them done in isolation from real production and exchange; they do not affect inventories on the shelves or goods and services that reach consumers - they only enrich some individuals and impoverish others; they are like a zero-sum game.

5. Withholding finance from activities other than those related to producing or exchanging goods and services helps channeling all finances in the economy to support activities that exclusively produce or exchange goods and services. Not only is this economically wiser but also it is socially more just. In other words, preventing finance that is provided solely on the credit worthiness of the user of funds, regardless of the purpose of his or her use, creates a better social-justice environment than personal financing does.

 Objectives of the Prohibition of Riba

Accordingly, we can proceed to establish the objectives of Shari`ah's prohibition of interest as follows:

1. Affirming the Islamic realistic perspective and maintaining its internal consistency in not allowing any transaction that is not a real life activity. There are several forms of expressing the negative statement of this objective; one of these forms is preventing finance from activities that are not meant on their own or for what their nature defines or from activities that are used only as a vehicle to reach objectives other than what the nature of the contract implies. Another form is preventing return from being assigned to an asset that does not produce return. Yet another form is avoiding distributing anything other than the real value added or value created in an asset.

2.Upholding the sanctity of property rights and respecting the consistency of entitlements with the rights of ownership.

3. Disallowing debts' trade and exchange along with similarly unrealistic, purely speculative transactions that are not based on real production or exchange, such as creating unreal assets and index unit properties, because these activities do not create value but only rotate wealth among individuals.

4. Redirecting or rechanneling the human and other resources used in purely speculative, non-value-adding activities (such as trading debts) toward real production and exchange of goods and services.

5. Preventing debts' discounting and rescheduling for increment because these are nonproductive activities as they only transfer wealth from one person to another. The alternative that Shari`ah provides for rescheduling is interestingly mentioned in the Qur'an within the same sequence of verses that deal with the prohibition of riba - that is, giving time to paying or even forsaking the principal of the debt itself. On the other hand, Shari`ah permits discounting for early payment provided it does not become a business practice (not in the contract and only between the two parties).

6. Preventing the use of business finances for what can be tagged as `abath (Arabic for frivolity) - that is, activities that have no disclosed purpose or whose purpose is not desired to be disclosed because of the embarrassment it may cause, as such activities either are nonproductive, involve certain degree of shame, or are not belonging to business, though they may be honorable or legitimate.

7. Sending personal finance to where it belongs as a personal service based on direct contact and involvement between the finance's provider and user. Thus, personal financing can be evaluated, judged, and granted or not on the basis of the personal relations and bonds that exist between the user of funds and their provider. The answer to the question as to who will give you a loan becomes "your mother" or "a person who knows you very well and loves you." This does not mean that a personal loan is not useful; it rather means that it must remain personal and not changed into a business activity that aims at making money. As such, giving a loan is rewarded by Allah, as known in Shari`ah  because it becomes an act of benevolence.

8. Rechanneling all business financing toward the production and exchange of goods and services or toward creating value and closing doors in the face of all the uses of finance that unnecessarily inflate the quantity or size of financing in a society relative to the real market of production and exchange.

Finally, it should be noted that the prohibition of riba is never meant to be a prohibition or elimination of materially rewarding financing in general or of debt-creating financing in specific.

II. Implications of the Objectives of the Prohibition of Riba.

There are two important results that arise from the objectives of the prohibition of riba :

1. A loan is a means of providing personal finance, and it should remain "personal."

2. Any efforts that aim at creating new Islamic financial Hybrids should observe the objectives of prohibition in the process of developing new contracts.

In this section, we will study these implications and proceed to look into the nature and characteristics of Islamic financial intermediation and give a few examples ofShari`ah-friendly methodologies of risk mitigation.

Main Implications of the Prohibition of Riba

Loans and personal finance. It is really enlightening that our traditional textbooks of jurisprudence assign loans and lending to the category of charities and benevolence because when one talks about "personal," one needs to have personal information, personal relations, touches, passion, and care. These are the essence of benevolence and charity. This is why a loan is also due at any time because [there is no way (to blame) against the doers of good] (At-Tawbah 9:91), as hinted by the Glorious Qur'an.

In other words, it seems that the immediate implication of the prohibition of riba  is to remove lending activities from the business arena and to send them to the charity arena, which usually consists of both individuals who have close ties and bondages to one another and nonprofit organizations that act also on the basis of creating personal databases and relations, as a loan is given to a person who has temporary "needs" that call for "relief" with temporary liquidity.

In Shari`ah, loans and personal financing are not considered tools for mobilizing resources of investment, trade, and business. Of course, this does not mean the prohibition of issuing loans to businesses, but it means that lending to businesses is an exception, not a rule; whenever it is done, it should abide by the rules of benevolence and charity. It should not be reformulated as a profit-generating activity.

Observing the objectives of prohibition.This paper does not intend to go into the controversial issue of prioritizing the objectives of prohibition according to direct or specific texts from the viewpoint of the principles of Islamic jurisprudence. However, from a financial, cumulative, economic viewpoint, the lack of full observance of the objectives of prohibition may render a hybrid contract into a mere superficial cover-up of what is prohibited and make Islamic financing completely ineffective and inefficient in performing its essential characteristics.

For instance, while financing commodity trade is absolutely permissible and is consistent with the objectives of prohibition, the mere fulfillment of the conditions of owning or possessing (though necessary) is not a sufficient condition, unless the objective of helping or facilitating trade or exchange of goods and services is also observed. The criteria for this objective are obviously the assurance that the financed commodity or service will actually reach the user.[14]In other words, this means providing finances for contracts that are meant for what they are made for, in contrast to contracts that are used for other purposes.

If this kind of observance of the objectives of prohibition is loosened, Islamic financing - as a unique value-oriented, value-based financing methodology - will loose its merits and substance because the moment one enters the arena of providing "personal finance," the financing methodology becomes incapable of fulfilling any moral or ethical standards and ceases to be real or value-adding.

Nature and Characteristics of Islamic Financial Intermediation

Financial intermediation is an industry that recruits savings from persons who have them but do not know how or like to directly invest them and distribute financing to persons who need funding but do not have sufficient resources. It came into existence with the practice of bankers who noticed that not all depositors (essentially for safety and convenience purposes) withdraw their savings at once, the point that allows bankers to provide some of these savings to users of funds without risking being unable to pay deposits on demand. Financial intermediation in the West uses the loan as a basic contract for deposits and for financing. This is done mainly for historical reasons:

1. It is a desired contract by depositors as it guarantees their deposits, so why not use it also for financing so that the banker would also be guaranteed

2. It was permissible for a Jew to take interest from the gentiles, and most early bankers were Jewish.

The initiation and rise of Islamic banking in the last few decades of the twentieth century disturbed a four-century status quo. Islamic banks have been a blowing evidence that financing does not have to take the form of lending or a loan contract. With Islamic banking, financing is now redefined as offering goods, services, and means of investment for a delayed counterpart.

Accordingly, Islamic financial intermediation is also redefined as recruiting resources from those who have surpluses, either as sleeping partners with the intermediary institution (Arbab  al-mal or owners of capita) for depositors who want to use their savings for return generation or on a loan basis from those who prefer guaranteeing their principals, and giving financing to those who need them on the basis of murabahah , ijarah, or venture capital (mudarabah investment).

Funds in Islamic financial intermediaries come from three sources that can be summed in two from the point of view of using them:-

1-Shareholders' funds about which the management behavior is wakalah -based  (authorization-based).

2-Demand deposit funds that are given to the bank, not to the management, as guaranteed loans in the dhimmah (Arabic for good consciousness) of the bank. The management acts on behalf of the bank on a wakalah basis too, because the funds become a property of the bank that becomes represented as credit records in the bank accounts.

3-Investment funds of arbab al mal through mudarabah contracts with the bank, not simply its management. The management of an Islamic financial intermediary as an institution plays with the depositors' money on the basis of wakalah granted to the bank and assigned by its decision-making body to the management in regard to funds provided by investment depositors. The management also plays on the basis of wakalah granted by the decision-making body of the institution in regard to the institution's "own property."

The term "own property" includes the shareholders' equity plus the demand deposits for which the institution's dhimmah is charged (munshaghilah). In other words, an Islamic financial intermediary institution is a wakalah-based entity. On the one hand, it is a wakalah from the shareholders to management, like any other company, but with the exception that demand deposits are treated (from the viewpoint of investment decisions and profit or loss distribution) on the same footing as if they were shareholders' money.

On the other hand, it is a wakalah from the investment deposits' owners to the institution itself, which is in turn reassigned to the institution's management.

The concept of wakalah implies an extra precaution on two grounds: the wakil (fiduciary) in Shari`ah has very limited power when it comes to tabarru` (contributory) contracts, a point that requires specific permission from the property's owner for giving donations.

On the other hand, a wakil is required to be extra cautious in selecting investments and uses of funds, a point that may induce the wakil to have a preference of more security over less of it and of less venturous uses of funds over risky alternatives. This may partially explain why Islamic bankers have been preferring murabahah and ijarah over mudarabah as contractual vehicles for their uses of funds.

A step further may be taken on a theoretical basis to dare to say that Islamic bankers must, on a pure Shari`ah ground, have a preference for murabahah and ijarah over mudarabah because of the security and risk considerations.

We also question the wisdom of some traditional Islamic finance writings that call on Islamic banks to use the mudarabah contract on their asset's side as if it is better, according to Shari`ah, to take more risk. Sometimes, this theoretical preference is mixed up with the premise of al-ghunmu bi al-ghurm  as if taking risk is what justifies deserving a return, and therefore the more risk an Islamic bank takes the more Islamic it is!

In fact, Shari`ah does not assign any moral value to risk-taking; it does not have any reference to preferring more risk over less risk, and it does not make risk the cause for earning a return.[15]The realism of our Shari`ah is manifested in the axiom that one has an entitlement to a return either by expending human hours or by owning an asset that actually and factually produces a return.[16]

This means that return in financing is only justified by owning an asset that not only has a potentiality to create an increment but also has actually (in contrast to "presumably" or "supposedly") produced an increment. This is factuality as it exists on the ground.

Before we attempt to distinguish Islamic banking, as a financial intermediary methodology, from direct financing, we need to revisit the idea of markup in murabahah and see how it is built up within the Islamic perspective of financial intermediation.

Dates of payment and delivery have an effect on prices of goods and services. This is a known fact in both Shari`ah and conventional studies. Accordingly, any commodity or service would have a spectrum of prices according to its date of payment and date of delivery.

If we take, for simplicity, three of these prices, fix the date of delivery at a given point for the three of them, and define them as (a) a price with payment before delivery, (b) a price with payment at the time of delivery, and (c) a price with payment after the date of delivery, we will notice that, under the condition of "all other conditions or things are the same," price (a) is the lowest among other prices, and then comes price (b), and the highest is price (c).

This may partially be explained by time value of commodities and means of payment, but more important is the fact of the acquisition and use of a commodity. When one uses a commodity without having to pay for it at the time of acquisition, one is deriving utility from it and one would be willing to pay more for that.

By the same token, when one pays for it but defer the acquisition and use to a later date, one would like to pay less for the commodity. This is why we find our classical Islamic jurists calling the salam sale a sale of the mahawij (the needy ones) or a sale of mustarkhisin (seekers of cheap price).

Once we establish that a commodity has such differences in prices because of the dates of payment and delivery, we can explain that a markup in murabahah is neither derived from the concept of interest nor based essentially on the time preference for money (although time preference of money is not inconsistent with it and we have no reason to argue against it).[17]Rather the markup is essentially derived from the time structure of the commodity's prices.

Merchants usually provide commercial credit directly to their customers as is known and practiced, especially in trades between wholesalers and retailers. They use their own equity resources and very often depend on credit facilities from banks, especially by discounting commercial papers and promissory notes.

On the other hand, Islamic banks undertake providing finance to individuals and businesses using the resources that consist mostly of depositors' funds. Their kind of financing is thus based essentially on financial intermediation. They do not need to open stores or showrooms to justify their earning of a markup as the latter is - financially and morally - justified by the fact that prices of commodities vary in regard to the dates of payment and delivery.

Therefore, the difference in price between the case of immediate payment and delivery (the buying price in murabahah) and the deferred payment (the marked-up selling price in murabahah) of a commodity is not an imitation of riba; it is rather a real market-based differential, because in reality (and Shari`ah goes along with reality), people do have such differences in prices because the dates of payment and delivery do in fact affect prices.[18]

Finally, the distinctive feature of Islamic financial intermediation vis-à-vis direct commercial credit is the point that Islamic financial intermediaries must not act on their own initiatives in creating a financing process; they must act only on an initiative from a customer. This means that the Islamic financial intermediary is not a direct investment industry; it is rather an institution supporting businesses by providing financing to their investments and purchases.

This also means that whenever Islamic banks undertake buying or owning assets on their own initiatives (of course outside buying goods and services for their own personal needs to practice their business), they are in violation of the basic definition of Islamic financial intermediation and turn into merchant, direct, commercial credit providers!

Examples of Shari`ah Friendly Methodologies of Risk Mitigation

In a recent book on risk management in Islamic banks,[19]Khan and Ahmad argued that Islamic banks not only face the type of risks that conventional banks face but also face "new and unique risks as a result of their unique asset and liability structures.

According to Khan and Ahmad,  this new type of risks is an immediate outcome of these banks' compliance with the requirements of Shari`ah. They added that even in regard to common or conventional risks, the nature of risks that Islamic banks face is different from that of those counterpart risks faced by conventional banks.

The obvious implication of this argument is that Islamic banks need variant "risk-identification processes" and different risk-management approaches and techniques. They require a different kind of supervision, as well.

A similar argument appeared a few years earlier in an International Monetary Fund publication (see Luca Errico and Farrahbaksh, Islamic Banking: Issues in Prudential Regulation and Supervision)[20]. Although the authors conceded that capital minimum requirement should take into consideration assets' composition (i.e. the PLS[21]investments versus non-PLS investments[22]),  they argued that the capital minimum requirement needed for risks' coverage should be higher in Islamic banks than in conventional banks because their PLS assets are not collateral.

The main focus of these two writers on Islamic banks is addressed especially from the viewpoint of supervisory authorities and minimum capital requirement. While we agree with these writings on the points that Islamic finance entails in fact a different kind of risk, we should note that some of the risks referred to (such as legal and litigation risks) are purely procedural and caused by the fact that courts are not yet fully familiar with Islamic finance.[23]

However, Islamic financial products pose a different kind of risk challenges that focus on the risks of the investors and undertakers. Undertaker risk essentially relates to covering the issued product. In this regard, the experience in the Middle East, Southeast Asia, and Pakistan indicates that there is a strong appetite for Islamic financial products to the extent that each issue or option is always over-subscribed. Also, both purchasers and investors hold on to them to the extent that little room is left for a secondary market.

This demand is essentially derived from religious enthusiasm rather than economic calculation. Many researchers feel that with the enlargement of the Islamic financial market this enthusiasm may not continue; undertakers will then need to resort to economic rationale, which appeals to all potential investors, regardless of their religion or religiosity. Investors' risk is a matter of worry for beneficiaries of new Islamic financial products and bankers.

Promoters of Islamic public issues, such as sukuk, look for means of mitigating these risks in anticipation that religiously motivated demand will faint some time and a new motivation must be offered to investors. Here comes the role of new fatwas that attempt to find out means to reduce the risk of such issues and other new Islamic financial products. It is clearly noticeable that the pace of fatwas has been expedited over the last few years, especially since the last two years of the past millennium and some of these fatwas seem to have been very controversial.

To understand the effects of some of the "new" fatwas and assess their consistency with the specific objectives of the prohibition of riba, we will first review the extent and nature of risks involved in Islamic finance and then suggest objective-friendly methodologies for risk mitigation that can be considered alternatives to the hazy "new" fatwas.

Risk profile of Islamic financial contracts.

Without having to reiterate the description and characteristics of the Islamic financial contracts, we can describe their risk profile as being derived from the axiom of realism. What goes on in real life is what is accepted in Shari`ah , without any "additives" or assumptions. In other words, the nature of these contracts defines their risk profile. The fundamental financing elements in the Islamic financial contracts are as follows.

 a. There must be an asset basis to justify earning: Assets are either handed over to a manager (entrepreneur) or retained for leasing or obtained for resale.       

b.The asset base of financing must be the kind that produces increments, either by its very nature (e.g. fruits or usufruct) or by the effect of real market forces (e.g. goods and services).[24]

d.The investor (property provider) earns by virtue of ownership of an asset that grows. This is apparent in sale and lease financing and it is implied in the agency's content of sharing (continued ownership of money's provider into bought assets).

1.      Moral and Shari`ah screening is essential for Shari`ah-compatible investment and financial contracts.

These characteristics have their own risk profile. The basic point (that Islamic financial products are essentially based on real market transactions; i.e., assets, goods, or services) requires that we deal with the real risk of owning goods, services, and productive assets. Hence, we have a combination of price risk and an opportunity cost risk; the latter is usually expressed as interest rate risk as we live in a market that is overridden by interest.[25].

What may be emphasized is that while price risk is uniquely important in Islamic financing, it is drastically reduced, though the "binding promise" is murabahah and financial lease, while it remains an issue of consideration in other forms of finance (sharing- and asset-based investment).

As for moral hazard risk, it is apparently much greater in sharing finance than that in lending-based finance, which means that if moving away from interest means adopting musharakah and murabahah, the moral hazard risk will be multiplied many folds. On the other hand, one can hardly find any substantial difference in the nature and extent of opportunity cost risk and credit risk between Islamic finance and conventional finance.

Examples of Objective-Friendly Approaches for Risk Mitigation

In this section, we will discuss a few arrangements of risk mitigation that are intrinsic to the classical Shari`ah literature and go on to imply that these arrangements provide a variety of potential applications that may reduce the need to using risk-mitigation fatwas that raise Shari`ah clouds that are dared sometimes by some products thrown in what is called the "Islamic capital market."

To minimize the investors' risk in new Islamic financial products, especially sukuk (bills of sale) and corporate investments, a handful of arrangements can be used; namely, revenue sharing, service- and usufruct-based finance, principal insurance, collaterals, third-party guarantee, reverse murabahah  and murabahah line of credit.

Revenue sharing and revenue-sharing sukuk (Bills of Sale) The idea of revenue sharing is based on applying the muzara`ah methodology to fund provision in mudarabah . While mudarabah assigns a share of net profit to the fund's provider (rabb al-mal), revenue-sharing financing assigns a share of the gross revenue to the provider of assets that are used in the production process. Revenue-sharing financing is thus a combination of a wakalah to purchase or build fixed assets and a muzara`ah-based partnership between the assets' owner and assets' operator.

In a sukuk-type application, a trust (which represents the pool of investors) provides funds on a wakalah basis to an SPV[26] that constructs (through an istithna' contract that may be concluded with the operator) the required airport, toll road, or corporate factory and hands it over to the operator (the management) on revenue sharing. The airport, for example, is thus owned by the trust, and the investors receive a percentage of the total revenues of the airport. Revenue sharing may be applied to financing infrastructures as well as corporate productive projects.

This arrangement allows investors to get a practically guaranteed positive (above zero) return because total revenues are always positive. Consequently, compared to mudarabah , revenue sharing provides returns to investors even when the operator or management is loosing. This is an element that reduces the need to worry about the investors' return or to produce "new" fatwas to guarantee returns that may be dubious from a Shari`ah point of view, such as issuing debt-based, tradable sukuk.

On the other hand, revenue-sharing arrangements do not provide protection against variations in the return of the investors, so it is still classified in the area of sharing finance, like mudarabah and musharakah. Stability of projects and strength of their feasibility studies will be crucial for assuring smaller variations in return.

However, similarly to mudarabah and musharakah, revenue-sharing arrangements can be supplemented by either one of the following two structures or by both of them:

1.      a condition that imposes a cap on the net profit of the operator or management or on the return to investors, whereby surpluses above the cap are either rendered to the other party or scaled at different percentages

2.      a fund contributed to by deductions from investors' distributions and any concerned third party or by the surplus above the cap for equalizing the investors' return over distribution periods, as well as for principal guarantee

Service- and usufruct-based finance. In an economy of ever-increasing inflation and ever-rising cost of labor (improving the level of living), service- and usufruct-based financing and sukuk provide an excellent shelter against erosion of returns or principal. The reason is that payment of returns is in-kind - that is, in terms of either units of service or units of usufructs. This is another Shari`ah-compatible hedge against inflation without resorting to doubtful fatwas of vehicles that may involve a form or another of indirect interest.

Consequently, while service and usufruct financing stands as a hedge against inflation, it can also be supported by collaterals that guarantee - in fact - both principal and return. This is simply because service and usufruct financing is based on the sale-of-manafi` (utilities) contract.

Third-party guarantee: deposit guarantee. Third-party guarantee can be offered by any entity or person that has interest in a financing contract without being a party to it. It may cover the principal, as well as the return. For instance, a government, based on its own resources, may offer a third-party guarantee to a financier who provides funds (on mudarabah or Musharakah basis) for certain strategic or infant industries, so that a minimum return is guaranteed to investors and their principals are guaranteed.

The only requirement is that the guarantor must be financially and legally independent from the managing partner (the mudarib or the one who practices mudarabah) because mudarabah and musharakah are amanah (trust) contracts that can only be charged in case of neglect, abuse, or violation of the contract's conditions, but they cannot be charged for commercial losses. Consequently, we can always create an interested outsider-to-the-contract guarantor who can provide a third-party guarantee, such as an SPV that is not owned by the managing partner.

The practice of a third-party guarantee may also be applied to Islamic-bank-investment deposits when the government provides such a guarantee with no charge to the depository banks (being the mudarib). This was done in Sudan when the government created a deposit guarantee corporation nourished by contributions from mudarabah depositors, the government and the central bank. Depository banks can also contribute to such a corporation for a special fund that covers operational risks.

However, the same principle is also invoked by deposit guarantee funds that are established by certain Islamic banks and nourished by deductions from arbab al-mal's shares of profit before distribution. This practice started with the provisional act that established the Islamic Bank of Jordan, but a few other Islamic banks also do practice it for the purpose of "smoothing out the dividends' distribution over the years." Similar funds can also be created for sukuk, either for each issue alone or by creating an international sukuk guarantee corporation. Offered guarantee can be extended to cover the principal and a certain return, as well.

Reverse murabahah and murabahah line of credit. The way of applying reversed murabahah is simple. Providers of Islamic finance have to rely on their own resources and on deposits obtained either on a loan basis or mudarabah basis for funding. More funds can be obtained on the basis of reversed murabahah, in which the Islamic bank is the one that gives the order of purchase.

Obviously, applying reverse murabahah to the purchases of the bank for its own use will limit financing through this methodology to a small amount. But if we apply it to the purchases of the Islamic bank that are part of its own murabahah financing, it may extend to be a source of funding for a major part of its operation.

Reverse murabahah is a contract in which an Islamic bank is a finance user, not a finance provider. Finance providers may be a central bank, another Islamic or conventional bank, or certain corporations or entities with large sums that need to be invested in an almost-secured, though modest, return; in the same way, murabahah gives the Islamic banks an almost-secure, modest return.

The ground for Shari`ah legitimacy of reverse murabahah is not different from that of murabahah itself. If, at the time of the second sale in murabahah, the Islamic bank is permitted to make a markup gain that becomes known and predetermined for the period of the created debt, the Islamic bank can also be a purchaser in such a murabahah! The only condition that distinguishes such transactions from tawarruq is the realism or truthfulness of the property of the transaction.

A reverse murabahah must maintain its truthfulness the same way truthfulness must be maintained in murabahah itself. It must be intended to transfer ownership of goods from the hand of a supplier to the hand of a user (i.e. the Islamic bank in reverse murabahah).

The condition of realism can be fulfilled if the transaction is genuine in a sense that it provides for the actual bank's purchases that it needs for its customer, whereby the purchased goods and services actually change hands and end in the ownership of the bank. They will then be genuinely sold to the Islamic bank's customers through murabahah or  lease contracts.

On the other hand, in tawarruq, goods are purchased and sold only as a vehicle for financing as - unlike in reverse - they do not end up with a final user who actually uses them for his or her own industry or consumption.

A simple way of creating genuine reverse murabahah is by adding a line of credit and a wakalah contract, along with two accounts, one for a demand deposit and the other for a reverse-murabahah deposit. For certain murabahah financing that the Islamic bank wants to introduce to its customers, the Islamic bank can transact a reverse murabahah by virtue of wakalah for purchasing goods and services it provides to its clients, and the bank can transfer funds from the current account of the finance provider to its reverse murabahah account. Of course, this will include the contacted markup.

Reverse-murabahah arrangements can be used with the central bank as a final-resort provider of funds for Islamic banks. It can also be used with large corporate deposits and as an alternative to interbank transactions-cum-financing. Some form of reverse murabahah, though without the name, has been used for decades by the Islamic Development Bank (IDB) in financing national developmental financing institutions in Muslim countries by what the bank called "extended line of credit."

Finally what needs to be noticed is that, like murabahah, reverse murabahah creates debts, and it cannot therefore be traded or discounted because of the prohibition of interest. In other words, no secondary market can be created for reverse murabahah; it is an arrangement that can be advanced prior to granting the murabahah to the bank's customers.

Bundle or package financing: applying the majority rule.The simple form of a bundle is common stocks. They represent a group of assets, tangible and intangible, including cash and receivables. Yet, they can be traded at a market price that may be different from the face value if the majority of the assets they represent can have prices different from their face value.

But if the majority of the group consists of assets subject to hawalah (transfer) or sarf (exchange), then the rule that applies to the majority applies to the group. Consequently, the recognized ruling of Shari`ah is that common stocks may not be traded at a market price if the majority of the company's assets is in the form of receivables and cash.[27]

Creating bundles of goods, services, and receivables may be cash, and securitizing them is not restricted to common stocks - it can be done by Islamic banks and other financing and refinancing institutions. The IDB has been doing the same in transferring contracts to the Islamic Unit Investment Fund (IUIF) for two decades, and this has been used as a means to discounting (securitizing) the bank's investments at the IUIF.

Bundling lays the ground for a series of financial products that can respond to all personal financing needs and consequently render baseless the argument of a "genuine need" for tawarruq. If there is a need for a certain form of "personal financing," it can be satisfied by means that do not allow themselves to be abused.

This is because what actually happens in the case of tawarruq is that it is often used to overcome the barriers placed by the prohibition of interest on rescheduling for increment and on abusing the financing for `abath (vain) or objectives that crisscross the moral screening of Islamic finance and cannot be otherwise financed according to the criteria of the Shari`ah.

Hedging through options (not trading options). Finally, hedging existing positions may be differentiated from trading options. While buying options for the purpose of price speculation may be argued as fictitious and as profiteering without owning a real asset that may have an independent demand and supply for its own intrinsic utility or productivity, covering an existing position through buying or selling an option may be looked at as a means to reduce potential variations in prices and then tame price speculation.

Accordingly, one-way hedging through options can be found useful and permissible, a matter that can also be used in Islamic financial innovation.

Conclusion

A word is needed for conclusion. This paper was an attempt to determine and define the objectives of the prohibition of riba from the main texts in the
Qur'an and in the contemporary contexts that take into consideration a contemporary interpretation of the Islamic concept of generation of returns or revenues. We noticed that although the condition of being asset-based is a necessary condition for Islamic financing, it is not sufficient.

We need two more conditions to pass the criteria of Islamism: The underlying asset must be of the kind that is liable to produce return, growth, or increment, and the transaction must be genuinely meant for what it is for or what defines it.

Together, these three conditions channel financing contracts in the desired or designed direction that is meant by the prohibition of riba and at the same time guaranteed to make it (by the nature of the described processes) subject to the moral or ethical screening that Shari'ah at large calls for and aims at.

We have within the limits of the objectives of the prohibition of riba a host of means that make risk management in innovative Islamic financial engineering a challenging arena that does not leave room for resort to dubious and counterproductive interest-mimicking approaches of financing. Such approaches often contradict the essence and basic objectives of the prohibition of riba  as well as other regulations of Islamic financing.

* Paper Prepared for the IIUM International Conference on Maqasid al-Shari’ah, August 8-10, 2006

Dr. Monzer Kahf is currently working as an independent consultant/trainer on Islamic banking, finance, zakah, awqaf (endowment), Islamic inheritance, Islamic estate planning, Islamic family law, and other aspects of Islamic economics, finance, Islamic transactions (Mu`amalat). If you would like to contact Dr. Kahf, please e-mail him at monzer@kahf.com.

[1]Is a hybrid financing contract consisting of buying cash and selling to the person who ordered the purchase on credit at a higher price.