How Contemporary Practice of Islamic Finance Attempts to Overcome the Difficulties Associated - Coursework Example

Running header: Riba and Gharar are Major Financial Prohibitions under Sharia and they have had a Significant Impact on the Islamic Finance Industry: How Contemporary Practice of Islamic Finance Attempts to Overcome the Difficulties and Challenges Associated. Name of Student: Institution: Instructor: Course Code & Name: Date of Submission: Table of contents Table of Contents Table of contents 2 Table of Contents 2 1.0 Introduction 3 2.0 Concept of Riba Prohibition 4 3.0 The concept of Gharar 6 4.0 Murahaba and Salam 10 5.0 Attempts to Overcome Challenges Associated with Islamic Financial Prohibitions 13 16 6.0 Conclusion 16 Riba And Gharar Are Major Financial Prohibitions Under Sharia And They Have Had A Significant Impact On The Islamic Finance Industry How Contemporary Practice Of Islamic Finance Attempts To Overcome The Difficulties And Challenges Associated. 1.0 Introduction The Islam religion has beliefs which make it not possible for the normal banking practices to be used by Muslim faithful. For this reason, there arises a need for the Muslims to find a solution to their finances. This saw the rise of Islamic banking and finance which are specifically established to conform to the rules and regulations of the Islam religion and culture. Islamic finance is finance that is associated with the law. Financial tools put in place by the law are intended to be used for the good of all Muslims. All tools being social or economic can either cause good or evil to the people subject to them. Islamic financial tools and injunctions are put in place by the law and are intended to do well. The most familiar prohibition of Riba is found in the Quran. Many people however negligently interpret these verses to relate only to the situation where a creditor charges high and exploitative interest’s rates. The common English man reads the certain verses containing Riba prohibition and translates the verse as meaning that the sole objective of Riba is to avoid injustice. The real meaning however as explained by various Muslim scholars is; if one turns back, he or she should collect their principle without inflicting or receiving any kind of injustice. The Quran says that one shall deal not unjustly and ye shall not be dealt with unjustly. Understanding the prohibition of Riba is an important aspect and in line with this essay avoiding its implications even more important. Alternatives to this prohibition should be looked into so as to deal with difficulties associated with them to the Islamic community and Islamic finance as well. 2.0 Concept of Riba Prohibition Law as put by the messenger of Allah says that gold for gold, wheat for wheat, barley for barley, dates for dates and salt for salt and any increase whatsoever is Riba. Bilal visited the messenger of Allah with some dates and this prophet inquired about their source. He explained that he had got two volumes of low quality dates and exchanged them with one volume of high quality dates. The messenger said that this was the forbidden Riba. The prophet should have sold the first volume and used the proceedings therefore to buy the other higher quality of dates. In the modern world, the dates represent the monies used today. There are two forms of Riba; one is whereby money is exchanged for money hand to hand though in different quantities. The other form is whereby money is exchanged for money with deferment. In the conventional financial sector, financial intermediation is effected through lending, the tune value of money being reflected in interest payments. According to law, this is Riba and was warned by Allah and his apostle. The messenger of Allah in the Quran curses the one who devours or takes a share of Riba and the one who pays it, witnesses it and also the one who documents it. The prophet put that there are seventy three different types of Riba. The worst of them is equivalent to invest in sin and the worst still being equivalent to destroying the honor of any particular Muslim. In the modern world, Riba can be translated as usury, money or interest. The ban applies in exchange of like materials of different values which precisely includes lending money for interest. The rules of this prohibition are quite complex and have n the recent past heated up debates in the Muslim community on the basis of their application. Liberalists have attempted to restrict its coverage to the charging of excessive money interest in line with laws in the west. This has however been rejected by Muslims who have continuously refused to accept any money interest1. This kind of prohibition simply means that loans should be charitable agreements between parties and any individual or creditor who intends to make gains out of loans is considered to be involved in Riba. This is thus prohibited in law and though some scholars have tried to restrict its application, majority view is in line with the concept of loans being charitable organizations. Prohibitions like Riba are the most known cause of the lack of co integration in the Islamic stock markets2. These prohibitions have made the Islamic finance industry prohibitions driven industry hence creating lack of integration with other financial markets. The prohibition of Riba requires that any reward or return be accompanied by the undertaking a certain level of risk and liability. However, Riba has been typically observed to be applied to deferred transactions and any future performance has been suspected to involve the double taint of Riba and another prohibition in the name of Gharar. 3.0 The concept of Gharar Gharar means that the existence of any unavoidable uncertainty in any particular commercial dealing would certainly lead to deceit or unjustly gain. This is the main concept of Gharar prohibition in law. Riba and Gharar always appear to be twin concepts whereby the effectiveness of this concepts have been moderated under the doctrine of necessity although still being under the scrutiny of scholars both Muslims and non Muslims in the financial sector 3. In some verses in the Quran, the term maysir mainly used to mean gambling was banned. In literal terms, this word means illicit gains. It could also be taken to mean unjust enrichment. This term is related to the ban on Riba and also related to the ban on Gharar. Gharar is the uncertainty, speculation or risk. Some Muslim reformers and scholars see in the ban on Gharar the desire to avoid an economic phenomenon. If this is true, this would help the Muslims in justifying that simple interest does not in itself amount to Riba. In today’s economy, Gharar is the risk of economic harm resulting from imperfect knowledge of the market and prevailing conditions. In real sense, no one commercial transaction can be without risk or uncertainty. Therefore, Gharar has always been assumed to mean a certain level of unacceptable risk or uncertainty. In the context of modern commercial dealings, Gharar is mainly involved in three instances where the information given is totally inadequate, unacceptable levels of risk, inaccurate information and in other cases where the dealing are complex and their transactions are not correctly identifiable. A sale attributed to a future date according to law and the Gharar prohibition is void. Prohibition of this kind of uncertainty means that options, forwards and futures contracts are not valid under the law. Another impact of this kind of prohibition is that conventional insurance is invalid under law. This is because the total amount of the premium paid by the policy holder is not determinable and this imposes an unacceptable level, of uncertainty and risk hence amounting to Gharar. Islamic banks have also not been able to engage in many modern and conventional banking standards and practices. Islamic banks use a kind of banking paradigm known as asset based financing and also profit and loss sharing agreements. The concept of time value for money where conventional banks operate is an area where Islamic banks do not venture. This is because this would involve debts and this would always amount to Riba. Gharar also prohibits derivative securities transactions and this is because the object of sale may not be in existence at the time the trade is to be executed. Reliance on law has not only posed difficulties in the banking and finance sector but has also rendered the compliant economies not viable for investment. Penetration of value added services for instance investments, insurance and savings have been extremely low due to the prohibitive Riba and Gharar4. In other words, Gharar can be seen as the sin of losing money in the process of financial speculation or engaging in risky investments. The ancient ban on insurance is a common manifestation of the Gharar prohibition and the other regulating of contracts. Bida is the sin of innovation in religion which has long prevented the exercise of individual conscience in Islam. The Muslim community is bound but his law o adheres literally to the interpretations of the Quran. Even the most liberal Muslims often think twice about ignoring such prohibitions5. For most Muslims, prohibition of Riba and Gharar means the avoidance of all interest and risk based finance. There are certain alternatives to this and it includes allowing a license based lenders who are supervised. The licensing should ensure that the borrower or the consumer has needed to be protected. The Muslim community has been trying to deal with these prohibitions and some have come out successfully. To meet the financial needs of the Muslims has been really a task taking into consideration the beliefs and the compliance to the law. The beliefs and the law have always precluded them from using conventional financial tools and instruments. However, large industries of compliant financial instruments have emerged and this has emerged in the recent past and has been improving with time. These instruments have been scrutinized by Muslim scholars and regulators to determine whether they are compliant. Financial instruments that allow forbidden forms of exploitative interests and charge riskless interest are forbidden by law. Financial instruments that entail uncertain financial transactions are prohibited and also zero sum games that are based on pure chance are also not acceptable according to law. Experts have also found ways of meeting other financing requirements without violating the law. Insurance through takaful has also come into being without being in conflict with law and the prohibitions that come with it. Innovation in this financial sector of compliant industries is associated with the goal of pooling of risks more or less like the conventional finance sector. For instance, there has been a growing demand for a certain type of bond introduced in Malaysia known as the sukuk. In the recent past, Muslims have been advancing charitable funds at a zero rate of return to other Muslims who are less privileged6 . 4.0 Murahaba and Salam Compliant mutual funds have been on the rise in the recent past in a bid to deal with the implications and shortcomings of the prohibitions of Riba and Gharar. Various Islamic indexes have been introduced to give the Islamic investor guidance on the way forward. Supervisory boards have always given preference to newer companies that raise money on equity markets rather than through banks and other financial institutions. Some other special funds for instance the pension funds and hedge funds have been on the rise in the Islamic financial scene7. The most common trust sale in the Islamic financial sector is the murahaba. It has a mark up over the invoice. It is in the case where a customer wishes to finance the purchase of some asset or commodity. The bank therefore obtains a binding agreement with the customer on financing the purchase and the customer will be bound to pay at a markup above the spot price. This is characterized as the murahaba profit and not interest. The bank consequently buys the property in question at the spot price and later sells it to the customer at the agreed upon credit price. This kind of financing has been used for a long time in financing large corporate customers. Other instruments have also been developed including the one referred to as the Salam. This structure could entail a bill being sold forward with a certain price payable now. It is like a forward contract of a kind. The background of Salam lies in the government whereby the government would collect Treasury bill prices by ostensibly selling a commodity usually aluminum or any other kind of metal. After this, instead of delivering the aluminum at the Treasury bill maturity, the government guaranteed that it would sell the aluminum on behalf of the bill holders at the price they initially paid plus a sum equal to the interest rate on its short term debt. This is what is known as short term Salam8 . Compliance has been a concern for non Muslim financial institutions. To be compliant, an institution should fully understand and conduct business in accordance with the prohibition of the general rule of Riba and Gharar. Another aspect is the furthering of Islamic social objectives. The promotion of social benevolence should be a main concern for institutions hat want to be compliant. The services provided in such institutions should be based on the mutual cooperation of all and the aspect of mutual assistance should be taken into consideration. Another aspect of compliance is the development and integration of an integrated Islamic financial institution. The system should be comprehensive and the structure should be based on sound law. Service provision should be aimed to benefit the Muslim community, ummah, as a whole. The promotion of all related parties and the development of a professional ethic and standards according to law should be considered. A supervisory board has been set up to dictate whether firms meet standards and also whether compliance is followed to the core for those organizations that comply with this kind of law. The compliance to law involves not engaging in interest based transactions as well as transactions that involve exploitation of any kind to any one party. The board also acts as the religious advisers to the concerned institutions. After all this has been done, certification is done to the organizations that meet the requirements of law. This is after the verification of the transactions compliance to law. Governance involves the features that have been put in place by regulators whereby most organizations need interpretation of the law to be compliant. However, various issues and disputes arises especially those relating to the confidentiality and independence of organizations and institutions that want to be certified. These disputes are solved by the supervisory board and clarification is made on unclear or misunderstood parts of the law9. The rising demand among institutions to be compliance shows just how much the Muslim community is willing to be freed from the shortcomings and implications of prohibitive law and most especially Riba and Gharar. The need for this particular group to be financed has been taken as a concern in both the Islamic financial sector and also the non Muslim financial sector. 5.0 Attempts to Overcome Challenges Associated with Islamic Financial Prohibitions There are various challenges associated with Islamic finance. To abide by the law and the teachings of Islam is the hard thing to do. For this reason, Islamic finance must integrate special features into their finance management in a bid to ensure that the finance remains the ideal choice for all Muslims. Gharar and Riba are major prohibitions in Islam banking. Each of them has different challenges which Islamic banking must counter so as to fulfill the demands of Islam. The following section tries to expound on how Murahab and Salam have been successful in trying to face the challenges of Islam finance. A common and major challenge that has been in existent in Islamic finance is the need to find an efficient and effective liquidity management tool10. The available options are interbank deposits and bonds issued by either the government or corporate. The two options are all interest bearing which is centrally to the Sharia law which does not embrace interest. For this reason, a need to have a tool which could integrate the financial need of Islam and the Sharia arose. Murahab has come in handy as a means of solving the liquidity problem. Commodity transactions using the Murahab structure has enabled Islamic banking to enjoy almost the same liquidity as the one present in conventional banks which has been a major step towards realizing the dream of an efficient Islamic finance structure. Riba prohibition had made it very hard for Muslims to engage in financial transactions. This is because Riba is one of the major prohibitions that Islam has while on the conventional banking and finance, maximization of interest is paramount11. Getting a transaction right and ensuring that Sharia has been followed strictly is a hard task where there is absence of a good valuation structure. Murahab and Salam have been able to counter this problem. Full description of the commodity is a must which ensures that there is no fraud/ conning. The terms and conditions of sale and payment are also outlined clearly which makes Islamic finance more transparent and luring since there is more security generated. Home ownership is a real problem facing many people in the world and Muslims are not spared either. Conventional banks are on the forefront providing mortgages and real estates. Islamic finance on the other hand has to come up with a way of providing good terms of acquiring hosing within the limitations of the Sharia law. With prohibitions in place providing a barrier to this problem, Islamic finance has come up with home financing techniques. Home finance is another way in which Muslims have tried to evade the prohibitions of the law. The character of this kind of finance lies in the absence of interest payments .Financial institutions both Muslim and non Muslim have come up with compliant home finance due to the rising demand from this group of people. The various forms of home finance include the murahaba which involve the home buyer finding a home, approaches a financier who then buys the home and subsequently the home buyer buys it from the financier. This could be a bank whereby the customer pays a fixed monthly installment over a period of time. The profit margin or the mark up takes the place of interest in the conventional mortgage industry. Another product is the ijara wa iqtina whereby the client finds a home and asks the financier to buy it. The financier then sells the house against deferred payment possibly at the same time but retains title until the last payment has been made. This is an agreement separate from the purchase agreement as the provides a separate contract for each individual transaction. These two products have reduced the failure of owning homes among Muslims who blamed the prohibitions of Riba and Gharar.A third product is the musharaka mutanaqisa. This entails a home buyer and the financier owning a home jointly. Over time, the financier’s share diminishes as the home buyer’s share increases with time. In most cases, the financier buys the home and registers it in the names of both the home buyer and the financier. Ownership is transferred fully to the home buyer after a certain agreed period. 6.0 Conclusion With only a few governed countries having central banks, some countries have started creating central banks and acting as lenders of last resort as opposed to Islamic law. Interbank money lending has also been transformed into compliant form of financing. With the liquidity levels of some countries falling to dangerous levels, the need to finance them has been on the increase. This has led scholars to look for ways to deal with the prohibitions of Riba and Gharar. The pricing of assets has been used to avoid Riba and has been successful in most countries12. Various solutions have been introduced by scholars and regulators. Different forms of finance specially structured for this particular group of the population have come up. The need to finance them has been on the rise in the recent past and most institutions have been concerned in away and have come up with different kinds of solutions. Islamic finance mainly involves banking, capital markets and insurance known as takaful. Bonds that are being introduced and the response to them is tremendous and the demand is high for such financing. Development of Islamic finance through the standard setting bodies and policing of the industry have really been fundamental in promoting Islamic finance. Adequate monitoring has been put in place by the supervisory board as more and more organizations embrace compliance and certification. There has been an ongoing debate on how far these Islamic financial products are really Islamic and not conventional. Critics have argued that Islam finance sector has put religious form over substance. They often trace the problem to the interest inherent in the law. Credit rating agencies have also been criticized in this regard. Sympathizers of Islamic finance have cited that the Islamic finance industry s experiencing growth and that this industry is facing various fiscal, economic and legal challenges. They argue that time is needed for the industry to move toward a more genuine risk and interest sharing ratio between the contracting parties13 . All in all, the entire Islamic finance sector is reportedly less than one per cent of the conventional finance sector. This does not make it insignificant. This sector has massive potential and the future very promising in regard to the changes that are taking place on this front. The products are likely to gain a very tremendous market penetration and expand as well as diversify to many areas. The overcoming of prohibitive laws is the first step toward great market penetration and success in the Islamic financial sector. 7.0 REFERENCES Davidson, A,How the City Really Works: The definitive guide to money and Investing in London’s Square Mile. Kogan Page Publishers. London 2010 Demirguc-kunt, A., Beck, T. and Honohan, P, Finance for all? : Policies and Pitfalls in Expanding Access. World Bank Publications, Washington, DC, 2008. Fabozzi et al., Handbook of Finance: Financial Markets and Instruments. Volume 1 Of Handbook Finance. John Wiley and Sons Publishers. New Jersey, 2008 Grais et al. Corporate Governance in Institutions Offering Financial Service. Issues And Options. World Bank Publications. Washington, DC, 2006. Hafeez, J. Islamic Commercial Law and Economic Development. Islamic Commercial Law Publishers, United Kingdom, 2011. Karim, B, Kassim, N and Arip M . International Journal of Islamic and Middle Eastern. Finance and Management. Vol. 3, no. 4, 2010, pp. 363. Masmoudi, F.& Belabed, T.Islamic Finance In The Face Of The Financial Turmoil : Opportunities And Challenges, Capmena, vol. 7, no. 3,2010,pp. 7. Ramadan, H. Understanding Islamic Law: From Classical to Contemporary. Rowman Altamira Publishers, Maryland, 2006. Roberts, G., Law and the Arab oil burst. Petro cost or cost f being Muslim. Universal Publishers, Florida, 2007. Roberts, G. Islamic Human Rights and International Law. Universal Publishers, Florida, 2006. Thomas, A. Interest in Islamic Economics: Understanding Riba. Elgar Publishing, Camberley, UK, 2010 Visser, H. Islamic Finance: Principles and Practices. Edward Elgar Publishing, Camberley, UK. Wilson, R. Regulatory Changes Posed By Islamic Capital Market Products and Services, University Of Durham, UK, 2009. Read More