INCEIF

The Global University in Islamic finance

Kuala Lumpur, Malaysia

CIFP part 1SH1002 Shariah rules in financial transactions

Title _________________________________________________________

Standardization versus diversity of Shariah rules in Islamic Finance

Semester September 2000

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Abstract_________

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Key terms of the research

1………………. 2……………. 3……………….4…………….5……………….

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Objectives of the research:

To discuss the issue of standardization and harmonization of Shariah rules in Islamic finance in order to achieve a uniformity in the practices of the Islamic Institutions

To discuss issues of diversity in Islamic law and its implication, and The proper methodology to address it within the framework of

standardization

Table of content

Introduction

The difference between Islamic finance and conventional finance

An overview of Islamic financial institution

Introduction to Shariah law

Issues of standardization and harmonization of Shariah rules in Islamic

finance

Shariah expertise

Shariah compliant securities

How do we solve this?

Conclusion and finding

References

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Introduction

Globally, Islamic finance has exhibited its potential through the ever-increasing number

of Islamic financial institutions (IFIs). Unofficial estimates figure Islamic financial assets

of the IFIs at nearly a trillion dollars. The Islamic financial industry is still growing and

is finding its niche in many Muslim as well as non-Muslim countries. The growth is

swift, but it is accompanied by standardization and harmonization issues and challenges

which will need to be addressed in order to facilitate and coordinate the innovation and

diversity that it brings.

The difference between Islamic finance and conventional finance

In order to understand Islamic finance it must be known that the underlying theme of

Islamic finance is the niyah or “good intention”—the element that drives the Islamic

socio-economic system for ensuring the enhancement of the welfare of society. The

niyah may represent the Islamic philosophy of conducting life and business, but it is not

restricted to Muslims. The tenet pertains to justice and fairness which can be practiced by

all, Muslim and non-Muslim alike. The Islamic financial system, therefore, hinges on the

niyah as an essential ingredient for every contractual transaction that is executed.

For the layman, the fundamental difference between Islamic finance and conventional

finance is the feature in the latter to put a cost on money in financial transactions, i.e.

interest, or riba as it is known in the Islamic financial world. Basically, whatever is

borrowed has to be returned but with an increment.

In Islamic finance one of the questions most often visited is: “Money has time value;

how can it not have a cost?” The simplest answer is that in Islamic finance there is no

concept of money as a commodity: There is always an underlying contract in the form of

a partnership or venture that is entered into between the lender and the borrower, with the

profits or losses and the risks all being shared. Therefore, a fixed return per se cannot be

assured. This perspective of Islamic finance confers a “soul” to business activity. The

motives are the welfare of the people; an egalitarian society; the opportunity for all to

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benefit without being exploited. Islamic finance covers the social aspect of being in

enterprise. Above all, it is trust-based

An overview of Islamic financial institution

A financial institution is an institution that provides financial services for its client or

members. Probably the most important financial service provided by financial institution

is acting as financial intermediaries. Most financial institutions are highly regulated by

government. Broadly speaking, there are three types of financial institution:

1. Deposit taking institutions that accept and manage deposits and make loans,

including banks, building societies, credit union, trust companies and mortgage loans

companies.

2. Insurance companies and pension funds; and

3. Broker, underwriters and investment funds

But to make our discussion easier to understand, I shall use Islamic banks, as my main

example to explain an overview of how Islamic financial institution works. Islamic

banking is a type of universal banking. However, Islamic banks have their own special

characteristics. The majority of Islamic banks perform two basic functions, namely

investment management and commercial banking. Unlike conventional commercial

banks, Islamic banks do not pay or charge interest on lending or borrowing of money.

This is because the Shariah strictly prohibits, among other things, the receipt and

payment of riba (interest). Hence, Islamic banks cannot hold or issue interest-bearing

securities such as treasury bills or bonds. The banking services provided by Islamic

banks to business customers are mainly confined to letters of guarantee, letters of credit,

and current or demand accounts.

Investment management is the main service provided by almost all Islamic banks. As an

alternative to borrowing funds and paying interest on them, Islamic banks use a version

of the profit sharing mudaraba contract to mobilize funds in investment accounts in order

to invest them on behalf of holders of these accounts. This service is performed also, but

to a lesser extent, on the basis of the agency contract. As an alternative to lending funds

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and charging interest on them, Islamic banks use various contracts (e.g. murabaha,

musharaka, ijarah, salam, etc.) including the mudaraba contract to invest funds under

management as well as their shareholders’ funds .

Although Islamic banks tend to perform a hybrid of services of both commercial and

investment banking, the structure and processes of Islamic banks do not readily fit in

with those of conventional universal banking, which combines banking and investment

businesses. For example, unlike conventional banks, Islamic banks do not erect firewalls

to separate, legally, financially, and managerially their investment and commercial

banking services. Rather, the majority of Islamic banks combine investment accounts’

funds with their shareholders’ funds, invest both funds under the bank’s management in

the same investment portfolio, and report these investments and their results in the bank’s

balance sheet and income statement. Hence, investment accounts’ funds are not ‘ring

fenced’ from the bank’s funds .

Furthermore, investment companies (e.g., mutual funds) ‘‘sell their capital to the public,

while Islamic banks accept deposits from the public. This implies that shareholders of an

investment company own a proportionate part of the company’s equity capital and are

entitled to a number of rights, including receiving a regular flow of information on

developments of the company’s business and exerting voting rights corresponding to

their shares on important matters, such as changes in investment policy. Hence, they are

in a position to influence strategic decisions. By contrast, depositors in an Islamic bank

are entitled to share the bank’s net profit (or loss). Moreover, depositors have no voting

rights because they do not own any portion of the bank’s equity capital. Hence, they

cannot influence the bank’s investment policy.’’

And unlike those of investment companies, Islamic banks’ financed assets are neither

marketable securities nor are they measured on the basis of ‘‘mark to market’’ or fair

value. Rather, as mentioned above, the assets of Islamic banks are governed by various

forms and are stated at cost and/or the lower of cost and market. However, given that

Islamic banks cannot hold treasury bills or bonds or other interest yielding securities, it is

claimed that bank supervisors would have difficulty in putting a value on the assets of

these banks. Steele (1984) argues that this is because ‘‘the traditional banking system has

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much of its assets in fixed interest instruments and it is comparatively easy to value that.

But it is very difficult indeed to value an Islamic asset such as a share in a joint venture

and the, bank supervisors, would have to send a team of experienced accountants into

every Islamic bank, to try to put a proper and cautious value on its assets ”.

Furthermore, the characteristics of Islamic banks tend to raise a set of issues concerning

corporate governance and agency problems that have no parallels in either commercial

banks or investment banks .

The mudaraba contract has detailed juristic rules that are derived from the Shariah and

which regulate the relationship between investment account holders (IAH) as providers

of funds and the bank in its capacity as mudarib (entrepreneur). The mudaraba contract

is a profit sharing financial instrument that is neither a financial liability nor an equity

instrument in the normal sense. Unlike equity instruments, investment accounts are

redeemable at maturity or at the initiative of their holders, but (usually) not without the

prior consent of the bank. Islamic banks can refuse to pay IAH until the results of the

investments financed by IAHs’ funds are determined. In addition, IAHs do not have the

benefit of a board of directors to monitor management on their behalf. On the other hand,

unlike debt instruments, investment accounts are not a liability of the bank because they

earn their returns by sharing in the profits generated from their funds, and also bear their

share in any losses incurred. Furthermore, Islamic banks do not guarantee the value of

these investment accounts. Thus, holders of these accounts have a claim on the bank’s

earnings or assets, which ranks pari passu with that of the shareholders. The fact that the

mudaraba contract is neither a debt nor an equity instrument means that it is not a hybrid

instrument comprising debt and equity (for example, it is not debt with an embedded

equity derivative).

In the unrestricted type of mudaraba, IAHs authorize the bank to invest their funds at its

discretion including commingling the IAHs’ funds with those of shareholders. In the

restricted mudaraba, IAH specify to the bank, among other conditions, the type of

investment in which their funds should be invested, e.g., real estate, currencies, leasing,

etc. However, in both types of mudaraba IAH do not have the right to interfere in the

management of the fund, and violation of this condition can nullify the contract. Hence,

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although holders of both types of investment accounts are exposed to different degrees of

risk, their relationship with the management of the bank is subject to the same

monitoring arrangements .

The aggregate investment portfolio of an Islamic bank is usually financed by IAHs’

funds, plus some of shareholders’ equity and other sources of funds (e.g., current

accounts) the latter being mobilized on bases other than the mudaraba contract. If the

aggregate investment portfolio yields a positive return, then the shares of profit are

allocated between the parties to the contract, IAH and the bank, according to their

proportionate shares of their respective investments in the portfolio. The bank’s share of

profit relates to both its shareholders’ funds and to other funds invested in the investment

portfolio that do not participate in profit-sharing (e.g. current accounts which are capital

protected but nonparticipating). It is to be noted that shareholders’ funds invested in the

investment portfolio (and elsewhere) and the other nonparticipating funds are not covered

by the mudaraba contract, and are not governed by its rules. Hence, the bank’s

shareholders receive the entire profit from these sources, and IAH cannot claim any

profit share from them. The bank also receives what is called the mudarib share of profit,

based in principle on a predetermined percentage of the profit attributable to the IAH,

which is specified in the contract. This is a reward for the managerial effort of the bank

in managing the funds of IAH. The mudarib share of profit allocated to the bank

constitutes a return to the bank’s shareholders.

If the bank’s aggregate investment portfolio yields a negative return, then, according to

the mudaraba contract, this loss should be borne by the IAH and shareholders pro rata to

their respective investments in this portfolio, bearing in mind what was said in the

previous paragraph. Like that of shareholders, the liability of IAH is limited to the

amount of their investment and no more. In the case of a negative return, in addition to

the shareholders’ proportion of the loss which is determined pro-rata as indicated above,

the bank in its capacity as mudarib receives no profit on behalf of its shareholders (the

mudarib share having a lower bound of zero). However, according to the mudaraba

contract, if the loss is due to misconduct or negligence of the mudarib, then the Islamic

bank has to make good the loss.

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Introduction to Syariah law

Islamic law is known as Shariah law, and Shariah means the path to follow Allah's law.

Shariah law is holistic or eclectic in its approach to guide the individual in most daily

matters. Shariah law controls, rules and regulates all public and private behavior. It has

regulations for personal conduct such as prescribing specific rules for prayers, fasting,

giving to the poor, and many other religious matters . 

Shariah law can also be used in larger situations than just guiding an individual's

behavior. It can be used as guidance for how an individual acts in society and how one

group interacts with another. The Shariah law can be used to settle business disputes or

conflicts between or within an organization. This law does not exclude any knowledge

from other sources and is viewed by the Muslim world as a vehicle to solve all problems

civil, criminal and international. 

Shariah law has several sources from which to draw its guiding principles. It does not

rely upon one source for its broad knowledge base. The first and primary element of

Shariah law is the Quran. It is the final arbitrator and there is no other appeal. The

second element of Shariah law is known as the Sunnah, the teachings of the Prophet

Mohammad (s.a.w) not explicitly found in the Quran. The Sunnah is a composite of the

teachings of the Prophet (s.a.w) and his works. The Sunnah contains stories and

anecdotes, called Hadith, to illustrate a concept. The Quran may not have all the

information about behavior and human interaction in detail but the Sunnah gives more

detailed information than the Quran. 

The third element of Shariah law is known as the Ijma. The Muslim religion uses the

term Ulama as a label for its religious scholars. These Ulama's are consulted on many

matters both personal and political. When the Ulama's reach a consensus on an issue, it is

interpreted as Ijma. The concepts and ideas found in the Ijma are not found explicitly in

the Quran or the teachings of the Prophet (s.a.w). Islamic judges are able to examine the

Ijma for many possible solutions which can be applied in a modern technical society.

They are free to create new and innovative methods to solve crime and social problems

based upon the concepts found in the Ijma. These judges have great discretion in

applying the concepts to a specific problem. 

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The Qiyas are a fourth element of Shariah Law. The Qiyas are not explicitly found in the

Quran, Sunnah, or given in the Ijma. The Qiyas are new cases or case law which may

have already been decided by a higher judge. The Shariah judge can use the legal

precedent to decide new case law and its application to a specific problem. The judge can

use a broad legal construct to resolve a very specific issue. For example, a computer

crime or theft of computer time is not found in the Quran or Sunnah. The act of theft as a

generic term is prohibited so the judge must rely on logic and reason to create new case

law or Qiyas. 

The fifth element of Shariah law is very broad and "all encompassing." This secondary

body of knowledge may be ideas contained in the other written works. The New

Testament is an example of this area of information, and legal discourses based upon

Civil Law or Common Law may be another example. All information can be examined

for logic and reason to see if it applies to the current case. It also may be a local custom

or norm that judge may find helpful in applying to the issue before him. The judge may

also weigh the impact of his decision upon how it will affect a person's standing in the

community.

Issues of standardization and harmonization of Shariah rules in Islamic finance

The contracts prescribed in Islamic law provide a significant part of the principles and

procedures explicitly laid down in the Fiqh or Islamic jurisprudence which must be

observed for shariah compliance. For instance, the Qur’an is replete with passages that

denounce riba as exploitative and against the norms of fairness. The problem arises

where the principles and procedures for specifics are not so easily found and therefore

have to be derived from the fatwas, or interpretations of the shariah scholars. The fatwas

awarded on financial transactions differ amongst scholars and across jurisdictions, which

produces the problem of pluralism in shariah interpretations. There are mainly five

schools of thought in Islamic jurisprudence for example,

Hanafi, Shafei, Hanbali, Maliki, and Ibadi amongst others. Each school of thought has its

own set of muftis (scholars) on Islamic financial issues which, more often than not,

creates conflict and ambiguity in decisions on the veracity of a transaction in terms of its

compliance with the shariah. In this context the Quran states “As for those who divide

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their religion and break up into sects, thou hast no part in them in the least: their affair is

with Allah: He will in the end tell them the truth of all that they did.” Al-Qur’an, Surah 6

(Al-Anaam) Ayat 159

So, the biggest challenge faced by the regulators of Islamic finance is harmonizing and

standardizing these interpretations into a consistent and efficient regulatory framework

that will ensure unimpeded Islamic financial intermediation amongst the participants .

The process of harmonization and standardization of transactions across and within

borders is undoubtedly a daunting one and has to be comprehensive. In some

jurisdictions certain transactions are considered shariah-compliant while in others they

may not be accepted as so. It is extremely difficult to adjudge as to which is the closest to

shariah. Consensus in the fatwas may be overcome by the centralization of the shariah

rulings in a central Islamic authority such as the Islamic Fiqh Academy of the

Organisation of the Islamic Conference (OIC), which is recognized by a large majority of

scholars. In the event of disagreement the Academy can give its verdict.

The pursuit should be toward uniform regulatory frameworks based on principles and

standards designed by universally accepted organizations such as the Islamic Financial

Services Board (IFSB) and the Accounting and Auditing Organization of Islamic

Financial Institutions (AAOIFI). The adoption of the guidelines drafted by these

institutions is the panacea for the shariah arbitrage that exists otherwise.

Not secondary to this issue is the problem of emulating the conventional financial system

and applying the BASEL II principles. Effective risk management measures applied to

the conventional financial system need to be applied to Islamic finance, but with certain

modifications and adaptations. The Islamic financial industry has to be adept with

techniques and competitive products to improvise and emulate the conventional banking

and finance industry. Only then can IFIs compete with the conventional giants and access

the international markets while maintaining their Islamic identity.

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Shariah Expertise

The lack of shariah expertise is also one of the challenges that face the regulators of the

Islamic financial industry. Due to the infancy of the system, very few institutions have

produced the desired skill set for the Islamic financial and banking industry. While there

are plenty of Islamic jurisprudence experts, there is a dearth of Islamic financial experts

with a knowledge of the dynamics of conventional finance and its transformation to an

Islamic/shariah-compliant system. Due to the regulatory obligation of instating Shariah

oversight, IFIs employ less-experienced shariah scholars, as only a limited number of

professionals are available, and they are usually attached to more than one IFI

concurrently .

The transition to Islamic finance is highly technical and complex. A balance has to be

maintained in order to provide, on the one hand, an adequate return and to remain, on the

other hand, within the boundaries of the Qur’an and Sunnah, which cannot be done

without quality shariah supervision. In order to achieve this, regulators of the capital and

money markets will have to encourage the development of educational institutions that

offer programs and syllabi for Islamic financial technical skills. INCEIF (International

Centre for Education in Islamic Finance) in Malaysia is an example that has designed an

outstanding course—namely, CIFA (Chartered Islamic Financial Analyst), which

prepares the student for a specialized course in Islamic finance.

Shariah-Compliant Securities

The limited number of shariah-compliant securities emanates from the lack of both

harmony and Islamic financial prowess, and poses yet another problem in the

development of the industry. Due to the paucity of available instruments in the market,

investors are constrained to take their funds elsewhere. The limited choices also affect

the liquidity of the securities as there is a limited market for them. The buying and selling

of such securities is not as lively as in the conventional securities market, possibly due to

their nonspeculative nature. Nevertheless, investors are eager to place their funds in

shariah-compliant securities, even for a comparatively lower return, provided that a

reasonable degree of assurance can be given with regard to their nearness to shariah. The

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market for shariah-compliant securities, in terms of buyers and sellers, quite certainly

exists, but it awaits the introduction and innovation of new Islamic instruments. Much

of the apprehension that exists in the market with regard to shariah-compliant securities,

or Islamic banking and finance for that matter, is owed to the slow pace of development

of products and awareness-creating endeavors. In this context, the Liquidity Management

Centre and the International Islamic Financial Market (IIFM) have a huge mandate and

are vigorously involved in bridging the gaps in terms of investment of surplus funds of

IFIs and creating Islamic financial markets.

“The combination of services offered by operating IFI and the prevailing practices

compound the difficulties of designing a regulatory framework to govern them”.

How do we solve this?

The solution to the harmonization problem is to design regulatory frameworks that are

standard. Thus, all criteria relating to the formation of Islamic financial institutions, the

induction of shariah experts, the risk management measures, and the various codes

should conform with a standard document, such as an enabling Islamic financial services

law, which prescribes common Islamic financial accounting standards, corporate

governance practices, and prudential regulations for risk management for the industry,

and which interfaces with the IFSB’s Ten-year Master Plan for Islamic Financial

Services.

To bolster the Islamic securities market, companies listed on the stock exchanges

(financial or

manufacturing) should be encouraged to pursue shariah compliance. To achieve these

objectives the role of the regulator(s) is emphasized.

Conclusion

A purely Islamic financial system would be ideal—one in which the niyah and trust are

predominant so that a self-perpetuating regulatory system prevails. There would be

minimal regulatory interference—only for transparency and disclosure. In such a system,

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issues of compliance diminish directly with the prevalence of a coherent and trustful

financial environment in which profits and risks are authentically disclosed and equitably

distributed.

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References:

A: Book

Wahba Al Zuhaili (2003), Financial transaction in Islamic jurisprudence, Beirut: Dar al-

Fikr al-Mouaser, First Edition, Vol.1: p50.

B: Journal:

Hassan, Ahmed. (2006), “Instruments in Islamic finance" INCEIF, Vol. 1 (5): p200.

C: Data from the net:

Guidelines_________

1. Format: Follow the format provided by the lecturer

2. Font: Times New Roman

3. Size: 12 for the Main page.

4. Footnote: Size 10

5. First page: Bold

6. The titles: Bold

7. Space: 1.5

8. Project paper length: 20 – 25 pages

Important notes:

The topic should have a link to the relevant issues faced by the industry, either in

the contents, issues discussed or by relevant examples.

You must submit your Project Paper before or on (21/11/2010).

Submission of the Project paper must be in soft copy to the system (LMS).

You should use the available references and data base in the libraries at your

convenient; please refer to the hard copy references first before you access to

other materials in form of soft copy in the data base.

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This is a professional paper you should use the academic references and citation,

please do not use the open domain in the internet only when necessary.

For any further clarification, assistance, or consultation, you can contact me according to

the following details:

Submission

You must submit your Project Paper before or on (21/1/2010).

Dr. Ahcene Lahsasna

Email: hasan@inceif.org

Contact: 27814000

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