Like all contracting laws, Islamic law presents two classes of principles that govern contracts: general and objective-specific.
- First, general principles of contracting include civil aptitude, consent, and moral foundation. These are common between all legal systems and societies, although there are variations in some respects.
For instance, while Islamic law defines civil competence for financial contracts at age 18, some states or countries carry the age limit to 21. Also, while all laws are founded on moral values, they differ on the extent to which they promote/incorporate moral values within the texture of law.
- The second group of principles reflects a specific viewpoint. In this regard, Islamic law has a strong and detailed moral/ethical commitment and screening, prohibits the practice of interest in all its forms, and sticks to the crude reality or real-life validity. This section discusses this second group of principles.
What Are the Ethical Principles of Islamic Finance?
To be acceptable under Shari`ah, a finance contract must pass a two-stage moral screen.
- First, the contractual relationship must be morally sound. This implies the prohibition of contracts for gambling, contracts based on substantial ignorance and uncertainty, misleading information, obvious imbalances in the respective obligations of the parties, and bad faith in implementation.
- Second, the objective of financing must be acceptable under Shari`ah. This implies the prohibition of financing certain activities that are immoral according to the Islamic religion, such as drinking alcohol and smoking cigarettes, pornography, casinos, and pork production and distribution.
Why Does Islamic Finance Prohibit Riba?
Islam, like other monotheistic religions, condemns and prohibits Riba. The prohibition of Riba in Islam is given in strong and clear-cut terms. The Qur’an says, “But God has permitted the sale and forbidden the Riba” (Al-Baqarah 2:275) and, “God destroys/eliminates the Riba” (Al-Baqarah 2:276); and, “O ye who believe, fear God and quit what remains of the Riba if ye are indeed believers; but if ye do it not, take notice of war from God and His Messenger.” (Al-Baqarah 2:278-9)
No other sin is prohibited in the Qur’an with such a notice of war from God and His Messenger!
The Traditions of the Prophet Muhammad (peace 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 God. In one of the Sayings, the Prophet mentions: “The Wrath of God is on the taker of Riba, its giver, its writer and its two witnesses.”
Riba is an Arabic word that means increment or increase. But the Qur’an did not mean any increase. It refers to a specific sort of transaction; the Riba that was practiced and known among the Arabs and other nations at the time of revelation.
For this reason, the reference in the Qur’an came with the article “the.” “The” Riba means a specific transaction known to the audience. It was done in one of two ways: deferring an already existing and due debt to a new maturity, provided the amount of debt is increased, or giving a loan that is due for repayment at a future date with an increment.
In other words, “the Riba refers to an increase in the amount a debtor owes his creditor due to the passage of time. This understanding is based on the text of the Qur’an itself, which states: “But if ye repent ye shall have your principal, doing no injustice (against others) and no injustice is done against you.” (Al-Baqarah 2:279)
This verse has two important indications. First, it defines Riba as any increment above the principal of a debt or a loan; and second, it describes such increments as unjust. The exclusion of profit, being another kind of increase that is an increase in the amount received for a good over its cost, is given by Verse 2:275: “But God made sale permissible.” (Al-Baqarah 2:275)
To be exact, in regard to financial transactions, Riba is defined as any increment above the principal of a loan that increases as a function of time—that is, interest.[1] 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. The Shari`ah does not recognize a counterpart for this increment. Consequently, once a debt is created, any payment above the principal of the debt is interest and is “Prohibited Riba” according to the terminology of the Qur’an.
Why Is Interest Prohibited in Islamic Finance?
A debt is the outcome of a contract that creates a liability on one party that is an abstract asset of the other. This liability/abstract asset is created in exchange for service, good, or cash provided by one party to the other. For the creditor, the owner of the abstract asset, creating a debt represents a transformation of money, goods, or services into an abstract asset.
The nature of a debt is such that it is not liable to increase or decrease. Debt cannot create value, because it has no intrinsic utility at the level of either consumption or production. It is only an ingredient of wealth. In other words, a debt cannot have different values at different times and places unless additives are created in the form of assumptions. That is done by creating a debt market and valuating or assessing debts in relation to time.
Additionally, the amount of the increment in debts is also assumptive; it depends on the conditions and externalities in an imaginary market that we create for debts. This may sound astonishing to those who are accustomed to talking and hearing about debt markets and interest. Are debts, in fact, able to increase or decrease or to create value?
Of course, they are not because they are abstract and mute assets; but once we create a market for anything, there will be speculative demand and supply that will interact, in much the same way as people trade indices that represent ownership of nothing!
It is important to remember that the Shari`ah recognizes real things and real growth or increment that comes about from the nature of real assets or by the effect of real market forces (that are founded on intrinsic value rather than assumptive speculation) on real assets, goods, or services.
Additionally, all real assets that may grow may also lose value, thus exposing owners to losses created by the same factors that create the growth; that is, real assets give their owner entitlement rights to any growth that they may create and at the same time expose them to losses that result from physical deterioration or from the demand and supply forces.
But a debt, among all assets, is not liable to decrease and does not expose its owner to such kind of losses. Some people may argue that exposure to default risk is similar to the loss of value exposure of real assets. This argument does not hold because of two reasons: One, in principle, every debt is secured by various kinds of guarantees and collaterals. Hence, default risk becomes virtually zero; and two, the nature of default risk is different from that of the risk of increase or decrease that results either from natural factors or from the play of real market forces.
A default risk is a qualification of the debt itself; it is of the kind of a faulty product or a product that does not maintain its normal characteristics for the entire period of the contract. A defaulted debt is like delivering a rotten apple in a sale contract. This kind of risk 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 that is “the price of money” or, to put it more accurately, “the price of time in debts.”
It is also argued that a creditor has made a sacrifice, and thus deserves compensation to induce her to bear the load in the first place. While the idea of a sacrifice is legitimate, the basic fundamentals of private ownership prevent legitimizing any entitlement claim by any party, creditor included, to any part of the increase in value of the debtor’s property.
This is an immediate and “sacred” principle of private ownership: the owner is the only one who is entitled to all and any increase in her property. Once a loan is given, lent money becomes a property of the debtor and she uses it at her own risk, to her own benefit, and by her own decision. The fact that she is under a personal liability to the creditor must not obscure her full right to the return of her property!
This is not an Islamic specialty; this is all laws and all systems specialty, and this is why Islamic finance is business as usual. The debtor did use the creditor’s property, but she uses her own property, doesn’t she? As for the creditor’s property, it has been transformed from cash to an abstract asset called debt![2]
Consequently, a personal loan must remain personal as it is given on a personal basis, touch and relations between the loan giver and loan recipient; it deserves thanks, gratitude, and appreciation from the borrower, and it may also deserve a reward from God—but it does not create value because the property of the lender is transformed into a mute abstract asset.
How Does Islamic Finance Rely on Real Assets?
Lastly, the principle of realism or validity means that all financing contracts must be founded on “real” transactions or exchanges. In other words, Islamic finance creates value from the sale of goods for deferred payments, or from leasing assets that produce utility through time, or from sharing in business projects that create value through innovation à la Schumpeterian sense.
This principle means that Islamic finance is asset- and goods-based and prohibits speculative contracts.[3] Interest itself is one example, both in its very existence and in its rates. Other examples include gambling and trading indices such as DJI or NASDAQ, because an index is a mere mental calculation that does not represent any real ownership.[4]
- What is Islamic Finance and Islamic Banking?
- Islamic Finance: Business as Usual
- 4 Things You Need to Know about Islamic Finance (IMF)
- What is the Difference Between Islamic Loan and Riba?
- An Introduction to Islamic Finance
- Sharing Risk in Islamic Finance is The Future
Reference:
This series is based on a paper published by Dr. Monzer Kahf in 2006.
[1] This definition excludes Riba al-Buyu`, that is known and discussed in the Islamic literature, because it is irrelevant to financing since the time element is not necessarily an ingredient of it. Riba al-Buyu` is discussed in Muslim Jurists’ literature as an increment in exchange contracts of certain items such as currencies, wheat, barley, date, salt, and the like. It is not a matter of finance as we know finance today.
[2] This is in contrast to giving the same sum on the basis of venture capital by a sleeping partner. In this case, the owner of the cash becomes an owner of the asset that is in the hand of the active partner, even after the original capital is transformed into intermediate goods or final goods because the active partner uses the cash property in the capacity of an agent of its owner. Consequently, the capital owner deserves increments that may be generated by her property.
[3] This is not a Fatwa on the prohibition of speculation. It is rather an explanation of what is meant by realism in Islamic finance. Speculation means here “pure speculation” such as gambling or creating prices (and profits and losses) out of non-real assets such as indices. Otherwise, any trade has an element of speculation because you buy or produce and don’t know what your sale price is going to be.
[4] On the other hand, one can own and trade units in an indexed fund because the fund owns shares in companies that are included in the index.