Debt, Exchange & Interest in Islamic Law

The Sharia law provides human beings freedom to enter into contracts and do business transactions. However, this freedom is not unbridled. Like conventional law, Sharia regulates human dealings to safeguard the welfare and liberties of the transacting parties. The dealings could range from a simple contract like Nikah (marriage) to complex Bay’ (trade/commercial) transactions. The prohibitions that regulate financial dealings are mainly of three kinds, the foremost of which is the ban on interest. We will talk about the other two in our next post.

The prohibition of Riba (or interest) is central to Islamic financial law and ethics. It has been a topic of much scholarly effort and debate. The word Riba literally means increase or excess. Officially, Riba is an excess amount received on a loan stipulated over time. It is not only prohibited in loan or debt contracts but also in sale or exchange contracts.

Riba

  1. Riba in Loan

In a conventional loan transaction, there are three elements present; a loan amount, a stipulated excess amount and a time period. The Riba in this type of scenario is called Riba al-Nasia (or interest relating to delay). Therefore a loan amount of $100 accruing an interest rate of 5% annually has a Riba element of $5 at the end of the year. Under Sharia, a Qard (or loan) has to be at par, with zero interest and is called a Qard-e-Hasana (a beautiful loan). Therefore under Sharia, the loan and debt amounts are one and the same, essentially amounting to interest-free loans. In today’s world, a few economic sectors have employed this type of financing quite successfully; for example automobile loans on 0% financing and consumer loans advertising “No interest if paid in full in 12 months” for big-ticket items like furniture, electronics, and sometimes even dentists bills.

Under Sharia, if a debtor is unable to pay the full amount of debt, he is given additional time to pay without a financial penalty for the extra time taken. If the debtor is able to settle the debt, the matter is closed; if he is unable to pay, the creditor is encouraged to forgive the shortfall and the difference is considered a part of charity. However, this partial debt forgiveness is not considered “contractual” in nature. People are strongly encouraged to pay off their obligations under Sharia and the forgiveness of differential debt amount is more for exceptional cases, rather than a general rule.

This approach to debt is in stark contrast with contemporary 0% consumer financing contracts where if a debt is not paid within the stipulated period, or a payment is made too late, or if the debtor loses his ability to repay, a hefty interest rate plus retroactive interest is applied on the original amount from the date the contract was initiated.

Even though interest on a loan is prohibited, Sharia accepts the concept of time value of money. We will elaborate this in a future post when we discuss the transfer of debt.

  1. Riba in Exchange

Unlike a loan, in a sale or exchange transaction, another element is introduced which is goods or commodities. Any excess or increase resulting in such an exchange is called Riba-al-Fadl (or interest relating to surplus). This is based on a narration of the holy prophet Mohammad (peace and blessings upon him).

Sell gold for gold, silver for silver, wheat for wheat, barley for barley, date for date, salt for salt, in same quantities on the spot; and when the commodities are different, sell as it suits you, but on the spot

The narration explains Riba vis-à-vis six defined commodities which can be classified into precious metals and food based commodities. Based on this narration, jurists have developed a tripartite rule.

  1. If an exchange is made between the same items, it needs to be on the spot and the items should be of equal weight.
  2. If the exchange is of two different items within the same category, it needs to be on the spot, and
  3. If the exchange is made between items from each category, there is freedom of choice.

For example, gold exchanged with gold needs to be on the spot and of equal weight, otherwise, it would be considered having Riba of surplus. Secondly, gold exchanged with silver needs to be on the spot but commodities can have different weights. And lastly, gold exchanged with wheat need not be on the spot and the commodities can have different weights.

While all six items given in the narration may give rise to Riba, we will expand our discussion on the first category i.e. precious metals as these have the characteristics of the “nature of money”. Therefore, the Riba rules would apply to anything that has the nature of money i.e. paper currency, IOUs, etc. Under Sharia, the two conditions for exchanging money for money are on the spot and in equal quantity. This is known as a currency exchange contract (‘aqd al-sarf). Any violation of the above ruling will result in either form of Riba. If money is exchanged on the spot but in different quantities, it will result in interest of surplus (Riba al-Fadl) or if more money is exchanged for money with deferment it will result in interest of delay (Riba al-Nasia). The underlying element in most contemporary financial products is the Riba of deferment (Riba al-Nasia). The present discussion of the two kinds of Riba will have implications when we discuss financial products like futures contracts, derivatives, project financing, leasing etc. in our future posts.

Our next posts will deal with the other two prohibitions concerning financial transactions which are uncertainty and chance.

Permission & Prohibition under Islamic Law

In order to build a structure, the edifice is built upon a foundation, and the foundation of Islamic Finance is based on the Sharia Law. Like conventional law, Sharia (or divine law) also has its do’s and don’ts. In our previous post, we explained that Sharia is derived directly from the Quran, the holy book and the Sunna, the teachings and practices of the holy prophet, Mohammad, (peace and blessings upon him) and that together these two cover all aspects of human life. The study of Sharia law is called Fiqh (or Islamic jurisprudence). In other words, Fiqh can be described as the human understanding of Sharia.

Conventionally, Fiqh has been categorized into two groups. The personal aspects of the law are covered under fiqh-ul-Ibadaat while the social aspects are covered under fiqh-ul-muamulaat. Fiqh relating to muamulaat (dealings or transactions) covers the study of interactions between human beings. Conventional classifications of law like family law, contract law, property law, civil law, trust law, international law etc. all fall under this branch of Fiqh. Islamic finance is also considered a part of muamulaat (or dealings).

law

Just as conventional law encompasses and binds human actions, so does the Sharia law. At this point, it is beneficial to understand how Sharia categorizes human actions. The ‘amaal (or actions) of human beings can either be Halal (permissible) or Haram (prohibited). On a descending scale, these are very clearly categorized as

  1. Fard/Wajib (obligatory)
  2. Mandub (recommended)
  3. Mubah (permissible)
  4. Makruh (reprehensible)
  5. Haram (forbidden)

The Fiqh not only looks at human actions but also studies the circumstances (wadia’) surrounding those actions. Rules in relation to circumstances comprise of

  1. Shart (condition)
  2. Sabab (cause)
  3. Mani (prevention)
  4. Rukhsah, Azeemah (permission, enforcement)
  5. Sahih, Faasid, Batil (validity, corruption, invalidity)
  6. Adaa, Qadaa, I’ada (in time, deferment, repetition)

In future posts when we start our analysis of a simple exchange transaction, we will return to these definitions as we attempt to explain the functionality of Islamic finance.

As per Sharia, God has permitted Bay’ (exchange or trade) and forbidden Riba (interest). Aside from Riba (or interest), other prohibitions include Gharar (uncertainty and/or deceit), Al-Qimar (gambling) and Al-Maysir (unearned income). These rulings are unequivocal and understood by all sects of Muslims as irrefutable.  As a result, the point of departure between Islamic and contemporary financial transactions becomes one of permission vs prohibition. Usually, Islamic financial transactions are trade-based while contemporary financial transactions are interest-based. By extension, the same argument is applicable to Islamic banking versus contemporary banking.

In a conventional bank setting, the bank is basically a money lender, the fundamental component of a transaction is interest, and the bank and the corresponding transacting parties are in a debtor/creditor (or vice versa) relationship. Comparatively, in an Islamic bank, the transactions are trade-based or equity-based and are conducted within the framework of Sharia law. The bank can play many roles such as an agent, a partner, a guarantor, a buyer, a seller, a lessee or a lessor. Because of the prohibition of Riba (interest), Islamic finance proponents have engineered many interesting financial products to make the transactions Halal (or permissible).

Before we start our analysis of a simple Bay’ (exchange or trade) transaction, we need to elaborate more about Riba (interest) and what constitutes Riba under Sharia. In the next few posts, we will expand on the prohibitions concerning financial matters, especially matters relating to Riba before tackling the permissible under Sharia.

The Purpose of Islamic Law

Before we elaborate on Islamic financial products, let’s talk about the basis of Islamic finance, its essence, its sine qua non. Like all aspects of Islam, finance also takes its fundamental structure from Sharia (or the divine law). Sharia is derived directly from the Quran, the holy book and the Sunna, the teachings and practices of the holy prophet, Mohammad (peace and blessings upon him). Together these two form a basis of all aspects of human life.

The purpose of Sharia, like the purpose of any law in the world, is the promotion of human welfare. Usually, the classic definition of the purpose of conventional law explores the obligations and purposes of law and government to protect public health, safety, and morals, and to advance general welfare including protection of people’s fundamental rights and basic liberties. In this regard, Sharia law is not at all different from conventional law.

Many jurists have expounded on the purpose and objectives of Sharia, called Maqasid-e-Sharia. Two popular and widely accepted viewpoints are by Ghazali, the 12th-century Persian philosopher, jurist and mystic and by Shatibi, the 14th-century jurist, and theologian from Andalusia, Spain. According to Ghazali, the ultimate objective of Sharia is to promote human welfare which encompasses safeguarding of

  1. faith
  2. life
  3. lineage
  4. intellect, and
  5. property

Shatibi, on the other hand, elucidates the purpose of Sharia in elaborate detail. For him, the Maqasid-e-Sharia (or the purpose of Sharia) comprise of those benefits for which God revealed Sharia in the first place. Like Ghazali, Shatibi also believes that the aim of Sharia is to bring welfare to the people in this life and the afterlife. He classifies the objectives of Sharia as encompassing

  1. Daruriyat (vital necessities)
  2. Hajiyat (needs or requirements), and
  3. Tahsiniyat (embellishment or enrichment)

Maqasid Sharia

The Daruriyat are those necessities which are essential for the establishment of welfare in this world. If they are ignored, order and coherence cannot be established resulting in Fasaad (chaos and disorder). Shatibi classifies all five of Ghazali’s objectives regarding safeguarding human welfare under Daruriyat (or necessities).

Hajiyat are those goods and services which facilitate life or remove hardship. Tahsiniyat are enrichment or beautification of life. While having enough food to subsist living falls under necessities (Daruriyat), having ample nutritious food falls under needs (Hajiyat) and having delicious, gourmet food falls under enrichment (Tahsiniyat). According to scholars, Sharia not only puts comfort into human life but also beautifies it.

Interestingly, scholars classify Islamic Finance under Daruriyat or necessities. Interestingly, in modern times, Maslow’s Hierarchy of Needs which he proposed in 1943 has a somewhat similar structure in which he discusses the four basic deficiency needs (physical, security, love & friendship, and esteem) followed by self-actualization needs. While Maslow discusses how these needs affect motivation, both Ghazali & Shatibi talk about how human needs are met through the application of law (Sharia).

The next few posts will be about permissibility and prohibition under Sharia law as applicable to Islamic Finance followed by a discussion on Islamic finance from an economic viewpoint.

Demystifying Islamic Finance

Our team at the Finance Board is excited to bring a series of topics on Islamic Finance every week. Our goal is to make the concepts of Islamic Finance easier to understand, both for the man on the street as well as the consummate finance professional.

What is Islamic finance and what are its basis? How does this type of finance relate to contemporary finance? Is it practical or even possible to employ this kind of financing in today’s complex business and commercial transactions? These are the questions we endeavor to undertake every week on the Finance Board blog. Each week we will introduce a new concept in Islamic finance along with its counterpart in conventional finance and highlight the comparison between the two.

We will start by looking at Islamic Finance through the lens of the Sharia law followed by describing various Islamic financial products and how they are engineered. Our objective is to clarify the concepts starting from the simplest of transactions and leading up to complex project financing deals. Along the way, we will also opine on the question “Is Islamic Finance a viable alternative to contemporary finance?”

The weekly posts are brought to you by Ms. Qazi  who is a finance professional with over 28 years of experience in the fields of corporate finance, risk management, financial systems development and Islamic finance. She has lived and worked in the U.K., Thailand, Pakistan, Canada and the U.S. and presently resides in Chicago. For a brief bio on her, please check our management team profiles.

Our blog is open for your comments and we look forward to hearing from you. Thanks for visiting.