ISLAMIC FINANCIAL INSTRUMENTS
IMTIAZ AHMAD PERVEZ
Friedrich Durrenmatt wrote: “What the world needs is not redemption from hunger and oppression; it has no need to pin its hopes upon Heaven, it has everything to hope for from this earth”.
This statement may have been made in deistical sense, but the writer, perhaps, did not realise that it is quite close to what is achievable in an ideal religious environment.
Islam ordains that praying to God and other religious acts are deemed as pure facade in the absence of welfare of the needy. Hoarding of wealth without recognising the rights of the poor is declared to be one of the main causes of the decay of societies in this world.
The prohibition of usury is a very important economic interposition directed at obtaining an end where society is free of injustices, exploitation and, in turn, of hunger and oppression. In that situation, turning to God will be a conscientious exercise to self-accountability and spiritual satisfaction since the more important divine objective, i.e., human welfare through complete fulfilment of the human obligations that ensure the rights of individuals, would have been achieved already.
My subject; the Financial Instruments used by Islamic Banks, may appear a long way off from what I have started with. But religion remains the sole factor that separates Islamic financial instruments from the traditional ones. The topic should therefore, be better understood if, at this stage, I dwell a little on the roots and philosophy of Islamic finance.
“The true laws of God are the laws of our own well-being”. That is what Samuel Butler wrote in his Elementary Morality (1902). And the well-being of humanity, in its individual or collective form, remains to be the ultimate objective of all religions. To prevent injustice, religion identifies and separates the lawful from the prohibited. This concept has been known to every people since ancient times. Only on the basis of their superstition and myth, have they differed on the scope, variety and causes of the taboos and prohibitions.
The divinely revealed religions that followed provided clearly the laws that guarantee the rights of individuals and thereby their dignity. Islam spells out these in great detail. Muslims believe that this was the mission of all Prophets and Messengers in the human history and it was the same fundamental faith revealed to Moses, Jesus and Mohammed (peace be upon them).
I. Prohibition of Interest
The prohibition of interest is not new in the human history. Aristotle rejected interest on the grounds that “money is sterile”. Cato even compared it with homicide. In 594 BC, Solon cancelled all private and public debts when he reformed the Athenian constitution. In 340 BC, Lex Genucia prohibited interest in the Republican Rome. In Judaism, interest, was considered unfriendly and unfair act:
“If you lend money to any of My people with you who is poor, you shall be to him as a creditor, and you shall not exact interest from him.” (Ex; 22:25)
“He that hath not given this money upon usury; nor taken reward against the innocent; He that doeth these things shall never fall.” (Psalm: 15)
“To a foreigner you may lend upon interest, but to your brother you shall not.” (Deut: 23.19)
“He that hath not given forth upon usury, neither hath taken any increase, that hath withdrawn his hand from iniquity, hath executed true judgement between man and man.” (Ezekiel: 18.8)
The moral teachings of Jesus in this direction, as indicated by the following, are clear and unqualified:
“Love your enemies and do good; lend, expect nothing in return.” (Luke 6.35)
When the Roman Empire became Christianised in the fourth century, the Church forbade the clergy from taking interest. In the eighth century, Charlemagne made usury a criminal offence. St Thomas Aquinas believed that money was invented chiefly for the purpose of exchange and that its principal use was its consumption and alienation whereby it is sunk in exchange.
Hence it was unlawful to make extra payments for the use of money lent. In the early Middle Ages, Popes and Councils continued opposing interest and civil governments passed laws forbidding interest. The anti-usury movement reached its height in 13 HAD, when Pope Clement V made the prohibition of usury obligatory and declared all secular legislation in its favour null and void.
Towards the end of the sixteenth century, in the face of strong movement in favour of relaxing restrictions on interest, charging of a reasonable level of interest generally became an acceptable practice. However, to guard against excesses, authorities stipulated maximum interest rates. This practice is still in vogue with certain added objectives.
Because of its harmful implications, the prohibition of interest in Islam is absolute. Quranic verses reflect the severity of the admonition to those who disobey the divine injunctions to the effect. Socio-economic justice in Islam is not an isolated phenomenon but a way of life. Islam considers interest in its present form unjustified and injurious to health of the society.
For consumption loans, interest violates one of the basic functions for which God created wealth: i.e., the needy be supported for his subsistence. For consumption loans, predetermined nominal rate is unjust because of the uncertainty surrounding the entrepreneurial profits. At the same time, interest encourages creation of an idle class of people who receive income without having to put in any labour for it. The society is, therefore, deprived of their labour and enterprise.
In the first instance, Islamic economists dispute the traditional definition of money in its entirety, i.e., 1) it is means of exchange, 2) a unit of value, 3) a store of value and 4) a medium of deferred value. While the first two parts of the definition are generally acceptable, money cannot, Samuelson says, be a store of value whose ultimate worth depends on the trend of prices. This is because money does not store but only hold claim to some goods of commercial value, which it may purchase in the future.
In effect, holding money is keeping transactions in abeyance. Money cannot either be equated with commodity for the reasons that 1) it has a technical (or artificial) property of yielding its owner real income simply by holding it, i.e., without exchanging it against other goods, 2) it is liquid and has virtually no carrying or production cost and no substitute, 3) demand of money is not genuine as it is derived from demand for goods that money can buy, 4) money is exempt from the law of depreciation to which all goods are subjected, and 5) money is the product of social convention having a purchasing power derived mainly from the sovereignty as against the intrinsic value of other goods.
Interest, on the other hand, is construed as only a theoretical construct that does not correspond to or be representative of real growth of capital. Traditionally, interest is the price paid (expressed in money or percentage terms) in addition to the principal amount, for the use of borrowed money over a period of time.
Islamic economists define it more precisely as a) that it is positive, fixed ex-ante, tied to time-period and amount of loan; (b) that its payment is guaranteed regardless of the outcome of the venture in which the capital is invested; and c) that the state apparatus provides for and enforces its collection.
Islam recognises two types of individual claims to property: a) the property rights that are a result of individual’s labour and natural resources, and b) the property that is obtained through exchange, remittance of the rights of those less able to utilise the resources to which they are entitled, outright grants and inheritance.
Money represents monetised claim of its owner to property rights created by assets that were obtained either as (a) or (b) above. Lending money is a transfer of those rights from the lender to the borrower. All that can be claimed in return from it is only its equivalent. Interest on money loaned represents unjustifiable property rights claim because it is outside the legitimate framework of individual property rights recognised by Islam. Islamic economists believe that:
a) Interest is tantamount to arbitrarily creating new capital without a corresponding increase in the supply of goods so that it interferes with market forces leading to economic anomaly.
In an Islamic economic environment, new capital must be generated from real commercial – not monetary – transactions and should succeed, not precede, a commercial activity. Accordingly, use of money, other than for humanitarian grounds, is invariably for productive purposes. Non-commercial financing (un-backed by tangible asset) is virtually eliminated, preventing volatility and inflationary pressures while helping stabilise the value of money.
Consumer demand, being unleveraged, is realistic hence sustainable unlike the past decade’s situation of the United States. Easy access to money through readily available loans in the eighties allowed individuals and small firms in the United States to borrow substantial amounts for consumption purposes resulting in a temporary economic boom in the shape of high consumption demand, more jobs, high profits and expanded production.
The ensuing debt servicing not only wiped out this artificial demand but also severely dampened the country’s normal consumption demand level. This brought in a prolonged spell of recession with loss of jobs, contraction of production as well as substantial losses, (collapse of Savings & Loan Associations, property market, for example), that proved not only a burden on the state treasury but also erased equity of a large number of less fortunate individuals.
b) Public Sector borrowing to meet current expenditure is actually raising debt burden for future generations to pay. When un-backed by any tangible assets, it is both unjustified and unethical. In an Islamic environment, only asset-based financing is permissible so that public sector borrowing is limited to acquisition of assets and the governments are forced to contain their current expenditure within the national resources available to them.
Islamic asset-backed financing does not constitute a debt burden for future generations in that the debt is invariably tied to assets of value that can be liquidated (privatised) to pay off the debt.
c) Concentration of wealth and its inequitable distribution remains to be universally an increasingly difficult problem to resolve. At the same time, high leveraging has facilitated creation of conglomerates outdoing smaller competitors by sheer financial muscle (dumping, mergers, take-overs, asset-stripping etc.).
Islam opposes monopolies and cartels and its sharing system encourages technology (which includes the optimally gainful use not only of applied but also social science) as against financial or political powers of the client. This facilitates creation of new products as also a greater number of new entrepreneurs rather than the acquiescent submission of financial institutions to the mega ones.
The Islamic system allows for the replacement of interest by a return generated by commercial activities and operations that is evaluated back-end but not pre-determined. Under no compulsion to provide a fixed rate to depositors. Islamic banks do not have to apply the concept of cost of funds. But they are, of course, under pressure to produce maximum return from their investment process while safeguarding the client assets.
Unlike the traditional banks whose client deposits are not fiduciary but borrowing, an Islamic bank is purely an intermediary carrying out strictly its trust obligations. Its client deposits are fiduciary and do not count as the bank’s own liabilities. As opposed to it, today’s traditional bank is a rather vulnerable proposition for the following reasons:
1). Its liabilities are normally 12 times its capital resources; a situation unacceptable to the bank itself in terms of its yardstick under which gearing ratio of even 2 is deemed unacceptable. Accordingly, its asset-cover-position is highly shaky.
2). The definition of a traditional bank has undergone many changes; from its complete intermediary role to entrepreneurial one. While its liabilities are short-term, a good portion of its assets are of longer and uncertain maturities. Its fractional reserve policy may not always be adequate, particularly in the event of any crises developing into a run on the bank.
3). Because the bank has promised (and that means it guarantees) the return of principal plus interest at a certain future date, the client deposit becomes a loan to or liability of the bank, while it runs asset value risk; hoping that its assets will realise full book value on the maturity date which is a tall order, particularly in a forced sale situation. This is besides the maturity mismatch problems that a traditional bank normally suffers from.
II. Financial Instruments used by Islamic Banks
We now come to the need for monetary instruments. In the traditional sense, their demand is influenced by the variation and level in the market rate of return what is meant, in the traditional sense, as the market interest rate. The demand from the household for monetary instruments is mainly for the purpose of circulation of income. Banks need these instruments for:
1) transaction purposes,
2) precautionary purposes in that some unexpected payments have to be made while some expected inflows may not be forthcoming on due date, and
3) for speculative purposes not only to avoid loss but also to obtain gain in the capital value of financial assets under the expectation that the market rate of return may move in a certain direction.
What differentiates a financial market from other markets is that no tangible good or service is exchanged for any monetary consideration. Only a ‘financial claim’ changes hands in the form of a promissory note or a title to any future flow of income adjusted for any capital appreciation etc. The marketability of the instruments is contingent upon the existence of other potential traders and their willingness to participate in the market. Financial markets help attain equilibrium between demand/supply of financial products/services, provide liquidity and facilitate such central economic actions as producing and trading, earning and spending, saving and investing, accumulating and retiring, transferring and bequeathing.
At the same time, prices of assets do not perform just the usual role of balancing demand and supply. They determine the incentives and also transmit news as to the quality of the asset to heterogeneously informed market participants. Any type of payoffs across the different states of nature is constructed by combining existing securities even without the aid of any new securities or any options. Lack of liquidity in a market can act as endogenous trading friction that reduces the benefit of participation in a market and ultimately limits the number of active markets in a competitive economy.
A traditional financial instrument is generally a written document that represents monetary value or claim to receive a sum of money, fixed or determinable without the support of any specific goods. This definition cannot be generalised in the case of Islamic finance. The shape of Islamic instruments is linked directly to the type of the underlying asset, an aspect which is central to the marketability and profitability of the instruments. There are basically four distinct types of Islamic financial instruments:
a) The first type is the financial claim of monetary value but with recourse to certain durable goods or property. The instrument has predictable future income stream, it can be in a marketable form and permitted for discounting since ownership of the instrument passes title to the goods and not debt.
b) The second type is similar to the first type (that it is backed by durable goods) except that the income is not predictable but is evaluated through the asset valuation process at the end of certain duration. It may be traded in the secondary market but not discounted.
c) The third type represents monetary claims to an expected income stream forthcoming from commercial transaction and evaluated at certain intervals through the asset-valuation period. No recourse to goods is available and the instrument is not permitted for discounting.
d) Th e fourth type represents purely monetary claims in respect of debts payable at certain future dates. These may be traded or sold at the face value but are prohibited for discounting.
In order for them to be acceptable in the traditional markets, Islamic financial instruments take cognisance of such factors as risk, yield, diversification, exchange risk, marketability and tax. The following are the major Islamic financial instruments presently in use:
1. Type ‘A’ Instruments: Ijara-based Instruments
One of the more versatile of the Islamic instruments, Ijara is a collateralised claim of monetary value with recourse to the underlying assets (i.e., goods or property) of durable type. The asset is leased, under financial or operating basis, to third parties for a fixed period which marks the tenure of the instruments. The instrument has a continuous revenue stream providing return on top of depreciation cost of the asset.
To avoid pitfalls in most of the operating leases, the arrangement includes separate sale of the underlying asset to a third party at an agreed price that, at least, covers the residual value of the asset at the date coinciding with the maturity date of the lease. Islamic principles of finance permit the purchase of assets for rental purpose which may be fixed or variable. If fixed rental is agreed for the full duration of the lease, the instrument will be of fixed income type. On the other hand, if the lease contract provides for the rentals to be revised at certain agreed intervals, the instruments will be of variable income or “floating”.
The Ijara Instrument represents ownership of goods. Since goods can be bought and sold at the prices agreed, the sale on discount or premium is completely legitimate.
2. ‘B’ Type Instruments:
a) Asset-based Mudaraba Instruments
This instrument represents monetary claims against a Mudaraba (fund) under the management of an Islamic bank on a fiduciary basis very close to the shape of investment trust units or mutual fund. There can be two types of Mudarabas:
i) Unrestricted Mudaraba is a contract under which the bank is authorised to use its full discretion in managing the affairs of the Mudaraba and do all the necessary things arising out of the Mudaraba, sell and buy property to make gain for the Mudaraba against immediate or deferred payment, appoint agent or agents to sell and buy on his behalf, and may safe-keep, pledge, rent and hire the Mudaraba assets for the purpose of the Mudaraba.
ii) The restricted Mudaraba is for a specified period, place, purpose, and type of business and does not permit the bank to mix its own property with the Mudaraba assets or appoint agents etc, but only do such things as are precisely prescribed in the Mudaraba agreement.
iii) If the bank also participates in the Mudaraba with its own capital, then it is called Musharaka. In this situation, as the instrument holder, the bank stands equal in rank to other instrument holders.
The following are the main characteristics of the Mudaraba:
1) Asset valuation of the Mudaraba is undertaken at the end of each prescribed period. A positive price movement over the previous asset-valuation date reflects return on investment that is declared on each asset-valuation date.
Net profit after payment of all Mudaraba costs is distributable between the instrument holders and the bank. The bank management fee is a fixed percentage of the profit (which is previously agreed in the Mudaraba contract). But the bank may, at its sole discretion, reduce, but not enhance, its fee by voluntarily forgoing a part thereof.
2) In the event of net loss in any valuation period, the net asset value is reduced while the bank loses its management fee for the period. The bank is responsible for loss only in the event of gross negligence or violation of the terms of the Mudaraba contract thereof.
3) Mudaraba creditors do not have any recourse to other assets of the instrument holders should their claims exceed the total assets of the Mudaraba.
4) While for the bank’s management fee, fixed percentage of the net profit is permitted, fixed amount is not.
5) In line with the Mudaraba contract, reserves, as a percentage of the net profit, can be built to meet any future contingencies and unforeseen losses. At the time of closure date of the Mudaraba, the amounts held in reserves so accumulated, after meeting all costs and claims etc, are distributed to the holders of the instrument.
6) Islamic scholars agree that an instrument representing a Mudaraba may be traded in the secondary markets only if at least 51% of the total assets held by the Mudaraba are tangible assets. The rate of return of the Mudarabas is not known until asset-valuation at back-end of each valuation period.
Even though asset-valuation may take place on a daily basis, there is no possibility of predicting future return. When the pre-determined rate of return is the objective, this Mudaraba instrument is not the most suitable one.
The marketable Mudaraba instrument can, more or less, equate with traditional nonfixed income paper that can be issued by central banks, local authorities, reputable corporations of strong track records, financial institutions in the shape of CDs and central banks in the shape of bonds and treasury bills (un-actionable). Its marketability depends upon it fulfilling the market standards which can be further boosted by redemption guarantee of sound financial institutions and good credit rating. For Islamic banks, this is the main vehicle for raising resources.
The price of a Mudaraba based instrument is declared at each asset-valuation date.
b) Traditional Equities
The limited liability concept is generally acceptable in Islamic finance provided that rules for insider trading, related party transactions, directors’ responsibilities, accountability and fees, and proxy rules are further strengthened and greater amount of information is made available more frequently to shareholders.
Investment in national and international equities is permitted except for the companies undertaking trade and/or manufacturing of prohibited items such as intoxicants, gambling, items of obscenity, destructive weapons, interest-based institutions and products including insurance companies, meat of prohibited animals/birds etc.
Islamically ideal equities are such companies that are without any interest-based debt or deposit income whatsoever. This obviously is a tall order today. Such companies are virtually non-existent in the developed world today.
3. ‘ C Type Instruments: Non-marketable Mudaraba Instruments
The instrument has the same characteristics as the marketable Mudaraba instrument except that its trade on discount or premium is prohibited. The tangible underlying assets of a Mudaraba represent less than 51% of its total assets which makes the instrument as debt even though its assets may represent concluded commercial transaction.
This instrument may be used, with certain limitations, for placement of surplus money between banks through the interbank market, certificate of deposits etc.
4. ‘D’ Type Instruments
a) Murabaha-based Instruments
The instrument representing Murabaha is a monetary claim to a sum of money in terms of an underlying commercial transaction.
Islamic bank purchases items of economic significance from a third party at the client’s request and sells these goods to the client on spot or deferred payment basis, at its own price. The difference between the purchase cost of the Islamic bank and the sale price is the transaction profit.
This instrument is normally of short term but may rarely be of longer term if the durable goods are involved and the parties agree to stay in the relationship for such long periods. This instrument provides a fixed predetermined rate of return to Islamic banks for which reason arguments have been raised as to its similarity with interest.
The Islamic objective of using money for commercial purposes is aimed at creating economic activity, and hence economic growth, which benefits individuals and society as a whole. This is, however, not always true in the case of purely monetary instruments. Murabaha transactions do invariably involve movement of goods, a process that creates the desired economic activity. The Qur’an is very clear on this issue:
“…they say trading is like usury. And Allah has allowed trading and forbidden usury.” (Qur’an 2.275).
Although pre-determined profit has been established, and the clients are under obligation to repay Murabaha amounts on the maturity dates, this instrument is, by no means, free of risk and cannot be equated with traditional trade finance which deal in documents while Murabaha deals essentially in goods. The following are the broad terms involved:
a) A seller, his agent or guardian must be the owner through purchase of the goods before these are sold.
b) If a buyer contracts to buy goods without making a condition for their being free of defects, it is necessary that the goods are sound and free of defects. If the goods are not of the required description or quality even after these have been received by the buyer but no damaging change occurred during his custody, the buyer has the option to reject the purchase.
But if the buyer contracts to buy after he has seen the goods but later finds these unsuitable, even if no change took place in the goods in the meantime, he does not have the option to rescind the purchase.
c) If goods are sold with the condition that the seller is to be free from claims for all defects, there is no option for the buyer for any defect.
d) The Islamic bank is not permitted to pass on the benefits of and recourse under manufacturer’s warranty, to the client. It is responsible for providing services under such warranty to the client and may have to act as an intermediary between the client and the manufacturer/supplier for the servicing of the warranty.
e) The seller is responsible for the goods until the purchaser has taken due possession.
f) The Islamic bank is obliged to provide the break-down of its cost and profit and all other expenses that comprise the sale price of the goods.
g) The client only promises to purchase the goods and is not obliged to necessarily take delivery of the goods upon arrival should he have a reasonable and justifiable excuse for such refusal.
h) At certain locations, trading is outside the operational scope of banks so that Islamic banks cannot make use of this instrument. Besides, Murabaha yield as trading profit may be subjected to tax while interest on bank debt is not.
In the absence of an adequate number of more efficient financial instruments. Islamic banks use Murabaha (commodity transactions) for the management of their liquidity through commodity sale and purchase deferred payment agreements. Being essentially a clean debt instrument, its discounting is not permitted.
b) Salam (Advance) Payment
This instrument represents a claim against a client who promises to deliver certain goods at a certain future date and place. Precise specification, quantity and quality of the goods are clearly laid down in the contract. Creditor cannot deliver goods before the date agreed unless so agreed by the buyer.
If the client fails to deliver the goods on time, he is liable to return the amount received in advance but without any additional surcharge. This debt instrument is not valid for discounting.
c) Istisna (Manufacturing)
Istisna is a claim against a manufacturer for the manufacture and supply of certain goods. Like Salam, the quantity, quality and precise specification as well as place and date of delivery are fixed. The payment by the bank may or may not be made in advance. Once the agreement has been concluded, none of the parties can withdraw from their obligations.
Until the delivery of the goods, the paper representing Istisna may be bought or sold at its face value.
d) Qard-Al-Hasana
This instrument represents purely monetary claim against the client issuing the debt document. It is mainly for humanitarian grounds and its repayment is obligatory upon the borrower.
Sparingly, this instrument is used to provide interest-free financial support to an existing client whose enterprise may be facing difficulties and needs additional cash injection for a certain period of time.
In Islam, repayment of debt by borrowers on the due dates is strictly commanded.
The Qard-Al-Hasana instrument may be collateralized but it does not carry any yield for the investor nor is it permitted for discounting.
Edited By Asma Siddiqi
Institute Of Islamic Banking And Insurance London
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