SECURITY IN ISLAMIC BANKING
JEREMY MARTIN
The development of an Islamic system of banking based on Islamic theology, which prohibits dealings in interest according to the Qur’an, has created problems in terms of how the Islamic banks are to protect their investments. In order to avoid the prohibition on interest, specific forms of financial arrangements exist and the nature of the security depends upon the type of transactions involved.
Islamic banks are in many ways at a disadvantage compared to conventional banks because, in addition to the currency risks, country risks, political risks and counter-party risks, there are additional documentation and structural risks. Approval of the Sharia Committee, and/or the Religious Advisory Board, can cause delay and restriction, and commercial businesses dislike delays.
When talking security, the Islamic financier or appointed agent is often in a much stronger position than a conventional banker in that he is either an owner or a lessor of goods. If a bank owns the asset, then the claims of other creditors are likely to become less significant.
The three main types of transactions are the Mudaraba, the Musharaka and the Murabaha.
Mudaraba
This transaction is a partnership in which the capital is provided by one party (the investor), and the energy and labour is provided by another party (the entrepreneur), with the bank or financial institution bringing the other two parties together.
This contract states that the investor will bear the whole of any loss up to the amount of capital paid in by him provided that the loss is not incurred due to the negligence, fraudulent behaviour or bad management of the entrepreneur.
The entrepreneur has a free hand to manage the business and does not have to give a pledge to the bank or to the investor and this, contract involves no form of security. One or two banks do take securities against negligence.
Musharaka
This contract is a partnership between two or more persons pooling their financial resources in order to undertake a commercial transaction. It is worth noting that from the Islamic point of view, no security can be requested from the entrepreneur for such partnerships because, according to Islamic law, capital and enterprise form a single factor of production in an arrangement of profit-and-loss-sharing.
However, in practice, most Islamic banks request security against the risk of negligence or willful misconduct of the customer or his non-compliance with the terms of the partnership contract.
This security is likely to take the form of either a security deposit to be held in an investment account with the institution, or other securities, such as the mortgage of land, assets, or project equipment. This provision for security is the major difference between the two contracts of Musharaka and Mudaraba.
The lending institution is expected to impose controls on withdrawals and deposits to the secured account. The capital is likely to be paid in at once and not by instalments as happens with Mudaraba contracts. In Musharaka, no one can take a profit without sharing the risk, so that even if there is a clause which says that all the loss should be borne by one party, that is contrary to Islamic jurisprudence.
Nevertheless, the entrepreneur may bear all the loss if he is guilty of wilful misconduct or fraud. The bank as a partner in the Musharaka is part owner of the goods. The bank may sell its share in accordance with the contract but must give first right of purchase to the customer.
The inadequacy of collateral provided to the bank means that Mudaraba and Musharaka are not of great attraction to lending institutions. Dr Omar Marashdeh, in an article entitled “Intellectual Capital: The Way Ahead” (in New Horizon, 1995), suggests that intellectual capital is the ultimate collateral, which can be a problem, but he suggests that this is an area which is ideally suited to the Mudaraba modes of financing.
He believes that the financing value of intangible knowledge is less susceptible to changes in the economic cycle as compared to tangible assets, such as real estate.
Bankers, like most organisations, are in business to make a profit and this argument from Dr Marashdeh is too nebulous to be obviously attractive. Again, Musharaka may well not amount to more than 10% of the business of an Islamic bank, so it is wise to concentrate on the most important and widely used form of Islamic banking contract, namely the Murabaha.
Murabaha
This transaction is essentially a contract to resell at cost, plus an agreed profit margin. From the point of view of a bank, Murabaha is the most successful way to finance domestic transactions under the Islamic banking system and equates to a loan or an overdraft for conventional banks. It is ideal where the customer does not have the money to buy the goods in the first instance.
Theologically, there are those who dislike Murabaha on the basis that it is very close to interest. It is however regarded as widely acceptable because the “profit” is open and known to both parties from the outset. The concept of the profit being open and known is important and it is not just the profit. It is right to stress the question of disclosure, which is essential in Islamic transactions.
In the Western world, we are all conscious of Credit Ratings, Moody’s Index and Triple A ratings. Such indices are not so widely available in many areas where Islamic banking is prevalent, and this fact makes the question of disclosure all the more important.
Full disclosure is required from the entrepreneur about his background, his financial strength, his business acumen and his track record. Disclosure is required from the bank about its profit margin management, security requirements and enforcing its security. Based on such disclosure, both parties evaluate the risk and the amount of profit required.
The security can of course be first class from the bank’s point of view in that the bank will own the goods and when the goods are paid for, the money will come direct, to the bank. An owner or lessor of the goods has much better security than a conventional bank because his security is less likely to be compromised by claims from other lenders.
With a specific deal, the Islamic lender can pin-point the cash attributable to that particular deal. The amount of profit the bank will require depends not only on the amount of risk but also the time spread between the advance and the repayment of the funds.
When the bank and the customer enter into the Mudaraba contract, the bank must be capable of delivering the goods to the customer. This means that the bank should acquire the title fi-om the supplier before contracting with its customer. The customer may pay in cash or in instalments. If the latter, then the “profit” will be higher Normally, the customer provides the bank with the specifications and quantity of the goods to be purchased. The customer promises to provide a guarantee at the time of the signing of the written agreement.
An Islamic bank will take security, and especially so from customers without a track record or when the customer wants to delay payment. Fatwa number 263 of Kuwait Finance House specifies that a guarantee should not be obtained until the Murabaha sale contract is signed between the bank as a seller and the customer as a buyer.
In practice this is likely to be done simultaneously. This procedure does not offend Sharia law and provides security for the bank. Money paid by the bank in fact belongs to its own investors, who have deposited funds with the bank for investment. The bank therefore has an obligation to protect investors’ funds from losses. It is to provide protection for its own customers that the bank can be said to take the guarantee. Banks are permitted Islamically to take one or more of the following forms of security.
Most of these can be used for leasing as well as standard Murabaha contracts.
1. Personal guarantee.
2. Real Estate owned by the customer or others on mortgage.
3. Assignment of funds relating to supply contracts.
4. Physical goods other than the subject of the sale. The minefield started by the Romalpa case and Romalpa clauses which have kept UK lawyers so busy since the decision in 1976 has not yet, as far as I know, excited the jurists in Islamic law.
5. A reserve of an amount of money from the current or investment account of the customer.
6. A bank guarantee from another bank.
7.Cheques for the instalments equal in value to the remainder of the sale price after deducting any advance.
8. Insurance of the subject matter of the Murabaha against all risks for the benefit of the bank until full payment has been made. Strictly the bank covers the risk by insuring the goods itself; in practice the customer pays for the insurance and meets all ancillary costs.
9. Some banks request the customer to pledge goods to the bank, especially if they are machines, cars or other durable equipment. Because of the other types of security open to an Islamic bank, pledges can be “a security of last resort”. They are, however, traditional and still useful. We all have experience of the various types of security outlined above but pledges are a substantial subject in itself, so much so that some of the specific rules involving a pledge are outlined below.
Pledges
The Qur’an supports the idea of furnishing a pledge against a debt. Pledge, or Rihn, is to give property as security in respect of a right claim, the payment for which may be taken from the value of the property. The main laws relating to pledges are:
1. The pledge becomes a concluded contract by offer and acceptance. The contract becomes irrevocable after the pledge is received by the pledgee. The pledgee can annul the contract at any time.
2. One pledge may be exchanged for another.
3. When something is pledged to secure a debt, an increase of the debt to be secured by that pledge is lawful.
4. Something that can be sold can also be pledged. It should be existent at the time of the contract, must be definable by price and be capable of delivery. When Oscar Wilde arrived at New York airport, and said he had nothing to declare but his genius, this genius would not have been pledgable.
5. Two different creditors may take a common pledge from a single debtor. This pledge will secure the whole of the two debts.
6. A consequence of making a pledge is that the pledgee has a right to possession until the payment of the debt. And if the pledgor dies, he can take full payment of the debt from the pledge. On the death of a pledgor, his inheritors, if they are of age, stand in his place, and it becomes necessary for them to free the thing pledged by paying the debt from the estate of the deceased person.
7. Acceptance of the pledge is no impediment to the demand for repayment of the debt by the creditor.
8. If the pledgor has destroyed or damaged the thing pledged, he must pay compensation. If the pledgee has destroyed or damaged it, the amount of its value is struck off the debt.
9. If the pledgor purports to sell the pledge without the leave of the pledgee, the sale does not become effective and the right of the pledgee to possession is not destroyed. Once the debt is paid, the sale becomes effective.
10. If the time for paying the debt has arrived and the pledgor refuses to make payment, the pledgee may approach the court to compel the pledgor to sell the thing pledged in order to pay the debt. The court may sell the pledge to pay the debt.
Note the difference between death and failure to repay. My understanding is that a clause may be inserted authorising the pledgee to sell in the event of default of repayment.
There are other detailed rules applicable to this subject of which the practitioner should be aware.
An example of the provision of security in a contract of Murabaha sale can be found in Articles 7 and 12 of the Dubai Islamic Bank Standard Contract. Article 7 provides that the bank may require guarantees of payment either in the form of certified cheques or bank guarantees and secure the repayment of debt.
There is a problem inevitably with delay in payment. Unlike a conventional bank an Islamic bank will not charge interest. Delays can therefore be a very serious problem and can present difficulties which should not be underestimated. Interest mounts up thus giving an incentive on the debtor to pay. The security offered to an Islamic lender often depreciates. The lender can, however, claim compensation for “harm or injury”. (A1 Ashker V Islamic Business Enterprise). Article 42(1) of the Civil Code of the UAE supports this.
Old texts supporting this idea of charity imply that banks should not force payment out of a man in financial difficulties. If the bank has taken security along the lines mentioned above, the problem should not arise. Modern trends seem to be taking the compensation route – see UAE Civil Code.
The Qatar Islamic Bank is known to be inclined to favour an arbitration procedure before a panel of three arbitrators. This panel has been known to award compensation on the average rate of return achieved by the bank. Evidence suggests that Islamic banks pursue borrowers less often than is the norm with conventional banks.
One of the reasons why small traders will use an Islamic bank rather than a conventional bank is that an Islamic bank takes the responsibility for the goods until they are delivered to the customer. A conventional bank does not. The Islamic bank loses one valuable tool of security but it gains in that it owns the goods. At least one Islamic Property Fund with which I have been connected has given and received security that has satisfied it and conventional UK bankers.
This fund has been approved throughout by its Sharia Committee and has three points in its favour. First it is leveraged, thus enabling investors to purchase a wider spread of UK properties. Secondly, it is an example of co-operation between an Islamic institution and conventional Western banks and, thirdly, the UK borrowing sets up a UK interest charge which is extremely efficient for UK tax purposes.
Traditional Islamic writings concentrate on the elimination of injustice and exploitation in financial dealings to bring about the equitable distribution of wealth and to encourage entrepreneurs and mutual co-operation – to support the individual against the institution, the borrower against the lender.
Modern trends (as shown by the UAE laws quoted above) indicate that the pendulum may be moving in favour of the banks by giving greater significance to compensation for “harm or injury”. That argument works just as powerfully for the bank as for the borrower.
Islamic banking is encouraged by the Islamic revival. What is sometimes branded by the media as Islamic fundamentalism is better regarded simply as an Islamic revival. In certain cases, it may not help the tourism industry of some countries. This revival in countries such as Pakistan, Iran and more recently Egypt, Libya and Algeria have all increased the importance of Islamic banking.
Edited By Asma Siddiqi
Institute Of Islamic Banking And Insurance London
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