2Second guide test

Book One Certificate in Islamic Commercial Law2

Chartered Institute of Management Accountants (CIMA)26 Chapter Street, London SW1P 4NP, UKT. +44 (0)20 8849 2287F. +44 (0)20 8849 2450E. [email protected] edition 2011

Published by Global Trade Media, a division of SPG Media Ltd

CIMA Diploma in Islamic Finance, set: ISBN 978-1-85971-585-7Islamic Commercial Law, Study Guide One: ISBN 978-1-85971-581-9

Copyright ©2011 CIMA

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Contents

Book One Certificate in Islamic Commercial Law 3

ContentsIslamic Commercial Law How to use this guide 4

What is finance? 8

Introduction 14

Chapter one An introduction to Islamic finance 18

Chapter two Shari’ah compliance 38

Chapter three Sources of Islamic commercial law 54

Chapter four Methodology of interpretation 76 of Islamic commercial law

Chapter five Formation of contracts 90

Chapter six Classification of contracts 104

Chapter seven Comparison of classifications 124 of contract

Chapter eight Traditional Islamic contracts 140 and Islamic finance

Chapter nine Overview of Islamic banking, 152 Takaful and capital market products

Chapter ten Application of Islamic 166 contracts in Islamic finance

Chapter eleven Implementation of Shari’ah standards, 182 policies and rulings in Islamic finance

Sample Examination 198

Glossary 204

Index 216

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Book One Certificate in Islamic Commercial Law

An introduction to Islamic finance

On completion of this chapter, you should be able to:

define Islamic finance whether in the form of banking, •insurance or capital market segments

describe the salient features of Islamic finance •comprising of interest-free transactions, uncertainty-free transactions, profit and loss sharing and the economic and monetary functions of money

illustrate how these features require the provision of •different financial products to those supplied through conventional finance

explain how Islamic finance can satisfy financial needs •without violating religious prohibitions.

Learning outcomes

Chapter one



1.0 IntroductionIslamic finance has its roots in the past as well as the present. Its links to the past relate to the fact that it is based on principles and features that were established more than 1,400 years ago. Its links to the present relate to the fact that these ancient features are now being presented to contemporary society in a form that is both modern and innovative. Islamic finance is distinct from conventional finance in many respects but has a common goal in achieving the same economic benefit as conventional finance offers to society. In this chapter you will be introduced to the main differences between conventional and Islamic finance, including the need to exclude interest and uncertainty. You will also be shown how the features of finance that are acceptable can be used on their own, or in combination with Shari’ah principles to create useful Shari’ah-compliant products. Islamic finance is essentially driven by principles and contracts that are structured in a manner that is not only compliant to Islamic teachings but is also capable of offering products and services comparable to and compatible with those of conventional finance.

1.1 Islamic traditionThe essence of Islam is that it derives its principles and values from the Qur’an and Traditions of the Prophet Muhammad. The history of Islamic law begins with the revelation of the Qur’an that contains legal principles and injunctions dealing with subjects such as ritual, marriage, divorce, succession, commercial transactions and penal laws. In contrast, the Traditions of the Prophet Muhammad record the sayings, actions and tacit approvals of the prophet Muhammad. The literature of the Traditions of the Prophet Muhammad covers a much wider range of topics than the legal verses in the Qur’an.

Unlike other legal systems, Muslims believe that Islam starts from a given or self-evident premise, namely the revelation. It was with the aim of directing and guiding humanity to the realisation of its moral potential and worldly worth that Islam undertook to create a system known as the Shari’ah. Muslims believe that Shari’ah refers to commands, prohibitions, guidance, and principles under Islam and is the clear path for the believer to follow in order to obtain guidance in this world and deliverance in the next.

Indicative syllabus contentIntroduction to Islamic finance.•

Salient features of Islamic finance.•

Conventional versus Islamic finance.•

Compliance with religious beliefs.•

The essence of Islam is that it derives its principles and values from the Qur’an and Traditions •of the Prophet Muhammad.

Muslims believe that Shari’ah refers to commands, prohibitions, guidance and principles under •Islam and is the clear path for the believer to follow in order to obtain guidance in this world and deliverance in the next.

Key points



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Shari’ah provides guidance in terms of belief, moral conduct and practical rulings or laws. The focus in this study guide will be confined to the practical rulings or substantive law governing Islamic finance. This does not negate the importance of moral values in Islamic finance. Essentially, a complete system of life is based on both legal prescriptions and moral and good conduct. Moral values have been incorporated as legal requirements in some specific contracts such as Amanah (honesty) in Murabahah (mark-up) financing. Other principles of moral values pertaining to commercial transactions include:

(a) timeliness in the payment of debt or delivery of an asset; the failure to observe this aspect might involve legal consequences

(b) tolerance in terms of bargaining, where the parties are encouraged to be considerate of each other’s requirements and circumstances

(c) mutual revocation of a contract on request by one party if he finds himself uncomfortable with the outcome of the transaction

(d) honesty or Amanah in all statements, representations and warranties.

These principles are not meant to be exhaustive but rather to highlight areas where morality is relevant in commercial dealings.

1.2 The meaning of Islamic financeIslamic finance is a term that reflects financial business that is not contradictory to the principles of Shari’ah. Conventional finance, particularly conventional banking business, relies on taking deposits from, and providing loans to, the public. Therefore, the banker-customer relationship is always a debtor-creditor relationship. A key aspect of conventional banking is the giving or receiving of interest, which is specifically prohibited by Shari’ah. For example a conventional bank’s fixed deposit product is based on a promise by the borrower, that is the bank, to repay the loan plus fixed interest to the lender, that is the depositor. Essentially, money deposited will result in more money, that is the basic structure of an interest based system.

In other non-banking businesses, conventional products and services such as insurance and capital markets could be based on elements that are not approved by Shari’ah principles such as uncertainty (Gharar) in insurance and interest arising in conventional bonds or securities. In the case of insurance, the protection provided by the insurer in exchange for a premium is always uncertain as to its amount as well as its actual time of happening. A conventional bond normally pays the holder of the bond the principal and interest.

Conventional practices could also involve selling or buying goods and services that are not lawful from a Shari’ah perspective. These might be non-Halal foods such as pork, non-slaughtered animals or animals not slaughtered according to Islamic principles, alcohol or services related to gambling, pornography and entertainment. In short, conventional business practices could be non-compliant from a contractual structure perspective (if they are based on interest and uncertainty) and/or from a transactional perspective when they are involved in producing, selling or distributing goods and services that are not lawful according to the Shari’ah.

Exercise 1.1Which of the following best defines Islamic finance?

(A) Financial products and services that are offered to Muslims only.

(B) Financial products and services that are offered by Islamic banks.

(C) Financial products and services that are conducted according to Islamic teachings.

(D) Financial products and services that were offered during the time of Prophet Muhammad.

Islamic finance is a term that reflects all aspects of financial business that are not contradictory •to the principles of Shari’ah.

Key point



1.2.1 Banking and interest (Riba)Islamic banking is the branch of Islamic finance that has seen the most growth to date. It is also the branch of finance that needs to be viewed from a different perspective as it cannot replicate conventional banking. This is because the most important underlying principle of conventional banking is that money creates money or that money has a premium, known as interest or usury. This practice (known in Arabic as Riba) is the antithesis of Islamic finance because Islamic law, from the beginning, has categorically denounced it. Money has never been perceived as a commodity for which there is a price for its use. Instead, Islamic law consistently views money as a medium of exchange, a store of value and a unit of measurement.

As money cannot earn money, a link has to be introduced between money and profit as an alternative to interest. It is against this backdrop that Islamic banking has been primarily involved in trading, leasing and fee-based as well as investment activities. Those involved in Islamic banking are not in a position to either borrow or lend money for interest. Subsequently, the nature of the Islamic banker-customer relationship varies according to the different contracts that Islamic banks and their customers enter into.

1.2.2 Islamic banking – the relationship between the user and the supplier of fundsThe relationship of the Islamic bank with the suppliers of funds can be of agent and principal, custodian and depositor, entrepreneur and investor as well as between fellow partners in a joint investment project. Similarly, the relationship of the bank with the users of funds can comprise of vendor and purchaser, investor and entrepreneur, principal and agent, lessor and lessee, transferor and transferee, and between partners in a business venture. This is in sharp contrast to that of conventional banking, which is simply a lender-borrower relationship.

Conventional banks will accept a deposit from a depositor and promise to repay the money plus interest which is fixed, let us say, at 3%. As a financial intermediary, the bank will use this money deposited to lend to customers who need a loan. Here, the bank will charge the customers interest, let us say, at 4%. The spread or the difference between the interest rate paid and interest rate charged, namely 1%, is the bank’s profit. The notion of interest has made this model of financial intermediary work well.

Riba is defined as usury or interest.•

In interest-based systems, money earns more money through lending.•

The application of financial interest or Riba is prohibited in Islam.•

Money in Islam is a medium of exchange, a store of value and a unit of measurement.•

Key points

Conventional Banking Islamic Banking

• Lender-borrowerrelationship • Depositor-custodianrelationship

• Lender-borrowerrelationship (but free from interest)

• Investor-entrepreneurrelationship

Table 1.1 Deposit/liability: contractual relationship conventional banks and Islamic banks

Financing/Asset: Contractual Relationship

Conventional Banking Islamic Banking

• Borrower-lenderrelationship • Purchaser-sellerrelationship

• Lessee-lessorrelationship

• Principal-agentrelationship

• Entrepreneur-investorrelationship



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The above illustrates that Islamic banking has departed from the concept of loans to use other contracts that are compliant and free from the element of interest in both deposit taking and finance provision.

1.2.3 Basic principles of Takaful – Islamic insuranceWith regards to Islamic insurance, better known as Takaful, the insurer, that is the insurance company, is prohibited from providing indemnity to the insured, that is the policyholders, as this is not acceptable to Shari’ah principles. This is because both the premium paid by policyholders and the indemnity paid by the insurer are uncertain and therefore not permissible as they contain the element of uncertainty or Gharar. A simple conventional insurance contact is based on buying protection.

David seeks to insure his life for 30 years. Let us say that the premium he has to pay is $100 per month for 30 years for the insured sum of $200,000. If David dies during the policy period, his nominee or beneficiaries will benefit from this insured sum irrespective of when David died during the thirty year period. He might have paid only $2,400. Alternatively, David could survive until maturity and in this case, he will receive no benefit at all. This leads to uncertain results that are not acceptable under Islamic beliefs.

Conventional life insurance companies are profit seeking entities and need to allow for things like average life expectancy and high risk customers when setting their premiums in order to ensure that it profits from offering life insurance to its customers.

Takaful introduces the contract of donation among the participants/policyholders as a substitute for the contract of sale of indemnity for a premium as practised in conventional insurance. This is to make uncertainty irrelevant because in Islamic terms uncertainty is only tolerable in gratuity or in a unilateral contract such as a donation. The presence of the element of uncertainty in a donation contract, which is unilateral in character, does not render it invalid. A donation contract can accept and tolerate any uncertainty because the purpose of any unilateral contract is not a commercial gain.

1.3 Other differences between conventional and Islamic financeIslamic capital markets that consist of both equity investments and fixed income instruments must avoid some conventional elements and principles from both contractual and transactional perspectives. In addition to interest and uncertainty, issues such as gambling, which is a zero-sum game, investments in unlawful activities and capital guarantee elements in equity-based products are to be avoided. In short, Islamic finance, unlike conventional finance, must be distinctive in its contractual and transactional features to render it different from conventional finance, although ultimately both may achieve the same economic benefits.

Exercise 1.2Briefly explain why:

(i) under Islamic commercial law, money cannot generate income by the mere act of lending it out to a borrower?

(ii) Islamic banking cannot rely on interest earned on a loan?

Takaful is a scheme that provides mutual contribution and mutual assistance to cover both life •and general policies.

Takaful is based on donation contract and not a sale contract. Thus, uncertainty in Takaful is •acceptable because the ultimate aim is merely to help one another and not to achieve any commercial gain.

Key points

Takaful is an Arabic term derived from the root word kafala, meaning to guarantee. To be more precise, it is derived from the verb ‘Takafala’ meaning to mutually guarantee and protect one another. Therefore, literally, it means mutual help and assistance.



1.4 The salient features of Islamic financeAs mentioned above, Islamic finance, especially Islamic banking, enjoys certain features that you would not find in conventional banking. These features are as follows:

1.4.1 Interest free Islamic banking is interest free, meaning that all banking business and activities must prima facie be free from any element of interest. In Islamic law, interest can arise when there is an exchange of two similar usurious items or assets such as money for money or main food for main food. In banking, the leading practice from which interest originates is the exchange of money for money, that is, money lending. Modern banking is based on the lending of money for a premium - interest. Islamic banks must eliminate interest in all its forms, be it in cash or kind. A fixed deposit account in a conventional bank is a good example of how the bank pays interest in cash. A good example of the avoidance of interest in kind is the prohibition of any advertisement of gifts for prospective saving and current account holders when these accounts are based on a Wadiah (safekeeping) or Qard / Hassan (loan) contract. This is deemed to be promising a form of interest in kind payable to savings and current account holders. Although a gift such as a pen or umbrella or savings box is not in monetary form, it is still deemed as an extra gain for the lender. The Qur’an states that interest, be it in cash or in kind, is not permissible.

Islamic finance challenge 1.1Z has a business idea that requires substantial capital funding from third parties. Z has heard from one of his friends that he could obtain this funding from an Islamic bank. Confused, Z has asked you to explain why he should approach an Islamic bank for funding and how borrowing from an Islamic bank would be different from borrowing from a conventional bank. Draft some notes for Z explaining the relationship between a borrower and an Islamic bank and explain what difference this will make to his loan.

Points to note:• underIslam,loansofferedinreturnforinterestearnedareprohibited

• profitmustbegeneratedfromothercontractssuchastrade,leaseorinvestmentbyconverting the money into a real asset prior to undertaking other contracts such as sale or lease

• moneymustbeputintorealbusinesstransactionstogenerateincome;thismightincludethe purchase of goods at ‘x’ and the sale of those goods to a customer at x + y on a deferred payment scheme

• thebankwouldarrangetosupplythenecessarycapitalequipmentforZonthisbasis

• supposeZapproachesaconventionalbanktoborrowasumof€100,000topurchasenew equipment for his printing business and for this he is quoted 4% interest per annum on the proposed loan; in contrast, an Islamic bank can offer him credit sale financing wherebytheIslamicbankwillpurchasetheequipmentfromthevendorat€100,000andsellittoZat€100,000plusamark-uporprofit,letussayof4%perannum

• Zwouldnotincurinterestbutthebankwouldearnaprofitonthetransaction.

‘Those who devour usury will not stand except as stands one whom the satan by his touch hath driven to madness. That is because they say: “Trade is like usury,” but God Almighty hath permitted trade and forbidden usury...’

Qur’an 2:275



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1.4.2 The need for underlying assetsIslamic finance requires that all banking business based on sale or lease must have an underlying asset. As the Islamic bank either acts as a seller or a service or usufruct vendor, or lessor, the asset or service is of paramount importance. The absence of an underlying asset will render the contract void ab initio. This is in contrast to conventional banking where the asset element is not a necessary requirement. Its importance lies only in terms of collateral security in the sense that the asset purchased using the loan money may be charged or assigned as security in favour of the bank. The asset was never part of the loan transaction.

1.4.3 The avoidance of uncertainty or gamblingAll transactions made by Islamic financial institutions (IFIs) must be free from elements of uncertainty (Gharar) and gambling (Maisir). This is because Gharar might lead to disputes caused by an unjustified term in the contract arising from misrepresentation and fraud. Gambling is seen as an action that always enriches one party at the expense of the other - a zero-sum-game.

1.4.4 Profit and loss sharingProfit and loss sharing is possible in some Islamic banking activities. The bank will share the profit made with its customers either on a proportionate basis or on an agreed profit-sharing ratio. In the case of a loss, the loss will be borne by the bank under a Mudarabah contract or by both parties proportionately in the case of a Musharakah contract. This concept is in direct contrast to fixed income-based products. Again, the concept of profit and loss sharing is peculiar to Islamic banking although, strictly speaking, Islamic banking is not an equity market, which is normally represented by the stock market.

1.4.5 Rights and liabilities of banks and customersThe rights and liabilities of both banks and their customers are well documented not only in conventional banking laws but also the legislation of many countries including contracts acts, the sale of goods acts, consumer protection acts and hire purchase acts. An important and significant feature of Islamic banking is the new perspective it gives to this relationship. This has pushed Islamic banking beyond normal and conventional ‘banking business’. An Islamic bank is neither a lender nor a borrower, but can instead become a bona-fide trader licensed under banking law. This aspect of the transaction has not been given proper attention until now, although certain amendments to various legal systems have been made.

Amendments to the stamp duty acts and the real property gains tax in jurisdictions such as Malaysia, the UK and Singapore illustrate this aspect. The buying and selling of property, for example, would otherwise attract a double stamp duty for the two transactions required to achieve the financing features of the product. The changes also preclude a gains tax arising from the sale of the property to the customer by the bank – the second of two sales transactions. The first transaction occurs when the financier purchases the asset from the vendor. The second transaction occurs when the financier sells the same asset at a mark-up to their customer. Without these necessary amendments, a gain would result from both transactions. In practice, this cost or extra tax would have to be borne by the customer making Islamic products more costly from a customer’s perspective.

1.4.6 Shari’ah complianceThe central focus of Islamic finance is Shari’ah compliance. To ensure compliance a distinctive feature of Islamic finance is the establishment of a Shari’ah advisory or supervisory board to advise IFIs, Islamic insurance companies, Islamic funds and any other providers which offer Islamic financial products. The establishment of a board, the opinions of which are binding on all IFIs, is required to guide the institutions towards Shari’ah compliance. An institution cannot claim to be doing Islamic financial business until and unless it sets up a Shari’ah board or committee consisting of qualified scholars who are of high reputation and who possesses the necessary skills.

1.4.7 Unlawful goods or servicesAnother equally important feature is that Islamic finance must not be involved in any activities pertaining to unlawful goods and services. These prohibited goods and services include, among others, non-halal foods such as pork, non-slaughtered animals or animals that were not slaughtered according to Islamic principles, intoxicating drinks, entertainment and pornography, tobacco-related

A Mudarabah contract is a profit sharing contract. Under a Mudarabah contract, the capital provider agrees to share the profits between themselves and the entrepreneur at an agreed ratio or percentage.

A Musharakah contract is a form of equity partnership investment. It is similar to equity investment in a conventional capital market but the investments made must be confined to stocks and financial securities or other assets that are consistent with the principles of Shari’ah.



products and weapons. Non-involvement is not only limited to buying or selling but also includes all chains of production and distribution, such as the packaging, transportation, warehousing and marketing of these prohibited goods and services.

1.4.8 Overriding principles of Islamic lawIslamic finance essentially refers to Shari’ah-compliant financial activities. In addition to observing the above-mentioned features, Islamic financial products and services must not contain any principles, terms and conditions that are contradictory to established legal maxims or legal principles. These legal maxims are the overriding principles and essential parameters of Islamic law, widely accepted by Muslim jurists. An example would be the principle that capital in equity-based financing or investment cannot be guaranteed by the manager or other partner. An equity contract must be free from capital guarantee to reflect the very essence of equity investment that is equity investors must bear the risk of loss of capital.

Exercise 1.3A bank has been set up to offer Islamic financial products and services. In order to attract new customers. This bank advertises in the media that the first 1,000 customers who open Islamic saving accounts based on the principle of Qard / Hassan (interest-free loan) will be given a gift worth $100 each. Does this product offering comply with Shari’ah principles?

Islamic banking comprises the following features:•

• interest free • the need for underlying assets • the avoidance of uncertainty • profit and loss sharing • rights and liabilities of banks and customers arising from commercial contracts other than a loan contract • Shari’ah compliance • prohibition of unlawful goods or services • overriding principles of Islamic law.

Key points

Islamic finance challenge 1.2John and Tom each intend to purchase a house. John intends to use an Islamic house financing facility while Tom intends to use a conventional bank loan. Each house is being sold by the developer at $100,000, but John will have to pay the bank $130,000 when he buys the house from them. Explain the stamp duty liabilities which will arise in:

(a) a country where stamp duty exists and no amendment has been made to the relevant act to take account of Islamic house financing transactions, and

(b) where the relevant stamp duty has been amended to allow for Islamic house financing transactions.

Solution(a) John will be required to pay 2% of $100,000 and 2% of $130,000 that is a total of

$4,600. Tom will only have to pay $2,000 that is 2% of $100,000 loan.

(b) In countries where relevant amendments have been made to the stamp duty act to facilitate Islamic financing schemes, John would only have to pay stamp duty on the first transaction only, that is 2% of $100,000 which is equivalent to $2,000 only. This will render stamp duty paid under both Islamic house financing and a conventional house loan to be the same amount.



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1.5 Riba and GhararAs a key to understanding Islamic finance it is important to further explain the meaning of two terms or concepts that must be avoided by Islamic finance in all circumstances: Riba and Gharar. The avoidance of these two elements is a basic requirement of all Islamic financial activities.

1.5.1 RibaRiba is simply translated into English as usury or interest. Any premium charged on money borrowed is tantamount to Riba irrespective of the amount paid. Riba in its simplest term is an advantage to one party at the expense of another for no appropriate consideration. Islamic commercial law addresses the issue of this unjustified advantage from two possible transactions, namely in a loan or currency exchange contract as well as in a barter trading contract.

Muslim jurists have unanimously agreed that two separate classes of assets are susceptible to Riba, namely currency or money and a few commodities, mainly food items. The requirements of an exchange involving these two types of assets are the same.

It is explained in the tradition that the Prophet Muhammad was reported to have said: “Gold for gold, silver for silver, wheat for wheat, barley for barley, dates for dates, and salt for salt, like for like, equal for equal, hand-to-hand, if the commodities differ, then you may sell as you wish provided the exchange is hand-to-hand.”

These requirements are only applicable when there is an exchange of one currency for another currency whether it is the same currency or different currencies. The requirements also apply to the exchange of a food item for another food item, be it of the same food item or of different types and kinds.

A summary of the above tradition and its inherent requirements is depicted in the following table.

The above table clearly illustrates that Riba is confined to these categories of assets, provided they are exchanged within the same class, that is, currency for currency. An equal amount of the counter value is required in exchange of assets of the same class. Spot exchange, or the simultaneous delivery of counter values, is also required when one currency is exchanged for another currency or when a food item is exchanged for another food item, irrespective of whether these currencies or food items are the same or different types. Any delay in the delivery will render the exchange tantamount to Riba, known as Riba al-nasiah, that is, Riba by virtue of deferment in the exchange or delivery of these two counter values.

Currency for currency Food item for food item

Subject matter Shari’ah requirements Subject matter Shari’ah requirements

3 Same currency(GBP for GBP)

3 Spot transaction

3 Equal amount

3 Same food item(barley for barley)

3 Spot transaction

3 Equal amount

3 Different currencies(GBP for USD)

3 Spot transaction 3 Different food items(barley for wheat)

3 Spot transaction

Table 1.2 Requirements for an exchange involving usurious items



From another perspective, the exchange of these two assets is also subject to the same amount or quantity of the two counter values if they are of the same type. The failure to observe this would lead to the practice of Riba called Riba al-fadl, namely Riba by an excess of one of the counter values. However, the requirement to have the same quantity is not applicable if they are of different types such as GBP for USD or wheat for barley.

This tradition is the foundation of the permissibility of currency exchange, done on the basis of the prevailing rate of exchange, for example to exchange £1,000 for $3,000, provided this is done on a spot basis. Any deferment of the exchange or delivery as in the case of a forward currency exchange is not in line with the requirements of the tradition, and is thus prohibited. The amount of exchange is not relevant when the exchange involves two different usurious items such as USD for GBP.

From the above, a loan in GBP provided by conventional banks and other institutions that imposes on the borrower the requirement to repay the principal amount borrowed plus a premium in the same currency would come under the purview of Riba (interest/usury). This practice of modern Riba in the banking sector relates to both Riba al-nasiah (Riba by deferment) and Riba al-fadl (Riba by excess) because the borrower is obligated to pay more than he borrowed and repayment will take place in

Exchange transation Time of delivery Remark

£1,000 to £100 Spot No Riba

£1,000 to £100 Deferred Riba

£1,000 to $3,000 Spot No Riba

£1,000 to $3,000 Deferred Riba

100 tons of wheat for 100 tons of wheat Spot No Riba

100 tons of wheat for 100 tons of wheat Deferred Riba

100 tons of wheat for 100 tons of barley Spot No Riba

100 tons of wheat for 100 tons of barley Deferred Riba

Table 1.3 Illustration of Riba by deferment (Riba al-nasiah)

Exchange Amount Remark

GBP to GBP Same/equal No Riba

GBP to GBP Not equal Riba

GBP to USD Same/equal No Riba

GBP to USD Not equal No Riba

Wheat to wheat Equal No Riba

Wheat to wheat Not equal Riba

Wheat to barley Equal No Riba

Wheat to barley Not equal No Riba

Table 1.4 Illustration of Riba by excess (Riba al Fadl)

The theory of Riba could therefore be summarised as follows:

RIBA(1) = exchange of two similar usurious item for different counter values and for deferred exchange, for example, £1,000 for £1,200 being exchanged of one another on deferred basis

RIBA(2) = exchange of two dissimilar usurious items for deferred exchange, for example, £1,000 being exchanged for $1,000 on deferred exchange.



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the future. This is the reason why conventional saving accounts and fixed deposit accounts, as well as all financing modes based on loan-for-interest are not compliant to Shari’ah principles. The theory of Riba also applies to currency exchange, which can only be done on a spot basis. Forward or future currency transactions are not allowed.

It is important to explain one exception to the above principles of exchange involving either currency or food items. Islamic commercial law does allow a loan contract, called Qard / Hassan but it must be free from Riba in the repayment of the loan. However, Islamic commercial law ‘tolerates’ the requirement of having to exchange two counter values on a spot basis as this is illogical to the concept and philosophy of a loan, which is essentially to allow the borrower to repay their loan obligation in the future. If they have to repay the loan almost immediately after borrowing, then the loan has no meaning. This exception is granted to allow the practice of lending of either money or fungible goods for no premium. What is more relevant is the prohibition of any excess in the repayment of the loan. The deferment in time can be tolerated if the loan is for the purpose of helping the borrower who seeks financial help in terms of money.

Exercise 1.4An Islamic bank has provided two loans. The first loan of $10,000 was made to a customer with the requirement that $11,000 be repaid after one year. The second loan of $10,000 made to another customer, had the requirement that $10,000 be repaid after one year.

Is either of these transactions Shari’ah compliant?

1.5.2 GhararGharar is another element that is to be avoided in any transaction. Gharar simply refers to a lack of knowledge or uncertainty that could result in an outcome detrimental to one party. This lack of knowledge, as well as a lack of control of the outcome of any transaction, may stem from misrepresentation, mistake, fraud, duress, or terms beyond the knowledge and control of one of the parties to the contract.

There are many examples of Gharar-based transactions that are prohibited including the sale of the off-spring in the womb of a pregnant animal as the outcome is obviously beyond the control of the parties involved and therefore uncertain. In addition, the sale of fish in the water, birds in the sky or a runaway horse are also prohibited. The reason behind this is that the ability of the seller to deliver these items is uncertain.

Gharar in practice relates potentially to issues such as pricing, delivery, quantity and quality of assets that are transactional-based and would affect the degree or quality of consent of the parties to a contract. For example, one cannot buy an ‘option’ at a certain price to have the right to purchase its underlying shares, as an ‘option’ is not ascertainable and is thus uncertain. An option is just a right. It is not an asset whose specifications are clear and attainable. In conventional insurance, the premium paid by policyholders and the indemnity provided by the insurer upon a claim are equally uncertain, thus making conventional insurance non-compliant from an Islamic legal perspective.

Unlike Riba, which is determined by a fixed formula as previously explained, the determination of Gharar is based on many aspects. This is because the parameter of knowledge or consent and the risk tolerance by society is not fixed. Above all, Islamic commercial law has accepted the distinction between major uncertainty (Gharar Fahish), which is to be avoided at all times, and minor uncertainty (Gharar Yasir), which is tolerated by society. The practice of paying a certain amount of money for the use of a public toilet in some societies reflects the tolerance level in that society. The society accepts different levels of consumption of facilities that are uncertain for a standard payment which is fixed.

The theory of Riba could therefore be summarised as follows: ‘The stipulation of an excess for the lender in loan is prohibited, and it amounts to Riba, whether the excess is in terms of quality or quantity or whether the excess in a tangible thing or a benefit, and whether the excess is stipulated at the time of contract or while determining the period of delay for satisfaction or during the period of delay and, further, whether the stipulation is writing or is part of customary practice.’

Qur’an 2:275. AAOIFI Shari’ah Standard, No. (19), Qard (loan), 4.4/1



1.6 Profit and loss sharingIn addition to these two prohibited items, Islamic finance is also closely associated with the practice of profit and loss sharing. This is unique as IFIs will share the profit or loss, as the case may be, with depositors as well as fund users if the contracts entered into by the two parties are based on either Mudarabah or Musharakah. In terms of deposit, IFIs act as the manager while the depositors are the capital providers who deposit their capital on the basis of a Mudarabah contract either through their savings or investment account. The depositors will share the profit with the bank based on a particular ratio. The depositor will also bear the loss entirely under the Mudarabah contract while the banks will lose their time, work, effort and expected profit.

IFIs may finance their customers using either Mudarabah or Musharakah. Here, the IFIs act as the capital providers and share the profit with their customers upon its realisation in any business venture. Loss will be borne by the IFI under the Mudarabah contract, but the loss is to be shared between the IFI and the customer under the Musharakah contract. This makes Islamic finance distinctive from that of conventional finance.

Exercise 1.5(i) Is profit and loss sharing distinctive to Islamic banks?

(ii) What type of Riba is involved where there is an increase of one of two counter values in the exchange of two similar usurious items?

(iii) Is an exchange of £50,000 for $50,000 on a spot basis tantamount to Riba?

1.7 Islamic finance compared with conventional financeIslamic finance does not, and should not, deal with money directly as money cannot earn more money by itself. Money must be put into real business activities to earn extra money. This is the whole basis of trading. In other words, IFIs facilitate the financing needs of customers by becoming sellers, lessors or partners as the case may be. The function of money has been transformed from a commodity into an enabler to facilitate trading, leasing and investment as illustrated in the following diagram.

The pool of money, collected through various Islamic accounts and or shareholders’ funds, is channelled to finance trade, lease or investment activities. From a micro perspective, the money has been transferred into real economic stock in order to generate more income. Thus, the profit generated by IFIs is the outcome of dealing with a real asset rather than a monetary asset.

Gharar simply refers to a lack of knowledge or uncertainty that could result in an outcome. •

Key point

Figure 1.1 The function of money in Islamic finance

Shareholders fund

‘x’ money Islamic Financial

Institution

Islamic Deposit Accounts

Purchase of an asset at ‘x’ from

the vendor

Capital investment in

‘x’ project

Customer/partner

Lease the same asset to customer at x+y

Sell the same asset to customer at x + y

‘x’ money

y% profit sharing x% profit sharing



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A simple illustration of this could be where a bank has allocated £100,000 to finance a customer to purchase a house from a vendor at the cost of £100,000. This initial £100,000 will be used by the bank to purchase the identified house from the vendor. By doing so, a monetary asset has been transformed into a real asset i.e. a house. Subsequently, the bank will sell the same house to the customer. The selling price, based on a Murabahah contract, is £120,000 which is payable over ten years. The whole process is a total departure from the conventional practice of lending and borrowing. The bank in Murabahah financing has to purchase the house before it can be sold to the customer. There are real sale and purchase transactions underlying this facility and in some jurisdictions, this would trigger a double stamp duty on the two sets of documents. In those jurisdictions, relevant amendments have been made to the relevant stamp duty acts to avoid double stamp duty for these two transactions.

1.8 Shari’ah compliance and the equity marketThe distinction between Islamic finance and conventional finance is more obvious in banking and insurance products as well as in fixed income instruments than it is in the equity market. Conventional banking and fixed income instruments are essentially based on interest, while the conventional insurance contract is based on the sale of an indemnity for a premium that contains a considerable degree of uncertainty. The distinction between the Islamic and conventional equity markets is however less clear because the prohibited elements are contained not in the structure of the respective contracts but in transaction-based activities.

There is no Shari’ah issue on the contract of investment in the equity market as it is essentially based on the principle of profit and loss sharing. In other words, buying a share in any stock exchange is permissible as this purchase reflects a contract of Musharakah among the shareholders. This contract per se is compliant. However, Shari’ah objections are mainly concerned with the activities of the companies in which the capital, through subscription to the shares, is put. These activities may include the sale or purchase of assets and services that are not approved under Shari’ah principles such as the sale or purchase of non-Halal food and drink. Non-approved activities also include activities related to the balance sheet of the company such as the borrowing or raising of more capital through interest-based transactions such as overdrafts and conventional bonds.

In the realm of investment where money has to be injected into real economic activities, Islamic commercial law is also relevant to the transactional activities of the companies. This shows that compliance at both contractual and transactional levels is important in Islamic finance, making it distinctive from conventional finance.

House Financing

Conventional Islamic

• £100,000ofloan• £120,000[Loan+Interest]

• £100,000ofpurchasepricepayabletovendorby the bank

• £120,000ofsellingpricepayabletothebank/seller by the customer

Islamic finance challenge 1.3Islamic finance does not view money as a commodity. Here, money has no intrinsic value of its own, but having money allows for the purchase of goods and services. Money can potentially grow by putting it into real economic activities such as trading and investment activities. How, on the other hand, does conventional finance perceive money in terms of both theory and practice?

Points to noteThere is more than one answer to this question. Many conventional textbooks on finance, define money as a medium of exchange, a unit of measurement and a store of value. In medieval times, money was viewed by many as a ‘commodity’ in as far as the owner of money could claim a premium if the money was loaned to another party. This is the origin and basis of modern interest. This view tends to be prevalent in the contemporary conventional financial market.



Exercise 1.6(i) A bank has extended a Murabahah facility to a customer whereby the bank purchases from

thevendoranassetat‘x’amounti.e.€200,000.Thebanksubsequentlysellstheassettoacustomerat‘x+y’amounte.g.€250,000payablewithinfiveyears.Whyisthisadditionalpayment permissible in Murabahah but not permissible in a loan contract?

(ii) A new Islamic bank has been established in your area. The bank accepts deposits on Islamic principles. It has received an application for financing except from a customer who intends to purchase a factory that produces alcoholic liquor. This customer has put in an application for Murabahah financing, which has been declined. The customer has asked you to explain why the application has not been accepted. How would you explain this to the customer?

1.9 ConclusionThis chapter introduced you to many of the key components that make up the subject of Islamic finance. Specifically, the chapter outlined the history and development of Islamic finance. It also introduced the differences between conventional and Islamic finance. Having studied this chapter you should now appreciate why such key aspects as the avoidance of interest and uncertainty in Islamic transactions, the need to ensure Shari’ah compliance and the concept of profit sharing underpin the need for the development of Islamic finance. The chapter also briefly introduced you to Islamic insurance or Takaful, concluding with an explanation of the critical matters relating to Shari’ah compliance and the equity market. All of these components will be discussed again in more detail throughout this and the other guides which comprise the Diploma in Islamic Finance.

The following chapter will examine the sources of Islamic Commercial law that underpin many of the Shari’ah principles governing commercial transactions.

1.10 SummaryHaving read this chapter the main points that you should understand are as follows:

1. the essence of Islam is that it derives its principles and values from the Qur’an and the Traditions of the Prophet Muhammad

2. the principles of Islam as enshrined in both the Qur’an and the Traditions of the Prophet Muhammad are known as Shari’ah

3. Islamic finance is a term that reflects financial business that is not contradictory to the principles of Shari’ah

4. the giving or receiving of interest (Riba) is specifically prohibited by Shari’ah, as is the existence of uncertainty (Gharar)

5. unlike conventional banking, where the relationship is simply lender-borrower, the relationship in Islamic banking can be of agent and principal, depositor and custodian and investor and entrepreneur, on the liability side of the bank; as for the asset side, the relationship could be of seller and purchaser, lessor and lessee, principal and agent, as well as between fellow partners in a joint investment project

6. in order to remove the element of uncertainty from Islamic insurance (Takaful), the contract of donation is introduced among the participants/policyholders in place of the contract of sale of indemnity for a premium as practiced in conventional insurance

7. all banking business based on sale or lease must have an underlying asset

8. profit and loss sharing is possible in some Islamic banking activities

9. Islamic finance must not be involved in any activities pertaining to unlawful goods and services

10. Islamic finance does not, and should not, deal with money directly; this is because money cannot earn more money by itself, money must be put into real business activities to earn extra money

11. the distinction between the Islamic and conventional equity markets mainly concerns the activities of the companies in which the capital through subscription of the shares are put; these activities may include activities such as the sale or purchase of assets and services which are disapproved by Shari’ah principles.



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Chapter 1 AnswersExercise 1.1(C) Any types of financial products or services, compliant to the requirements of Islam, fall within the scope of Islamic finance. They can be offered to anyone and by anyone without any restriction because Islamic finance is inclusive in character. The only restriction is with regard to the products and services themselves. These must be structured according to the teachings of Islam. For example, the payment or charging of interest is not allowed in Islam. Thus, products of Islamic finance must be free of any element of interest.

Exercise 1.2(i) Under Islamic commercial law, money must be put into a real business transaction to

generate income. This might include the purchase of goods at ‘x’ and the sale of those goods to a customer at x + y on a deferred payment scheme or credit sale.

(ii) Under Islam, loans offered in return for interest earned are prohibited. Profit must be generated from other contracts such as trade, lease or investment by converting the money into a real asset prior to undertaking other contracts such as sale or lease.

Exercise 1.3The bank’s product offering is not compliant because Islamic finance must be free from interest either in cash or in kind. Giving a gift, which is advertised prior to the opening an account, is deemed as interest in kind. This is because the bank will borrow the money from the depositor under this contract and therefore, any extra payment intended to be paid by the borrower to the depositor/lender in the form of gift is tantamount to Riba.

Exercise 1.4The first transaction is not compliant. However, the second is compliant. Although Shari’ah principles require the repayment of loans to be on a spot basis i.e. not deferred, Shari’ah principles tolerate non spot transactions if the loan is meant to help the borrower and not to provide any commercial advantage to the bank from its lending activities.

Exercise 1.5(i) Yes. No such arrangement of profit and loss sharing is being practised in an interest-based

banking system.

(ii) The type of Riba is called Riba al-fadl or Riba by excess because of the premium in one of the counter values in the exchange involving two similar usurious items, for example, £1,000 for £1,200.

(iii) No. There is no Riba involved as the requirement of equal amounts does not apply to an exchange involving two dissimilar usurious items, that is, GBP for USD. The rate of exchange is to be agreed by both parties with spot delivery. In practice, the exchange rate agreed will be the same as prevailing conventional exchange rate (though in theory they could adopt a different exchange rate).

Exercise 1.6(i) Murabahah financing to purchase an asset is permissible because it does not deal with

money directly. The financier is selling the asset to a customer at a mark-up. The financier did not advance a loan and charge a premium on the loan.

(ii) Financing to purchase a factory that produces alcohol is not acceptable as alcohol is not compliant. The factory therefore would be used for the production of prohibited goods. Both the contract and subject matter (or the use to which it might be put) must be compliant. If the factory was to be used in the production of a Shari’ah-acceptable product then the finance could proceed.



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Revision Questions Question 1 Multiple choice1.1 As well as being interest free, Islamic finance must also be free from:

(A) Gharar

(B) profit

(C) loss sharing

(D) equity.

1.2 In Islamic finance, how can profit be realised?

(A) By lending money out to the borrower.

(B) By leaving the money idle.

(C) By trading or leasing.

(D) By creating a charge on money for a loan.

1.3 Which of the following is a non-lawful asset from a Shari’ah perspective?

(A) A car.

(B) A house.

(C) Printing equipment.

(D) Non-slaughtered animals.

1.4 Fixed deposits, as practised by conventional banks, are not permissible because they include:

(A) Gharar (uncertainty)

(B) Riba al-fadl (Riba by excess)

(C) Riba al-nasiah (Riba by deferment)

(D) both Riba al-fadl and Riba al-nasiah.

1.5 Which of the following is not a correct description of the profit sharing concept in a Mudarabah investment account?

(A) Investors bear the loss of capital.

(B) Manager shares the loss of capital with the investors.

(C) Profit is to be shared between the investors and managers.

(D) Profit must be shared according to an agreed ratio.

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Question 2Identify which of the following descriptions reflects Riba (Tick 3), and which are free from Riba (tick 7)

1. A $1,000 is being loaned out to a person with a condition the repayment must be made in the future for $1,000.

2. An importer purchases 1,000 tons of wheat from an exporter at £10,000 to be paid in the future.

3. A and B enter into a forward currency contract to deliver to each other a certain currency, i.e. USD, for Saudi Riyal at the exchange rate of 1:4. The delivery date will be six months later.

Question 3Match the following subject headings to the descriptions.

Subject Matter Descriptions

1. Islamic finance Both parties must share the profit and loss.

2. Riba Lack of knowledge that could render one of the parties in a disadvantageous position.

3. Shari’ah board Financial activities which conform to Shari’ah principles

4. Gharar A board consisting of qualified scholars to advise on Shari’ah compliance.

5. Musharakah A premium or deferment in the exchange of two usurious items.


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AnswersQuestion 1 Multiple choice1.1 (A) Gharar, as well as Riba, must be avoided as they may put one or other party in a

disadvantageous position.

1.2 (C) Money can grow if the owner of the money is willing to take risks. Among others risks, he can use his money to purchase goods at a cost of ‘x’ and sell them to another party at ‘x+y’. In short, profit gained through a sale transaction is allowed by the Shari’ah.

1.3 (D) Non-slaughtered animals are deemed to be not pure or clean from a Shari’ah perspective.

1.4 (D) Both Riba al-fadl and Riba al-nasiah.

1.5 (B) The manager will not share the loss of capital under Mudarabah because he does not essentially provide any capital. The investors will bear all of the loss of capital.

Question 2

1. A $1,000 is being loaned out to a person with a condition that the repayment must be made in the future for $1,000.

(The deferment of time of repayment does not lead to Riba provided there is no extra repayment amount).

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2. An importer purchases 1,000 tons of wheat from an exporter at £10,000 to be paid in the future.

(Any sale contract for a future payment involving money for a commodity is not Riba because Riba could only occur when there is an exchange of similar commodities or money for money.

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3. A and B enter into a forward currency contract to deliver to each other a particular currency, i.e. USD, for Saudi Riyal at the exchange rate of 1:4. The delivery date will be six months later.

(Forward Forex is not compliant as the exchange of the two currencies is not spot. Currencies must be exchanged on a spot basis).

3


Question 3

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Subject Matter Descriptions

1. Islamic finance Financial activities which conform to Shari’ah principles.

2. Riba A premium or deferment in the exchange of two usurious items.

3. Shari’ah board A board consisting of qualified scholars to advise on Shari’ah compliance.

4. Gharar Lack of knowledge that could render one of the parties in a disadvantageous position.

5. Musharakah Both parties must share the profit and loss.


Shari’ah compliance


define the meaning of Shari’ah compliance•

appreciate the importance of Shari’ah compliance in •all financial activities of an Islamic financial institution (IFI)

identify the key stakeholder interested in Shari’ah •compliance.

Learning outcomes

Chapter two



2.0 IntroductionShari’ah compliance is the key issue of Islamic finance. In this chapter you will be introduced to the term ‘Shari’ah compliance’, the requirement for Islamic financial products to comply with Shari’ah principles and the stakeholders interested in Shari’ah compliance. You will also be introduced to methods used to ensure compliance, which is essential at both the structuring and operational stages.

2.1 Meaning of Shari’ah compliance2.1.1 The general meaning of complianceThe need for compliant behaviour for every society is based on established norms and values that are adopted as the basis for particular laws, regulations, guidelines or principles. Compliance or conformance is necessary to ensure the preservation of a social order which will facilitate the achievement of societal objectives. In this respect compliant behaviour is universal and in Islam it relates to Shari’ah principles and rules.

The policies and practices of financial institutions and behaviour of market participants in the Islamic financial services industry are required to comply with Shari’ah principles and rules expressed in the form of regulatory requirements, guidelines and standards. The scope for such compliant behaviour includes all activities where reasonable assurance should be provided to the investing public and society that such activities do not confound or violate Shari’ah principles and rules. Any form of non-compliance will impair such assurance and affect investor confidence in the Islamic financial system.

Exercise 2.1Before proceeding, in your own words what do you understand by the term compliance?

Compliance essentially refers to the status of conforming to a certain standard, which subsequently dictates the status of being compliant or otherwise. Compliance imposes on a person or corporation the requirement to adhere to all those requirements that are prescribed by a certain point of reference. This guides the process of compliance and sets a standard which those seeking compliance are expected to achieve. Compliance with a standard can only be expected if the relevant standard has been made known to all parties concerned.

Standards are usually set by experts in the field and are determined after lengthy debate over what should be included. Most standards are not legally binding but are expected to be followed by virtue of the fact that they are supported by leading experts. It is normally left to the conscience of the individual as to whether they adopt a standard. Not following a standard would be going against that which was generally accepted as best practice and would need to be supported by evidence that the standard did not apply in the given circumstances.

2.1.2 Compliance with Shari’ah standardsIn the context of Islamic finance, a standard is embodied in Shari’ah principles and thus, Shari’ah compliance means adherence to all Shari’ah principles. Products and services coming under the

Indicative syllabus contentThe meaning of Shari’ah compliance •

Salient features of Shari’ah compliance •

Stakeholders in Shari’ah compliance •

Regulation and Shari’ah compliance •



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banner of Islamic finance must adhere strictly to the requirements of the Shari’ah principles in all aspects pertaining to a financial product or service. This means that compliance is not only limited to the design and structure of the product or service, but also the terms and conditions, the legal documentation, the accounting treatment, the standard operating procedures, IT aspects, through to the marketing brochures relating to the product or service. To be Shari’ah-compliant requires that each of these must conform to the requirements of Shari’ah principles.

Products that are in conflict with, or depart from, Shari’ah principles are deemed to be non-compliant. Normally, any areas of non-compliance will be addressed and, if applicable, relevant action will be taken to bring the products into compliance. In some jurisdictions, such as in Malaysia as per the Islamic Banking Act 1983 (Section 4), non-compliant activities may lead to the revocation of a license granted to an IFI. Although this is not specifically mentioned in other jurisdictions, this is a logical consequence for any licensing process because IFIs must adhere to their articles of association that normally mention their duty to comply with Shari’ah principles. Mention should also be made that, with the exception of Malaysia, other jurisdictions have no separate legislation or act covering Islamic banking.

Compliance is a Shari’ah requirement of conducting Islamic finance activities. The availability of Shari’ah standards is an important aid to facilitate Shari’ah compliance and to make Shari’ah compliance measurable and comparable across jurisdictions.

2.2 Salient features of Shari’ah complianceThere are three salient features of Shari’ah compliance:

(a) the fulfilment of all mandatory requirements of a particular contract

(b) the avoidance of any prohibited practices, terms and conditions

(c) the maintenance of compliance throughout the life of the product.

This diagram shows that full-fledged compliance should meet these requirements at all times, otherwise there will be a breach of Shari’ah compliance. A possible breach may take place in one of these areas or, in a worst-case scenario, in all three areas. However, the most likely breach

Shari’ah compliance means total adherence to all Shari’ah principles.•

Products and services coming under the banner of Islamic finance must adhere strictly to the •requirements of the Shari’ah principles.

The availability of Shari’ah standards is an important aid to facilitate Shari’ah compliance •and to make Shari’ah compliance measurable and comparable across jurisdictions.

Key points

Figure 2.1 Salient features of Shari’ah compliance


Fulfilment of all the necessary requirements

Avoidance of all prohibitions

Continuous compliance



is normally a failure to sustain continuous compliance. A product such as house financing may be endorsed as compliant because it fulfils all conditions and is free from all prohibited terms. However, if a customer were to default, an IFI may wish to impose on the customer some additional payment that would not be compliant.

Shari’ah compliance must be represented in both the process and the outcome. It should start from the product design and go through to product implementation and, as stated above, relate to all supporting services such as accounting, IT, marketing and advertisement, legal documentation, risk management, application forms and all other documentation.

As shown in the above diagram, Shari’ah compliance transcends the scope of product design and structure to cover other relevant considerations. For example, a product may be compliant and lawful in its product offering but it may contain a risk management tool that is not compliant, such as an interest rate swap to hedge any asset liability mis-match of the bank. In this case, the Shari’ah compliance requirements would demand the risk management tool to be equally compliant, such as having a compliant profit rate swap instead of an interest rate swap. The concept of a profit rate swap will be discussed in Study Guide Three.

Exercise 2.2Explain how information technology might impact on an IFI’s ability to achieve Shari’ah compliance?

Figure 2.2 Coverage of Shari’ah compliance

Risk management

Recovery and restructuring

IT solutions

Accounting treatment

Legal documentation


Product design and structure

Islamic finance challenge 2.1The DEF Company is an airport operator. They have issued a Sukuk Ijarah amounting to €500 million. The Sukuk is based on the following structure. The DEF Company has sold the airport to investors through an SPV/Issuer at €500 million and leased back the airport from the investors at €700 million payable within five years. The prospectus of the Sukuk issuance mentioned that the proceeds of the Sukuk will be issued to finance the construction of a new terminal and an airport hotel.

Given this information, what are the key areas that the Shari’ah advisors of this Sukuk must supervise to ensure strict compliance to Shari’ah principles?

SolutionOne of the key areas would be the actual utilisation of the Sukuk proceeds. The proceeds must be used to finance the projects as mentioned. Special attention must be given to the development of a hotel as it may involve some services which are not compliant to Shari’ah principles.

Sukuk – certificates of investment



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2.3 Stakeholders in Shari’ah complianceCompliance with Shari’ah principles is key to the operation of Islamic financial activities. There are many parties concerned with Shari’ah compliance including regulators, shareholders, a bank’s management, customers and the public at large. These stakeholders have a direct and indirect interest in the achievement of Shari’ah compliance in any given IFI.

2.4 Regulators – central governmentRegulators are concerned with compliance issues relating to a licensed financial institution as the licence will have been granted subject to compliance with Shari’ah principles. It is common for a company, which intends to be licensed as an Islamic bank, to incorporate in its memorandum and articles of association that the primary business of the company is banking under Shari’ah principles. Some countries, such as Malaysia, also state in their statutes that the award of an Islamic banking license depends primarily on the establishment of a Shari’ah board for the company. The Malaysian Islamic Banking Act 1983, Section 3(5) (sub-section b) provides that, “the central bank shall recommend the grant of a license and the Minister shall not grant a license, unless the central bank or the Minister, as the case may be, is satisfied:

Although similar direct provision cannot be found elsewhere, it can be envisaged that the approving authority may not award a license if certain prerequisites are not met.

2.5 Regulators – Shari’ah advisory and supervisory boardsA prudent regulatory policy to be imposed on an Islamic bank is the requirement to set up its own Shari’ah board prior to its licensing. A Shari’ah board can take the form of either a Shari’ah advisory board or a Shari’ah Supervisory Board (SSB). The two boards differ as follows:

a. A Shari’ah advisory board is mainly entrusted to issue Fatwas/religious opinions on particular products or issues, whereas the Shari’ah supervisory board is expected not only to issue an endorsement where applicable, but also to supervise the day-to-day activities of the bank. In other words, the supervisory role is wider than the advisory role and from the perspective of Shari’ah compliance, the supervisory function of the Shari’ah board is more appropriate. Having said this, what determines the supervisory or advisory role is not the title and the nomenclature, but the actual terms of reference of the Shari’ah board. If the terms of reference in the appointment of a Shari’ah advisory board include a supervisory and review function,

Stakeholders

of Shari’ah compliance

Bank’s

shareholders

Bank’s

management

Customer and public

Regulators

Figure 2.3 Stakeholders in Shari’ah compliance

‘That there is, in the articles of association of the bank concerned provisions for the establishment of a Shari’ah advisory body to advise the bank on operations of its banking business in order to ensure that they do not involve any element which is not approved by the religion of Islam.’



then its position is as good as a supervisory board. Likewise, the title of a Shari’ah supervisory board does not necessarily reflect the power of supervision and review unless this power is clearly mandated in the terms of reference of the establishment of the Shari’ah board.

b. The Shari’ah supervisory board is used to reflect the comprehensiveness of Shari’ah advice and reviews all the activities of an institution, whereas the Shari’ah advisory board is used in some contexts and jurisdictions to reflect the limited power and coverage that this Shari’ah board has. If the institution being supervised is a full-fledged IFI, Islamic insurance (Takaful) or Islamic asset management company, then the term ‘Shari’ah supervisory board’ is more appropriate. The board members, consisting of qualified scholars, must ensure that all activities of the institution, as explained in section 2.1.2, conform with Shari’ah principles. In the case of an Islamic window operating from within a conventional bank, that is a conventional financial institution offering selected Islamic financial products, Islamic insurance or Islamic funds, the term ‘Shari’ah advisory board’ would be deemed to be more appropriate. The function of the scholars who are on this board is mainly to ensure that a particular product, scheme or fund being offered by this Islamic window or conventional entity is in line with Shari’ah principles. The design, structure and legal documentation of these products must be Shari’ah compliant. Other dimensions of a full-fledged IFI such as IT solutions, accounting treatment and risk management methodologies should support Shari’ah compliant products and systems. The Shari’ah board is not entrusted to endorse except on product design, structure and the main activities, as well as on respective legal documents or prospectus, as the case may be.

The Shari’ah supervisory services to be provided by a Shari’ah board are expected to guide the Islamic bank in carrying out all of its activities according to Shari’ah principles. From a regulator’s perspective this would probably be the best method to achieve compliance as the bank’s management may not be able, academically and intellectually, to achieve this statutory requirement without the assistance of a Shari’ah board. An Islamic bank’s licence may be revoked if the bank fails to establish this Shari’ah board or fails to observe Shari’ah principles. Such a provision is included in the Malaysian Islamic Banking Act 1983 section 4 (3), which states:

Definition of SSB

‘A Shari’ah supervisory board is an independent body of specialised jurists in Fiqh al-Muamalah (Islamic commercial law). However, the Shari’ah supervisory board may include a member other than those specialized in Fiqh al-Muamalah, but who should be an expert in the field of Islamic financial institutions and with knowledge of Fiqh al-Muamalah. The Shari’ah supervisory board is entrusted with the duty of directing, reviewing and supervising the activities of the Islamic financial institution in order to ensure that they are in compliance with Islamic Shari’ah rules and principles. The Fatwas, and rulings of the Shari’ah supervisory board shall be binding on the Islamic financial institution.’Governance Standard for Islamic Financial Institutions No.1. Accounting, Auditing and Governance Standards for Islamic Financial Institutions 2004-2005, Shari’ah Supervisory Board: Appointment, Composition and Report p.5

Shari’ah advisory board Shari’ah supervisory board

3 Limited in issuing Fatwa on products. 3 Entrusted to issue Fatwa and review the whole activities pursuant to Fatwa.

3 Appropriate and relevant to Islamic window or conventional financial institutions offering Islamic financial products.

3 Appropriate and relevant to fully-fledged Islamic Financial Institutions (IFIs).

Table 2.1 Advisory versus supervisory boards

‘where a licence is subject to conditions, the Islamic bank shall comply with those conditions.’



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2.5.1 Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI)The Accounting and Auditing Organisation for Islamic Financial Institutions’ (AAOIFI’s) governance standard on the appointment of the Shari’ah board is equally important as the standard is directed to the appointing authorities and that may include the central bank and other agencies. Article 7 of the standard provides:

This is followed by Article 8, which notes:

2.5.2 Independence of boardsThe establishment of the Shari’ah board, either as the Shari’ah advisory board or the Shari’ah supervisory board acts as an external organ to the Islamic bank. The Shari’ah advisers appointed to the board are neither shareholders nor employed as salaried staff of the bank. Independence from the bank gives this board the power and authority to guide it towards Shari’ah compliance. It is common practice to allow shareholders in their Annual General Meeting (AGM) to appoint Shari’ah advisers or endorse a proposed list of these Shari’ah advisers as suggested by the bank’s management. AAOIFI’s governance standards, Shari’ah Supervisory Board: Appointment, Composition and Report, specifically allows for this. Article 3 states that:

The requirement of establishing a Shari’ah board implies that the compliance to Shari’ah principles should be maintained by the bank and not by the regulators. The main aim is to have an independent Shari’ah board whose role is to guide the Islamic bank and also, possibly more importantly, to objectively review and audit the Shari’ah compliance of the bank at both the process and outcome level.

Exercise 2.3An Islamic financial institution has established a committee of three scholars to advise on its operations. The main task is to issue the Fatwa and to review its operations for the purposes of issuing a Shari’ah certification of compliance, to be included in the annual financial report. Does this reflect the work of a Shari’ah advisory or Shari’ah supervisory board?

‘The Shari’ah supervisory board shall consist of at least three members. The Shari’ah supervisory board may seek the service of consultants who have expertise in business, economics, law, accounting and/or others. The Shari’ah supervisory board should not include directors of significant shareholders of the Islamic financial institution.’

‘The dismissal of a member of the Shari’ah supervisory board shall require a recommendation by the board of directors and be subject to the approval of the shareholders in several meetings.’

‘Every Islamic financial institution shall have a Shari’ah supervisory board to be appointed by the shareholders in their annual general meeting upon the recommendation of the board directors taking into consideration the local legislation and regulations.’

Islamic finance challenge 2.2What are the advantages and disadvantages of having a central Shariah Board at the Central Bank?

Solution

Advantages Disadvantages

Harmonisation of Fatwas in one given jurisdiction.

Turn around time might be long /not efficient

Imposition of common standards Could lead to lack of innovation



2.6 Regulators – central bank Shari’ah boardThe matter of Shari’ah compliance for the regulators has been made clear by recent developments that allow central banks or monetary agencies to appoint a Shari’ah board. The Central Bank Act of Malaysia 1958 (revised 1994), for example, incorporated this power to the central bank to establish a Shari’ah board. In addition, the central bank has issued guidelines for the establishment of Shari’ah committees at each individual Islamic bank and Islamic Takaful company in Malaysia. In other relevant guidelines, such as the Guidelines on the Offering of Islamic Securities, issued by the Securities Commission of Malaysia (2004), a standard or criteria has been placed on those who are qualified to act as Shari’ah advisers to advise on the issuance of Islamic securities, such as Islamic Sukuk. These criteria are as follows:

“An independent Shari’ah adviser who has been approved by the Securities Commission and who meets the following criteria:

i. is not an un-discharged bankrupt

ii. has not been convicted for any offence arising out of a criminal proceeding

iii. is of good repute and character

iv. possesses the necessary qualifications and expertise, particularly in Fiqh al-muamalah and Islamic jurisprudence, and has a minimum of three years’ experience or exposure in Islamic finance.”

These specific requirements are not provided in other jurisdictions. The requirement of good character of the Shari’ah advisors is normally documented in the letter of appointment of the Shari’ah advisors by the IFIs.

These requirements, both statutory and non-statutory, are necessary to safeguard the very essence of Islamic finance that is the attainment of Shari’ah compliance. The power invested in Shari’ah boards gives them the authority to enforce compliance be it Shari’ah or otherwise and ensure the soundness and stability of the entire financial and monetary system in a given country.

2.7 ShareholdersMuslim shareholders of IFIs, who contribute their capital to support banking and financial business activities, are equally likely to be concerned with the degree of Shari’ah compliance that their bank adheres to. They would expect that all the activities of the bank would conform with that stated in its articles of association, whether it is a private limited company or a public listed company. However, the expectation may be higher if this bank is a public listed company. The investors buying into the shares of this company may have made their decision on the basis of statements made in the company prospectus to only undertake Shari’ah-compliant business.

As previously mentioned, the role and function of the shareholders, among others, is to endorse the appointment of the members to the Shari’ah board of the company. This is seen as an important role as the selection of qualified and high-calibre Shari’ah advisers will not only ensure Shari’ah compliance but will also work with management to produce new and innovative Shari’ah-compliant products, hence adding value to the shareholders.

In addition, AAOIFI governance standards prescribe that the annual Shari’ah report, which is likely to include the Shari’ah review report, should be submitted to the AGM for endorsement. This provides a platform for all shareholders to assess the performance of their institution as far as Shari’ah compliance is concerned. Active participation by shareholders could potentially enhance the Shari’ah-compliance process and environment in the institution.

Related to this issue is a new phenomenon where some conventional banks, with the consent and approval of their shareholders and relevant regulatory authority, have decided to convert their total operation into an Islamic bank. Here it is essential that shareholders are regularly updated on the whole process of conversion. In some cases, the consent of the shareholders is required to write-off some assets in the balance sheet of the (existing) bank where these assets cannot be converted into Islamic assets for one reason or another. Examples of such assets include, for example, credit card receivables and housing loan receivables. These are existing receivables that originate from interest-based contracts, thus not a lawful income to the new entity seeking to comply with the Shari’ah principles. The write-off of these receivables may be necessary because they cannot be easily converted into Islamic assets. The consent to write-off reflects the concern of shareholders to be compliant and their commitment to the future business of the new entity, which should be free from Riba and Gharar. These assets may be disposed of or sold to a third party

Fiqh al-muamalah – Islamic commercial law



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prior to the decision of the conversion policy. Otherwise after a decision has been made by the shareholders to convert the bank, any proceeds from the disposal of non-approved assets to a third party must be given to charity.

The management of the bank has to fulfil the mandate, expectations and resolutions passed by the AGM of the shareholders and, in this context, undertake all financial activities in tandem with Shari’ah principles. Most of the management team of existing IFIs are not well-versed in Shari’ah principles. Therefore, it is difficult, if not impossible, for them to ensure strict compliance to Shari’ah principles in terms of product design as well as implementation of the products. Hence the need for a Shari’ah board or committee. The Shari’ah board, although not part of the management, is useful to guide the management to attain Shari’ah compliance in all aspects of the activities. The presence of the Shari’ah board not only meets the expectation of the central bank and the shareholders, but also assists management in avoiding any non-compliance.

2.8 Shari’ah compliance officersNew and recent developments in Islamic finance have seen the management of many IFIs appointing dedicated staff with Shari’ah backgrounds as full-time officers entrusted to assist with Shari’ah compliance. The duties of these Shari’ah compliance officers are, among others:

(a) to follow-up on the implementation of Fatwa and resolutions issued by the Shari’ah board by the management in all aspects (as the Fatwa and resolutions of the Shari’ah board are binding on IFIs)

(b) to vet all relevant documents pertaining to a product, such as legal contracts and documents, relevant forms and marketing brochures

(c) to liaise with the Shari’ah board on any issues and matters relevant to Shari’ah compliance

(d) to assist in carrying out an annual Shari’ah review under the guidance of the Shari’ah board

(e) to inculcate and maintain the environment of Shari’ah compliance in all aspects of the business by conducting training for other staff, assisting in replying to staff queries on Islamic finance, advising the management on the direction of Islamic finance, etc.

Exercise 2.4 A Shari’ah compliance officer functions like a legal compliance officer in most financial institutions. In what sense, does the role and function of the Shari’ah compliance officer differ from a Shari’ah supervisory board.

2.9 Customers and public at large The customers and public at large are also privy and party to the requirements of Shari’ah compliance. Relatively speaking, their interest in Shari’ah compliance is more sensitive compared with other stakeholders as the customers are the direct consumers and users of Islamic financial products. The reason why they have opted to open an account with an Islamic bank or to obtain an Islamic house financing scheme, for example, is because they are reliant on the endorsement by the respective banks that their financial products are compliant with Shari’ah principles. Any element of non-compliance will be a misrepresentation on the part of the bank, which should uphold the interests of the customers at all times.

There have been cases where IFIs have decided to write-off an amount owed to them when it discovered there were some non-compliant issues pertaining to the debts. It could happen that in a house financing under Murabahah, the bank, upon the request of the customer who faces financial

‘While the SSB is responsible for forming and expressing an opinion on the extent of an IFI’s compliance with the Shari’ah, the responsibility for compliance therewith rests with the management of an IFI. (Consideration should be given to the definition of management in relevant national legislation and regulation). To enable management to carry out this responsibility effectively, the SSB of the IFI shall assist by providing guidance, advice and training relating to compliance with the Shari’ah. The Shari’ah review of an IFI does not relieve management of their responsibility to undertake all transactions in accordance with the Shari’ah. It is the management’s responsibility to provide to the SSB all information relating to the IFI’s compliance with the Shari’ah.’

Governance Standard for Islamic Financial Institutions No.2. Shari’ah Review, Accounting, Auditing and Governance Standards for Islamic Financial Institutions 2004-2005, p5



difficulty, agrees to reschedule the tenor of the payment period and, subsequently, the amount of monthly payment to a lower amount, but the total payable under this rescheduling exercise will be increased from the original selling price. Although the rescheduling is acceptable, the additional price due to rescheduling is not compliant as this is deemed to be of Riba transaction. Therefore, any extra income generated from this rescheduling exercise, if any, has to be written off. This is the highest manifestation of adherence to Shari’ah principles as income generated from these non-compliant activities cannot be recorded as legitimate income.

In some cases, the bank may commit a mistake that triggers the breach of Shari’ah compliance. In this scenario, the customer cannot be burdened in their obligation and thus, their obligation will be distinguished to ensure that they are not oppressed by a mistake committed by the bank. For example a bank agreed a selling price and calculated the monthly payment incorrectly that is lower than was agreed. If and when the bank notices this shortfall after a period of time, then it cannot revoke the contract due to its own mistake. Also, the bank is not entitled to ask the customer to make good of the past under-payment as this will incur an extra burden to the customer. Obviously, the bank may charge the correct amount of payment from the date the error was spotted, but cannot back-date the payment.

From the above it is obvious that Shari’ah compliance is integral to all stakeholders of Islamic finance. This is a phenomenon that is totally absent in the conventional banking system. The non-adherence to this requirement will defeat the very meaning of Islamic finance in both its law and the spirit of the law.

2.10 ConclusionShari’ah compliance lies at the heart of all aspects of Islamic finance. This chapter explained why Islamic financial products must comply with Shari’ah principles and outlined the reasons why stakeholders need to be confident that compliance has been achieved. Systems need to be put in place to achieve stakeholder confidence. This chapter also introduced you to the methods which have been developed to ensure compliance, both at the structuring and operational stages.

The following chapter will look at the legal sources that underpin the development of Islamic finance. It will also consider the various schools of thought that exist and explain how Shari’ah standards, policies and rulings are implemented in the framework of Islamic finance.

There are many parties that are concerned with Shari’ah compliance. These include •regulators, shareholders, a bank’s management, customers and the public at large.

Key point

Islamic finance challenge 2.3Shari’ah compliance is only effective if the Shari’ah board members are provided with full information on the operations of the IFIs. They should also be given access to relevant documents and IT systems. What remedies do the Shari’ah boards have where these are not made available?

SolutionThere are many remedies available to the Shari’ah board, including:

(a) report to the Central Bank or relevant authority

(b) make a special report to the annual general meeting of the shareholders

(c) if necessary, undertake public awareness in the society.



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1. compliance essentially means conforming to a certain standard that subsequently dictates the status of being complaint or otherwise

2. compliance imposes on a person or corporation the requirement to adhere to all prescribed requirements

3. standards are usually set by experts in the field and are determined after lengthy debate over what should be included

4. products that are in conflict with, or depart from, Shari’ah principles are deemed to be non-compliant

5. Shari’ah compliance must be represented in both the process and the outcome.

6. parties concerned with Shari’ah compliance include regulators, shareholders, a bank’s management, customers and the public at large

7. regulators are concerned with compliance issues relating to a licensed financial institution, as the licence will have been granted subject to compliance with Shari’ah principles

8. Muslim shareholders expect all the activities of the company to be Shari’ah-compliant, as investors buying into the shares of this company may have made their decision on the basis of the prospectus of the company to undertake Shari’ah-compliant business

9. the interest of customers and the public at large lies with the fact that they are the direct consumers and users of Islamic financial products; they probably articulate with the bank because the bank has stated that its financial products are compliant with Shari’ah principles.



Chapter 2 AnswersExercise 2.1The key aspect to include in your answer is that compliance means doing something that conforms to an agreed standard, rule or piece of legislation. In not contravening a standard, rule or piece of legislation, an individual is said to be complying. Compliance normally means acting in a way that is consistent with both the spirit as well as the letter of the standard, rule or piece of legislation.

Exercise 2.2The IT function is to record all transactions using information technology. The method of recording this data and how that would generate overall data processing might breach some Shari’ah principles. Any gap in the IT must be fulfilled as the IT system reflects the actual recording of transactions. For example, if the IT system does not follow the proper sequence of a contract, then the recording of the transaction will not be in accordance with Shari’ah principles. In the case of a Tawarruq deposit product, the IT system must record that the IFI purchases an asset from the customer/depositor after the customer/depositor has purchased that asset from a commodity broker through the IFI. Also, the IT system may be set up to impose a penalty interest on any overdue payment which is not compliant.

Exercise 2.3This reflects the function of a Shari’ah supervisory board as it includes the review exercise.

Exercise 2.4While the Shari’ah board is external to the financial institution, the Shari’ah compliance officer is internal and is employed as a full time member of staff. Thus, he has more time and resources to check all relevant activities and documents to ensure Shari’ah compliance and to report any non-compliance matters to the SSB.

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Revision Questions Question 1 Multiple choice1.1 What is Shari’ah compliance?

(A) Adherence to the Fatwa of the Shari’ah board.

(B) Adherence to regulations issued by regulators.

(C) Adherence to all Shari’ah principles required in a given contract.

(D) Adherence to all Shari’ah principles governing a contract and all supporting materials and processes.

1.2 Which of the following is not integral to the Shari’ah compliance process?

(A) The avoidance of all prohibitions in a certain financial product.

(B) Continuous compliance throughout the life of a product.

(C) Annual reporting to regulators.

(D) The fulfilment of required principles, terms and conditions.

1.3 Which of the following is not a stakeholder of Shari’ah compliance?

(A) Regulators.

(B) The AAOIFI.

(C) Customers.

(D) A bank’s shareholders.

1.4 Who has the authority to dismiss a member of a Shari’ah board?

(A) The regulators.

(B) The shareholders.

(C) Other members of the Shari’ah board.

(D) The board of directors.

1.5 Which of the following best describes a Shari’ah compliance officer?

(A) A Shari’ah audit officer appointed by the regulator to oversee the day-to-day Shari’ah compliance requirements.

(B) A full-time Shari’ah officer appointed by the IFI to ensure the compliance of the IFI to Shari’ah principles.

(C) A representative of the board of directors who is well versed in Shari’ah principles.

(D) Member of the audit committee of the bank who holds a Shari’ah degree.

Revision questionsShari’ah compliance

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Question 2Match the following roles and functions to the appropriate column, depending on whether they are performed by the Shari’ah advisory board or the Shari’ah supervisory board

(A) Issuance of Fatwa.

(B) Issuance of Fatwa and its supervision.

(C) Supervisory role of Shari’ah board.

(D) Advisory role of Shari’ah board.

Question 3Why do IFIs need to write off non-approved assets?

Question 4According to AAOIFI’S Governance Standard on Shari’ah Supervisory Board (article 3), which party is normally acknowledged as the best authority to appoint the Shari’ah board members?



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AnswersQuestion 1 Multiple choice1.1 (D) Shari’ah compliance presupposes adherence to all Shari’ah principles relevant to a

particular contract. These might include other supporting materials and processes. It is wider than adherence to the fatwa of the Shari’ah board and any guidelines issued by respective regulators.

1.2 (C) The duty of annual reporting to respective regulators is not relevant to Shari’ah compliant processes though it may be relevant from a regulatory framework perspective.

1.3 (B) The AAOIFI is a standard-setting body that is not linked to the financial institution and its products.

1.4 (B) According to the AAOIFI Governance Standard, the dismissal of any member of the Shari’ah Board can only be decided by the shareholders. This serves to reinforce the notion that the Shari’ah board is an independent body that is separate from the management of the bank.

1.5 (B) A Shari’ah officer is an employee of the financial institution who is responsible for ensuring the compliance of all activities of the institution. The Shari’ah officer is also required to report any non compliant issues to the Shari’ah board.

Question 2

Question 3These non-approved assets, which may occur accidentally or through negligence, cannot lawfully be distributed to shareholders or depositors to the IFIs.

Question 4The best authority to appoint Shari’ah board members, according to AAOIFI’S Governance Standard on Shari’ah Supervisory Board (article 3), is the shareholders in their annual general meeting. This ensures that the board is independent from the management of the IFI. In this way, the Shari’ah board is responsible to shareholders instead of the board of directors.


(A) Issuance of Fatwa. (B) Issuance of Fatwa and its supervision.

(D) Advisory role of Shari’ah board. (C) Supervisory role of Shari’ah board.


Sources of Islamic commercial law


define the meaning of source of law from an •Islamic perspective

state the importance of source of law in Islamic law•

distinguish between the primary and secondary •sources of Islamic law

distinguish between Shari’ah (divine sources of law) •and Fiqh (Islamic substantive law or positive law)

identify the most workable technique of law in •developing contemporary Islamic commercial law

describe the early development of Islamic (Sunni) •schools of law.

Learning outcomes

Chapter three



3.0 IntroductionIslamic commercial law, as distinct from conventional modern law, is derived from sources which, according to Muslim belief, were revealed by God Almighty. According to Islam, the requirements as stated in these sources must be adhered to when establishing a point of law. Basically, a source is a place from which something is derived or extracted. In this chapter you will be introduced to the sources from which Islamic law developed including both the primary and secondary sources of law. You will also be introduced to the practice of reasoning (Ijtihad) and to the principles that underlie this process. Ijtihad allows modern scholars to solve modern issues and problems using their reasoning and interpretative skills and this has resulted in the development of several Islamic schools of law.

3.1 The meaning of source of law in Islam3.1.1 The meaning of Shari’ahLiterally, Shari’ah means the path to the watering place. Muslims believe that Shari’ah is the clear path for believers to follow in order to obtain guidance in this world and deliverance in the next. In its common usage, Shari’ah refers to the commands, prohibitions, guidance and principles that Muslims believe God Almighty has prescribed to mankind.

3.1.2 The sources of lawThe essence of Islam is that it derives its principles and values from a given source. In a legal sense, the term source has more than one meaning. Source can denote the originating fount of a system. For Islam and Islamic law this source is the Qur’an and is held to be divine in character. Source can also refer to the main body of the law such as in the case of judicial precedent in English common law. When used in the plural, it generally refers to the totality of rules and authorities arranged in a structural hierarchy. Essentially, the source of the law is not the law itself. Rather it is the place from which a law can be derived and extended. To put it simply, the source indicates where a rule or legal argument is taken from.

However, in some cases, the divine source also contains laws that are substantive in character. Both of these are known as the sources; one provides the proof and the other the law from which a principle of law can be extracted. This phenomenon can be compared with the way European civil law and English common law work. European civil law relies heavily on enacted laws and statutes while English common law relies on case law. Both statutory and case law are the sources of law for European civil law and English common law respectively.

Indicative syllabus contentThe meaning and source of Islamic law.•

The importance of source.•

Primary and secondary sources of law.•

Shari’ah law and Fiqh law.•

Schools of law.•



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3.1.3 Combined sources of lawIslam has combined these two elements in two divine sources of law namely the Qur’an and the Traditions of the Prophet Muhammad. The Qur’an on its own contains principles of law as well as substantive law. For example, the Qur’an prescribes that an obligation is to be fulfilled (chapter 5: verse 1). This is a leading principle in Islamic commercial contract without which the sanctity of the contract cannot be upheld. On the other hand, the Qur’an also prescribes a specific law for a specific case such as the prohibition of interest (Riba), (chapter 2: verse 275) and the permissibility of providing a collateral or a pledge to secure a loan or financing (chapter 2: verse 283).

The source of law in Islam provides the overriding and general principles for general application as well as detailed specific law for a specific case. The source of law in Islam is seen as divine as it was revealed by God Almighty to the Prophet Muhammad. It is from this source that the whole Islamic legal system evolves and develops.

Islam is a religion based on a system of principles and rules designed to achieve the betterment •of humankind.

According to Islam, Shari’ah refers to the commands, prohibitions, guidance, and principles •that God Almighty has prescribed to mankind.

Islam has combined these two elements in two divine sources of law namely the Qur’an and •the Traditions of the Prophet Muhammad.

A source of law may establish a general principle as well as prescribe a specific law for a •specific case.

Key points

Islamic finance challenge 3.1Using the internet or your local library look up the case of Donoghue v. Stevenson [1932] All ER Rep 1; [1932] AC 562; House of Lords and explain how case law can be a source of law in English common law.

Points to noteA case decided by a court must have been based on a reason, known as ratio decidendi, or simply the legal basis on which a law is established (in Islamic law, this is known as ‘Illah). In the case of Donoghue v. Stevenson, the primary test or principle used in determining the existence of a duty of care is known as the neighbour principle. In this case, the defendant, a ginger beer manufacturer sold ginger beer drinks to a retailer. The ginger beer bottles were opaque. ‘A’ bought a bottle and entertained a friend, the plaintiff who drank the ginger beer. When ‘A’ refilled the glass, the remains of a snail came out of the bottle. The plaintiff suffered shock and was severely ill as a consequence. The plaintiff sued the manufacturer and claimed that the manufacturer had a duty in the course of his business, to prevent snails from entering into his ginger beer bottles and further that he had a duty to ensure that all empty bottles were carefully inspected before they were filled with ginger beer. The issue in this case was whether the defendant owed such a duty to the plaintiff. The House of Lords held that the test to determine the existence or otherwise, of such a duty, was whether the plaintiff was the neighbour of the defendant. This decision in this case can be used to decide on future case because the neighbour principle is an objective test in the sense that the court will ask the hypothetical question: would a reasonable man, who is in the same circumstances as the defendant, foresee that his conduct will adversely affect the plaintiff? If the answer is ‘yes’, this means that the plaintiff is a neighbour of the defendant and the latter owes the former a duty of care. The ‘neighbour principle’ is the basis of law to which future cases must refer.



Exercise 3.1Briefly explain:

(i) What is the origin of the sources of law in Islam?

(ii) Why the sources of law are different from substantive law?

(iii) What the sources of law in Islam are?

3.2 The importance of the source of law in Islam3.2.1 The Qur’an The source of law is important in any legal system. The history of Islamic law begins with the revelation of the Qur’an, which contains legal principles and injunctions dealing with subjects such as ritual, marriage, divorce, succession, commercial transactions and penal laws.

3.2.2 The Traditions of the Prophet MuhammadAnother divine source of Islam is the Traditions of the Prophet Muhammad, which is a record of all the sayings, actions and tacit approvals of the Prophet Muhammad. The literature of the Traditions of the Prophet Muhammad is extensive and covers a much wider range of topics than the legal verses in the Qur’an. This is not a difficult matter to appreciate as the Prophet Muhammad was often approached by his companions and the community for his decisions on a particular case or problem. The Prophet Muhammad answered and addressed these cases either through the Qur’an or through his Traditions, which is seen as equally divine in character. The Prophetic Traditions, generally speaking, like English case law, concern a particular fact or situation by recording an answer given to a specific question or a remedy provided for a specific grievance. Among other examples, he was asked by his community on the permissibility of Salam sales, that is forward sales or a sale of deferred delivery against a cash payment in advance. To this he replied that a sale is valid provided the asset to be delivered in the future is certain in its specifications and its weight or its measure. The time of delivery must also be certain.

3.2.3 The importance of the two divine sourcesThese two divine sources are important as they provide not only the parameters of what is approved and what is not but also some specific injunctions for specific cases in life. Once these are prescribed, they become binding on Muslims who are expected to strictly follow these guidelines and injunctions. Muslim jurists may extend these guidelines and injunctions to other cases where relevant but they are not authorised to change the fundamental principles and injunctions as contained in the Qur’an and the prophetic traditions.

Islamic law developed historically through the divine-text approach in the sense that Muslim jurists are guided not by intuition but by textual evidence. This textual evidence constitutes the source of law from which the law is derived, and is later extended by jurists through other legal techniques of application and extension. For example, the source of law in the prohibition of liquor is the verse that clearly prohibits the consumption of liquor (chapter 5: verse 60). This verse has been the basis from which the same prohibition was extended to other items that are intoxicating in nature such as drugs. The method of extension will be illustrated later under the technique of analogy (section 3.3.6).

Exercise 3.2 According to Islam, the “source” denotes a place from which one may find what one is looking for. Explain the importance of “source” in the context of Islamic law.

The Qur’an contains legal principles and injunctions on dealing with subjects such as ritual, •marriage, divorce, succession, commercial transactions and penal laws.

The Traditions of the Prophet Muhammad are a record of all the sayings, actions and tacit •approvals of the Prophet Muhammad.

These two divine sources are important as they provide not only the parameters of what is •approved and what is not but also provide specific injunctions for specific cases in life.

Key points



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3.3 Primary and secondary sources of Islamic lawIn Islamic law, sources of law may be classified into two broad categories, namely primary and secondary depending on their origin. While primary sources are based on revelation, secondary sources are based on human interpretation and reasoning, which, in practice, are, or should be, traced back to primary sources. Islamic law has combined both revelation and human reasoning. Although Islamic law is sacred, it is by no means irrational to the effect that determining the law is a matter of speculation or ad hoc finding. There is always interplay and synergy between revelation and human reasoning, or primary and secondary sources, in order to provide legal answers and solutions to a given case.

3.3.1 General principles and maxims of the Qur’anAlthough the Qur’an contains specific rulings on matters such as marriage, divorce, inheritance and criminal offences and punishments, the larger part of Quranic legislation consists of broad and general principles and maxims. It has been observed that the Qur’an provides general principles through the following two means:

(a) Constitutional principles

The first is by embodying in a specific verse a principle of law, which is meant for general application in all places and in all ages. For example, the sanctity of life; the obligation to fulfil an obligation; the duty towards one’s parents; the prohibition of illegal means of enrichment; the provision of financial protection for the poor and needy; the duty to obey authority; the equality of man and woman, and many other principles of law are thus directly or indirectly laid down in the Qur’an. The ability to identify all relevant ‘constitutional’ principles of the Qur’an depends on one’s ability to deal with the Qur’an from a methodological perspective to derive as many principles as possible. Many of these principles are also common in the constitutions of most modern states such as the sanctity of life, the rule of law, equality of sexes, etc.

(b) Empirical reading of the verses

The second approach is found through an empirical reading of the verses of the Qur’an. The Qur’an is full of verses that have common themes, so much so that a scholar can extract a principle of law that is common to all of those verses. What is of relevance and importance here is the main message of the principle of law underlying these verses, irrespective of the form in which these verses are presented in the Qur’an. A principle of law could be inspired through a direct legalistic form, a narration or an implied prescription. Muslim jurists have undertaken such an empirical study of the Qur’an and concluded that there are five objectives that Islam was essentially revealed to protect.

Islamic finance challenge 3.2Explain how the case of a Salam sale can be used as a principle of law for future cases?

Solution Salam sales, although specific, allude to many principles of law that are of general application. These include, amongst others, the following:

(a) forward sales are only permissible if the payment is made in advance

(b) the underlying asset of a Salam sale is something which is either weighable or measurable

(c) a Salam sale allows both parties to ‘lock in’ the price at the time of contract against future fluctuation of the price; this is useful for financial risk management, particularly against market risk.

Primary sources of law in Islam are based on revelation.•

Secondary sources of law are based on human interpretation and reasoning.•

Key points



These are the protection of:

• religion

• life

• intellect

• lineage

• property.

This is because the Qur’an has constantly and empirically endorsed these aspects of protection and promotion, which makes it clear under Islamic belief that these five aspects are fundamental to the survival and very existence of humankind.

The same approach to looking at verses of the Qur’an could add other objectives to these five identified objectives of Islamic law. The Qur’an also discusses the importance of education, freedom, justice and fairness as well as other themes that are empirically founded and endorsed. These could also be promulgated as the Quranic fundamental requirements for the benefit of mankind. Being a source, the Qur’an should be general enough to transcend the limits of time and place and, therefore, the effort to understand and interpret the Qur’an is equally everlasting.

3.3.2 The Traditions of the Prophet MuhammadThe other revealed source of Islam is the Traditions of the Prophet Muhammad. This simply refers to the sayings, deeds and tacit approvals of the Prophet Muhammad in so far as they relate to legal rulings. Legal rulings in Islamic law have five categories, namely:

• theobligatory

• therecommended

• theforbidden

• thereprehensible

• thepermissible.

The Prophetic Traditions are the manifestation of rulings that originated from the Prophet Muhammad and can best be described as the case law of Islam. Unlike the Qur’an, the cases that were referred to the Prophet Muhammad were normally based on particular facts to which the Prophet Muhammad gave his judgment either in the form of sayings, deeds or tacit approval.

The Traditions of the Prophet Muhammad are full of precedents, which Muslim jurists throughout the ages have referred to as a guide in arriving at a particular legal ruling by way of analogy and other techniques of legal interpretation. What is important in the Prophetic Traditions is not the case per se but the facts of the case and the ‘ratio’ or legal basis on which the Prophet’s pronouncement was made. It is this basis that is relevant and extendable to modern and current application of law. Each new case requiring a legal solution must share the same legal basis of the precedent or original case as prescribed in the Qur’an, Prophetic Traditions or both.

3.3.3 General principles of financial law as laid out in the Traditions of the Prophet MuhammadIn terms of general principles, the Traditions of the Prophet Muhammad provide, inter alia, the maxim that the benefit is in proportion to the liability or detriment (Al-kharaj bi al-Daman). This tradition simply establishes a maxim that in order for someone to earn a benefit or profit from their commercial transaction, they must take a corresponding risk. This tradition precludes activities which would bring benefit without taking any risk such as the enjoyment of interest in a fixed-deposit account, as offered by conventional banks.

Like English common law cases, the Traditions of the Prophet Muhammad deal with particular facts of various situations by recording an answer given to a specific question or a remedy provided for a specific grievance. Someone, with a question, problem, grievance or dispute, would have gone to the Prophet Muhammad who gave an answer or ruling for such a remedy. The Traditions of the Prophet Muhammad therefore, to some extent, represent the case law of Islam.

One example of such a case involved the Prophet Muhammad’s two companions who wanted to mutually exchange palm dates. The exchange would have involved two different quantities and amounts of dates. The Prophet Muhammad instructed that the transaction be stopped because it would be tantamount to



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Riba (interest/usury). Instead, the Prophet Muhammad instructed the owner of the lower-grade dates to sell his dates in the market first for cash and only after that could he buy the better dates from another party through the payment of money. Riba was avoided as the dates were exchanged for money and not for dates of different quality and quantities, as initially proposed.

Exercise 3.3Explain the ‘ratio’ or the legal basis for the prohibition of the exchanging of two different amounts of dates.

The above case indicates that barter trading is discouraged as it may lead to fraud and injustice. In addition, the case highlights the principle of Riba, particularly Riba al-fadl, that is Riba by an excess that arises when two similar usurious items, which have different values, are exchanged (refer to section 1.5.1).

Exercise 3.4 The Qur’an provides general principles of law and the Traditions of the Prophet Muhammad, to a large extent, provide explanations to these principles. Provide one example to illustrate this relationship.

3.3.4 Ijtihad or legal reasoningThe law-making methodology based on the Qur’an and the Traditions of the Prophet Muhammad is generally known as Ijtihad, legal reasoning.

Jurists and scholars use this legal reasoning or Ijtihad to arrive at what is thought, on a best effort basis, to be the law as intended by the law giver, God Almighty. All subsidiary sources come under the purview of Ijtihad.

Ijtihad in most cases relies on the faculty of mind, namely Ra’y (a considered opinion). Ra’y has a flexible and dynamic nature. It decides the cases in light of the spirit, wisdom and fairness of Islam. It is the well-considered and balanced opinion of a person who aspires to reach a correct decision. These subsidiary sources include Qiyas (analogical reasoning), Istihsan (juristic preference), Maslahah Mursalah or Istislah (unrestricted public interest), Sadd al-Dharai’ (blocking the means), ‘Urf (customary practice) and Istishab (presumption of continuity). All these terms are juristic in character and are cited in Arabic. An English translation and a brief illustration of each of these terms will be provided in the next section. Students are encouraged to refer to the glossaries to assist in understanding these terms.

The above subsidiary sources are all discussed in Islamic law as the bases of law finding for cases not specifically covered by the legal texts. Generally, all of these sources are aimed at arriving at a decision, as a result of thought, contemplation and a genuine search for the truth, in a case where indications are conflicting or lacking. In Islamic law, a considered opinion is binding within the sphere of law simply because it is arrived at by a competent scholar, as a result of diligent and conscientious reasoning (Ijtihad). In other words, a tentatively constructed rule has the full force of a bona fide rule of law if the interpretation or reasoning upon which it is based is diligent and conscientious. Therefore, it can be said that a considered opinion in Islam is binding in matters of law.

The sources of Shari’ah are of two types: revealed and non-revealed. These are only two revealed sources- first the Qur’an; second, the teachings and exemplary conduct (Sunna) of the Prophet Muhammad. The authority of the Sunna as a source of Shari’ah as next to the Qur’an is indicated in the Qur’an itself. The non-revealed sources of Shari’ah are generally founded in juristic reasoning and may take a variety of forms, including analogical reasoning (Qiyas), juristic preference (Istihsan), considerations of public interest (Istislah) and even general consensus (Ijma) of the learned.”

Mohd Hashim Kamali, “Law and Society - The Interplay of Revelation and Reason in the Shari’ah”, in the Oxford History of Islam, p.118

For Muslims, the Sunnah is the secondary source of Islamic law after the Qur’an. Some things not explained in detail in the Qur’an are clarified in the Sunnah as a result of religious actions instituted by the Prophet Muhammad.



3.3.5 Ijma’ – consensus of Muslim juristsThe first tool or technique of Ijtihad is Ijma’. This refers to the consensus of Muslim jurists on a particular legal issue at a particular point of time after the demise of the Prophet Muhammad. Once a consensus is achieved, it becomes a binding authority on Muslim communities. It must be upheld unless the basis of arriving at that consensus has changed due to a new discovery of principles or a new Ijtihad, which is more appealing. It is to be noted that a technical and valid Ijma’ or consensus is hard to achieve as it requires the unanimous consent and agreement of all qualified jurists at a particular time, on a particular legal issue that requires a common standpoint. In modern times, Ijma’ will arguably be the least effective means of Ijtihad, particularly in the area of Islamic commercial law as this aspect of law is very dynamic, hence consensus is often difficult to attain.

However, the decisions and resolutions on Islamic finance, issued by international Islamic bodies, such as the International Islamic Academy of Fiqh of the Organisation of Islamic Conference (OIC) and the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) could be persuasive if not binding because these decisions reflect the views of the majority of contemporary Muslim jurists on a particular legal point. The decisions of these two bodies, although not satisfying the strict requirements of a technical consensus, are well-respected and acknowledged by many regulators and stakeholders in contemporary Islamic finance.

Exercise 3.5Explain why the process of Ijma’, that is consensus or agreeing differences, is difficult to achieve in practice?

3.3.6 Qiyas – analogical reasoningOf all the subsidiary sources, Qiyas or analogical reasoning is the most important and workable instrument. Qiyas, broadly speaking, is the legal method of extending the law beyond what is stated in the authoritative legal sources. It is an extension of a precedent and not the establishment of a fresh ruling by itself. To do this, it is necessary to draw a parallel or to find a similarity between what is mentioned in the legal texts and a new problem. This is known as ‘Illah or ratio decidendi, loosely translated as the ‘reason’. Once it is known that both the original and the assimilated cases share the same ‘reason’, the judgment (Hukm) of the original case is extended to the assimilated case. As a result, the new problem carries the same ruling as the original. In the case of wine prohibition, the basis is intoxication. In the case of strict requirements of exchanging certain food items, the legal basis relates to the nature of these items, namely main foods instead of specific items as mentioned in the relevant Tradition of Prophet Muhammad. In the case of Donoghue v. Stevenson, it was held that negligence has occurred if someone has a duty of care but has breached that duty which as a result has caused harm to another party.

Although Qiyas is based on reasoning and is speculative in character, it is the most accepted instrument and legal method. It is more systematic and less arbitrary than other forms of legal reasoning. This is due to its internal system and processes that free the application of Qiyas from relying merely on discretion or personal whim. Credit goes to the detailed procedure and methods used to establish the proper ‘Illah or “reason” applicable in the proper context.

Islamic finance challenge 3.3Explain the need for Ijtihad when two divine sources of law already exist.

SolutionThe written texts are limited in number but the incidents of daily life are unlimited and it is impossible for something infinite to be enclosed by something finite. Each case is therefore looked at on its facts and a decision is made. The sources of law are provided to ensure that the reasoning and interpretation are not devoid of Divinely guided principles. Therefore a Muslim jurist cannot decree that interest can be made lawful in certain circumstances because this reasoning (Ijtihad) would be null and void. Although Ijtihad is useful in solving modern problems, it cannot in any way contradict the principles of law which are prescribed by the sources of Islamic law.



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Qiyas assists the jurist not only to find and discover a correct ‘Illah, ratio decidendi or reason contained in textual evidence, but also to ensure the application of this ratio to a correct context and situation. This is to avoid the discovery of an improper reason or the discovery of the proper reason wrongly applied to an improper case. Clearly the finding of the correct reason does not necessarily guarantee the proper extension of the legal ruling to a new case. Therefore, the most crucial factor is to determine the element of similarity that justifies the transfer of the rule from one case to another, because it is this element that determines the validity of the conclusion.

3.3.7 ‘Illah – reasonThe central theme of Qiyas is the ‘Illah, ratio decidendi or reason. Among other salient features of the ‘Illah are the following:

(i) the ‘Illah must be an evident attribute and hidden considerations such as intention, consent, and goodwill are not to be considered as ‘Illah since they are not ascertainable; in other words, the ‘Illah must be definite and perceptible; the ‘Illah for a valid contract, for example, is the offer and acceptance instead of the buyers’ and sellers’ actual consent, simply because consent is imperceptible

(ii) the ‘Illah must also be a constant and regular attribute that is applicable to all cases without being affected by differences of persons, times, places and circumstances, etc

(iii) the ‘Illah should also be co-extensive in a way that whenever it exists, the rule of law will also exist

(iv) the ‘Illah should also be co-exclusive, that is, if the ‘Illah does not exist, the rule of law will also not exist.

An accurate appreciation of these features would prevent Muslim jurists from making unnecessary and invalid legal conclusions.

3.3.8 Qiyas al-tard – case-to-case comparisonThe most common logical argument used in Islamic legal theory is analogy or Qiyas al-tard. This is basically a case-to-case comparison. The basic course of reasoning is the extension of a legal rule from one case to another due to a similarity, deemed by the jurists to be a ‘material similarity’. The form of this argument is as follows:

A has the property X.

B has the property X.

A has the rule J.

X is a relevant property in inducing J.

Therefore, rule J must also apply to B.

Qiyas al-tard or analogy is relatively similar to a syllogistic argument.

The law making methodology based on the Qur’an and the Traditions of the Prophet •Muhammad is generally known as Ijtihad – legal reasoning.

Ijtihad, in most cases relies on the faculty of mind, namely Ra’y - a considered opinion.•

Key points

A case in point is the Quranic prohibition of wine drinking. The jurist may argue that the reason for its prohibition is its intoxicating quality. They may therefore formulate their findings in the categorical proposition: “All intoxicating substances are forbidden.” Once they establish the major premise, they will be able to set forth a syllogism in which the minor premise is, for example: “Vodka is an intoxicating substance” and the conclusion is “vodka is forbidden”. Since wine drinking is prohibited because of its intoxicating properties, the prohibition, therefore, would apply to other intoxicating substances.



3.3.9 Istihsan – juristic preferenceAnother principle or technique of law is known as Istihsan or juristic preference. This principle in Islamic legal theory is discussed by Muslim jurists in connection with the principle of Qiyas. Literally, Istihsan comes from the root (in Arabic) Hasuna, meaning beautiful’, ‘comely’, ‘good’, ‘pleasing’ ‘appealing’ and other similar words. Broadly speaking, Istihsan takes place when a jurist makes a decision in a particular case that is different from a similar case that has already been decided. The case decided based on Istihsan is a departure from a precedent for a reason, which is stronger than the one found in similar cases. In other words, Istihsan’s application is to discard the application of Qiyas by virtue of another reason that is stronger and more ‘appealing’. The features and functions of Istihsan are very similar to equity in common law. The equity principle was developed to remove the rigidity and, occasionally, the harshness of the principles of law.

Istihsan can be loosely associated with the doctrine of ‘equity’ in English law. It normally applies where there is a conflict between law and equity where equity should prevail. In the case of Walsh v. Lonsdale [1882] 21 ChD 9, it was decided that equity should prevail over the established principles of law for the sake of justice and fairness. In this case a person who was let into possession of land under an invalid instrument was relieved by treating the instrument as an agreement for a lease.

3.3.10 Maslahah or public interestThe next technique of law is centred on the doctrine of Maslahah or public interest. Briefly, Maslahah in the eyes of jurists is an expression for the search for something useful or the removal of something harmful. Literally, Maslahah is an Arabic word that means ‘utility’, ‘what is good’ or ‘beneficial’, ‘an advantage’ and ‘something for the public good’. In a legal sense, it tends to underline the aims of legal rulings and the intended utility of the law. These aims are well-manifested in the preservation of Maqasid (objectives) of the law, which consist of five safeguards for human beings: faith, life, intellect, posterity and property. What assures the preservation of these five principles is Maslahah and whatever fails to preserve them is Mafsadah (evil and harm). Maslahah, as a principle of legal reasoning, is to argue that good is lawful and that lawful must be good.

3.3.11 Sadd al-dharai` or blocking the meansAnother principle or technique of law, which is largely related to Maslahah, is Sadd al-dharai`, that is, blocking the means or ‘to consider the ultimate result of any action’. By virtue of blocking the means, any particular action that would bring harm to mankind would be deemed unlawful and illegitimate. Therefore, blocking the means must imply blocking the means to evil and not something good. A typical case for the application of this principle will normally arise when lawful means are expected to lead to unlawful results, or lawful means that normally lead to a lawful result are used to procure an unlawful end.

In this context, it is worth mentioning an example of the application of Istihsan in modern cases. Islamic law lays down rather precise prescriptions regarding the custody and maintenance of children. The presumption is that the welfare of the child is always in the custody of prescribed relatives. Among other prescriptions, the law says that a girl should remain with her mother until puberty, at which time she goes to the custody of her father. However, what if either parent is an unfit guardian? The recognition of a judge’s right to exercise Istihsan in custody cases requires the departure from this principle by allowing the welfare of the minor to prevail over the letter of the law. The guardian in this case could be either the mother or the father or indeed a party other than the parents if both parents are found to be unfit.

The following example illustrates the legal reasoning based on Maslahah. It relates to the case of creating a trust for the benefit of the investors in Islamic capital market products, for example, Sukuk al-ijarah. The creation of trust will transfer the legal ownership of the leased asset to the trustee and away from the issuer/lessee. In the case of the issuer/lessee going into liquidation, the leased asset will be removed from any bankruptcy action. Hence, the interest of the investors will be protected even though the issuer/lessee has been served with a liquidation order.

A good example is a ‘doubtful’ deposit received without checking the source. This might mean that monies from illegal activities are being accepted. Thus there is the need to avoid money laundering activities.



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3.3.12 ‘Urf or customary practiceIn addition to other subsidiary sources, Islamic law also gives importance to ‘Urf or customary practice. Essentially, the prevailing practice or standard reflects a kind of public interest that has been accumulated and accepted in given society. This is valid as long as the practice or standard does not contradict the established principles of Islamic law, as no legal system would recognise a practice that runs counter to its fundamental principles. The recognition of custom is expected to initiate new laws, where other sources of law are silent or are to be applied to the standing law or be used as circumstantial evidence in cases of dispute. It is on the merit of this argument that many practices have been accepted in society without any dispute, as if they are an integral part of the law. This includes the obligation of delivery on the part of the seller in some merchandise contracts and a right of warranty in some products and goods. Islamic law has affirmed the position of ‘Urf or custom by having many legal maxims such as ‘custom is binding or authoritative’. ‘Urf or custom should conform to the following conditions in order to be recognised as valid in Islamic law:

(i) it should be commonly practised by the community or a community, the former being a phenomenon common to all sections of Muslim society and the latter common to a particular group or in a particular area

(ii) a practice should be current at the time of the contingency to which it relates and from which it is to be consulted; a previous ‘Urf is not admissible nor is ‘Urf that post-dates the contingency

(iii) ‘Urf should not contradict an explicit provision of the Qur’an or the Traditions of the Prophet Muhammad; consequently, wine drinking, adultery, usury and the like cannot be justified on grounds of common custom in the society

(iv) in cases of dispute, ‘Urf is to be considered only where there is no explicit stipulation between the parties concerned; if an explicit stipulation exists, that stipulation should be adopted and custom discounted.

3.3.13 Istishab or ‘presumption of permissibility’The last technique of law is the principle of ‘presumption of permissibility’, that is, Istishab. This is based on an important maxim in Islamic law that dictates that the original ruling for every matter is permissible unless proven otherwise. This principle is useful in Islamic commercial law as it announces from the very beginning that all contracts and terms are deemed to be legitimate and lawful. If research fails to find any prohibition to these contracts and terms then they are upheld as compliant to Islamic law.

A fair value concept is a good example of how Islamic law accepted a new concept of valuation in addition to book value and market value.

Islamic finance challenge 3.4Outline the reasons for the introduction of equity in common law tradition and explain how this can be seen in Islamic law.

SolutionEquity is based on natural justice, good conscience and fairness. Common law was regarded as technical and rigid whereas equity was not. In the case of Walsh v. Lonsdale, there was a conflict between law and equity and it was decided that equity should prevail. In this case, a person who was granted possession of land under an invalid instrument was relieved by treating the instrument as an agreement for a lease. This is so as not to bring injustice to that person. The same line of argument took place in Islamic law. A person entered into an agricultural partnership or Muzaraah contract. The person cultivated the land that was provided by the other party. However, the cultivator died before the harvest was ready. According to the established principles of partnership, the partnership terminates with the death of one of the partners. Were this to be upheld, the deceased partner or his family would have been treated unfairly. The Istihsan principle comes in to ensure that the partnership is presumed to continue until the harvesting is gathered. In this way the family of the deceased cultivator are able to share the crop as agreed.



3.4 Comparison between Shari’ah (divine sources of law) and Fiqh (Islamic substantive law)3.4.1 Shari’ahMuslims believe that God Almighty sees the Shari’ah as essential to human life. The Shari’ah, as the divinely-ordained blueprint for human conduct, is a self-contained system. It encompasses all aspects of human life, on the individual as well as at collective levels, in matters of faith, moral conduct, practical rulings and observance in all aspects of life, be it family, worship, financial transactions or justice administration. To this effect, the Shari’ah has been described by leading western scholar Joseph Schacht as “the epitome of Islamic thought, the most typical manifestation of the Islamic way of life, the core and kernel of Islam itself.”1.

3.4.2 FiqhFiqh is an Arabic word that means a deep and thorough understanding and intelligence. Technically speaking, Fiqh refers to a set of practical rulings and laws that are the outcome of the legal interpretation (Ijtihad) as interpreted by Muslim jurists. This expression implies that Fiqh is about practical rulings and laws (excluding matters of faith and morals). It is also a product of human understanding and interpretation of the sources of law.

3.4.3 Differences between Shari’ah and FiqhThe basic differences between Shari’ah and Fiqh can be summarised as follows:

(i) While Shari’ah is divine in character, Fiqh reflects the effort of humans, namely Muslim jurists, to understand the Shari’ah and to apply its principles and general guidance to specific cases, which are not provided for in sources of the Shari’ah or in a case where the texts of the Shari’ah are less clear and need some Ijtihad.

(ii) The methodology of the Shari’ah is to provide general principles and maxims, such as the requirement to fulfil an obligation. In addition, Shari’ah is not typically concerned with detailed explanations or illustrations. On the other hand, the function of Fiqh is to provide explanations and detailed prescriptions to meet the complexities of human life. For example, in the case of a breach of contract, Muslim jurists have to address the issue of compensation in detail, such as the basis of a valid and enforceable composition, the quantum of compensation and the method of payment. These detailed prescriptions are only documented in Islamic Fiqh literature and books and are not available in the texts of the Shari`ah. Thus, Fiqh is also known as ‘the substantive or positive law of Islam’.

(iii) The Shari’ah covers matters of faith, moral conduct and laws. Fiqh relates only to the last aspect of the Shari’ah, that is, the practical aspects of the Shari’ah, known in modern terms as ‘laws’ or ‘rules’. The practical aspect of observance and compliance includes almost all aspects of human affairs, such as personal worship, financial activities, family affairs, dispute resolution and justice administration and international law. Thus Islamic finance is a subset of Fiqh, an area of practical rulings known in Arabic as Fiqh al-Muamalah or simply Islamic commercial law. Islamic commercial law essentially covers a number of issues such as the formation of contracts, the sale of goods and services, investment activities, security and collateral. The overall relationship between Islam, Shari’ah, Fiqh, Islamic commercial law and its various applications is depicted in the following diagram.



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Exercise 3.6 A friend of yours is confused about the relationship between Shari’ah and Fiqh. So has asked you to explain how they relate to each other.

3.5 Ijtihad – the technique of developing contemporary Islamic commercial law3.5.1 Islamic legal theory Islamic law, as seen in previous sections, is a very distinctive law. On one hand it relies heavily and primarily on divine texts that are represented by the Qur’an and the Traditions of the Prophet Muhammad. On the other hand it relies on the jurists to interpret these sources and apply their interpretations to new cases. Here lies the importance of Ijtihad as the technique in developing contemporary Islamic commercial law to relate revelation to reason and vice versa. The process and procedures of Ijtihad are compiled in a discipline called Usul al-Fiqh or Islamic legal theory, which assists and guides the jurists to interpret and deduce the law from both revelation and reason systematically. This is because, although legal constructions are humanly conceived, the validity of arguments in Islamic law, unlike in western and modern law, rest primarily upon the epistemological value of the revealed premises from which they are constructed. In other words, the legality of Ijtihad or interpretation in Islamic law is always subject to its confinement to a parameter, which is provided by Shari’ah principles. Reasoning cannot be void of Shari’ah guidance. All reasoning efforts must conform to general principles of the Shari’ah. Ijtihad, though it is a human reasoning, must be

Shari’ah

Figure 3.1 The overall relationship between Islam, Shari’ah, Fiqh, Islamic commercial law and its various applications

Faith

Morals

Worship

Family affairs

Financial activities(Islamic commercial

law/Fiqh al-Muamalah)

Justice

administration

Penal code International

law

Contracts

Banking products

Insurance products

Capital market

products

Fiqh (Law and Rules)

Fiqh refers to a set of practical rulings and laws that are the outcome of the legal interpretation •(Ijtihad) as interpreted by Muslim jurists.

Shari’ah is divine in character whereas Fiqh reflects the effort of humans to understand the •Shari’ah and to apply its principles and general guidance to specific cases.

Key points



properly governed to ensure it is undertaken and exercised according to particular standards and principles so as to avoid the whims and fancies of those involved.

It is clear that the search for new laws requires the process of legal reasoning to arrive at what is most likely to be the ruling of God Almighty in a given situation. Therefore, in Islamic legal theory, determining the law is not a matter of speculation or intuition. Rulings for individual cases have to be arrived at through a highly complex methodology known as Ijtihad. Above all, Islamic jurisprudence is not only concerned with the law proper (Fiqh) but also with questions of linguistics, logic, methodology, custom, epistemology, fairness and justice. In conclusion, Ijtihad seems to be an effective means of addressing the challenges facing contemporary issues in Islam particularly with regard to financial matters. A more detailed illustration of the function of Ijtihad will be given in the forthcoming chapters.

3.6 Early development of Islamic schools of law in Sunni IslamAs there are many ways and methods of understanding both the Qur’an and the Traditions of the Prophet Muhammad and their interpretations, disagreement is inevitable in Islamic law. These differences of opinion are well documented in the legacy of Islamic law, particularly in the writings of all major schools of Islamic law.

3.6.1 Madhhab – schools of Islamic legal thoughtFrom the middle of the eighth century (AD), a number of juristic scholars emerged whose independent interpretations of the general principles and specific cases of both the Qur’an and the Traditions of the Prophet Muhammad stimulated the development of separate legal schools in Islam. Islamic jurisprudence became a highly technical process and disputes about methods and judicial opinions crystallised into various legal schools designated by the names of their founding scholars. The differences in legal thought were mostly due to the various ways in which the Qur’an and the Traditions of the Prophet Muhammad were interpreted in relation to local customary law and the quality of reasoning used in extending the principles to unprecedented cases. As a result, several legal systems or schools called Madhahib (plural of Madhhab) developed corresponding to different methods of conducting jurisprudence. These Madhahib usually differed with regard to the details of practical applications, but divergence of opinions with regard to general principles of Shari’ah has been negligible.

3.6.2 The ‘Hanafi’ school of lawThe oldest legal school is the one that followed Iraqi tradition and is called the ‘Hanafi’ school of law. It is named after its founder Abu Hanifah, who died in 767AD. The Hanafi school of law is known for its endorsement of reasoning and logic as legitimate sources in the application of practical rules to the practical questions of life.

Abu Hanifah’s unusual ability to broaden juristic practice with the use of analogy and juristic preference allowed Hanafi jurists to carry out meticulous investigations of legal sources to formulate their juridical decisions. The Hanafi school of law has been the most flexible and workable school in the area of commercial transactions. In terms of the geographical distribution the school came to dominate most territories of what was the Ottoman Empire, particularly in the eastern Mediterranean, simply because it was the official school of law of the ruling government. The Hanafi school of law is also predominant in the Indian subcontinent and central Asia covering both Russia and China and could therefore be considered the largest school of law in the Muslim world.

3.6.3 The Maliki school of lawChronologically, the next school is the Maliki, which originated in Medina and was named after the prominent legal scholar and traditionalist Malik bin Anas (d.795AD).

Those who adhered to the rulings of Malik bin Anas were known as the Malikis. In his legal formulations Malik relied heavily upon the well-established practices of the early companions of the Prophet Muhammad in Medina. Although he was bound by the practice of the Medinese in his legal doctrines, Malik also used analogical deduction in cases not treated in the Quranic verses or in the Traditions of the Prophet Muhammad to arrive at a rule. Maliki jurists regard ‘juristic preference’ and ‘public interest’ as valid sources of juridical decisions. The adherents of the Maliki school of law tend to be concentrated today in North and West Africa, although they are found in other parts of the Arab world, including the Hejaz in Saudi Arabia, and Kuwait.



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3.6.4 Shafi’i school of lawThe third major surviving school is called the Shafi’i school of law. This school was named after Muhammad bin Idris al-Shafi’i (d.820AD).

The Shafi’i school of law was the result of a synthesis conducted by a single scholar who was thoroughly familiar and well versed with the doctrines of both the Maliki and Hanafi schools. From the Maliki school of law he reaffirmed the Traditions of the Prophet Muhammad as a source of law co-existing and co-equal with the Qur’an. He articulated the view, which subsequently found widespread acceptance, that the Traditions of the Prophet Muhammad explained the meaning of the Qur’an. From the Hanafi school of law he accepted the role of independent sound judgment and used that as a tool for analogical inference in his legal theory.

Al-Shafi’i’s contribution lies in his synthesis of legal theory in Islamic jurisprudence. It can be noted that the legal theory in Islamic jurisprudence developed by al-Shafi’i deals best with areas of law that are fixed. These include devotional matters and the like because al-Shafi’i and his school of law was never involved in areas of law that are flexible and worldly, as in the case of the Hanafi school of law. The distribution of the members of the Shafi’i school of law tends to correspond to the pattern of the major trade routes, with which Shafi’i communities mostly associated. One finds large numbers of the Shafi’is in East Africa, Yemen, Malaysia and Indonesia.

3.6.5 The Hanbali school of lawThe last of the four schools of law is the Hanbali school of law. It was named after its founder Ahmad bin Hanbal (d.855AD) who compiled work on the Traditions of the Prophet Muhammad. This became the source for juridical decisions of the Hanbalis.

Generally speaking, the Hanbali school of law leaned more on tradition than the science of law and jurisprudence. The Hanbali school of law has dwindled in size so that its adherents are rarely found outside central Saudi Arabia. However, the widely-appreciated originality and intellectual distinction of some of its medieval jurists has allowed it to retain an influence entirely out of proportion to its number.

3.6.6 All schools are equalMuslims attribute an equal value to all four surviving schools as the differences between them are in the detail. These differences are in the domain of the application of law (branches of law) and not in the principles of the law (roots of law). It is important to note that these four schools are in agreement on all points vital to Islam. They acknowledge the authority of the Qur’an and the Traditions of the Prophet Muhammad as the ultimate sources of law in Islam. They have a different emphasis of adherence to other subsidiary sources. These differences have led to different perspectives on many legal issues.

Exercise 3.7Briefly explain:

(i) Why various schools of law developed in Islam?

(ii) Whether these schools of law are contradictory to each other in their final conclusions and opinions?

3.7 ConclusionThis chapter introduced you to the sources from which Islamic law developed including both the primary source (revelation) and secondary source (human interpretation). It also introduced you to the crucial process of Ijtihad and to the principles which underlie this process. You will have seen that the use of Ijtihad has resulted in the development of several Islamic schools of law. You were introduced to the four major Islamic schools of law that are the Malikis, Hanbalis, Shafiis and Hanafis. As explained, these schools of law have a direct effect on the geographical development of Islamic

Madhhab is a school of Islamic legal thought.•

All schools of law agreed on principles of law though they may differ in specific cases and legal •formulations.

Key points



finance. You will see in later chapters of this guide and throughout the other three guides that this effect on geographical development has led to fierce debate throughout the Muslim world as to what constitutes acceptable practice in Islamic finance.

The next chapter will explain Ijtihad in further detail and show how it can be applied as a solution in modern financial issues.


1. Islam is a religion based on a system of principles and rules

2. the essence of Islam is that it derives its principles and values from a given source; for Islam and for Islamic law, which is part of Islam, these sources are the Qur’an and the Traditions of the Prophet Muhammad

3. the two sources are important as they provide not only the parameters of what is approved and what is not permitted but also some specific injunctions for specific cases in life

4. secondary sources are those based on human interpretation and reasoning which in practice are, or should be, traced back to the primary sources in one way or another

5. Ijtihad is the legal reasoning used by jurists and scholars to arrive at what is thought, on a best-effort basis, to be the law as intended by the Qur’an and the Traditions of the Prophet Muhammad

6. Ijtihad is the most workable technique in developing contemporary Islamic finance. However, the exercise of Ijtihad must be properly governed to avoid resorting to the whims and fancies of an individual

7. Ijma’ refers to the consensus of Muslim jurists on a particular legal issue at a particular point in time; this then becomes a binding authority on Muslim communities

8. Qiyas is a form of analogical reasoning that extends the law beyond what is stated in the authoritative legal sources; it is an extension of a precedent and not the establishment of a fresh ruling by itself

9. Qiyas al-tard is the use of analogy, that is, the extension of a legal rule from one case based on a similarity, deemed by the jurists to be a ‘material similarity’

10. the ‘Illah or reason given in a Qiyas must be an evident attribute, as well as constant and regular; it should also be co-extensive and co-exclusive

11. Istihsan or juristic preference takes place when a jurist departs from a precedent and takes a decision in a case by virtue of another ‘reason’ that is stronger and more ‘appealing’

12. ‘Urf is the acceptance of customary practice where the prevailing practice or standard in society reflects a kind of public interest that has been accumulated and accepted; this is valid as long as the practice or standard does not contradict the established principles of Islamic law

13. Istishab suggests that in Islamic commercial law all contracts and terms are deemed to be legitimate and lawful until research determines whether there is any prohibition

14. while Shari’ah is divine and contains general principles, Fiqh is the understanding by Muslim jurists of the Shari’ah and also deals with detailed prescriptions of the law

15. there are at least four surviving Islamic schools of law in Sunni-Muslim society; although they may have many different perspectives on specific laws and legal matters, they have one common perspective on Shari’ah and the general principles of Islamic law.

Notes:1. Schacht, Joseph, Origins of Muhammadan Jurisprudence, Oxford 1950, 124ff



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Chapter 3 AnswersExercise 3.1(i) The origin of the source of law in Islam is revelation as both the Qur’an and the Traditions of

Prophet Muhammad are regarded as being divinely revealed and inspired.

(ii) The source denotes a place from which a substantive law originates. Substantive law generally speaking is detailed and specific to a particular case in point.

(iii) The sources of law in Islam are the Qur’an and the Traditions of the Prophet Muhammad.

Exercise 3.2The source of law is important in Islam because it denotes a place from which the whole body of law will later develop. To ensure that Islam is always centred upon revelation, this source must be equally revealed and divine in character. The main function of the source is to provide a guideline or parameters for general application on matters such as an obligation to fulfil a contract. The source also provides general principles to be extended to other similar cases, such as the extension of the prohibition of liquor to other intoxicating items such as drugs. Islamic law has developed historically through the divine-text approach because all legal formulations and conclusions by the jurists had to be based on the divine texts of both the Qur’an and the Traditions of the Prophet Muhammad.

In conclusion, the source denotes a place from which a required solution can be arrived at. This source, as far as Islamic law is concerned, is based on revelation applied and extended through interpretation and extension. This reflects a significant synergy between the sources of law, which are divine and the process to benefit from these sources, which is human driven.

Exercise 3.3The legal basis is not related to a specific item such as dates or barley. Although dates are mentioned in one of the Traditions of the Prophet Muhammad (refer to section 1.5.1) the dates, as well as other items mentioned in that tradition, are not the real reason for this prohibition. Some jurists have extracted the basis of this prohibition as the “main foods” and therefore, any exchange of two main foods must be subject to the same requirements. Therefore, an exchange of corn for corn is equally governed by the same ruling and requirement (on the assumption that corn is a main food in some societies) that are of equal and spot exchange.

Exercise 3.4The Qur’an has categorically prohibited interest or Riba. However, the Qur’an never explained the forms and classifications of prohibited Riba. It is only the Traditions of the Prophet Muhammad that explain Riba in detail. A good example is the Prophet’s pronouncement on the exchange of two different qualities of dates as explained in section 3.3.3.

Exercise 3.5Ijma’ requires all living scholars to agree on a particular part on law. Any disagreement will result in an invalid ijma’. Getting all living scholars to agree to any one solution to a difference of opinion is unlikely to be easy. Indeed it may not be possible.

Exercise 3.6Shari’ah is a comprehensive system that governs many other components. One of the components is known as Fiqh, which relates to practical rulings on human conduct. Thus, Fiqh is part of the Shari’ah as the Shari’ah is wider in scope. Also, while Shari’ah is Divine, Fiqh is human in the sense that Fiqh is derived from interpretation by man.

Exercise 3.7(i) The emergence of various schools of law in Islam was the result of Ijtihad. Ijtihad is bound

to result in more than one opinion, thus the development of many schools of law.

(ii) Many of the legal conclusions and opinions of these schools of law could be contradictory. Differences of opinion occur, however on the detailed application of the law only and not on the principles.



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Revision Questions Question 1 Multiple choice1.1 Which of the following is NOT a valid description of both the Qur’an and the Traditions of the

Prophet Muhammad?

(A) Both were revealed through Revelation.

(B) Both are primary sources of Islamic law.

(C) Both can be extended to other specific and new cases.

(D) Both primarily provide detailed rulings of Islam.

1.2 What does Qiyas or analogy refer to?

(A) Public interest that is good for the society and which does not contradict Shari’ah principles.

(B) The customary practice of the society, which is both beneficial and acceptable.

(C) An extension of a ruling prescribed in the Qur’an or the Traditions of the Prophet Muhammad to a new case which shares similar reasoning with the original ruling.

(D) The consensus of the Muslim jurists and scholars at one point in time, on a specific legal issue.

1.3 Which of the following defines Ijtihad?

(A) The consensus opinion of a number of leading Muslim jurists and scholars.

(B) Customary practice.

(C) A reliance on the texts of the Qur’an and the Traditions of the Prophet Muhammad.

(D) The process of legal reasoning by the jurists to arrive at a legal solution for new cases.

1.4 What is the function of ‘Urf (customary practice)?

(A) To provide an explanation as circumstantial evidence in cases of dispute.

(B) To extend the law to new cases.

(C) To block any means to consequences which are unfair or harmful.

(D) To presume that everything is permissible unless proven otherwise.

1.5 Which of the following statements is NOT correct with regard to the Islamic schools of law in Sunni Islam?

(A) The schools of law were named after their founders.

(B) The schools of law were distributed across the globe.

(C) The schools of law differed from each other in matters of specific rulings.

(D) Various schools of law developed in order to encourage a variety of opinions.

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Question 2Match the following descriptions to both Shari’ah and Fiqh respectively.

Descriptions

3 General principles.

3 Humanly interpreted.

3 Governs faith, moral and law.

3 Detailed rulings.

3 Revealed by God Almighty.

3 Relates to law only.

Question 3Fill in the blank(s) to correctly complete the following sentences.

1. Juristic preference (Istihsan) is to prefer one ruling over another ruling that is already prescribed as the precedent. This preference is due to a reason which is and .

2. All contracts and terms under the principle of presumption of permissibility are deemed unless proven otherwise.

3. Reason (‘Illah) is the effective cause or reason for a ruling in Islamic. Among the attributes of valid reason in Islamic law are that it must be evident, constant, and .

4. The distinctive features of Hanafi school of law are and .

5. Differences of opinion among the scholars did not relate to but they were always related to .

Shari’ah Fiqh


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AnswersQuestion 1 Multiple choice1.1 (D) Muslims refer to the Qur’an and also to the Traditions of the Prophet Muhammad as their

main reference for rulings. However, the Qur’an provides detailed rulings of Islam only in a few limited cases.

1.2 (C) Qiyas uses rulings in the Qur’an and the Traditions of the Prophet Muhammad as the basis for a decision in a new case. Qiyas is an extension of an original ruling to a new case.

1.3 (D) Ijtihad is a legal reasoning by the jurists to solve a new case that requires a legal solution. The solution required is either not clearly or directly provided in the text or not provided in the text at all.

1.4 (A) In most cases ‘Urf or customary practice provides a useful reference to settle disputes in a society, particularly in matters that are commonly upheld by the society.

1.5 (C) The difference between the schools of law in Sunni Islam is only on the details of practical applications.

Question 2

Question 31. Stronger and more appealing.

2. Lawful/permissible.

3. Co-extensive and co-exclusive.

4. Reasoning and logic.

5. Principles of law, branches of law.

Shari’ah Fiqh

3 General principles

3 Revealed by God Almighty

3 Governs faith, moral and law

3 Detailed rulings

3 Humanly interpreted

3 Relates to law only


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Documents

2Second guide test