Principle of Islamic Finance

1. Prohibition
2. Principle of profit//sharing
3. Principle of risk and ownership
4. Principle of debt against debt
5. principles of conditional contracts

1. Prohibition
 Prohibition of Riba
 Prohibition of garor
 Prohibition of Misar

Prohibition of Riba
Riba is charging predetermine incremental amount charged on loan . Prophet Muhammad
(PBUH) said “Every loan that draws excess is Riba”,ahadith quoted by Ali ibn at Talib (RA.A).

The shariah appellate bench of Supreme Court of Pakistan also declared that ‘to ban the
interest, regardless which name is given to interest or whatever form of interest. This bench
have four renowned members that are Justice Khalil Ur Rahman, Justice Munir a Shaikh, Justice
Wajeehudin and Justice Maulana Muhammad Taqi Usmani.
Arguments: certain financial institutions and banks filled sixty-seven appeals against the shariah
bench decision. All the issues that put against in appeals is similar and decided to give a single
final judgment. These arguments are categorized in 5 different lines such as:
1. The prohibition of Riba in Quran in end days of Holy Prophet Life and he didn’t have
enough time to interpret the definition of term riba. Accordance with this approach, the
principle can’t be enlarged to modern banking and limited to those transactions
mentioned in hadith.
2. Another argument was on based that riba is there when higher interest rate charged
from creditors on loan that result an exploitation so, as concern with modern banking, it
can’t say riba as interest rate is not as excessive that result in exploitation.
3. The 3rd argument aroused from consumption loan and commercial loan
differentiations.as per their approach they used the word ‘Al-Riba’ that used in Quran
that prohibit not to charged excessive amount on consumptions loan that poor people
 taken to fulfil day to day needs to spread humanity and welfare. But in modern banking,
it can’t be applied to commercial and productive loans because in most cases debtors
are not poor and economically well off that they took loan to utile them in generating
more profit.
4. Another argument was that the Holy Quran prohibited the Riba al jahiliyya only when
loan transaction where additional amount on principal amount was not demanded in
loan agreement. However after due date the additional amount would be charged if
debtors didn’t paid on due date. According to this approach ,an incremental amount
demanded in initial agreement can’t be consider as Riba al Quran
5. The main last argument was that commercial interest is back bone of every economy
around the globe so its suicidal act to remove interest from transaction
In order to sort out these issues, number of experts (sharaih scholars), bankers, and economist
were invited and after all it was decided that all whether or not commercial interest fall in
definition of riba prohibited by Quran.

Prohibition of Gharor: The garor is Arabic word associated with uncertainty and risk. It is
described as “sales of these commodities which are not yet present”. The renowned expert Ibn-
Qayyim explained the gharar ‘the sale in which the seller is not in the condition to hand over
the matter of subject. It’s basically an excessive uncertainty which is caused due to lack of
clarity and ambiguity of commodity/subject matter in contract.
The Prophet Muhammad (PBUH) prohibit the gharar in many ahdith. The one of close
companion Abu Hurayrah translated that Prophet Muhammad (PBUH) prohibited gharar in
every sale and business transactions.
Examples: you are a fisherman and you sell 100 KG of fish that you haven't caught yet.

Prohibition of Misar: In arbic language, it is also called as Qimar.it applies to all activities in
which one party win and other lose his property or wealth. Simply it is a game in which one is
win at the cost/expense of the other party. For example betting, lotteries etc.
Allah says in Surah al Maidah:

“O you who believe! Wine, gambling, altars and divining arrows are filth, made up by Satan.
Therefore, refrain from it, so that you may be successful” (5: 90). Satan wishes only to plant
enmity and malice between you through wine and gambling, and to prevent you from the
remembrance of Allah and from Salāh. Would you, then, abstain? (5: 91).”

In Surah al-Baqarah Allah says:

They ask you about wine and gambling. Say, “In both there is great sin, and some benefits for
people. And their sin is greater than their benefit.”

The Prophet Muhammad (PBUH) said:

“Whosoever says to his companion: 'Come let us play a game of chance or gamble', should
give charity (as atonement)” (Sahih al-Bukhari and Muslim).

In modern financial system and banking .insurance is not allowed because it has part of riba and
misar.

EXGANGE RULE OF Islam

Riba E Nasiya:it is premium amount charged on loan and that must be paid by lender. Riba
comes from Arabic word that mean delay or defer.

Riba al fadl

What is Islamic Banking?why

Islamic banking is a system that is based on shariah principles and laws .Islamic bank made
legitimate trading in business, as we are Muslims to its obligation on us to invest in legal trade
to obtain capital and flourish growth of economy. The fundamental principles derived from two
main sources Quran and Sunnah

Islamic Banking is a system where interest is not accepting in trading and regulated on basis of
Islamic sharia’h laws. Moreover the unethical practices, and involvement is not allowed to
achieve their objectives. Commonly, Islamic bank do transactions on profit-sharing mode
(agreement) with risk involvement accordance with both parties ownerships.

Q2. What is the philosophy of Islamic banking and finance?

There are different school of thoughts regarding philosophy of finance, these are:
One school of thought said all the banking products are sharaih complaint as they fulfill all
conditions and on other hand school of thoughts added sharaih objectives along contract of
sharaih complaints to understand freedom .The sharaih main six objectives are safety of faith,
life, generation, intellect, wealth. Apart from this justice, freedom, elimination of poverty and
fair distribution also be look after.
Criticism
Their main argument was that it’s not possible easily to follow objectives in long term, to
achieve long term objectives state can be run into Islamic practices too.

Principle of profit/loss sharing

Musharaka: Its type of partnership agreement where between two or more parties with
mutual consent.

 The profit sharing ratio can be pre-determined at the time of contract. The profit can’t
be determine in lump sum (amount) of capital or % of capital.
 The working partner set his profit with mutual consent of all members that is more than
its share of capital.
 On other hand sleeping partner can only get his profit according to be contribution
share of capital in business. For-example if sleeping partner invest 20% in business he
get profit accordance with 20% not more than 20%.
 However in case of loss occurrence, every partner will suffer loss accordance with
contribution of their investment. For-example if partner invest 50% then he will also
bear the loss of 50% in business
 In musharakah agreement, the capital can be handed in a form of monetary assets with
mutual consent of all partners. The assets must have monetary value in term of
currency and partner become owner of that monetary value not asset after
contribution. For-example if partner contributed his 1000000 rupees of ware house than
he is owner of 1000000 rupees not warehouse.
 Generally every partner have right to work and participate in business and management
and every partner is considered as agent of other in business matters.

Application of musharakah in Islamic banks

The musharakah contract is underlying contract for a lot of Islamic banking and their finance
products that are home financing, trade financing, Islamic funds and sukuk etc.
The mechanism involve in this contract is that the client and Islamic bank do partnership with
mutual consent and become partners in mushrkah joint venture. Both parties contributed their
pre-agreed ratio of capital in mushrakah venture such as 70:30.At execution time, both partners
agree on ratio of profit accordance with their contribution, after realization of profit, it is
distributed between partner’s accordance with pre-defined ratios and in case of loss both
partners suffer from loss with their share of contribution

Dimishing Muaharkah
AAOFI explained the diminishing musharakah,

“Diminishing musharakah is a form of partnership in which one of the partner’s

promises to buy the equity share of the other partner gradually until the title to
the equity is completely transferred to him.”

Mudaraba the word comes from Arabic word ‘daraba’ that means “travelling for business”.it is
acutally a form of partnership in which one party invested capital and other provides their skill
and labor in business, so there are two parties one is financing provider(Rab-ul-mal) and other
is manager. The Prophet Muhammad(PBUH) also entered into mudarabah contract with Hazrat
Khadijah(R.A)

The capital provider only bears a loss if it happens, because the manger doesn’t invest
anything. So, when the mudarabah business occurs a loss, the profit is used to offset
the loss at first instance, if the loss is greater than accrued profit at the time of
liquidation, then it is deducted from the capital.

Differences between mudarabah and musharakah

Both musharakah and mudarabah contracts are based on profit and loss sharing. There are
slightly differences between them;

1. In musharakah contract, both partners share their capital, But in mudarabah, one party
(rabbul mal) contributed his capital.

2. Every partners have a right to contribute/participte in the business of musharakah

contract. But in mudarabah, the Rabul mal cannot have right to participate in business
management.

3. In musharakah, all partners bear loss accordance with their capital investment, while in
mudarabah, only Rab-ul-mal suffer all loss
Two tier Mudaraba

This is initiated by Islamic bank in 1974 in Egypt and engaged two mudraba activities as the first
mudarba is between bank and customers (that have surplus capital) and second mudaraba is
between bank and customer (who need of money).

In first tier.Rab ul mal (debositor) invest in bank without any surety of return and principal
amount that bank used on rab-ul-mal behalf. This is liability side of bank. on other hand bank as
a Rab-ul-mal give finance to 3rd party (act as Mudarib), as in this any loss incurred due to any
misuse then mudarib have to bear that loss and profit ,that can be shared as pre-agreed ratios.
This side is assets side of bank. Assets side is more risky than liability side in case of loss as Rab-
ul-mal can’t interfere or manage risk

In two tier mudarba if one party donot provide true information then bear huge loss.

Profit sharing in Ijarah(LEASING)

The Islamic banks leases their shares in the house or property to client and bank charges rent
from client on his share contribution in the house.It aslo allowed that partner can lease his
undivided contributed share in property to other partner

Bai(Sale)

The client brought the bank share on lease period with agreed interval time and the client
gradually acquired all the shared of bank over periods and become sole-owner of the property