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Islamic Banking Law

von Schéele, Magnus (2003)
Department of Law
Abstract
The hub and main characteristic of Islamic banking is the prohibition of interest (riba), and this is the most significant difference between an Islamic bank and a conventional bank. The proscription has evolved from the stance that making money from money is unacceptable. Riba is often referred to as interest and usury, but it has often been disputed whether the expression involves both terms. Nevertheless, a majority of Muslim scholars and theologians now agree that the correct interpretation of riba is that interest and usury are one and the same. Interest must therefore at all times be condemned as usury. Some countries claim to have converted their entire financial system to a wholly interest-free scheme. Other countries, like... (More)
The hub and main characteristic of Islamic banking is the prohibition of interest (riba), and this is the most significant difference between an Islamic bank and a conventional bank. The proscription has evolved from the stance that making money from money is unacceptable. Riba is often referred to as interest and usury, but it has often been disputed whether the expression involves both terms. Nevertheless, a majority of Muslim scholars and theologians now agree that the correct interpretation of riba is that interest and usury are one and the same. Interest must therefore at all times be condemned as usury. Some countries claim to have converted their entire financial system to a wholly interest-free scheme. Other countries, like Malaysia, Saudi Arabia and Egypt employ a dual banking system where interest-based (conventional) banks may coexist with interest-free (Islamic) banks. Where dual structures are permitted more players are also commonly able to compete with the Islamic banks. This can be achieved by applying a concept of Islamic windows, where interest-based banks may offer Islamic banking methods in addition to its conventional banking services, hence allowing traditional western banks to participate in an Islamic banking system. Islamic law (Sharia) also regulates the lawfulness of investments. A number of investments are considered to be Sharia-divergent, however not necessarily because of the proscription against interest (riba). For example, besides the prohibition to fund undertakings that engage in interest-based activities, the financing of projects that deal with gambling and alcohol are regarded as forbidden businesses also. As part of the gambling prohibition, trade in derivatives like options and warrants is also condemned. The Islamic banking ideals are four-fold. First of all it is unacceptable to make money from money, constituting the first ideal. Subsequently there is a prohibition against riba. Secondly, there is the aim of a profit and loss sharing system, involving both the lender and the borrower. As a third element Islam prohibits gharar, meaning that business involving excessive uncertainty, risk or speculation shall be avoided. Finally there is the requirement that all investments must be halal, that is, permitted according to Islamic beliefs. Islamic banks face difficulties in providing a competitive alternative to the saving account facilities that are being offered by conventional banks. First of all, returns are not always certain and secondly the nominal capital is not assured. Because of this, many Islamic banks do not abide by the Sharia laws, offering monthly rewards very similar to interest. In fact, in some countries where dual banking systems exist, e.g. in Malaysia, Islamic banks often present the best interest rates and do not even hesitate to call it by this name. Another concern is that many Islamic banks, at variance with the Islamic law, often guarantee the capital value on savings- and investment deposits. For instance, until recently nearly all Islamic banks in Pakistan on a regular basis guaranteed its depositors the capital value. Financing is perhaps the primary function of an Islamic bank. Between 50 and 80 percent of the total assets in Islamic banks are used for financing activities. Roughly, financing facilities can be categorised into three areas: investment, trade and lending. Different financing techniques are used to facilitate these areas, some are based on the PLS scheme, others on mark-up (commissioned purchase) and a few rely on benevolent loans. In essence, there are two methods that dominate the concept of investment financing, both operating on a scheme where profits and losses are divided between the investor, respectively the entrepreneur. As a partnership funding principle, the musharaka technique to a large extent resembles a joint venture agreement. The investor, normally the bank, as well as the entrepreneur himself, both provide capital for the business enterprise and more often than not, both parties take part in the management. While losses are born in proportion to each party's capital contribution in the project, profits do not need to reflect the participation in the management nor does it need to mirror the financial inputs. It has been said that the musharaka instrument is the purest form of Islamic banking and the practice is supported by several verses in the Koran. Profit- and loss-sharing financing has been put forward as an ethical banking method and is said to endorse shared responsibility. Meanwhile, critics are unconvinced about the concept's superiority, as dishonest clients may be tempted to exploit the PLS techniques by not disclosing the real profits. Moreover, there are obvious problems associated with the central banks' duties when it comes to supervision and control. The reason for this is that certain liquidity requirements need to be satisfied, but that it is rather problematic to determine the value of funds in an Islamic bank, especially if a large proportion of the assets consist of shares in various business projects and joint ventures. Additionally, there are apparent difficulties in evaluating the profitability of such enterprises, since returns are not guaranteed. As a form of commissioned purchase, murabaha differs from the mudaraba and musharaka since the two latter are based on the PLS method, meanwhile the former refers to financing through a mark-up method. Some commentators argue that commissioned purchase is not much different from conventional interest lending because the trade element of murabaha, in its original meaning, does not longer exist. Instead, the practice has been reduced to mere paperwork where the bank does not really take possession of the traded goods albeit this is a legal requirement. A related issue is that the bank may only seek compensation for its services if there is an evident risk associated with the transaction. Normally the merchandise is in the bank's possession only for half a second and it is well questionable whether this is sufficient to support the utilization of the principle. Even the risk related to defects in the goods has been passed on to the clients, making them liable for any such shortcomings. Moreover, the use of time-value in dealings has been debated, because of its resemblance with interest-based lending. Another problem is the adverse impact that the appliance of these principles may have on the relationship between the bank and the presumptive client. For instance, PLS financing in general has been claimed to be too costly, time demanding and uncertain. (Less)
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author
von Schéele, Magnus
supervisor
organization
year
type
H3 - Professional qualifications (4 Years - )
subject
keywords
Förmögenhetsrätt, Bankrätt, Komparativ rätt
language
English
id
1562818
date added to LUP
2010-03-08 15:55:30
date last changed
2010-03-08 15:55:30
@misc{1562818,
  abstract     = {The hub and main characteristic of Islamic banking is the prohibition of interest (riba), and this is the most significant difference between an Islamic bank and a conventional bank. The proscription has evolved from the stance that making money from money is unacceptable. Riba is often referred to as interest and usury, but it has often been disputed whether the expression involves both terms. Nevertheless, a majority of Muslim scholars and theologians now agree that the correct interpretation of riba is that interest and usury are one and the same. Interest must therefore at all times be condemned as usury. Some countries claim to have converted their entire financial system to a wholly interest-free scheme. Other countries, like Malaysia, Saudi Arabia and Egypt employ a dual banking system where interest-based (conventional) banks may coexist with interest-free (Islamic) banks. Where dual structures are permitted more players are also commonly able to compete with the Islamic banks. This can be achieved by applying a concept of Islamic windows, where interest-based banks may offer Islamic banking methods in addition to its conventional banking services, hence allowing traditional western banks to participate in an Islamic banking system. Islamic law (Sharia) also regulates the lawfulness of investments. A number of investments are considered to be Sharia-divergent, however not necessarily because of the proscription against interest (riba). For example, besides the prohibition to fund undertakings that engage in interest-based activities, the financing of projects that deal with gambling and alcohol are regarded as forbidden businesses also. As part of the gambling prohibition, trade in derivatives like options and warrants is also condemned. The Islamic banking ideals are four-fold. First of all it is unacceptable to make money from money, constituting the first ideal. Subsequently there is a prohibition against riba. Secondly, there is the aim of a profit and loss sharing system, involving both the lender and the borrower. As a third element Islam prohibits gharar, meaning that business involving excessive uncertainty, risk or speculation shall be avoided. Finally there is the requirement that all investments must be halal, that is, permitted according to Islamic beliefs. Islamic banks face difficulties in providing a competitive alternative to the saving account facilities that are being offered by conventional banks. First of all, returns are not always certain and secondly the nominal capital is not assured. Because of this, many Islamic banks do not abide by the Sharia laws, offering monthly rewards very similar to interest. In fact, in some countries where dual banking systems exist, e.g. in Malaysia, Islamic banks often present the best interest rates and do not even hesitate to call it by this name. Another concern is that many Islamic banks, at variance with the Islamic law, often guarantee the capital value on savings- and investment deposits. For instance, until recently nearly all Islamic banks in Pakistan on a regular basis guaranteed its depositors the capital value. Financing is perhaps the primary function of an Islamic bank. Between 50 and 80 percent of the total assets in Islamic banks are used for financing activities. Roughly, financing facilities can be categorised into three areas: investment, trade and lending. Different financing techniques are used to facilitate these areas, some are based on the PLS scheme, others on mark-up (commissioned purchase) and a few rely on benevolent loans. In essence, there are two methods that dominate the concept of investment financing, both operating on a scheme where profits and losses are divided between the investor, respectively the entrepreneur. As a partnership funding principle, the musharaka technique to a large extent resembles a joint venture agreement. The investor, normally the bank, as well as the entrepreneur himself, both provide capital for the business enterprise and more often than not, both parties take part in the management. While losses are born in proportion to each party's capital contribution in the project, profits do not need to reflect the participation in the management nor does it need to mirror the financial inputs. It has been said that the musharaka instrument is the purest form of Islamic banking and the practice is supported by several verses in the Koran. Profit- and loss-sharing financing has been put forward as an ethical banking method and is said to endorse shared responsibility. Meanwhile, critics are unconvinced about the concept's superiority, as dishonest clients may be tempted to exploit the PLS techniques by not disclosing the real profits. Moreover, there are obvious problems associated with the central banks' duties when it comes to supervision and control. The reason for this is that certain liquidity requirements need to be satisfied, but that it is rather problematic to determine the value of funds in an Islamic bank, especially if a large proportion of the assets consist of shares in various business projects and joint ventures. Additionally, there are apparent difficulties in evaluating the profitability of such enterprises, since returns are not guaranteed. As a form of commissioned purchase, murabaha differs from the mudaraba and musharaka since the two latter are based on the PLS method, meanwhile the former refers to financing through a mark-up method. Some commentators argue that commissioned purchase is not much different from conventional interest lending because the trade element of murabaha, in its original meaning, does not longer exist. Instead, the practice has been reduced to mere paperwork where the bank does not really take possession of the traded goods albeit this is a legal requirement. A related issue is that the bank may only seek compensation for its services if there is an evident risk associated with the transaction. Normally the merchandise is in the bank's possession only for half a second and it is well questionable whether this is sufficient to support the utilization of the principle. Even the risk related to defects in the goods has been passed on to the clients, making them liable for any such shortcomings. Moreover, the use of time-value in dealings has been debated, because of its resemblance with interest-based lending. Another problem is the adverse impact that the appliance of these principles may have on the relationship between the bank and the presumptive client. For instance, PLS financing in general has been claimed to be too costly, time demanding and uncertain.},
  author       = {von Schéele, Magnus},
  keyword      = {Förmögenhetsrätt,Bankrätt,Komparativ rätt},
  language     = {eng},
  note         = {Student Paper},
  title        = {Islamic Banking Law},
  year         = {2003},
}