An Introduction to Islamic Finance Theory and Practice Second Edition An Introduction to Islamic Finance Theory and Practice Second Edition ZAMIR IQBAL AND ABBAS MIRAKHOR John Wiley & Sons (Asia) Pte. Ltd. Copyright © 2011 John Wiley & Sons (Asia) Pte. Ltd. Published in 2011 by John Wiley & Sons (Asia) Pte. Ltd. 1 Fusionopolis Walk, #07–01, Solaris South Tower, Singapore 138628 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as expressly permitted by law, without either the prior written permission of the Publisher, or authorization through payment of the appropriate photocopy fee to the Copyright Clearance Center. Requests for permission should be addressed to the Publisher, John Wiley & Sons (Asia) Pte. Ltd., 1 Fusionopolis Walk, #07-01, Solaris South Tower, Singapore 138628, tel: 65–6643–8000, fax: 65–6643–8008, e-mail: [email protected]. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering professional services. If professional advice or other expert assistance is required, the services of a competent professional person should be sought. Neither the authors nor the publisher are liable for any actions prompted or caused by the information presented in this book. Any views expressed herein are those of the authors and do not represent the views of the organizations they work for. Other Wiley Editorial Offi ces John Wiley & Sons, 111 River Street, Hoboken, NJ 07030, USA John Wiley & Sons, The Atrium, Southern Gate, Chichester, West Sussex, P019 8SQ, United Kingdom John Wiley & Sons (Canada) Ltd., 5353 Dundas Street West, Suite 400, Toronto, Ontario, M9B 6HB, Canada John Wiley & Sons Australia Ltd., 42 McDougall Street, Milton, Queensland 4064, Australia Wiley-VCH, Boschstrasse 12, D-69469 Weinheim, Germany Library of Congress Cataloging-in-Publication Data ISBN 978–0–470–82808–3 (Hardback) ISBN 978–0–470–82810–6 (ePDF) ISBN 978–0–470–82809–0 (Mobi) ISBN 978–0–470–82811–3 (ePub) Typeset in 10/11.5pt Sabon Roman by MPS Limited, a Macmillan Company Printed in Singapore by 10 9 8 7 6 5 4 3 2 1 In the Name of Allah, the All Merciful, the All Benefi cent Contents Glossary ix CHAPTER 1 Introduction 1 CHAPTER 2 The Economic System 29 CHAPTER 3 Riba vs. Rate of Return 57 CHAPTER 4 Financial Instruments 75 CHAPTER 5 Risk Sharing as an Alternative to Debt 99 CHAPTER 6 The Islamic Financial System 113 CHAPTER 7 The Stability of the Islamic Financial System 137 CHAPTER 8 Islamic Financial Intermediation and Banking 151 CHAPTER 9 Capital Markets 173 CHAPTER 10 Non-bank Financial Intermediation 207 vii viii CONTENTS CHAPTER 11 Performance of Islamic Financial Services 225 CHAPTER 12 Financial Engineering 245 CHAPTER 13 Risk Management 275 CHAPTER 14 Regulation of Islamic Financial Institutions 299 CHAPTER 15 Corporate Governance 323 CHAPTER 16 Globalization and its Challenges 351 CHAPTER 17 Issues and Challenges 365 Bibliography 393 Index 399 Glossary of Arabic terms A ajar: Reward for doing good akhlaq: Personality disposition stemming from individual character akl amwal alnas bi al- batil: Enrichment through non - permissible means al - adl: Justice al - amal: The concept of work al - bay’: Exchange al - ihsan: Behaving with full consciousness of the Supreme Creator al - khiyar/khiyar: Option al - mal: Wealth or property al - Mo’meneen: Active believers amanah: Trust aqidah: Binding principles of faith awqaf (sing. waqf): Endowments B bai’ bithamin ajil (BBA): Sales contract where payment is made in installments after delivery of goods. Sale could be for long term and there is no obligation to disclose profi t margins barakah: An invisible but “material” blessing whose results can be observed by any believer who engages in righteous conduct bashar: Man. This concept refers to the physical/outward attributes, rather than the inner character bay’: Contracts of exchange bay’ al-arabun: A portion of the full sale price paid in good faith as earnest money (could be considered as non- refundable down payment) bay’ al-dayn: Sale of debt or liability bay’ al-istisna’: Sale on order (usually manufactured goods) bay’ al-muajjil: Deferred - payment sale, either by installments or a lump sum bay’ al-salam (also salaf): Sale in which payment is made in advance by the buyer and the delivery of the goods is deferred by the seller D dayn: Debt dharoora: Necessity ix x GLOSSARY OF ARABIC TERMS F fadl: Addition faqih (pl. fuqaha’): Jurist who gives rulings on various issues in the light of the Qur’an and the sunnah fatwa: Religious verdict by fuqaha’ fi qh: Corpus of Islamic jurisprudence. In contrast to conventional law, fi qh covers all aspects of life— religious, political, social, commercial, and economic. Fiqh is based primarily on interpretations of the Qur’an and the sunnah and secondar- ily on ijma’ and ijtihad by the fuqaha’. While the Qur’an and the sunnah are immutable, fi qhi verdicts may change in line with changing circumstances fi qhi: Relating to fi qh G ghabun: The difference between the price at which a transaction is executed and the fair price (unjustifi ed exploitation, loss) gharar: Literally, “deception, danger, risk, and excessive, unnecessary uncertainty (ambiguity).” Technically, it means exposing oneself to excessive risk and dan- ger in a business transaction as a result of either having too little information or asymmetric information about price, quality and quantity of the counter - value, the date of delivery, the ability of either the buyer or the seller to fulfi ll their commitment, or ambiguity in the terms of the deal— thereby, exposing either of the two parties to unnecessary risks H hadia/hibah: Gifts hadith (pl. ahadith): Oral tradition of the Prophet Muhammad (pbuh) as narrated by his companions hajj/umra: The pilgrimage to Mecca hajr: Blocking the use of a resource haram: Prohibited hawala: Bills of transfer hifz al - mal: Protection of wealth or property hila (pl. hiyal): Refers to strategies in applying juristic rules to ease constraints on a particular transaction that would have been non - permissible otherwise I ’ibada (pl. ibadat): Adoration of Allah (swt) through rule compliance ijarah: Leasing. The sale of the usufruct of an asset. The lessor retains the owner- ship of the asset with all the rights and the responsibilities that go with ownership ijarah sukuk: Instrument issued on the basis of an asset to be leased. The investors provide funds to a lessor (say, an Islamic bank). The lessor acquires an asset (either existing or to be created in future) and leases it out if it is not already leased out. They are issued by the lessor in favor of the investors, who become owners of the leased asset in proportion to their investment. These entitle the Glossary of Arabic terms xi holders to collect rental payments from the lessee directly. Can also be made tradable in the stock exchange ijarah wa “qtinah”: Hire - purchase agreement ijma: The consensus of jurists ijtihad: Exertion of personal effort to understand the wisdom behind the pre- scribed rules and/or efforts to extend juristic rulings to new situations based on study of the Qur’an and hadith ikrah: Coercion iman: Active belief insan: This concept refers to a “human being” who is fully conscious of the human state in relation to the Supreme Creator. cf. bashar israf: Overspending istihsan: Judicial preference istisna’ (short form for bay’ al- istisna’): A contract whereby a manufacturer (contractor) agrees to produce (build) and deliver well - described products (or premises) at a given price on a given date in the future. The price need not be paid in advance and may be paid in installments in step with the preferences of the parties, or partly at the front end and the balance later on, as agreed itlaf: Waste itraf: Opulent and extravagant spending J jo’alah: Performing a given task for a prescribed fee in a given period K kanz (pl. konooz): Treasure(s). Refers to wealth held in the form of gold, silver, and other precious metals khalifa: Vicegerent, trustee khawf: Fear of the consequences of thoughts and actions khilafah: Trusteeship, stewardship khisarah: Loss khums: One - fi fth of income payable for the purpose of redeeming the rights of others kifala: Taking responsibility for someone else (see also takaful, which is derived from this) M ma’aad: The ultimate return of everything to the Creator for the fi nal account- ability and judgment madhahib: School of thought manafaah al - ikhtiyarat: Gains from taking options manfaa maal/ manfa’ ah: Usufruct. Benefi t fl owing from a durable commodity or asset. Also, gains from transaction maqasid al- Shari’ah: Basic objectives of the Shari’ah: the protection of faith, life, progeny, property, and reason xii GLOSSARY OF ARABIC TERMS maslahah: Literally, “benefi t.” Technically, it refers to any action taken to protect any one of the fi ve basic objectives of the Shari’ah mithaq: A covenant muamalat: Interpersonal transactions mubaya’a: Contract between the ruler and the community that he will be faithful in discharging his duties in compliance with the rules prescribed by Allah (swt) mudarabah: Contract between two parties — a capital owner or fi nancier (rabb al - mal) and an investment manager (mudarib). Profi t is distributed between the two parties in accordance with the ratio upon which they agree at the time of the contract. Financial loss is borne only by the fi nancier. The investment man- ager’s loss lies in not getting any reward for his labor services mudarib: Investment manager muhtasib: A market supervisor murabahah: Sale at a specifi ed profi t margin. This term, however, is now used to refer to a sale agreement whereby the seller purchases the goods desired by the buyer and sells them at an agreed marked - up price, the payment being settled within an agreed time frame, either in installments or as a lump sum. The seller bears the risk for the goods until they have been delivered to the buyer. Also referred to as bay’ mu’ajjal musharakah: Partnership. Similar to a mudarabah contract, the difference being that here both partners participate in the management and the provision of capi- tal and share in the profi t and loss. Profi ts are distributed between the partners in accordance with the ratios initially set, whereas loss is distributed in propor- tion to each one’s share in the capital. Also, this contract is more suitable for longer-term partnership contracts and long- gestating projects musharakah ’aqd: The contract of musharakah musharakah mulk: Specifi cation of property rights of partnership musharakah mutanaqisah: “Diminishing partnership” mysir: Gambling or any game of chance N nafaqa: Expenditure nafs: The psyche (sometimes translated as “soul”) nisab: A level of wealth beyond which levies are due niyyah: Intention Q qard: A loan qard - ul - hassan: Loan extended without interest or any other compensation from the borrower. The lender expects a reward only from Allah (swt) qimar: Gambling qist: Social (inter - relational) justice qiyas: Analogy Qur’an (also written as al - Qur’an): The Holy Book of Muslims, consisting of the revelations made by Allah (swt) to the Prophet Muhammad (pbuh). Prescribes the rules of social and personal behavior, compliance with which guarantees social solidarity, economic growth and development