02 Basic Prohibitions and Ethics

ISF 1101 FOUNDATION OF ISLAMIC FINANCE
Basic Prohibitions
and Ethics in Islamic
Finance
Outline
Riba and its types
The prohibition of riba
Addressing misconceptions about
riba
Rationale for the prohibition of
riba
The prohibition of gharar
The prohibition of gambling
Ethics in Islamic financial services
ISF 1101 FOUNDATION OF ISL AMIC FINANCE
Riba
Literally means excess, increase, expansion,

growth
Riba can be defined as every excess in return of
which no reward or equivalent counter-value is
paid
Categorization of riba
Riba al Qard
Applies to a loan or to any debt regardless
of the cause of that debt (debt resulting
from a loan contract or from a deferred
payment sale)
This kind of riba is the one commonly
found in conventional banking products
Riba al Bay (sale)

Applies to sale transactions in certain
commodities
Riba al Qard
Riba al Qard can be present in a number of situations
Loan with interest or other benefits
Riba exists when there is a predetermined excess or

surplus over and above the loan received by the creditor
conditionally in relation to a specified time period
If one of you has advanced a loan and the debtor offers

the creditor a bowl (of food), he should not accept it, or if
the debtor offers him a ride of his animal (cattle) the
debtor must not take the ride unless this type of gift has
been a usual practice between them before advancing
the loan
[ Anas Ibn Malik ]
Loan of usufruct (benefit/utility) of asset with stipulations
The lending of beneficial use of an asset but with

stipulated benefits in return implicates riba
Every loan that derives a benefit (to the creditor) is

riba.
[ Sayyidina Ali ]
Penalty imposed on delinquent debt repayment or default
Before the Prophet s.a.w. brought the message of Islam,

it was very common for creditors to double the amount
of debt outstanding in the event that the debtor is not
OF ISL AMIC FINANCE
able to repay debt onISF
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dueFOUNDATION
date
Riba al Bay
The basis for the prohibition of riba in the

exchange of commodities is the Hadith of the
Prophet on six commodities
Gold for gold, silver for silver, wheat for

wheat, barley for barley, dates for dates, salt
for salt like for like, equal for equal, and
hand-to-hand (spot); if the commodities
differ, then you may sell as you wish,
provided that the exchange is hand-to-hand
or a spot transaction.
[ Muslim ]
Background
The Arabs used certain commodities like

wheat, barley, dates and salt (termed as
ribawi items) as medium of exchange to
purchase other things, and as such they were
like money
Riba al Bay (2)
Summary of rules under the

hadith
Exchange
Condition
Money1 + Money1
Equality
Hand-to-hand (spot)
Food1 + Food1
Equality
Hand-to-hand (spot)
Money1 + Money2
Hand-to-hand
Food1 + Food2
Hand-to-hand
Money + Food
No conditions free trading
Money + Others
Food + Others
Others + Others
Riba al Bay (3)
Money1 and Money2 refer to different currencies
Food1 and Food2 refer to:

[Hanafi & Hanbali] Any commodity which is sold
by weighing or measuring
[Shafii] Either eatables or used as universal legal

tender
[Maliki] Either food items or they can be stored
Modern day fuqaha would include staple food

(such as rice) in this category of ribawi items
What about non-food commodities such as oil?

Such restrictions are imposed upon the trading of
these ribawi commodities
Presumably, to curb price speculation on essential

items
To discourage barter trading where injustices may

occur (resulting from information asymmetry
and/or deception)
Some jurists have relied on this Hadith to render
ISF 1101 FOUNDATION
OF ISL AMIC FINANCE
modern-day currency derivatives
impermissible
The Prohibition of Riba
Riba was prohibited gradually in the Quran in four stages
First stage (30:39)
Comparison made between riba and zakah & charity
That riba actually does not increase real wealth but

zakah & charity do
Approach prohibition of riba by way of moral

persuasion
Second stage (4:160 - 161)
Associating the practice of riba with the Jews
Considering such practice as iniquity (zulm)
That those who practice riba will suffer the same

fate as the Jews
Third stage (3:130)
Prohibiting the charging of double and multiple riba

(usury)
Compounding interest one of the worse forms of

riba
Fourth stage (2:275 - 281)
The final prohibitionISF

of1101
ribaFOUNDATION
was madeOFconclusively
ISL AMIC FINANCE
and decisively
The Prohibition of Riba (2)
Those who live on riba will not rise up before

Allah except like those who are driven to
madness by the touch of Shaitan. That is because
they claim: Trading is no different than riba,
but Allah has permitted trade and prohibited riba.
He who has received the admonition from his
Rabb and has mended his way may keep his
previous gains; Allah will be his judge. Those who
turn back (repeat this crime), they shall be the
inmates of hellfire wherein they will live forever.
Al-Baqarah verse 275
O You who believe! Fear Allah and waive what is

still due to you from riba if you are indeed
believers; or war shall be declared against you by
Allah and His Messenger. If you repent, you may
retain your principal, causing no loss to debtor
and suffering no loss.
Al-Baqarah verses 278-279
The Prohibition of Riba (3)

The prohibition of riba is also evident in various
Sunnah of the Prophet s.a.w., for example,
The Prophet of Allah s.a.w. cursed the

receiver and the payer of riba, the one who
records it and the two witnesses to the
transaction and said: they are alike (in guilt)
[ Narrated by Abu Dawud on the authority of Ibn Masud and Jabir ]
There are seventy three types of riba; the

least sinful of which is equivalent in sin to a
man committing incest with his mother
[ Narrated by Al-Hakim on the authority of Ibn Masud ]
All jurists agree that riba is prohibited (haram)
Addressing Misconceptions about

Riba
There have been a number of misconceptions
about riba and its prohibition
Bank interest is not riba because it is not

excessive (usurious)
Riba should be allowed under dharurah
Riba should be prohibited only when there is
injustice
Interest should be allowed because of inflation
Interest is justified on the grounds of credit
(default) risk
If it is not excessive, it is not riba

Argument
Al-Imran (3:130) - O those who believe do not eat up riba

doubled and redoubled
If rate of interest is not excessive (e.g. doubled) then it does
not constitute riba and therefore not prohibited
Addressing This Misconception
Verses of the Quran on the same subject matter must be

studied in relation to each other
Al-Baqarah (2:278) O those who believe fear Allah

and give up whatever remains of riba, if you are
believers
Every amount, regardless of magnitude, over and above

principal is riba
The Quran is a book of guidance, not originally a book of
statutes and legal text
Embodies many expressions having persuasive value
E.g. Al-Baqarah (2:41) Do not sell My verses for a little

price does not imply that one can sell Verses for a
high price
The expression doubled only meant to emphasized added
severity of the sin due to its excessiveness
Riba allowed under dharurah
Argument
Doctrine of Necessity under dharurah

circumstances, the haram is permissible
E.g. It is permissible to consume pork to save

ones life from dying of hunger
Two sets of questions need to be answered with
sincerity
Can the necessity be met with by any other
permissible means? Have all other permissible
alternatives been exhausted?
Is the necessity real or exaggerated by
imaginary apprehensions? Is the purpose of
the riba-based loan to protect an absolute
necessity?
Riba allowed if there is no injustice

Argument
The basic cause of the prohibition of riba is zulm (injustice)
Thus, if injustice is absent, riba in the form of interest should

not be prohibited
While imposing interest on poor debtors cause injustice,

lending money to the rich and charging them interest will not
produce injustice
Validity of a transaction is not based on the financial status of a

party
Intrinsic nature of transaction itself should determine its

validity
For example, if one sells to the poor, the most that can be
said is that some concession should be accorded on
humanitarian grounds, but one cannot say that the profit
derived is haram
A trader deserves reasonable profit for his investment
and labour
Profit is the traders means of earning his livelihood
Similarly for other prohibited transactions

E.g. Gambling and bribery
are
prohibitedOF
forISL
both
rich
ISF 1101
FOUNDATION
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FINANCE
and poor

(2)
Addressing This Misconception (Continued)
Need to differentiate illat and hikmat
Illat Basic feature of the transaction
Hikmat Wisdom or rationale behind the rule

or prohibition
Application of law depends on illat and not

hikmat
E.g. The philosophy behind the prohibition
of liquor is that it inculcates hatred
amongst people and it prevents one from
remembering Allah
Can one consume alcohol if he claims
that it does not promote hatred and
prevent him from remembering Allah?
E.g. Does it make it legal for a motorist to
run the red light if he is reasonably sure
that there is no risk of accident?

(3)
Addressing This Misconception (Continued)
Subjectivity and relativity of financial status
The illat of a law is always determinable by hard

and fast definition that leaves little room for dispute
On the other hand, zulm (injustice) is relative,

ambiguous and subject to manipulation
Who will have the authority to determine exact
degree of poverty required for exempting of
interest charges?
Possible rationale for making application of law

based on illat and not hikmat
For e.g., why does Islam provide a long list of
prohibitions and commands instead of issuing
one single command to avoid zulm?
Human reason, despite its wide capabilities,
cannot claim to have unlimited power to reach
the absolute truth
Reason often confused with desires, leading to
disguised justice
Thus humans need guidance of divine
revelations
Inflation justifies interest

Argument
Interest represents compensation for the erosion of the

value of money (due to inflation) during the period of
borrowing
Loans should be indexed so that there is no injustice to the
creditor
Indexation of loans is problematic due to the lack of precise

measures of inflation
Indices are, at best, aggregated generalizations about

price levels
The effects of inflation differ from individual to individual

If surplus on loan amount is only attributable to actual value
loss due to inflation, there will be no commercial incentives
to banks
Interest is one of the causes of inflation
Using interest to remedy inflation which is a

consequence of interest-based lending in the first place
A better solution is to not charge interest to begin with

Inflation would take place regardless of use of money
It would inequitable for the creditor to pass the burden

ISF 1101
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of the cost of inflation
to the
debtor OF ISL AMIC FINANCE
Interest compensates for default

risk
Argument
Lenders face the risk of delinquencies in repayment of loans

(late or default entirely)
Interest represents the compensation to the lender for the
absorbing of such risks
Credit or default risk is not inherent in the contract of loan

itself
The risk arises from possible non-compliance to the terms of the

contract
Such a risk is present in all contracts
Interest, interpreted as compensation for default risk,

unfairly penalizes good debtors
If interest purely recompenses credit risk, there will be little
or no incentive for commercial lending
If all borrowers pay on time and in the full amounts, does it

mean lenders will not make any returns?
In the event of default, the bank has recourse (collateral,

punitive measures by authorities)
Contrast with market risk associated with trading
Risk is inherent in trading activity itself
If downside risk materializes (e.g. cannot sell goods at

ISFcontractual
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OF ISL
AMIC FINANCE
profit), trader has no
or systemic
recourse
Rationale for the Prohibition of Riba
For Muslims, the prohibition of riba as evidenced in the

Quran and Sunnah should be sufficient
However we can attempt to articulate some rationale or
reasons for its prohibition to better appreciate the wisdom
behind the injunction
Some of the possible rationale for the prohibition of riba are
1.
Element of injustice in financing productive

activities
2.
An interest-based production loan constitutes a

contract with unequal counter-values certainty of
interest obligation vs. uncertainty of business
outcome
Injustice to debtor obligated to pay interest even if
business venture results in no profit or loss
Injustice to creditor in the event of substantial
profits, creditor receives a return disproportionate to
amount of generated profits
Element of exploitation in financing consumption
Riba assumes money as a commodity, one which the

rich has in abundance
The rich is able to generate more wealth without
exerting much effort
or contributing to productive

(2)
3.
Riba inconsistent with Islams perspective on debt
In Islam, incurring debt is discouraged

The Prophet s.a.w. refused to offer salat-ul
janazah of a person who died indebted
Borrowing money should be limited to
cases of dire need
On the other hand, permitting riba enables

lending to become a viable business
Banks are motivated to lend as much as
possible
Banks exploit mans inherent greed to
spend beyond their means by offering
credit
Given that spending on credit is a product
of human greed, it will result in negative
repercussions
The outcome is the proliferation of a credit
society

(3)
4.
Negative effects of a credit society
Easy availability of credit cultivates a materialistic

society
People have to work harder and harder in order to

repay bank debt
The banks in essence exercise control over

economic agents, people become enslaved to the
banks
The quest for economic development clouds good moral
judgment and the Islamic value system
Unethical business practices
Degradation of the natural environment
Less emphasis on the institution of family leads to

social ills
Longer working hours, multiple jobs, forced
female and teenage labour
Essentially, Muslims forget their roles as abd and
khilafah
Social relations amongst the people are negatively
affected
Members of society should help each other in times

of need

(4)
5.
Negative effects on production
Impediment to healthy growth of the economy
Riba-based lending is security oriented rather than

growth oriented
Lending is confined to established businesses with known

creditworthiness and adequate security (collateral)
Potential entrepreneurs without security to pledge are

denied credit
Inefficient allocation of resources
Bank interest return does not vary with actual profits, no

incentive to give priority to ventures with highest profit
potential
Lending based on creditworthiness, not profitability

Discourages Innovation
Interest obligation act as disincentive for experimenting

with new, unproven methods of production, especially for
small-scale enterprises and agriculture
Leveraged financing favours large-scale businesses
Domination of big businesses over smaller entrepreneurs

will curtail competition and in turn will affect product
variety and innovation

(5)
5.
Negative effects on production (continued)
Anti-productive
Inflexibility in a loss situation leads to
bankruptcies loss of productive potential
and unemployment
Funding not channeled to deserving economic

agents
Utility of certain projects is with reference
to criteria other than profitability
E.g. projects that benefit the public,
poverty alleviation
Financing of luxurious or wasteful

consumption and/or production

(6)
6.
Negative effects on distribution
Because the primary basis of interest-based lending is

creditworthiness, there will be disproportionate supply of
credit to the already affluent segments of population
Wealth inequality (in terms of purchasing power) is

widened
The rich become richer, and the poor become poorer
Domination of large enterprises leads to demise of smaller
economic units
Lacking collateral and established economic standing,

poorer segments of the economy are at an economic
disadvantage when competing for credit to finance
economic activities
As a result, wealth and income disparities worsens

Transfer of real assets to the lenders
Most debt financing requires some form of

collateralization in the form of real assets (real estate,
equipment & machinery)
Given that with the current monetary system, bank

debt is un-repayable in aggregate, loan defaults are
inevitable
Interest-based lending will, by design, lead to transfer

of real assets from the borrower to the lender, in the
The prohibition of gharar
Literal meaning covers a number of negative elements
Deceit, fraud, uncertainty, danger, peril, or hazard

that might lead to destruction or loss
Technical meaning
uncertainty and/or ignorance of one/both parties in

a contract over the substance or attributes of the
object of sale, or doubt over its existence and
availability at the time of contract
All jurists agree that gharar should be avoided in
commercial exchange contracts
Prohibition of gharar
Indirect references made in the Quran
Conclusively prohibited by the Sunnah of the

Prophet s.a.w.
Classical examples of gharar sale
Sale of fish still in the sea
Sale of birds in the air
Sale of unborn animals

The prohibition of gharar (2)
Rationale for the prohibition of gharar
To ensure full consent and satisfaction of the

parties in a contract
Without full consent, a contract may not be

valid
Full consent can only be achieved through

certainty, full knowledge, full disclosure and
transparency
Gharar in commercial contracts may lead to

injustice, exploitation and/or enmity among
contracting parties
Types of gharar
Gharar yasir (minor or slight)

Tolerated and will not invalidate a contract
Gharar fahish (major or excessive)

Not tolerated and may result in contract
voidability
Examples of gharar elements in sale contracts
Material ambiguity in specifications,

attributes, quantity or quality of object
Material ambiguity pertaining to price,

mode of payment and delivery
Non-possession of object
E.g. Selling item owned but stolen
Conditional sales, insertion of extraneous

stipulations that introduce uncertainty
E.g. Will sell if rain falls
There are a number of situations where

uncertainty exists, but they are allowed
exceptions to the prohibition of gharar
The uncertainty is slight or trivial
(gharar yasir)
Contract is unilateral or charitable (al
tabarruat) such as gift or bequest
There is a public need for the
transaction or contract (consideration
of maslahah)
E.g. bay al salam, istisna
Risk (ghurm) inherent in productive
economic activities
Risk (Ghurm) and Gharar
Permissibilit
y in Islam
Risk (Ghurm)
Gharar
Allowed in Islam, as
per Islamic legal
maxim Al ghurmu bil
ghunmi (no risk no
gain)
Hadith gharar sales

prohibited (e.g. selling
fish in the sea, birds in
the sky)
Characteristi Inherent in productive

c
economic activities
Unnecessary,
avoidable,
intentionally created
Common
Risks of trading, doing
day example business, making
investments
Not stipulating price or

product specification
in a sales contract
Effects
Exploitation for self

interest, can lead to
harm and injustice
Encourage
entrepreneurial spirit
and productivity
An Islamic Perspective on Risk

On one hand, recent calls for more meaningful risk sharing
Move away from fixed-return financial arrangements that
mimic conventional interest-based instruments
On the other hand, risk in itself should not be a commodity
Risk is legitimate only when necessary for value creation
Some opine that risk cannot be traded independently
from ownership of underlying asset
This has implications for derivative instruments
When risk becomes a commodity
Price volatility becomes inevitable
When risk is separated from underlying real transactions,
its trading becomes its own being
It becomes unconstrained, possibly leading to price
distortions
This detaching of risk is similar to separation of TVM from
real transactions in interest-based lending
Gambling (maysir), which Islam prohibits, is arguably an
example of commoditization of risk
The Prohibition of Qimar and Maysir

(Gambling)
Qimar
Acquisition of wealth or money which depends
on luck or chance
Receipt of money or benefit at cost of other
party having equal entitlement to that money or
benefit
Maysir
Literally means getting something too easily or
getting a profit without working for it
Their prohibition
O you who believe, intoxication and gambling,
dedication of stones, and divination of arrows
are an abomination of satans handy work.
Eschew such abomination, that you may prosper
Al-Maidah: 90
Consequences / Rationale for their

Prohibition
Element of injustice
Winner obtains wealth without effort/justification
Loser parts with wealth without fair compensation
or counter-value
Hostility and enmity
Wealth taken away from loser unwillingly
(expropriation)
Unproductive economic activity
Although results in documented GDP contribution,
and creates employment, at a philosophical level, it
merely represents redistribution of wealth, with no
clear value add
Zakat/charity also a form of redistribution of wealth,
but how are these different from gambling?
Can be viewed as entertainment or social
activity but bear in mind the zero sum game
nature of gambling
Gambling in Contemporary Islamic Finance?

Are there elements of maysir/qimar in contemporary
Islamic finance?
Does trading of financial assets (stocks, bonds,
derivatives, commodities, currencies, etc.) entail
gambling?
Is there an element of gambling in conventional
insurance?
Offering of prizes as a form of marketing
Chance to win prizes when purchase consumer
products/services
Prizes offered for bank deposits
Structured as hibah/gift to garner Shariah
compliance
But, are the costs of the prizes factored into the
overall product/service costs, such that losers
are indirectly paying?
Would it depend on the individual
niyyah/intention?
Ethics in Islamic Financial Services

Justice and Fair Dealings
Fulfilling of Covenants and
Paying Liabilities
Mutual Cooperation and
Removal of Hardship
Free Marketing and Fair Pricing
Free from Dharar (Detriment)
Justice and Fair Dealings

Full disclosure and transparency are essential
As it is, financial services can be a complex
subject matter
Contemporary Islamic financial products even
more complex (financial engineering and use
of multiple contracts)
Buyer beware versus some fiduciary duty
on part of bank
Explanation of implications of key elements
in financial contracts in layman terms
Not concealing potentially critical
contractual terms in fine print
For example, nominal rates versus effective
rates
Fulfilling Covenants and Paying

Liabilities
Earnest commitment to contractual
agreement
Should honour the spirit of the contract
and not seek to dissect contractual terms
and exploit legal deficiencies and
loopholes
Examples of court cases where defendant
argues contract is not Shariah compliant
to escape/reduce liability
Why enter into the contract in the first
place if feel it is not Shariah
compliant?
Mutual Cooperation and Removal of Hardship

What is the real aim of contemporary
Islamic financial institutions?
To engage in mutually beneficial financial
arrangements and to alleviate hardship?
Or, to make a handsome profit?
Cases to ponder over
Abandoned housing projects and liability
of customers of Islamic financing
Takaful claimants denied their claim on
technical grounds
Extending of financing facilities to those
with doubtful ability to repay (for
example, subprime mortgage crisis)
Free Marketing and Fair Pricing

Generally in Islam, the market forces of
demand and supply should dictate pricing
Market intervention, including setting of
market prices should be limited to instances
where gross injustices exist, or to address
manipulation, fraud, market distortions, etc.
Interestingly, in the case of financial
services, relevant government authorities
set prices
In case of Malaysia, BNM sets OPR, which
in turn translates into BFR, and the rate
customers receive/pay
Would this be considered an acceptable
pricing mechanism in Islam?
Free from Dharar (Detriment)

To what extent are Islamic financial
institutions bound to avoid imposing
harm or damage on their customers?
Case of delinquent payment/repayment
How do we distinguish between
genuinely insolvent (financially
distressed) customers and simply
errant (solvent) debtors?

02 Basic Prohibitions and Ethics

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02 Basic Prohibitions and Ethics

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ISF 1101 FOUNDATION OF ISLAMIC FINANCE

ISF 1101 FOUNDATION OF ISL AMIC FINANCE

Literally means excess, increase, expansion,

Riba al Bay (sale)

Riba al Qard can be present in a number of situations

Loan with interest or other benefits

Riba exists when there is a predetermined excess or

If one of you has advanced a loan and the debtor offers

Loan of usufruct (benefit/utility) of asset with stipulations

The lending of beneficial use of an asset but with

Every loan that derives a benefit (to the creditor) is

Penalty imposed on delinquent debt repayment or default

Before the Prophet s.a.w. brought the message of Islam,

The basis for the prohibition of riba in the

Gold for gold, silver for silver, wheat for

The Arabs used certain commodities like

ISF 1101 FOUNDATION OF ISL AMIC FINANCE

Riba al Bay (2)

Summary of rules under the

No conditions free trading

No conditions free trading

No conditions free trading

No conditions free trading

ISF 1101 FOUNDATION OF ISL AMIC FINANCE

Riba al Bay (3)

Money1 and Money2 refer to different currencies

Food1 and Food2 refer to:

[Shafii] Either eatables or used as universal legal

[Maliki] Either food items or they can be stored

Modern day fuqaha would include staple food

What about non-food commodities such as oil?

Presumably, to curb price speculation on essential

To discourage barter trading where injustices may

The Prohibition of Riba

Riba was prohibited gradually in the Quran in four stages

First stage (30:39)

Comparison made between riba and zakah & charity

That riba actually does not increase real wealth but

Approach prohibition of riba by way of moral

Second stage (4:160 - 161)

Associating the practice of riba with the Jews

Considering such practice as iniquity (zulm)

That those who practice riba will suffer the same

Third stage (3:130)

Prohibiting the charging of double and multiple riba

Compounding interest one of the worse forms of

Fourth stage (2:275 - 281)

The final prohibitionISF

The Prohibition of Riba (2)

Those who live on riba will not rise up before

O You who believe! Fear Allah and waive what is

The Prohibition of Riba (3)

The Prophet of Allah s.a.w. cursed the

There are seventy three types of riba; the

All jurists agree that riba is prohibited (haram)

ISF 1101 FOUNDATION OF ISL AMIC FINANCE

Addressing Misconceptions about

Bank interest is not riba because it is not

ISF 1101 FOUNDATION OF ISL AMIC FINANCE

If it is not excessive, it is not riba

Al-Imran (3:130) - O those who believe do not eat up riba

Addressing This Misconception

Verses of the Quran on the same subject matter must be