Understanding Islamic Finance - Doha Academy of Tertiary Studies

The Philosophy and Features of Islamic Finance 81payable in the situation when a party to the contract has done some job or undertaken aresponsibility but is not entitled to any remuneration due to any problem in contractualterms; he is then paid any customary compensation. This implies a generally prevalent ratein the market at any point in time. Such rates of return, prevalent in the market under varyingsituations of business, are taken for granted as a guiding indicator. 8For conventional finance there is only one benchmark or reference rate (the interestrate). Islamic finance requires two benchmarks: one for debt/semi-debt contracts and theother for non-debt (equity) contracts. Therefore, two reference scales are needed: the price(mark up/rent) reference scale and the sharing ratio reference scale, through the central bankMudarabah ratio or inter-bank Mudarabah ratio.The benchmarks should be decided by market forces provided there are no distortions ofa gross nature. Islamic banks working in parallel with conventional banks normally use thesame benchmark as the conventional banks are using. According to the Sharī´ah scholars,using any interest-based benchmark for the pricing of goods and their usufruct in trade andIjarah-based activities of Islamic banks does not make their operations un-Islamic so longas other rules of trade and Ijarah are applied. 94.2.6 Entitlement to Profit – With Risk and ResponsibilityThe assumption of business risk is a precondition for entitlement to any profit over theprincipal. The important Sharī´ah maxim: “Al Kharaj bi-al-Daman” or “Al Ghunm bilGhurm” is the criterion of legality of any return on capital, meaning that one has to bearloss, if any, if he wants to get any profit over his investment. Profit has to be earned bysharing risk and reward of ownership through the pricing of goods, services or usufruct ofgoods.Investment in the Islamic context is not merely a financial or monetary transaction inwhich transfer of funds is the only activity. Investment, both by banks’ depositors and thefinancial institutions, will be considered only if it is a part of real activity or is itself areal activity. This is because money has the potential for growth when it joins hands withentrepreneurship. In itself, it is not recognized as capital and, therefore, it cannot earn areturn.In all economic activities there could be some commercial risk and one has to bear thatrisk for the validity of the profit or earnings. In other words, the return on invested fundsthat plays a productive role in any business is a factor in the willingness and ability to cause“value addition” and bear the risk of a potential loss in the business. Reward should dependon the productive behaviour of the business where funds are used, implying that interest,lotteries, gambling, etc. are prohibited, because return in respect of them either does notaccept the business risk or is based on pure luck, chance or hazard.In debt-creating modes, Islamic banks will face credit/party risks, ownership transfer risks,market risks, commodity risks, price or rate of return risks, legal and documentational risksand other mode-specific risks. Remaining within the Sharī´ah principles, Islamic banks areallowed to take risk mitigation/management measures. Hence, risk can be mitigated but nottotally eliminated. Transfer of commercial risk to anyone else without transferring the relatedreward is not permissible.8 For details, see Hasanuz Zaman, paper read at IRTI, IDB upon getting the IDB Prize on Islamic Economics.9 Usmani, 2000a, pp. 118–120.