Impact of Islamic Finance Contracts on Financial Access, Social Equality, and Income Distribution

Subject: Religion
Type: Profile Essay
Pages: 20
Word count: 5220
Topics: Islam, Ethics, Finance


Islamic finance is based on Islamic ethics, but its ideals and legal form do not necessarily conform to Islam in entirety. The principles of Islamic finance focus on sharing of market risks to enhance enterprise and asset management, allocation of resources in real economic activities and promote economic prosperity, and enhance equal distribution of resources. However, modern practices in Islamic finance have taken a more legal than economic or ethical form; hence creating a gap between theory and practice of Islamic finance. After the global financial crisis of 2008, various countries have implemented measures and regulations on financial institutions to minimise financial risks and promote good governance, transparency and accountability in the financial markets. Islamic finance can help in redeeming the responsibility and stability of the financial sector. Based on the Islamic ethics, Islamic finance must enhance positive impact on society.

Islamic finance is one of the fastest-growing sector of global finance; but it also has significant legal and ethical concerns. Questions have been raised on whether religion should influence finance; whether Islam should guide economic and financial transactions; the effectiveness of equity finance versus debt financing in promoting economic prosperity; and the impact of Islamic jurisprudence on financial access and income distribution. The Islamic finance contracts play a significant role in financial inclusion, equity and distribution by solving the problem of excessive risk-taking behaviours of financial managers in conventional financing. Based on the Islamic finance contracts, the financial institutions and customers share risks associated with asset ownership and business transactions. Islamic financial contracts encourage mutual risk-sharing arrangements to commit assets to the real economy and facilitate income redistribution and social equality.

Legal Principles of Islamic Finance

Islamic jurisprudence recognises the role of Islamic ethics in economics and finance; thus Islamic financial institutes abide by the Islamic legal principles to comply with Islamic beliefs and practices. Islamic finance bases its objectives and practices on Islamic principles from the Quran and the Sharia laws. The religious commitments of the institutions set it apart from the conventional finance institutions which rely on natural and secular laws. Islamic banks basically offer financial services to customers without charging interest (riba), and all the Islamic law also prohibits the charging of interests in any financial or economic activity. 

Interest, or riba in Arabic language, is an additional amount of money to a principal amount of a loan charged on the basis of duration and amount of the loan. Historically, the term riba was applied to mean usury; but it is now used universally to refer to all forms of interests recognised by law. It covers any addition to the principal, regardless of how small it may be, and whether it is compound or simple. This prohibition makes Islamic banks different from conventional banks in principal. Any legal case arising from financial transactions involving an Islamic bank is decided in a sharia court rather than the conventional legal courts. Any case decided in the secular judicial system does not recognise any religious taboo that regulates financial transactions. 

The prohibition of interests in Islam is provided by the Quran and the Sunnah, the traditions and teachings of Prophet Muhammad, on which the Islamic religion and beliefs are based. The Quran and the Sunnah consider interest and usury as an exploitation or a form of injustice on the economic system because it contravenes Islamic ideas of property rights and fairness. The Islamic finance derives its principles from the idea that there is no place for interest in Islamic religion. However, there are also other goals of Islamic finance, including the contribution of banks to economic development and distribution of income; increased equity participation; and social solidarity. 

The fact that Islamic banks do not charge interest poses a challenge of how financial institutions may benefit from their financial intermediation roles. Islamic financing replaces interests with profit and loss sharing (PLS) as the appropriate mechanism of sharing allocating resources and providing financial intermediation. In this regard, partnership in profit-sharing is a significant element in Islamic finance. Rather than charging interests, an Islamic bank participates in the sharing of returns obtained from the use of loaned funds. Depositors also share the profits of the banks according to an agreed ratio. Therefore, there are two forms of partnerships in Islamic banking – partnership with depositors who deposit their excess funds, and investment clients who manage the depositor’s resources to generate income. This partnership differs from the conventional banking framework in which banks borrow surplus funds from depositors and use them to offer loans to borrowers at an interest. 

Islamic courts recognise only good loan in which the predetermined payments above the principal amount is prohibited. Traditional Islamic courts also interpret the principle of predetermined payments to include any benefit that the lender might receive from a loan, including the riding on the mule of the borrower, using the shade of his wall, and eating at his table. These prohibitions suggest that any advantage that can potentially accrue to the lender through the borrower’s deposits is prohibited. 

Apart from the prohibition of interests and sharing of profits and losses, another Islamic principle applicable in finance is risk sharing. Islamic banks play the role of promoting risk sharing between borrowers and lenders. On the other hand, conventional banks operate on a predetermined interest rate which may face uncertainties and risks. The entrepreneur bears all the risks in a conventional finance and economic system because he or she pays all the interests regardless of whether the business earns profits or not. On the other hand, an Islamic finance system legally allows the bank and the investor to share risks. Islamic laws correct this distributive injustice by requiring the bank and the investor to share the profits or losses of the project equally; hence achieving equitable distribution of resources. 

Islamic finance also focuses on productivity rather than credibility. Conventional banks are primarily concerned with the borrowers’ timely and effective payment of loans and interests. To avoid risks of default, conventional banks conduct a thorough check of potential borrowers to determine their creditworthiness. Under the Islamic profit-sharing framework, the bank only benefits from the returns of the project. Therefore, banks will investigate the project’s viability rather than creditworthiness of the borrower; hence money is channelled to the most viable projects to improve productivity and economic progress. The possibility of success of the project depends on the business plan and managerial prospect of the entrepreneur; thus the Islamic banking law encourages managerial and entrepreneurial skills as well as commitment of the entrepreneur.

The Islamic law also promotes asset-backed financial transactions to prevent financial institutions from making money using money. Islamic sharia laws prohibit the use of money as an asset, suggesting that money should be used only as a means of exchange and as a measure of value. Money should not be allowed to generate income because it has no value on its own. Without products or services to buy, money does not have any value. Therefore, Islamic traditions and beliefs do not allow banks to generate money through interest payments. On the contrary, Islam encourages rewards for human initiative and effort involved in the production of goods and services. Islamic jurists treat money as potential capital rather than capital in itself; hence money only becomes capital when it is invested in a productive activity. Islamic sharia laws also prohibit the charging of interest because loans are regarded as debts rather than assets; hence they are not entitled to any returns whether in the form of interest or monetary compensation.

The Islamic law on interest-free loans is also based on the Islamic principle of prohibiting money hoarding. According to Islam, money should be invested in productive projects rather than being left to stay idle in banking institutions. Muslims believe that resources should be used to support economic and social development. Thus, money is a source of purchasing power as the proper means of using money; the purchasing power of money should not be used to generate more money; but it must be used for the purpose of producing goods and services. Religiously, Muslims are not allowed to hoard money and wealth; but to distribute them to help others who do not have the means and resources of earning a living. Therefore, banks are required to make use of the money by lending them free of interest to investors who will use the money to implement projects that will help communities. 

The Islamic jurists also rely on the principle of uncertain gains which prohibits Gharar (uncertainty, risk and speculation). Muslims are required to enforce contracts with perfect knowledge and information about the material elements of their transactions, including prices and amount of goods received. Furthermore, contracting parties should not base their transactions on speculations because no one can guarantee predetermined profits. The prohibition of speculative actions protects the poor from exploitation and manipulation by the informed and knowledgeable finance managers. In this regard, financial instruments such as futures, forwards, and options are prohibited in Islamic law. 

Due to these Islamic principles and ideals, Islamic financial institutions should enforce only sharia-approved contracts such as ijara, Murabaha, and Musharaka. Conventional banks have secular rules and regulations; but the Islamic system requires contracting parties to work within the confines of the Islamic values and beliefs. For instance, the sharia laws prohibit finance institutions from financing casinos, nightclubs, distilleries, and other activities that may cause harm to societies.

The Islamic finance contracts should also be based on the elements of trade and commerce that are sanctified by the Holy Quran. According to the Islamic Holy book, there should be no obstructions to a legitimate and honest business; so that people can honestly make a decent living, support their families, and participate in community projects and charitable courses. Islam not only regulates the religious and social lives of Muslims, but also governs business and economic activities. According to the Holy Quran, followers of the Islamic religion should conduct economic activities and commerce in a fair, honest, and equitable manner based on the moral values and guidelines of the religion. 

There is no provision for caveat emptor in the Islamic religion, so contracts must be enforced on the basis of mutual obligation between contracting parties. Nonetheless, Islamic laws prohibit price-fixing and monopoly activities. Islamic sharia laws regulate contractual obligations and enforce information disclosures as a sacred duty of a Muslim. Therefore, the contractual obligation provided by the Islamic laws reduces information asymmetry and moral hazards associated with risk-taking behaviours of conventional banks.

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The Features and Roles of Various Contracts in Islamic Finance

Ijara Contract

Ijara is a method of capital financing in Islamic finance in which the bank (lessor) transfers the usufruct rights of an asset to a customer (lessee) in exchange for an agreed-upon price (rent) for a specified period of time (leasing term). In this case, a customer identifies the assets for which he needs financing, and the bank buys it from the manufacturer and transfers its use to the customer for an agreed period of time. The sharia law requires the user of the asset (lessee) to pay a specified amount of rent to the owner of the assets (lessor), and the owner (financial institution) exercises all rights and responsibilities of ownership such as insuring, repairing, and maintaining the assets. The user or lessee may assume this responsibilities in exchange for the reduction of the rental amount of the asset. The customer also has the option of buying the financed asset at the end of the leasing term to assume full ownership and responsibilities thereof.

Property leasing may be used in Islamic finance in the place of conventional mode of capital financing. However, there must a distinction between interest-based loans and Islamic finance leasing contract. Based on Islamic sharia laws, the term ‘interest’ cannot be substituted with the term ‘rent’, and ‘mortgage’ cannot be substituted ‘leased asset’. The difference between Islamic ijara and the conventional bank’s lease is that the leasing agency or bank owns the leased property under Islamic leasing contract for the period of the leasing term. In this regard, a customer should be careful to avoid unscrupulous leasing contracts in Islamic finance that charge interests on loans intended for property acquisition.

The Islamic ijara contract may be applied in many cases of acquiring an asset for the purpose of capital. For instance, a customer may lease a car to use for transportation of employees or products to different stations. In this regard, the business may choose to borrow an interest-bearing loan from a conventional bank, or lease the property from an Islamic bank. However, in case of a court case the interest-bearing loan cannot be qualified in sharia courts. Therefore, an Islamic customer who intends to pay rent on a car rather than interest in compliance with the sharia law must investigate the bank’s terms to ensure that the lease complies with the sharia laws in terms of ownership and price of the asset. 

The car financing in conventional finance constitutes capital financing through a loan; but the Islamic car financing involves a lease contract rather than capital financing scheme. The customer in a conventional bank may pay interest instalments for a period agreed upon by the contracting parties; but an Islamic financing involves pure rentals rather than instalments. Furthermore, a conventional customer bears all the risks from the time of purchase from the manufacturer; but in Islamic financing the bank bears all the risks and liabilities involved in the property throughout the lease period. However, the lessee bears responsibility for any wear and tear that occurs as he or she uses the property, and losses caused by his or her negligence. He or she is not responsible for losses beyond his control such as fire and accidents not directly caused by the lessee.

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The Musharaka Contract

Musharaka contract in Islamic finance refers to a form of partnership in which two or more people combine their labour or capital, and share profits using an agreed ratio or losses based on the contributions of each partner. Musharaka is a mutual contract that must fulfil certain conditions to qualify as a valid contract under the sharia law: the partners should be of legal age, and partners must enter into the contract with their free consent or without duress and coercion.

Each partner in the musharaka contract must participate in the management and operations of the contract. Sometimes one partner may be given the responsibility to work for the joint partnership while the other partner becomes a silent partner who receives profits only based on the extent of his contribution, which should not exceed the size of his investment. If both partners work for the joint partner, they are considered as equal agents, and the decision made by one partner is binding upon all partners. One form of musharaka partnership occurs when all partners enjoy equal, unlimited, and unrestricted partnership, rights and responsibilities in management, right of disposition, and capital contribution. In this form of partnership, all partners are equal agents and guarantors of each other. The second form of musharaka is the limited partnership in which the partners contribute money, contributions in kind, and labour to the capital fund. In this type of partnership, the partners are just agents, but not guarantors of each other. 

According to sharia laws, Musharaka is based on actual profits of a venture as opposed to conventional banking in which the bank uses interest rates to establish a predetermined fixed rate of return irrespective of the actual profits or losses. However, Musharaka is considered a financial instrument because it has an element of risk. A finance manager has several options to cushion himself from risks and losses in case the funded project fails, including recovering the loan through collateral. However, a Musharaka financier does not have the method of recovering his investment; hence suffering losses in case the joint venture fails to produce the desired results.

The sharia laws provide certain rules for the compliance of a Musharaka. First, the partners must contribute capital that is specific, easily accessible, and existent. In this regard, a Musharaka is not expected to establish a business on borrowed money for the purpose of making profits. The sharia laws also allows partners to have unequal ownership of a business venture as long as the ownership percentage is provided in forthright in the agreement. The capital of any Musharaka should also be in form of liquid cash or monetary form. However, some sharia courts also allow the use of merchandise as capital; but the partners should value the merchandise in an agreed upon manner and included in the contract as capital. Furthermore, the joint venture should be based on honour and mutual respect such that no one partner is compelled or forbidden from working on the project. Each partner should permit and issue a power of attorney to allow other partners to use the capital in a necessary manner for the purpose of conducting business. However, the sharia law also permits one of the partners to carry out full responsibility of the project as long as he or she is authorised by other partners. The sharia laws also consider each partner as a trustee of the joint venture’s funds and should be held responsible of the use of such funds. 

The Islamic laws also require the partners to avoid uncertainties (gharas) by ensuring that the share of profits for each partner is known. The sharia law also recognises the necessity of equal distribution of returns using percentages rather than fixed sums. One of the principles of Musharaka is the sharing of profits in proportion to the capital contributions of each member. However, some Islamic jurists may allow variations in profit shares provided that the partners have agreed on the terms and amount of the profit shares. For example, one of the partners may have unique business management skills or competencies that yield a lot of profits for the business. In such a scenario, the more skilled party may demand a bigger share of the profits; and if the other members accept the terms, the courts will allow the disparity in profit shares.

Another sharia rule on Musharaka suggests that financial-related partnership should be in the form of a nonbinding and permissible contract such that members accept to join and rescind the agreement freely as long as partners are aware of the arrangement. A partner may lose his interests in the partnership if he or she rescinds the partnership agreement without informing the other members. In some cases, the partnership becomes binding until the purpose for which the partnership was created is accomplished, or up to the liquidation of capital. 

Based on these sharia rules, an Islamic bank acts as a financial partner of investors and clients in the specific projects or assets with a given forecast of income. The investor or partner make an agreement with the bank, specifying the share of profits of each party. However, the agreement may require the partner to pay the principal amount of the loan from the proceeds of the project and keep the rest of the income. A special form of Musharaka called the Diminishing Musharaka requires Islamic banks to enter into contracts with customers to offer loans for the funding of projects, and payments paid in instalments for an agreed period of time; thus reducing the bank’s equity progressively until the partner buys back all the partnership interests of the bank, leaving him as the owner of the property. 

Musharaka is often applied in the financing of a house. A customer who wants a house but cannot afford one can approach an Islamic financial institution that is willing to partner with him or her to purchase the house. For example, the customer may pay 20% of the total cost of the house and the bank pays 80%; hence the bank owns the highest value of the house, and pays rent for using the bank’s share of the house. The house may be divided into eight equal units of 10% ownership, and the client buys each unit after an agreed period of time until the whole house is purchased. 

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Mudaraba Contract

Under sharia laws, Mudaraba is based on a profit and loss sharing (PLS) approach in which the two parties share profits and losses on an agreed ratio. It is a form of partnership that one partner, usually a bank, provides the funds, and the other partner (client) provides the expertise and management of the project; and both parties share the returns from the project, but the provider of the capital suffers all the losses. In this case, the bank is an investor with a stake in the customer’s investment projects. This approach of financing enables a poor but competent entrepreneur to acquire funds for viable projects.

The Mudaraba contract is based on the Islamic principle that the entrepreneur should be not be concerned with servicing debts; but rather concentrate on building a long term project that will potentially provide social and economic benefits to the parties as well as communities. This contract is fair to the parties involved because it does not allow any party in the contract to exploit the other parties; hence reflecting the ideals of Islam in relation to economic and social equality, and fair redistribution of resources. 

Based on the sharia laws, one of the characteristics of Mudaraba is that both parties of the contract enjoy proportional share of profits, but not guaranteed returns or lump sum amounts. Furthermore, the investor cannot lose more than the amount he or she contributed to the partnership; while the Mudarib does not incur losses except the effort and time spent in building the project. The Mudaraba and Musharaka offer an opportunity for the capital owner to invest without participating in the management of the investment or being exposed to unlimited liabilities. The Islamic finance contracts differ from conventional banks because they enhance a balance between the owner of the capital (bank) and the business person who implements the project. The problem with these contracts is that the principal amounts and profits cannot be guaranteed. If the business fails, the bank cannot be able to recover its capital investment because it does not charge interest.

Murabaha Contract

Murabaha is a contract involving the profitable sale of an asset in which the bank buys the asset and sells it to the borrower at a higher price. The additional payment reflects the interest that would be paid for the loan. Due to the profitable sale of the asset, this contract is the most consistent Islamic finance contract with the conventional housing financing system. In Shamil Bank of Bahrain Vs Beximco, the court argued that Murabaha agreements should be instituted in Islamic banks to allow firms to successfully claim for liability from banks that charge interest. A bank that purely operates under Islamic contracts must state in their governing clauses and agreements that they are bound by the sharia laws. Any contract between the bank and client specifying that the partners will share profit under the sharia laws restricts banks from charging interests.

The Murabaha contract is applied in housing finance whereby a bank buys a house by from the seller and sells it to the customer at a higher price. This plan was introduced in Pakistan in 1997. For example, the Ahli United Bank has a house finance scheme called the Manzil House Purchase Plan which follows the principles provided by the sharia laws. Once the customer identifies the house to purchase and agrees the buying price with the seller, he fills a form requesting for financing from Manzil Bank. The bank then buys the property and immediately sells it to the customer at a profit. The selling price of the house is determined by the property’s value, the term period of the contract, and the amount that the customer is willing to pay as down payment. After purchasing the property, it is registered under the customer’s name and recorded. The customer starts to pay his monthly instalments one month after the purchase is completed.

This type of Islamic finance contract is relevant to the sharia laws because it avoids the charging of interest in loans. Rather than giving out money to finance the house at an interest like in conventional banks, Islamic banks purchase property for resale. Sharia laws suggest that a bank should not make money out of money. Under Mubaraha, the bank makes money out of property rather than loaning money at an interest. In this regard, the trade in property between the bank and the customer is a profitable business like any other commercial transaction; hence it is a project that helps the bank generate money, employ people, and grow. The program also helps the bank to use its money in a productive way by spending it on property rather than leaving it idle; hence distributing resources to other sectors in the community; hence achieving equal distribution of income as required under Islamic ethics.

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Discussion and Analysis

The four types of Islamic finance contracts operate as commercial or partnership contracts in which the bank and the customer benefit from transactions in compliance with the Islamic sharia laws, Islamic ethics, and economic progress. Unlike conventional banks that offer loans on interest, Islamic banks do not offer interests on loans. The sharia laws provide various prohibitions including prohibitions of interests (riba), risk-taking and uncertainty (gharar), and money hoarding. The Islamic finance contracts operate in compliance with these prohibitions by allowing the banks to partner with customers in sharing profits; or buying properties and selling them to customers at a profit as in the Mubaraha contract.

Most Islamic economists and researchers have proposed the use of partnership-based financial instruments such as musharaka and mudaraba contracts to strengthen Islamic economics and ethics. Islamic sharia laws based on the principles of Quran prohibit interest, but allow partnerships and profits. In this regard, Islamic contracts focus on partnerships and profit sharing as appropriate means of distributing resources in the economy to fund important projects. Profits are encouraged in Islam because they lead to the growth of the economy, employment, and distribution for charitable courses to help the needy members of society. Furthermore, the partnership-based contracts allow banks to contribute towards social and economic equality by sharing profits and losses with debtors instead of burdening the industry with fixed interest rates.

The Quran which is the source of Islamic beliefs and teachings gives legitimacy to partnership-based and interest-free financing in Islamic banks. Profit and loss sharing partnerships (PLS) in Islamic finance allow parties to share the benefits of a venture; hence preventing exploitation of one party on other parties. Both parties also share risks so that the bank and the customer share the losses incurred, leading to equality in terms of economic distribution. In conventional banks, the bank recovers its capital regardless of whether the business succeeds or not; hence the customer bears all the costs and risks involved in the project. Profit-sharing approach in Islamic finance contracts such as Musharaka and Mudaraba conforms to the teachings of Islam because they allow partners to support each other in implementing joint ventures and sharing misfortunes and benefits of the project. In this regard, both partners participate in the profit sharing.

Islamic sharia scholars also argue that risk-sharing is one of the economic wisdoms of Islamic finance contracts because they solve the problems of risk-taking behaviours usually experienced in conventional banks. For example, prior to the 2008 crisis U.S. banks offered a lot of mortgages to real estate developers without exercising care in establishing creditworthiness of customers due to the ballooning demand in the industry. As a result, the financial sector collapsed. Managers in conventional financial institutions also use various financial instruments such as forwards and futures to take advantage of uninformed investors and charge high interests at the expense of customers.

The prohibitions of interests and uncertainties in the banking sector also allows Islamic banks to provide finance contracts that comply with Islamic ideals. Islam places moral regulation on the economic behaviour of Muslims. In compliance with these moral principles, Islamic finance contract emphasise risk-sharing, profit-sharing and equity-based financing to promote social justice and equal distribution of income. Rather than putting people into debts, Islamic banks should help them meet their needs for survival. In this regard, Islamic finance contracts allows banks to offer-interest free loans and share profits for the purpose of supporting the less fortunate members of society. By charging interest on loans, conventional banks fail to offer the required support for those who are not able to access resources. Islamic finance contracts also prevent the hoarding of money as required in Islamic ethics by investing in joint ventures with customers or buying assets for sale through the Murabaha contract; hence achieving income redistribution in various economic and social activities to boost community development and improved purchasing power and living standards of the communities.

Despite these positive implications of Islamic finance contracts on income distribution and social justice, the courts often face challenges in enforcing sharia laws due to its contradictions with the laws of England. For example, in the case of Shamil Bank of Bahrain Vs Beximco, the Bank and the client signed Murabaha agreements in which a governing clause suggested that the agreement shall be governed by the laws of England subject to the principles of the Glorious Sharia. The borrower defaulted because the bank charged disguised interest on the loan against the rules of Islam. However, the court ruled that the sharia laws were not applicable in the Murabaha because it was not the intention of the parties to apply the principles of sharia. In this regard, the legal jurisprudence of the Islamic and English laws should be considered when drafting Islamic finance contract agreements to ensure that the agreements show the intention of partners to rely exclusively on the sharia principles.

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There are four types of Islamic finance contracts that promote the sharia principles of charitable endowment and giving, interest-free loans, profit-sharing, and uncertainty avoidance. The Musharaka and Mudaraba contracts are based on a profit-sharing approach in which the bank and the customer contribute capital to establish a joint venture and share the profits and losses of the project in an agreed ratio. These profit-sharing contracts prevents banks from taking risks, and enables them to participate in profit and loss sharing to enhance redistribution of income. The Ijara also complies with the Islamic principle of interest-free loans by requiring banks to lease property to customers subject to payment of rental instalments for a given period of time, rather than offering fixed rates of interests on loans. Furthermore, Murabaha prevents banks from hoarding money and charging interests on loans. This form of contract allows banks to buy property and sell them to customers at a profit rather than offering loans for interests. Islamic sharia laws prohibit Muslims from using money to make money; so the Murabaha contract encourages profit-making business to help banks participate in economic redistribution rather than hoarding money or using it to make more money. Overall, the Islamic finance contracts comply with Islamic principles of market-based risk sharing to enhance asset and enterprise development, finance deployment into real economic activities, and redistribution of income and wealth.

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