Shariah and Law in Relation to Islamic Banking and ... - UM Repository

Shariah and Law in Relation to Islamic Banking and Finance Sherin Kunhibava* & Shanthy Rachagan** Islam has a unitary approach to life. It does not put the various aspects of human behaviour into water-tight compartments. It considers man as an integral whole. In other words, the numerous functions that he or she performs, e.g., economic, political, social and religious, are not independent of each other. In the economic field, activities are conditioned by social milieu, moral values, cultural heritage, and above all by religious beliefs. It is therefore said that the word religion being just one aspect of life among many others is an insufficient translation for the Arabic term deen, which is often used to characterise Islam. — “Islamic Banking in Europe — the Reintegration of Faith and Economy” Rashid Mengers, the Assistant Director of the Institute of Islamic Banking and Insurance in London, 5th SLIM Annual Lecture, Wednesday, May 15, 2002, Southwark Cathedral.

This article is devoted to exploring the two sources of laws that governs Islamic banking and finance. It starts off by explaining the sources of Shariah and the sources of conventional laws, and comparing the two. Thereafter the fundemental principles of Shariah that governs Islamic banking and finance are highlighted. Lastly, a country case study will be done to show how the country has accomodated their laws to incorporate Shariah to govern Islamic banking and finance. The country chosen is Malaysia. Malaysia is chosen because of its advanced position in Islamic banking and finance and because of its comprehensive legal and regulatory dual system, that is where conventional banking and finance functions parallel to Islamic banking and finance.

Cet article est consacré a` l’examen des deux sources de lois qui régissent les domaines bancaire et financier du monde islamique. L’auteur décrit d’abord les origines de la charia et les origines des lois conventionnelles, puis compare les deux. Les principes fondamentaux de la charia relatifs aux domaines bancaire et financier du monde islamique sont ensuite mis en e´ vidence. Une e´ tude de cas démontre comment le pays visé par l’étude, soit la Malaisie, a composé avec ses lois afin d’intégrer la charia en vue de régir les domaines bancaire et financier. La Malaisie a e´ té retenue pour cette e´ tude a` raison de sa position avancée

* **

Sherin Kunhibava PhD is a Senior Lecturer at University of Malaya. Shanthy Rachagan PhD is an Associate Professor at Monash University.

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dans le monde islamique, relativement aux activités bancaires et financières; le caractère complet de son double système législatif et réglementaire y permet au système traditionnel des mondes bancaire et financier de fonctionner en parallèle avec les systèmes bancaire et financier du monde islamique.

1. INTRODUCTION Conventional banking and finance as we know it today, is governed by the laws of a nation, that is legislation passed by the State and common law decisions made by judges when there is a lacuna in the law (collectively named as conventional laws in this article). Islamic banking and finance on the other hand, is governed by two sets of law, one divine Islamic law (Shariah) the other man made (conventional laws). This article is devoted to exploring these two sources of laws that governs Islamic banking and finance. It starts off by explaining the sources of Shariah and the sources of conventional laws, and comparing the two. Thereafter the fundemental principles of Shariah that governs Islamic banking and finance are highlighted. Lastly, a country case study will be done to show how the country has accomodated their laws to incorporate Shariah to govern Islamic banking and finance. The country chosen is Malaysia. Malaysia is chosen because of its advanced position in Islamic banking and finance and because of its comprehensive legal and regulatory dual system, that is where conventional banking and finance functions parallel to Islamic banking and finance.

2. SHARIAH AND CONVENTIONAL LAW Shariah literally means “the way to a watering place”.1 It is the path that must be followed by Muslims, and governs man in conducting his life in order to realize the Divine Will. It includes all forms of behaviour — spiritual, mental and physical.2 There are four fundamental sources of Shariah law: the Holy Book — AlQuran, the hadith, ijma and qiyas.3 The first source is the Islamic Holy Book called Al-Quran. The Holy Quran is the original and eternal source of Shariah law. It constitutes messages that Allah (swt) inspired the Prophet (pbuh) to relay for the guidance of mankind. These messages are universal, eternal, and fundamental.4 The hadith, the second foundation of Shariah, is next in importance to the AlQuran. It is a piece of information, such as an account, narrative or story and constitutes a record of the Sunnah of the Prophet (pbuh), handed down from generation to generation and which has become the rules of faith and practice of Muslims. The Sunnah (pl. sunan) signifies the custom, habit, or usage of the Prophet (pbuh). It designates his behaviour, mode of action, his sayings and declarations under a variety of circumstances in life.5 1 2 3 4 5

Abdur Rahman I. Doi, Shariah the Islamic Law (A.S Noordeen, 1984) at 2. M.A Laldin, Introduction to Shariah and Islamic Jurisprudence (Cert Publications, 2006) at 3. Doi, supra, n. 1 at 7. Laldin, supra, n. 2 at 56. Ibid., at 75.

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The third source of Shariah law is the ijma. Ijma means a consensus of opinion of the mujtahids (the learned scholars of Islam), or an agreement of the Muslim jurists of a particular era on a question of law.6 Qiyas is the process of reasoning by analogy of the mujtahids with regard to certain difficult and doubtful questions of doctrine or practice, by comparing them with similar cases already settled by the authority of the Al-Quran and Sunnah and thus arriving at the solution of undecided questions.7 As for conventional law, there are two defined sources of legal jurisdictions, known as the Common law legal system and the Civil law legal system. Whether a jurisdiction follows a Common law legal system as opposed to a Civil law legal system typically depends on the historical background of a nation. Common law systems usually descend from the English legal system, and therefore all Commonwealth countries have Common law systems.8 Common law systems place emphasis on judicial decisions, which are considered “law” just as are statutes.9 Civil law jurisdictions, on the other hand, descend from Roman law through either the Napoleonic Code or the German Civil Code and also from Canon law. Roman law itself evolved in Rome before the Christian era. Canon law, on the other hand, is the body of laws and regulations made by or adopted by ecclesiastical authority, for the government of the Christian organization and its members.10 Under Civil law jurisdictions case law was traditionally given less weight. However, it would seem that the distinction between the two systems is becoming blurred as the importance of judicial decisions in civil jurisdictions are increasingly being given more weight and with the growing importance of statute law and codes in Common law countries.11 While the Civil law system descended from Roman law and Canon law, Common law is vaguely described as having been developed and institutionalized from the 11th to 12th centuries at the time of King Henry I and II.12 However Makdisi,13 believes that the origins of Common law are actually from Islamic law, due to the uniqueness of Common law which is separate from any other European legal system, including Roman law and Canon law, but has similarities with Islamic law. Nevertheless, it is safe to say that Common law and Civil law share common characteristics. They both deal with the interpretation of man-made laws whether it is

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Ibid., at 91. Ibid., at 97. R. W. Lee, “The Civil Law and the Common Law: A World Survey” (1915) 14 Michigan Law Review. “On the American Continent the Civil Law and the Common Law exist side by side. The former prevails in the south, the latter in the north” at 93. Roderick T. Long, “The Nature of Law, Part III: Law vs. Legislation” online: . A. Boudinhon, “Canon Law” Robert Appleton Company (1910), online: . Lee, supra, n. 8 at 90. George Burton Adams, “The Origin of the Common Law” (1924) 34 The Yale Law Journal 116-117. John A. Makdisi, “The Islamic Origins of the Common Law” (1999) 77 North Carolina Law Review 1638.

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case law or statute. On the other hand, Shariah deals in religious matters and God-made laws, and therefore differs from Common law and Civil law in that respect. However, it is not a religious law the way Canon law is. Shariah deals not only with purely religious matters but also with all those subjects which comprise the content of Common law and Civil law systems. Shariah comprises of three basic elements, namely, aqidah, fiqh and akhlaq.14 Aqidah concerns all forms of faith and belief in God Allah (swt) and His will, held by a Muslim. Fiqh is concerned with governing the relationship between man and his Creator and between man and man (fiqh will be further defined below). Finally, akhlaq covers all aspects of a Muslim’s behaviour, attitudes and work ethic with which he performs his practical actions.15 It is with the Shariah branch of fiqh that Islamic finance is governed. Fiqh can be further divided into two areas called ibadat and muamalat. Ibadat is concerned with the practicalities of a Muslim’s worship of Allah, whereas muamalat is concerned with man-toman relationships. Nevertheless, aspects such as political activities, economic activities and social activities fall within the ambit of muamalat.16 Islamic finance, being part of economic activities, is thus linked with Shariah principles through muamalat. Injunctions relating to aqidah, ibadah and akhlaq are fixed and unchangeable as they are considered to be suitable to be implemented at all times and places. However, injunctions of Shariah which regulate the relationship between man and man and other creatures may change with the changes in circumstance, custom, time and place.17 This includes rulings relating to muamalat such as contractual law transactions, criminal law, the judiciary and Islamic finance. It is this feature of Shariah that makes it suitable to be implemented at all times as it can accommodate the needs of people in different times and situations.18 The rulings in relation to muamalat are derived from the sources of Shariah. However, due to the changing circumstances of the world and the needs and interests of the people (maslahah) many of the legal injunctions had to be formulated from the sources of Shariah through reason by rightly qualified Muslim Jurists. This is known as ijtihad, that is, “exerting one’s reasoning faculty to determine a point of law.”19 During the time of the Prophet Mohammad (pbuh), the Qur’an was clarified and exampled by the Prophet. After the Prophet’s death and the death of the Sahaba (Companions), Muslims confronted a number of difficult questions with the spread of Islam into new cultures and lands.20 There was a need for proper guidelines on how to derive law from Islamic sources. Thus, law schools arose (or madhab) which developed a comprehensive set of methodologies on how to inter-

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Laldin, supra, n. 2 at 4. S. Haron, Islamic Banking, Rules and Regulations (Pelanduk Publications, 1997) at 18. Ibid., at 18-19. Laldin, supra, n. 2 at 8, see explanation on fiqh. Ibid., at 11. Irshad Abdal-Haqq, “Islamic Law: An Overview of its Origin and Elements” (1996) 1 Journal of Islamic Law 9. Ibid., at 44.


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pret Shariah.21 The process of applying and deducing laws from Shariah and the laws thereby deduced is collectively known as fiqh. There are four madhab or schools of law for Sunni Muslims.22 The teachings of each school depends largely on the geographical area, although there is a scattering of the followers of all four schools in most of the Muslim world.The four madhabs23 are the Hanafi, Maliki, Shafi’i and Hanbali. Since the 10th century the main law-making activity had ceased, and activity of the jurists remained limited to interpretation and explanation of the existing doctrines, bringing it up to date with life as conditions changed, because it was believed that any principle that could be deduced by ijtihad had already been deduced or extracted.24 After this time any new decision or fatwa (legal opinion) was based on previously recorded determinations made by a particular madhab. This concept is known as taqlid or conformity and is sometimes compared to the concept of stare decisis or judicial precedent in Common law.25 However many well known

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Ibid., at 45. Approximately 90 percent of the Muslims in the world are Sunni while the remaining are Shia. The differences between the two are basically that the Shia principally in Iraq, Iran, Lebanon and Syria, believe that the leadership of the Muslim community the Caliph must be from the Prophets lineage, they await the emergence of a Muslim leader from the line of the Prophet who will embody wisdom and spiritual power of the twelfth Imam. Until that time his representatives, the ayatollahs provide interim leadership. As for the Sunni they do not believe that physical lineage is necessary to be a Caliph. The second difference is that the Shia continue to believe ijtihad (personal reasoning) as a legitimate source of Islamic law, whereas Sunni Muslim prohibit the current use of ijtihad. Abdal-Haqq, supra, n. 19 at 51-52. This article will focus on the legal opinions from the Sunni school of law. The Hanafi school was formed in Kufa, Iraq, under Abu Hanafi who lived from 702 to 767. It preserves many of the older Mesopotamian traditions. It based its rulings largely on ra’y — results of logic deduction of its scholars. Suzy Ashraf, On the Islamic Schools of Law. (n.d.), online: essays. The Maliki school comes from Medina, under Malik ibn Anas ibn Amir who lived from 717 to 801. This school ruled heavily in favour of the practice (sunnah) of the local community of Medina, because at the time it was formed, the word sunnah did not yet mean “practice of the Prophet” Ashraf. Muhammad Idris ash-Shafi’i (760 to 820 in Egypt) was the first one to systematize Islamic Law. Originally, he studied in Madina under Malik ibn Anas ibn Amir founder of the Maliki school. In his book, the Risala (the Message), balancing the two trends, he laid down the sources of Law, Fiqh. He fixed them (in order of priority) to be: Quran Sunnah of the Prophet, based on: Hadith from the Prophet Hadith from the Companions of the Prophet Ijma and Qiyas Abdal-Haqq, supra, n. 19 at 49. Ahmad Ibn Hanbal from 778 to 855 founder of the Hanbali school, the latest of the four madhabs had followed Shafi’i method with ever greater emphasis on the ahadith, avoiding reasoning as far as possible, but not completely denying it. Thus, the difference between the schools is primarily in the various weight given to those four components, and in some original decisions remaining from the very beginnings of these schools, and belonging to its first masters Ashraf. Abdal-Haqq, supra, n. 19 at 26. Ibid., at 37.

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scholars have argued the relevance and importance of ijtihad in modern times (see Doi26 and Kamali27). Therefore, finding the injunctions of Islamic law requires reference to not only the sources of Shariah but also the books of fiqh. Legal opinion of scholars in Islamic finance often refers back to these sources of law when formulating an opinion on the permissibility of a contract or instrument in Islamic finance. Another significant feature of Islamic law which differentiates it from conventional law is the fact that not all acts done under Shariah are characterized as legal or illegal. There are intermediate values as to a person’s action.28 There are generally five categories of assessment. These are acts that are:29 i) obligatory, where performance will amount to a reward and omission will amount to a punishment from God; ii) recommended, performance of act is rewarded but neglect is not punished; iii) permitted, acts which neither get reward nor punishment; iv) discouraged, acts where there is a reward for avoidance but no punishment for performance; and, v) forbidden, where there is reward for avoidance and punishment for non avoidance. While in other legal systems an act might be allowed, prohibited or indifferently treated, in Shariah an individual is not only guided as to what he is “entitled or bound to do in law, but also what he or she ought, in conscience, to do or refrain from doing”.30 In other words Shariah encompasses legal injunctions and moral or ethical injunctions whereas conventional law is concerned with legal issues alone. Thus Shariah encompasses religious laws and laws other than those based on religion. It is derived from the Quran, Hadis, Ijma and Qiyas. The process of applying and deducing laws from Shariah and the laws thereby deduced is collectively known as fiqh. Shariah is unwritten law like Common law. Common law systems and Civil law systems, on the other hand, both involve the interpretation of statutes and case law; they vary only in the degree of the weight given to either statute law or case law. Next this article discusses the main fundamental injunctions in Shariah which govern Islamic banking and finance.

3. FUNDAMENTAL INJUNCTIONS IN SHARIAH Islam permits and encourages its followers to become involved in trade activities. As stated in the Quran in verse 275 of Surah 2: “‘Trade is but like usury’, but

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Doi, supra, n. 2 at 80-81. M.H Kamali “Prospects for an Islamic Derivative Market in Malaysia” (1999) 4 Thunderbird International Business Review 539. Abdal-Haqq, supra, n. 19 at 42. Ibid., at 42-43. Gamal Moursi Badr “Islamic Law: Its Relation to Other Legal Systems” (1978) 26 The American Journal of Comparative Law 189.


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God hath permitted trade and forbidden usury.”31 The Prophet (pbuh) in his early life used to be a trader, and, similar to many of his eminent companions, a businessman. The Prophet (pbuh) was once conferred the title of “amin” or “trusted one” because of his honesty in all dealings.32 Likewise the principles of Islamic business include honesty and the belief that trade is to be conducted in a faithful and beneficial manner. Trade manipulations and malpractices aimed at earning undue profit through operations like hoarding, blackmarketing, profiteering, short-weighting, hiding the defective quality of merchandise, and adulteration cannot be regarded as honest trade.33 To ensure honesty, transparency and ethical dealings in trade, fundamental injunctions were established in Shariah, such as the prohibition of riba, gharar, maisir, qimar and jahala. These injunctions are the fundamental principles governing Islamic banking and finance today. These are described in greater detail below.

(a) Riba, Usury and Interest The giving and receiving of riba is strictly prohibited in Islam. Literally, riba means increase, addition, expansion or growth.34 However, not every increase or growth is prohibited in Islam; the prohibition is related to the manner through which an addition is gained.35 Riba, with regards to Islamic finance is taken to mean interest paid to depositors and interest charged upon fund users, and is strictly prohibited in Islam.36 Interest itself is defined as “an amount, or fee, payable for loaning money to the borrower; interest is usually expressed in a percentage.”37 The prohibition of riba is not a new phenomenon. Until a few hundred years ago any extra amount demanded by the lender in addition to his capital was called usury. Early European philosophers such as Plato (350 BC)38 and Aristotle (350 BC)39 condemned the practice of taking usury. Further, the issue of riba is an old

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Translated by, Abdullah Yusuf Ali, The Holy Quran Original Arabic Text with English Translation and Selected Commentaries (Saba Islamic Media, 1999). Haron, supra, n. 15 at 13. Ibid., at 13. Mohd Daud Bakar, Riba and Islamic Banking, 1–21, online: at 5. Ibid., at 6. Muhammad Taqi Usmani, “The Text of the Historic Judgment on Interest [14 Ramadan, 1420]”, Supreme Court of Pakistan (1999), online: