International Journal of Islamic and Middle Eastern Finance and Management

The internal challenges facing Islamic finance industry

Abdulazeem Abozaid
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Abdulazeem Abozaid , (2016),"The internal challenges facing Islamic finance industry", International Journal of Islamic and
Middle Eastern Finance and Management, Vol. 9 Iss 2 pp. -
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 The Internal Challenges Facing Islamic Finance Industry

Introduction

Since its start, Islamic finance industry has been facing various challenges. Some of these
challenges are external and are of legal nature, and they result from failure to recognize the
special nature of Islamic banking and finance as an industry that cannot sell cash but rather
assets and services. For example, some jurisdictions do not allow Islamic banks to trade in
assets, while other laws allow Islamic banks to own assets but impose some taxes upon every
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transfer of asset title. This has forced some banks tend to avoid payment of taxes by reducing
some necessary contractual steps, which potentially raises some Shariah concerns. Laws may
also prohibit banks from leasing assets to clients and therefore, Islamic banks are left with no
choice but to dodge and execute Ijarah (lease) in the form of sale. Besides, the market of a
vital Islamic capital market tool like sukuk is not yet regularized to the full extent due to
various legal constraints. Furthermore, many courts do not recognize Islamic law (Shariah)
while dealing with disputes relating to Islamic finance. Notwithstanding the seriousness of the
above-mentioned legal challenges, Islamic finance is also facing internal challenges that may
put at stake its credibility and pose a more serious threat to its long-term success and its very
survival. These challenges come from inside the industry and cannot be blamed on external
factors. They include ones pertaining to the lack of enforceable robust Shariah governance,
creating thus an avenue for fatwa (Shariah opinions given by Shariah scholars) shopping and
invasion of some controversial products. In addition, they also relate to the methodology used
in Islamic banks in structuring their financing products since this methodology has yielded a
number of products borrowing their legitimacy from the mere adherence to certain useless and
perplexing technicalities, only to make them look different from their conventional
counterparts. Such challenges necessitate a diligent approach to Shariah endorsement of
products and transactions, especially with the growing Shariah awareness of the average client
and the existence of unprecedented court cases of Shariah-compliance nature. The following
discussions address these internal challenges by first highlighting the deficiencies in the
existing Shariah supervisory work and then the deficiencies in the product-development
methodology followed in Islamic banks.

1
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 I. The absence of a proper Shariah governance

It is no secret that Islamic finance is facing challenges related to lack of proper and effective
Shariah governance and that the industry of Islamic banking and finance has been regulating
itself since its start, without the supervision or intervention of genuinely independent
authorities. AAOIFI (Auditing and Accounting for Islamic Financial Institutions) is a
regulatory authority from within the industry, and it has introduced a standard for Tawarruq1
though this product has been ruled as categorically unlawful by the Fiqh Academy; the largest
representative of the cotemporary Shariah scholars! IFSB (Islamic Financial Service Board),
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another regulatory authority from within the industry, has dodged the issue of setting
governance rules for Shariah boards to weed out the unqualified Shariah supervisory board
members (Aljarhi, 2009). This shows that the self-regulation of this industry has been
unpractical and unreliable. The intervention of central banks has also proved unsuccessful,
because the core problem Islamic banking is facing relates to the credibility of its products
and their resemblance to the conventional banking products. Naturally, central banks will not
be pleased with Islamic banks offering genuinely Islamic products, because these products
will then inherently carry various business risks. Therefore, a balanced Shariah regulation is
required, and the full independence of any potential Shariah regulatory authority from the
Islamic financial institutions is a must.

The basic elements of Shariah governance

Shariah governance involves a variety of issues; the focus in this paper will be on two basic
elements: Islamic banking products and Shariah control.

1. Islamic banking products and transactions

What necessitates subjecting Islamic banking and finance products to Shariah governance is
the invasion of many controversial products as well as the unjustified conflict in endorsing the
products. The same Islamic banking or financial product could be deemed lawful and
permissible in one bank but unlawful and as conducive to Riba (usury/interest) in another!
This is simply due to having differences in the views of each bank's Shariah board. It is true

1
Tawarruq is basically a sale used as a legal device to indirectly deal in Riba (usury/interest).

3
 that the traditional Fiqh (Islamic law) schools had differed in many areas of Islamic law, but
never had their differences reached this level of clash and conflict, especially in the Riba
related matters. Schools of Islamic law did differ in validating certain Riba-related
transactions to the extent of the ability of such transactions to produce their legal
consequences, but they never differed in deeming the permissibility (non-sinfulness) of the
contract conditional on the essence of the contract or the intention of the contractors.2

Furthermore, some of what was perceived in the early stage of Islamic finance as
‘unIslamiseable’ due to its essence being in blatant conflict with the principles of the Shariah
entered latter the sphere of Islamic finance and received Shariah endorsement in some
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institutions. Examples can be found in the many financial derivatives that attracted the
attention of many Shariah advisory firms to turn them into allegedly Shariah-compliant
speculating instruments! 3

Besides introducing products that were unperceivable Shariah-wise before, some Islamic
financial institutions have loosen up rules they set before. For example, the 5% benchmark set
for tolerating the unlawful income in stock trading or REITs has been increased to 10%.
Similarly, the 30% benchmark set for the assets composition ratio of the tradable assets to the
total assets, in order for Sukuk (Islamic Bonds) or stocks to be tradable, has been reduced in
more recent standards to 10%! (Al-Jarhi, 2009; Abozaid, 2012). This subjective and
unjustifiable leniency towards Islamic finance rules has raised more doubts as it became
evident to the public that such rules were groundless and lacked textual evidences.

Hence, the volatility and conflict in fatwas pertaining to Islamic banking and finance products
have created confusion in the minds of the public and triggered some suspicions over their
legitimacy. Based on recent surveys, a wide spectrum of Muslims refrain from dealing with
Islamic banks altogether or avoid some of their services for the said reasons. Other Muslims

2
For more details on this issue and the difference between a valid contract and a permissible contract see “Ilam
al-Muwaqi’een” by Ibn al-Qaiyyem 3/200; "Contemporary Islamic Financing Modes between Contracts
Technicalities and Shariah Objectives", Journal of Islamic Economics Studies, Islamic Research and Training
Institute, Islamic Development Bank, Volume 17, No2. Jan, 2010.
3
For examples on the attempts to Islamize derivatives see “Shariah Analysis of Financial Derivatives”. Islamic
Economic Research Journal, Volume 27, No 3, 2014.

4
 deal with Islamic banks not out of confidence in them but rather as a commission of the lesser
of the two evils, the other evil being dealing with conventional banks.4

In fact, the intellectual discourse on Islamic banking reflects a deep disappointment, concern
and an increasing resentment. A lot of the writings on Islamic banking and finance critically
address issues like the ethics and morality of Islamic banking. Several academic institutions
have introduced courses on Islamic finance and the general Maqasid (objectives) of the
Shariah to critically review the performance of Islamic finance in light of the established
objectives and philosophy of Islamic law.
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The said resentment and concern over the ethical performance of Islamic banking and finance
is more evidently manifested in the recent themes selected for the academic conferences on
Islamic banking and finance. Among these themes are ones like: “Islamic Finance: Reality v.
Expectations”; “The Social Responsibility of Islamic Banking & Finance”. Such themes
reflect a huge perplexity and concern over the performance of Islamic banks among the
educated class, and that if Islamic banking products could have been somehow technically
labeled Shariah compliant, then there is something beyond the Shariah technical requirements
in finance; it is the essence and spirit of this finance which until now has been far from
achieving the social justice believed to be imbedded in the Islamic economics system.

In conclusion, it can be said that with the increasing contrast and conflict in endorsing Islamic
financial products from one side, and with the increasing resentment of the public towards
such disorder, standardization of Islamic banking products has become critical to restore and
maintain the credibility of Islamic banking and finance. However, the standardization has to
be limited to the products only and it cannot be extended to the day-to-day transactions of the
Islamic financial institutions, because most of these transactions are tailored according to the
requirements of the clients and in consideration of the special conditions governing these
transactions. Nevertheless, certain contracts may be fundamentally ruled as unlawful to be

4
Surveys conducted in different countries have shown that Islamic banks' customers and people in general have
many doubts over what is marketed to them as Shariah compliant products. See for example, Rahman (2012)
(Survey done in UK).

5
 used as underlying contract in structuring any transaction. These include the contracts that are
commonly used as subterfuge to Riba, like eina or tawarruq. 5

Finally, standardizing products can be handled by some existing regulatory authorities like
Fiqh Academy or by AAOIFI after restructuring these authorities in a way that ensures
professionalism, scholarship, integrity and full independence. Then, some mechanism needs
to be worked out to get the Islamic banks and financial institutions to abide by the
standardized products, preferably by the force of law; but if not feasible then by blacklisting
the non-abiding banks.
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2. Shariah control and supervision

Logically, Shariah control over Islamic financial institutions is supposed to be a legal

requirement in every institution to ensure the compliance of the institution’s activities with the
rules of Shariah. However, Shariah control in many countries has been left to the discretion of
the Islamic financial institutions, and the interference of the higher authorities has been
technical and superficial, which means that the Islamic financial institutions have effectively
been self-regulated in terms of Shariah control.

Being self-regulated, Islamic financial institutions have exercised self-Shariah control only to
the extent that would enable them to market themselves as institutions complying with
Shariah rules. This requested banks to hire some people known to be Shariah specialists to
execute some Shariah supervision and audit. These Shariah controllers would be requested to
basically review the products and activities of the financial institutions and supervise the right
implementation of their fatwas and pronouncements.

However, although the above arrangement seems to be fine and acceptable, it harbors in fact a
lot of avenues to manipulation and deviousness to realize the self-interest of these institutions.
This starts from the selection of the Shariah supervisory board members when banks naturally

5
Eina is a sale that is mostly resorted to for the purpose of circumventing the prohibition of riba by
selling a commodity to the person seeking financing at a deferred price then instantly buying it back at
a lesser spot price. Tawarruq is to purchase a commodity from one party on credit then sell it
immediately to another for cash. Thus, tawarruq shares the same objective of eina as both are meant
for extending cash money. However, Tawarruq remains technically distinguished from eina as in the
later the commodity is resold to its original seller, while in tawarruq it is sold to a third party.
6
 tend to hire those who are known in the market to be lenient, influential but not necessarily
competent. Then it is the same banking institution that is effectively capable of dismissing or
replacing a Shariah board member to its own convenience. Besides, all internal Shariah
auditors or compliance officers effectively report to the management of the bank. These
practices combined would create conflicts of interest and render Shariah control work neither
independent nor transparent, and it would open the door to the manipulation of the Shariah
control work to realize the self-interests of the banks.

This, in fact, explains why Shariah supervisory boards are dominated by a very limited
number of Shariah specialists, despite the existence of a huge number of highly-qualified
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Shariah scholars and specialists worldwide.

Therefore, in order to tackle this problem it is necessary to break the bond of interest or the
marriage of convenience between bankers and Shariah scholars and to also ensure the genuine
independence of the Shariah control personnel. Doing so would put things in perspective and
make Shariah control work in line with the general norms of Shariah. In fact, it is
unprecedented in Islam that one whose job is to pronounce binding Shariah rules is selected
and paid by the same entity bound by those rules.6 The judge in Islam, for example, can never
be selected by those who are to be bound by his judgments nor can he be paid or even gifted
by them. Obviously, Islamic financial institutions are bound by the pronouncement of their
Shariah boards but oddly enough, they are the ones who select them, dismiss them and pay
them salaries! In fact, it is very wrong to consider these pronounces as merely Shariah advises
or even fatwas,7 because unlike the advice or the fatwa, these pronouncement bind the
institutions. Besides, Islam does not attach infallibility to anyone but to prophets, so no

6
The relative silence of Muslim about this unprecedented existing practice can be attributed to a variety of
reasons; most importantly, the fact that Muslims pegged a big hope on Islamic banks when they were first
established, for they represented to them a glimpse of hope after decades of economic and cultural deterioration
and therefore, they were not willing to criticize the initiative by any means. However, recently there have been
an increasing criticism and objection to this practice in the wake of the controversial fatwas sweeping the
industry.
7
Fatwa refers to the Shariah opinion given by a Shariah specialist over something. Unlike the judgment given in
the court of law, it is non-binding and so it is left to the one who seeks it to apply it, ignore it or seek for a
different fatwa from a different Shariah scholar.

7
 Shariah scholar is immune against the temptation of wealth or other worldly gains, especially
if we refer to the multi-million dollars annual income a Shariah scholar may get! 8

Some proposed governance rules:

To help solve the above Shariah governance deficiencies, the following can be suggested:

a) Accreditation of Shariah board members

Shariah boards should have only accredited Shariah scholars so that not any holder of some
Shariah or Islamic studies degree can jump in and pose as a Shariah board member. As a
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prerequisite, a Shariah board member should have an MA or Ph.D. in Islamic financial law, in
addition to some basic knowledge in banking and finance (Al-Jarhi, 2009). He or she must
also be accredited by an institution set up for this purpose, through passing some exams and
taking some intensive courses if necessary. It is true that there exist in the world many learnt
Shariah scholars who have no academic degrees in Shariah, but we still need to demand a high
university degree in all Shariah board members in order to protect this industry from intruders,
especially that many Muslims still fail to realize that a preacher is not necessarily a Shariah
scholar, and that Islamic law is of different branches the most sophisticated of which is the
Islamic law of transactions, so specialization is required.

b) Independence of Shariah boards and internal Shariah controllers

As pointed out earlier, the independence of Shariah boards and all Shariah controllers is vital
and indispensible for the integrity and credibility of their work. To ensure independence and
avoid conflict of interest, Shariah board members must be selected, appointed and possibly
dismissed by an independent third party, like the central bank or by an international institution
like CIBAFI (Council for Islamic Banking and Financial Institutions) for example. This step
is extremely important especially to ensure the integrity of Shariah boards, because if the
Shariah board member finds himself appointed by the bank, paid by the bank and possibly
dismissed by the bank he is giving fatwa to, then his human nature will drag him towards

8
The annual income a Shariah scholar can make from sitting on scores of financial institutions may reach a
couple of millions of dollars knowing that the average salary he gets from sitting on one board is around 25-30
thousand dollars. Some scholars have been reported to have been sitting on around 100 boards!

8
 taking a lenient approach in fatwas in order to maintain his position and attract other Islamic
banks to him.

c) Adding to Shariah boards financial and legal experts

Shariah boards should also include financial and legal experts with no voting right to advise
the Shariah scholars and brief them on any relevant financial or legal concerns as well as the
possible implications of any Shariah resolutions. This step is particularly important when the
Shariah board members do not have adequate legal, finance or market experience, so they
need to consult trustworthy and independent experts before they can make a decision. In point
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of fact, a wrong fatwa in many cases could be a result of a misrepresentation by the bankers or
a misunderstanding by the Shariah board members.

d) Limiting the number of Shariah boards on person may join:

It is commonly observed that a few Shariah scholars are monopolizing Shariah boards. This is
due to various reasons, but primarily because of the proven convenience of their fatwas and
the fact that newly-opened institutions usually ask existing ones to recommend scholars for
their Shariah governance boards – a practice that ends up with the same scholars working for
a number of institutions (Al-Jarhi, 2009). This phenomenon is far from professional as it
carries the seeds of many negative implications on the industry; being some of them the
subjection of the whole industry to the views of limited dominating figures, and the
incapability of them to efficiently and fully discharge their responsibilities. Therefore, the
number of boards one person may join must be limited to a reasonable number, in order to
also give the chance to other brains to join and benefit the industry.

e) Setting an international Shariah supervisory board

To help solve the problem of conflicts in Islamic products universally, an international

Shariah supervisory board needs to be established. Its responsibility shall then be to endorse
products only, since it would not be feasible for it to look into the daily customized
transactions of the operating Islamic banks. It should have a specific number of the most
credible, experienced and qualified Shariah scholars from various jurisdictions and school of

9
 thoughts. They must be fully independent and not sitting on any individual Shariah board.
Such a committee could also be made affiliated to the OIC (Organization of Islamic
Cooperation) and also paid by the OIC. Its resolution should be binding on the individual
Islamic banks, and in case of a proven infringement by one of these banks it should have an
authority to declare the violating bank as non-operating according to Shariah rules. Individual
Shariah boards should also be empowered to report to this international board any
infringement by their respective banks. Even if this international board is not given the legal
power to withdraw the license of the non-compliant bank or cause it to be withdrawn, it will
still have a great influence over the banks and their Shariah boards when it declares a
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particular bank as one not complying with Shariah; because both the bank and its Shariah
board will then lose credibility in the eyes of the public. To ensure compliance with its
regulations, this board should have its audit arm to carry out unannounced inspecting visits to
the banks to scrutinize their products and report any infringement.

II. The methodology used for product development in Islamic Finance

Another challenge facing Islamic banking and finance industry is the methodology used for
product development in this industry. While Shariah enjoins that its rules must be observed in
contracts, some of these rules are not genuinely observed in the process of product
development.

To elaborate, Sharia dictates that in any structure, the underlying contract must fulfill the
essential Sharia requirements in contracts. Some of these requirements relate to the
contractors, like being eligible to initiate agreements and possessors of the necessary legal
capacity. Others relate to the contract itself being independent and absolute; unconditional on
the occurrence of any event. The subject matter of the contract needs also to be in line with
the Shariah, most importantly being permissible itself and meant for permissible use. Having
fulfilled all the structural requirements, the contract must also harmonize itself to meet, or at
least not to be in conflict with, the general objectives of Sharia since an apparently valid
contract may be misused to reach an evil end, or its implementation may result in causing
serious harms and negative impacts. Therefore, it is indispensable to distinguish in Sharia

10
 validation of contracts between two elements, the form of the contract and the substance of
the contract. The first relates to the structure of the contract, and the second relates to the
essence, the spirit and the implications of the contract. Both are equally important and
essential in product development; however, this equation has not been fully observed in many
of the developed products.

In fact, the current methodology of product development in Islamic finance in general is

commonly criticized for not looking beyond the product formal and structural conditions.
Although maintaining a proper form is a Shariah requirement, but it is also a more important
Shariah requirement to maintain a proper substance. In fact, a careful review of the literature
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of Islamic law leads to unveiling the fact that in contracts the form is meant to protect the
substance. In many Fiqh applications, it is noticeable that the schools of Islamic law have
somehow compromised some aspects of the contract’s form but never compromised the
contract’s essence or spirit. (Abozaid, 2004: 367). This implies that jurists viewed form as
something not meant for itself but rather to help protect the essence of contracts and
agreements. Some modern practices of Islamic financing product development have implied
the opposite; taking care of the form and neglecting the substance of the contracts.

The negligence of contract substance is manifested in different practices as in the following:

1. Negligence of the contract substance by the deactivation of some contract rules

Undoubtedly, Shariah contract rules and conditions are meant to enable the contract to serve
its purpose in fulfilling the contractors’ needs in a just, positive and productive manner. This
explains why contractors in Shariah are not allowed to make personal stipulations that may
annul the contract rules (Ibn Qudamah, 2002: 4/167). Naturally, a contractor, when given an
absolute right in making stipulations, inclines to tilt the scale to his favor, probably at the
expense of the other contractor. However, we find in some cases, especially in uqud al-ez’an
(contracts of subjection) where only one party to the contract formulates the contract, that
some contracts rules are indirectly neutralized by means of adjusting some clauses or
incorporating new ones as in the following example.

11
 Example: Ijarah Muntahia Bittamlik9

Being basically a contract of lease, Ijarah Muntahia Bittamlik in the Islamic banking
application is supposed to fulfill the following basic Shariah structural conditions:

• The leased asset requested for financing is valuable from Shariah perspective and not
declared by the client to be used for Haram (unlawful) purposes. This would exclude
for example financing clients in acquiring machineries that process tobacco products.

• The leased asset is clearly identified by the parties, and the rent is specified in the
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contract. If there is any gharar (uncertainty) involved with respect to the asset or the
rent payment, then it shall not be excessive, for Shariah tolerates minor gharar only.

• The leased property remains in the ownership of the lessor for the duration of the
Ijarah period, and then it is transferred to the lessee by virtue of a completely
independent contract, like sale or gift.

• The bank, as lessor, bears all liabilities related to ownership, like property taxes and
major maintenance required for keeping the asset valid for usage by the client.

• The lease period commences from the date on which the leased asset has been
delivered to the lessee.10

These are the basic rules of Ijarah Muntahia Bittamlik, and a general investigation of any of
its contracts in Islamic banks will prove consistency and full abidance. However, some
apparently-valid clauses are added to this contract, leading to the deactivation of some of
these basic rules and thus, to the negligence and distortion of the Ijarah essence. One clause
relates to the division of lease rental into three elements: fixed, variable and complementary.
The problem, however, lies with the complementary rent and to a certain extent with the

9
This type of Ijarah (lease) is not found in classical books of Fiqh. It comprises two different contracts: contract
of leasing (ijarah), and contract of sale. (bay’). Bank promises the client that upon the successful completion of
the Ijarah, bank will sell the asset to the client at a nominal price or will gift it to him.
10
-These detailed Shariah rules can be soursed from main Fiqh books like Al-Shafi’i. Al-Um, 3/14; Ibn Abedeen.
Hashiyat (Rad al-Mukhtar ala al-Dur al-Mukhtar) 4/88; Al-Kasani. Badai' Al-Sanai' 5/67; 6/71; Al-Bahuti.
Kashaf Al-Qina’, 3/53; Al-Dasuqi, Hashiyah 3/143.

12
 variable rent. The complementary rent represents any cost the bank as owner has incurred in
the past Ijarah period. The cost includes taxes, insurance and major maintenance expenses.
Although these are supposedly the responsibility of the bank as the owner of the leased asset,
the bank after paying them reclaims the same from the client by adding it up to the next Ijarah
rental under this clause!

Obviously this paralyzes and renders ineffective the basic contract Shariah rules pertaining to
the liability of the owner in Ijarah for the property risks. In fact, this practice of effectively
shifting property risks to the lessee is especially critical in the application of Ijarah Muntahia
Bittamlik since it brings this financing instrument closer to conventional financing after
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removing the justification for profiting, which is based on the notion of “al-Kharaj bid
Daman”11 (liability justifies the gain). The core difference between Riba and trade remains
risk taking which is normally embedded in trade. This risk taking is totally eliminated when
the bank indirectly shifts the leased property liabilities to the client, and even in case of
property partial or total damage, it is the client who bears the damage as he is the one who
effectively pays the insurance premiums.

On the other hand, the problem with the variable element of Ijarah rental relates to the
uncertainty (gharar) this practice involves. Banks tie this element to an interest rate
benchmark like LIBOR. The problem starts when the Islamic banks tend to cap only one end
of this excessively volatile benchmark, i.e. its floor. However, a ceiling needs also to be set
and capped at a certain figure in order to minimize the gharar (uncertainty) then involved in
order to maintain the validity of the contract. Nevertheless, banks tend to only protect
themselves from the undesirable movements of the interest rate benchmark by capping the
minimum amounts payable by their clients, and they have no desire to cap the maximum
amounts payable by their clients. This practice creates excessive gharar and leads to
breaching the Shariah requirement of determining the lease rental beforehand in any Ijarah
contract, not to mention the injustice involved therein.

Moreover, the above deviation from Ijarah Muntahia Bittamlik rules manifests itself more
blatantly in cases where the asset leased in Ijarah Muntahia Bittamlik has been originated
11
“Al-Kharaj bid Daman” is originally a Hadith narrated from the prophet (peace be upon him); however, it was
recorded as a Fiqh maxim by Al-Soyoti in his “Al-Ashbah Wal Naza’ir”, p 154.

13
 from the same client. A client who needs cash or refinancing will be instructed by the bank to
sell to it an asset or a common share thereof, then to lease it back from the bank through
Ijarah Muntahia Bittamlik. The bank frees itself from all the asset liability in the manner
described above, and the client repays with a mark-up the financed amount in form of rentals.
This transaction has been widely used recently to enable banks to restructure non-performing
debts in the wake of the recent financial crisis.

Thus, we see how the same clause in one contract can be neutralized by another, leading
eventually to the distortion of the contract substance and thus to stripping the contract of its
Shariah spirit and objective. Although Islamic finance has developed Ijarah contract into a
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new model and helped maintain most Ijarah rules in this innovative instrument, it has
however left a room for the Islamic banks to twist the substance of the contract and deprive it
of its nature as lease.

2. Negligence of the contract substance by attaching another contract

Contracts of financial transactions in the Shariah are meant to fulfill the various needs of
contractors, like acquiring an asset, acquiring an asset’s usufruct, investment of capital and
delegation of authority. However, it can be observed that some of these contracts are driven
totally out of their objectives when they are prearranged to be followed by other reversing
contracts.

Murabaha12, which is a sale contract originally designed in its banking application to finance
clients in their acquisition of assets, is used sometimes for a different objective altogether. It is
used to provide clients with cash money through a stratagem to sell them assets on Murabaha
basis in order to immediately sell the same assets on their behalf for cash price in the market.
Clients get the desired cash and remain indebted to the bank for the Murabaha deferred price.
Herein we have two independent sale contracts each of them is lawful in itself but the end
result of executing them consecutively is a cash financing technique which is effectively no
different from the conventional cash financing. Obviously, the result of this transaction is
against the objective and essence of Murabaha sale contract. Murabaha in this transaction

12
Murabaha in the banking application refers to a sale contract preceded by an agreement with client to buy the
desired commodity from its supplier then to sell it to the client at the cost plus a markup (Ribh).

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 does not lead to real holding of asset ownership by the client. This is a deviation from the
objective and substance of Murabaha, which is a commodity financing instrument that helps
clients own their desired assets.

3. Negligence of the contract substance by the misapplication of the contract

Contemporary collective fatwas have helped structure many products that are essential for the
operations of Islamic financial institutions. However, the application of some of these
products may have deviated from what these prodcuts were originally designed for. A good
example would be in using for speculation what was designed for hedging.
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To explain, Islamic finance has developed certain tools to hedge against some inevitable
excessive market risks. These tools include unilateral binding promises and tools whose
underlying contracts are Salam13 contract and Urbun14 sale. Now, a part from the Shariah
debate over the validity of these tools to be used as hedging instruments in contemporary
Islamic finance or Islamic capital market, some of these tools have been misapplied and used
for speculation as well, although speculation is considered an invalid domain in what is
known as “Islamic derivatives”.

Recently one Islamic financial institution has offered a product whose structure is basically as
follows: The client opens a designated investment account with the bank. The bank operates
the designated account in its capacity as investment manager. The investment manager then
uses the amount deposited in the said account to purchase Shariah compliant assets at some
prevailing market prices. In most cases the assets will be shares selected from an Islamic stock
index.

The client gives a unilateral promise to the bank to sell the shares at a predefined price called
the “Settlement Price”. The bank in return gives a unilateral promise to the client to buy the
shares at the Settlement Price.

13
Salam is the sale of future delivered goods against upfront paid price.
14
Urbun is a sale with the condition that buyer has the right to revoke the agreement in return of forfeiting the
advanced down payment, which is called urbun. If, however, the sale is concluded, then the urbun advanced is
deemed as part of the price.

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 The settlement price relates to the performance of some specified underlying reference asset
(the “Reference Asset”, which could be an index) rather than the performance of the Shares in
the Islamic Account. Thus, two scenarios can be perceived:

Scenario I: The value of the relevant shares goes up more than the performance of the
Reference Asset. In this case, the bank can purchase the relevant Shares from the client at a
price lower than the market value for such shares at that time. Thus, the bank would hold the
client to his promise, while the client would not be interested in holding the bank to its
promise as selling the shares at a value which is lower than the market value at that time
would incur a loss.
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Scenario II: The value of the relevant shares goes less than the performance of the Reference
Asset. In this case, the bank can purchase the relevant shares from the client at a price higher
than the market value for such shares at that time. Naturally, the bank in this case would not
be interested in holding the client to his promise, while the later would hold the bank to its
promise as he can then sell the relevant shares at a value higher than the market value for such
shares at that time.

Therefore, in both scenarios noted above the client will sell the relevant shares to the bank for
the settlement price as agreed on the basis of the performance of the reference asset. This sale
is certain as it will serve the interest of either the bank or the client. The certainty of this sale
makes the mutual promises to execute the sale biding on both parties and thus, such promises
tantamount to a forward sale contract, which is a breach of Shariah laws of sale contract.

Obviously, the substance of this transaction is hardly distinguishable from that of any
conventional derivative with the speculation element embedded therein; both contractors are
speculating on the movement of the value of the reference asset, which is mostly an index. It
is very likely that such a structure may even develop to involve financing the client to
purchase the shares, then settling the deal by paying the price difference by the losing party to
the other.

In conclusion, this transaction involves a misapplication of the promise which can originally
function as a hedging tool for risk mitigation

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 Reasons for neglecting the contract’s substance in some Islamic financing products

A direct examination of the Islamic banking market conditions, challenges and products
identifies the following reasons for any deviation from the true rules of Sharia.

a. The desire to offer the same financing facilities of conventional banks

Conventional banks treat money as commodity, therefore they have no problem in providing
cash financing with profit to clients. This cash financing can take the form of personal loans,
over draft facility or refinancing, all through interest-bearing loans. However, since lending
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money on interest is unlawful in Islam, the Islamic banks willing to offer these profitable
financing facilities had to design certain products that would serve the same purposes.
Logically, the designed products would necessarily lose Shariah spirit and breach contracts
essence, because they are basically meant to fulfill unlawful objectives, i.e. profiting from
providing cash to clients. The structured products relied on bogus operations of selling and
buying commodities, using mostly the highly controversial eina and tawarruq sales as their
underlying contracts. (Al-Jarhi, 2009; Abozaid, 2004)15. In fact, sale contract is designed to
help people acquire commodities for their own use or to resell them and make profit thereof,
and it is not designed to justify unlawful dealing in cash by buying then selling simultaneously
as is the case in eina or tawarruq sales. This is a deviation from the very rationale of the sale
contract and a defeat of the purpose behind Riba prohibition. If engaging in cash financing
with a mark-up through the technicalities of sale contracts like eina or tawarruq is halal, then
the whole purpose behind Riba prohibition will be defeated. Any two willing to deal in loans
with a return would simply do so through eina or tawarruq-like sale contract, the end result
being exactly the same.

15
For details on these sales see Abozaid, Abdulazeem. (2004). “Contemporary Eina is it a sale or usury” a book
published in Arabic by Dar Al-Multaqa, Aleppo, Syria; Abozaid, Abdulazeem. (2008). “Contemporary Islamic
Financing Modes between Contracts Technicalities and Shari’ah Objectives”, Eighth Harvard University Forum
on Islamic Finance, Harvard Law School – Austin Hall, April 19-20, Boston, USA.

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 b. The unwillingness to bear genuine property/contracts risks

Being commercial financial institutions, Islamic banks tend to avoid as much as possible the
risk that is normally embedded in the Shariah contracts used in financing products structuring.
This avoidance of risk may lead to depriving contracts of their Shariah identity and rendering
them spiritless. The application of Ijarah Muntahia Bittamlik in the manner described earlier
is an example. Therein, the liability risk related to the ownership of the leased asset is
effectively transferred from the bank to the client and thus, the essence of the lease contract is
distorted. Murabaha is another example when the bank frees itself from the Murabaha
commodity liabilities. Neglecting the sale essence in Murabaha product is at its peak when
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the Murabaha client is appointed as the bank’s agent to buy the commodity from its supplier,
then to take delivery and deliver to himself, without the bank being responsible for even the
commodity defects. In this scenario the bank's role is limited to only advancing money to the
property supplier, mimicking thus the limited role of conventional banks.

c. Legal constraints facing the right application of Shariah rules in products

In some countries the legal system stands as a stumbling block to the proper application of
Shariah rules required in product structuring in Islamic finance. Some Islamic banks for
example find it inescapable to make the purchase of commodities appear in the client’s name
rather than the bank’s name, because according to some laws banks are not allowed to trade in
assets. Other laws prohibit Islamic banks from leasing assets to clients and therefore, they are
left with no choice but to dodge and execute Ijarah in the form of sale. Imposing high taxes
on registration of assets purchased is also a legal constraint as it eventually leads to increasing
costs on clients when banks are commanded by law to register in their names what they buy
before they sell to clients. Some banks tend to avoid payment of high taxes by reducing some
necessary contractual steps or faking some contracts.

Conclusion

From the past discussions it can be concluded that Islamic banking and finance is facing
some internal challenges which require immediate action. While facing the external

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 challenges may be beyond the capacity of the industry players, Islamic banks have no
excuse to overlook or turn a blind eye to their internal challenges, which can be faced by
enacting Shariah governance for both products and Shariah control. Reform of the
methodology of product development is also within the capability of Islamic banks, and
most of the burden falls on the shoulders of the Shariah boards for they have to ensure
before endorsing a product that it passes in essence as well as implication the Shariah core
requirements. If the existing challenges remain untackled, it is feared that a day may come
when people would totally lose confidence in Islamic finance, and then Islamic banks and
financial institutions would lose their biggest asset; i.e. their Islamic identity, which gave
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them a firm foothold in the global financial industry.

In final analysis, having the industry players realize and appreciate the necessity for urgent
Shariah governance and product methodology reform is the real challenge, while working out
a solution mechanism is easy, because even though it does not take a genius to assess the
problem, there is no genuine will by market players to change the status quo for the reasons
described in this article.

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 References

• Abozaid, A. (2004). Contemporary ‘Eina is it a sale or usury. Aleppo: Dar al-

Multaqa.
• Abozaid, A. (2004). Fiqh Al-Riba. Beirut: Al-Risalah Publishing House.
• Abozaid, A. (2010). Contemporary Islamic Financing Modes between
Contracts Technicalities and Shariah Objectives. Journal of Islamic Economics
Studies, Islamic Research and Training Institute - Islamic Development Bank,
17 (2), 58-68.
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• Abozaid.A. (2014). Examining the Shariah Parameters Set for Tolerating the Haram if
Mixed with the Halal. Al-Tajdeed IIUM, 15 (31), 32-36.
• Abozaid.A. (2014). Shariah Analysis of Financial Derivative. Islamic Economic
Research Journal, 27 (3), 56-63.
• Al-Dasuqi. (2005). Hashiyah. Beirut: Dar Ihia’a al-Kutub al-Arabiyyah.
• Al-Jarhi, Mabid. (2009). Doctors of law needed to take Islamic finance forward.
Emirates24/7, Interview Published on Sunday, June 21,
http://www.emirates247.com/eb247/banking-finance/islamic-finance/doctors-of-law-
needed-to-take-islamic-finance-forward-2009-06-21-1.34117
• Al-Kasani. (1982). Bada’ al-Sanai’. Beirut: Dar al-Kitab al-Arabi.
• Al-Shafie. (1973). Al-Um. Beirut: Dar al-Ma’rifah.
• Al-Suyoti, Jalaulddin. (2003). Al-Ashbah Wal Naza’ir. Damascus: Dar al-Fikr.
• Ibn Abdeen. (1987). Hashiyat (Rad al-Mukhtar ala al-Dur al-Mukhtar). Beirut: Dar
Ihiya’ al-Turath al-Arabi.
• Ibn al-Qaiyyem. (2001). Ilam al-Muwaqi’een. Beirut, Dar al-Fikr.
• Ibn Qudamah. (2002). Al-Mughni. Beirut: Dar al-Fikr

Author Biography:

Abdulazeem holds PhD and Master in Islamic financial law, three BAs in Islamic law,
Arabic language and English Literature; two higher studies diplomas in Islamic law and
Human sciences. He worked at universities as well as Islamic banks. His recent position is
associate professor at Qatar Foundation, Islamic Finance Program.

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