LEGITIMATE PROFIT, CREDIT AND RISK MANAGEMENT IN ISLAMIC FINANCE
The balanced and disclosed correspondence of the counter-values results in Islamic finance in a favour towards equity-based and property-based instruments and a correspondent dismissal of both debt-based products (causing ribaa) and hazard-affected securities (invalid for gharar and maysir).
This departure can be explained thanks to the principle al-kharaj bil-ḍaman governing the receipt of legitimate profits in the management of credit (money) and risk (ḍaman).
The favour towards equity-based and property-based products in Islamic finance can be examined in relation to the principle al-kharaj bil-ḍaman, ‘profit follows responsibility, risk of loss’, lucrum pro periculo.
This principle is incorporated in a famous ḥadith, according to which the risk for loss falls upon the same person who receives benefit from the property / business: any (dis)advantage cannot be separated from the contextual ownership / possession of the asset or the participation in the investment (“liability for loss accompanies every gain”). This axiom provides useful insights into the Islamic legal conceptualization of credit and risk management.
‘CREDIT’ AND ‘RISK’ IN ISLAMIC FINANCE
Islamic law does not recognize credit (money) and risk as valuable commodities per se, since any valuable mal requires a material existence: as previously seen, in fact, in Islamic law, “it is the thing… that takes primacy. And it is evident that the thing must have a material, concrete existence. It does not exist trace of what has been called res incorporales” (Chehata).
For this reason, the trading of ‘credit’ (money) and ‘risk’ cannot be admitted in Islamic finance, rendering invalid a number of financial instruments (e.g. interest-based loans, insurance, derivatives) which are widespread in the conventional market.
Remarkably, and with specific reference to Islamic finance, El-Gamal argues that “the forbidden ribaa is essentially [equivalent to] “trading in credit [money]”, and the forbidden gharar is “trading in risk”, as unbundled commodities”.
The assertion imposes further investigation on the Islamic conception of money and risk.
MONEY AS ‘PROPERTY FOR THE EXCHANGE’
In Islamic law, money is a dayn (fungible) property created and given generously by God to the disposition of the human being with the specific aim to measure the value (maliyya) of things, i.e. for the exchange.
The notion of money as ‘price’ (athman) or ‘value’ (qiyam) of other things logically implies that money lacks a proper own value, as noted by the Maliki al-Baghi (“[it]… doesn’t have its own value (qima), since… [it] serves to evaluate (taqwim) things, but there are no things beyond… [it] that evaluate… [it]”).
Accordingly, the well-known contemporary scholar Usmani asserts that
“money has no intrinsic utility; it is only a medium of exchange; each unit of money is 100 per cent equal to another unit of the same denomination; therefore, there is no room for making profit through the exchange of these units inter se. Profit is generated when something having intrinsic utility is sold for money or when different currencies are exchanged, one for another”.
And, in contemporary economic literature, Van Greuning and Iqbal state that
“money is treated [in Islamic finance] as “potential capital” – that is, it becomes actual capital only when it joins hands with other resources to undertake a productive activity. Islam recognizes the time value of money, but only when it acts as capital, not when it is [mere] “potential” capital”.
In conclusion, it may be said that, as measure of things (investments, machinery, workforce, facilities…), money doesn’t hold an intrinsic value but it assumes its own ‘value’ only in the actual exchange.
THE CONCEPTION OF RISK IN ISLAMIC LAW
In a similar way, risk does not constitute a valid mal in Islamic law, since it is conceived as something related to the ownership/possession of a good or to the participation in an undertaking, and not as an unbundled commodity.
In other words, risk follows the res or belongs to an investment: the fact that the object is owned or managed by somebody appears in the mentality of Islamic jurists a quality of the object, and not a ‘commodity’ by itself, capable of being traded; in the same way, risk is not conceived independently but incorporated in the management of an undertaking.
TRADE FINANCING AND RISK-SHARING FINANCING
With specific reference to the ownership or the possession (trade financing), when a property is transferred, also the risk is passed, as the benefits do: “risk of loss… in Islamic law is generally a function of either legal ownership or possession of the res” (Fadel).
The principle al-kharaj bil-ḍaman as ‘risk linked to the res’ finds a direct application in the definition of ṣukuk by the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI). According to Article 2 of the AAOIFI Shari‘ah Standards, investment ṣukuk are
This approach has been recently confirmed in an AAOIFI resolution (13-14th February, 2008, Bahrain):
“ṣukuk, to be tradable, must be owned by ṣukuk holders, with all rights and obligations of ownership, in real assets, whether tangible, usufructs or services, capable of being owned and sold legally”.
The same conclusions on risk as non-autonomous commodity in Islamic law involves the management of an enterprise (risk-sharing financing), where the remuneration of the participants cannot be determined ex ante, as a fixed premium, but derives from a principle of risk-sharing in the profit (muḍaraba, silent partnership) of the business, which may be extended also to the liabilities of the affairs (musharaka, partnership).
To summarize, from the principle al-kharaj bil-ḍaman it follows that
- when the contract deals with a res, a mark-up (e.g. murabaḥah) or fixed return (e.g. rent in the ijarah) are possible, since the risk follows the ownership (or possession) of the property (either in the ‘substance’, raqaba, or in the ‘usufruct’, manfa‘a);
- vice-versa, when the subject matter of the contract is an activity whose future gains are uncertain at present, the profit cannot be fixed according to a predetermined mark-up, since this would determine rib and gharar (a preliminary trading in credit and risk, which is forbidden in Islamic law): consequently Islamic law imposes the sharing of the risk of the subject matter (in the sense of risk ‘belonging’ to the object of the activity), only on profits (muḍaraba) or on profits and liabilities (musharaka).
For the list of the contractual types just quoted, see the end of the page on Contracts in this website.
APPLICATIONS IN ISLAMIC FINANCE: PROPERTY- AND EQUITY-BASED CONTRACTS
The lack of economic value for money as commodity in Islamic law explains why the contract of loan (qarḍ) is gratuitous: money, in fact, is not a commodity and even interest-free lending would be a form of unlawful increase, in the form of ribaa ’l- nasi’a, if classified as commutative contract (mu‘āwaḍāt) and not liberal (tabarru‘āt). Consequently, the qarḍ is usually described in the treatises as ḥasan, ‘goodly’, ‘beautiful’, ‘benevolent’, since it represents a charitable act. Excluded the possibility of receiving profits through ‘lending’ money, how do Islamic financial institutions (IFIs) act as commercial undertakings?
From a technical standpoint, IFIs don’t ‘lend’ money (as their Western counterparts) but ‘invest’ money in goods or commercial businesses, on behalf of their customers: both IFIs and their customers, in fact, necessarily assume an entrepreneurial risk either on the ownership of goods or in the financed activity in order to reach a legitimate profit (al-kharaj bil-ḍaman).
Thus, in case of commercial activities, where participants provide capital and/or labour, the contracting parties necessarily share the risk of the undertaking, and, consequently, participate in the future profits (muḍaraba), which are unknown at present. In a musharaka contract the risk sharing is extended also to liabilities (equity-based contracts).
On the contrary, in the exchange of property for a price (bay‘) or in the selling of usufruct (ijara), i.e., when a transfer of the substance (raqaba) or the proceeds (manfa’a) is at stake, since the distribution of legal entitlements (ḥuquq al-‘aqd) is certain (provided a full description of the subject-matter) the risk follows the ownership or the possession of the res and a fixed return as compensation becomes admissible (property-based contracts).
The principle al-kharaj bil-ḍaman clarifies also the Islamic model of insurance.
As seen, risk cannot be transferred per se: consequently, a (Western) insurance contract, where the risk of negative events is transferred from the beneficiary to the insurer with the contextual payment of a premium, is deemed invalid in Islamic contract law and replaced by the model of takaful (‘guaranteeing each others’). In the case of takaful, in fact, the risk of the negative events is shared among the participants in a mutual guarantee linked to an investment fund, ruled according to a muḍaraba / musharaka or wakala model. Thanks to the sharing of risk, ‘guaranteeing each other’ becomes lawful for Islamic fiqh.
To sum up, in Islamic finance, the debt-based model is replaced by property- and equity-based contracts.
In this way, in any sector of the financial market, Islamic finance provides an attractive risk-sharing model,
- both for joint ventures aimed at promoting social wealth, like in microfinance projects,
- and for equity fund structures, where the peculiar distribution of risks of Islamic contracts matches with advanced business strategies.