ISLAMIC FINANCE: CURRENT LEGAL AND REGULATORY ISSUES
Social dynamics of the debate on default in payment and sale of debt.
Presented
at the Sixth Harvard University Forum on Islamic Finance, May 8—9, 2004
The
current debate on regulatory issues reflects a variety of approaches. Most
experts in Islamic law, the fuqaha use analogical
reasoning and try to make past rulings their guide to a rule for today. Most
economists, on the other hand, argue in terms of socio-economic consequences
and seek rules that would bring in the desired state of the world. This paper
demonstrates this with reference to two important issues. It then proceeds to
make a plea for a more integrated approach.
Jurists
are trained to arrive at new rules governing a situation that is wholly or
partly novel mostly by analogical and deductive reasoning. Social philosophers
are concerned with certain values. They are always evaluating new rules on
these criteria, often concluding that new rules are not good enough. Insofar as
there is a good case for betterment the jurists are obliged to have a second
look, invoking methods which are more accommodative of the very values that
concern the social scientists like justice and fairness, even promotion of the
common weal. In the Islamic tradition we often come across rules arrived at by
analogical reasoning (qiyas) being abandoned
in favor of rules designed to protect/promote the benefit (maslaha)
desired. In economic literature there has been a debate between those who would
maximize production, thereby creating as much new wealth as could be created,
and those whose primary concern is with social justice and ensuring dignity and
security for every human being.
Law
is concerned, primarily, with fairness whereas social good, including economic
good, is conceived in terms of provisions that depend, ultimately, on
production. Fairness is necessary for ensuring dignity whereas wealth is needed
to guaranty security.
In
this brief paper I propose to demonstrate that a tension similar to the one
described above is discernable in the current debate on legal and regulatory
issues in Islamic Finance. To illustrate I select two issues that are
attracting considerable attention: How to deal with delays in payment of debts
resulting from sales on credit, mostly in murabaha deals, and; Permissibility
of securitization and sale of debts resulting from murabaha and other credit
transactions.
It
is well known that widely different positions have been taken on these issues.
I will try to show that differences may be rooted in the priorities of the
position taker. Those giving more importance to production and creation of
wealth care more for efficiency. They want to ensure the flow of credit,
economize on use of cash, etc. Those who care more about fair dealings and social
justice are more concerned with avoiding any involvement with riba/interest, whose prohibition is the first
threshold of keeping away injustice and unfair practices.
It
goes without saying that Islamic economics as a discipline cares about
efficiency as well as justice and fairness. It is well aware of the fact that
in a balanced realization the two reinforce each other. This does not, however,
preclude the possibility that scholars having different backgrounds may differ
in their priorities. Economists tend to care more for efficiency, or at least
think that efficiency comes first. The more you produce the fairer you can
afford to be in distribution. The less you have the more the temptation to be
self-serving. In dealing with a certain situation economists are always
thinking of how to improve that situation, how to have more of what we already
have. Law, on the other hand, focuses on fairness in a given situation.
Improving situations or caring for more is hardly in focus. As the debate on
current legal and regulatory issues in Islamic finance involves scholars drawn
from various disciplines, tensions develop which have the pleasant potential of
leading to resolutions a narrower approach would fail to achieve.
The Debate on Delay in Payment
The
debate on mumatalah or delay in
payment of a debt incurred in a credit purchase predates the debate on sale of
debt (bai‘ al-dayn). It started in all earnest in the early
eighties of the last century. The practice of murabaha, the chief source of
debts under discussion, had spread in the late seventies, bringing this issue
into focus. The possibility of delay in payment raised the questions: How and
when to penalize the defaulter and whether to compensate the creditor and if
so, how? The principle of penalizing a defaulter who is capable of payment is
universally accepted but neither the need for compensating the creditor nor the
method of doing so is agreed upon, fearing it may open the door for riba (Saleh, 2002, pp. 92-93).
The
debate was conducted in various forums, e.g., Shariah Advisory Boards, Seminars
and Conferences and Academic Journals. In this brief note I confine myself to
the last one, especially to the Journal published by the Center for Research in
Islamic Economics at the
A
good summary of the debate, as at the end of the eighties, is provided by a
paper jointly authored by Mohammad Anas Zarqa and Mohammad Ali Elgari,
henceforth referred as Zarqa & Elgari[1].
To
restate the issue: How do we deal with one who buys on the promise of paying
the price on a certain date in future but delays payment thereby inflicting
harm on the seller/creditor? Zarqa & Elgari rightly begin by noting the importance of this issue
for a system that does not charge interest as more time passes before payment
is made. They also note the importance of credit for the economy that thrives
by division of labor and exchange.
Islamic
finance needs a mechanism capable of eradicating the phenomenon of delay in
payment by those capable of making payment on time, a phenomenon they
characterize as delinquency.
How
to deter the delinquent? Do we compensate the creditor? If yes, why, how and
when? Answers to these questions differ. Some see deterrence in punishment by
incarceration, even corporal punishment for the debtor. Black listing
delinquents and exposing them in public is also suggested. All these involve
courts of law, and litigation takes time. This is rightly seen as a negative
point decreasing the efficiency of the Islamic financial system. Efficiency
calls for a mechanism that is triggered automatically. Such a mechanism can be
a penalty, in terms of a fine, a certain quantity of money. Such a fine can be
proportional to the sum of money involved. It can also be related to the actual
period of delay. That would make it similar to riba/interest
in form if not in spirit. Some claim that it may also fail in its avowed purpose
of being a deterrent, insofar as the market rate of interest at any particular
time may be higher than the rate at which the fine is imposed. The delinquent
debtor may simply decide to pay the fine and ‘roll on’ the debt, much to the
chagrin of the creditor!
As
hinted above, in the Islamic analysis, riba/interest
acts as a surrogate for justice and fairness. Characterizing any procedure as
involving riba/interest amounts to declaring it to be
unfair and unjust.
Answers
to the question, how to deter the delinquent, can be classified in two
categories. A monetary penalty automatically triggered ensures efficient
operations. It may be noted, however, that some opting for a fine nevertheless
opine that only a court of law can fix its quantity. It cannot be made a part
of the contract coming into effect automatically. On the other hand, the
obligation to avoid interest makes some scholars reject the fine option
altogether, irrespective of who levies it. Out of the eight opinions listed by Zarqa & Elgari, one scholar (Nazeeh Hammad) insists that only
punishment by a court of law can deter a delinquent whose own conscience fails
to deter him. Two scholars (Shaikh Mustafa Zarqa and Zakiuddin Sha‘ban) opt
for a fine that must be decreed by a court. Two other scholars agree to a
predetermined fine that, according to one of them, goes to a charity (Ali al-Saloos, who combines incarceration with a fine). Another
suggestion is to send it to a special fund under the aegis of the state
(Siddiqi). The remaining (Siddiq al-Dareer and Zaki Abdul Barr) agree
on a fine which would serve as a deterrent but insist that the fine should not
exceed the actual harm done the creditor/Islamic bank. Al-Dareer
regards the average rate of profit earned by the bank in the relevant period as
a good measure of the loss suffered by it. Abdul Barr also emphasizes the role
of other kinds of punishment as a deterrent.
When
it comes to compensation, one opinion (Nazeeh Hammad) totally rejects the idea, saying it is only the sum
owed him that the creditor gets. One can say the possibility of delay must have
been taken into consideration in the mark-up, the increase over and above the
cash price. Sheikh Dareer would compensate only to
the extent of actual profit lost, which he then equates with the average profit
earned by the creditor (Islamic bank, for example). This in effect is what the
creditor gets according to the formula approved by Shaikh
Zarqa. But Zaki Abdul Barr
is not comfortable with this formula. He would rather get it looked into by a
court and the compensation given in exceptional cases only. Siddiqi would make
the affected creditor seek compensation from the special fund under the
auspices of the state to which all the fines for delay go.
To
complete the picture, mention must also be made of the proposal of the authors
themselves, Zarqa and Elgari.
The delinquent debtor is to be obliged, by a court of law, to make a counter
loan (interest free, of course) to the creditor in the amount owed and for a
period equal to the period of delay. The idea is to compensate a lost
opportunity by providing a similar opportunity, and no more. The proposal did
not get any endorsements, however. One commentator (Rabi‘ al-Roobi, 1992) said it was neither efficient nor fair. The marginal efficiency of money to the
creditor was not necessarily the same at the two points of time involved. The
different timings of the two opportunities, the one lost due to delay and the
one being provided as compensation, could not be treated as equal. Also, the
counter loan being provided as part of the contract made it similar to riba/interest, insofar as the extra time was matched by a
‘benefit’.
Zarqa and Elgari visited the issue again when they
co-authored with Siddiqi: ‘Banking Law—A Suggested Model for Organizing the
Islamic Banking Sector’ ( Elgari, et al,
1993).Appendix 9 to this Law details what is provided briefly in clause 4 of
the Law. All fines for delay are to go to a public Fund supervised by the
Central Bank. The Fund serves society in various ways but the lender does not
benefit from it in any way.
In
the year 2000,the Islamic Fiqh Academy, a subsidiary of the Organization of the
Islamic Conference, headquartered at Jeddah,
passed a resolution on this issue that went beyond its earlier resolution in 1990 which said: ‘If the buyer/debtor
delays the payment of installments after the specified date it is not
permissible to charge any amount in addition to its principal liability,
whether it is made a precondition in the contract or it is claimed without a previous
agreement, because it is Riba, hence prohibited in Shariah’(Islamic
Fiqh Academy, 2000, p. 104). The new resolution reaffirmed the above, but
added: ‘It is permissible to include a Penalty Provision in all financial
contracts except when the original commitment is a debt. Imposing a Penalty
Provision in debt contract is usury in the strict sense.’ It also lays down
that: ‘The loss that may be compensated includes actual financial loss incurred
by the partner, any other material loss and the certainly obtainable gain that
he misses as a result of his partner’s default or delay. It does not include
moral loss.’(Islamic
The
issue of delay in payment is taken up in Chapra and
Khan (2000). Obviously concerned with efficiency of the Islamic financial
system, they observe: ‘If the late payment does not lead to any penalty, there
is a danger that the default may tend to become a widespread phenomenon through
the long run operation of self-enforcing mechanisms. This may lead to a
breakdown of the payment system if the amounts involved are significantly
large’ (p.72). They proceed to suggest an index of ‘loss given a default’ (LGD)
‘to determine the compensation in a way that reduces subjectivity as well as
the possibility of injustice to either the defaulting or the aggrieved party’
(p. 73). This comes, however with the proviso: ‘If the concept of compensation
for loss becomes accepted by the fuqaha’( p.73
). The authors report without any comments the ‘conservative view’ that
‘prohibits the imposition of any compensation to the aggrieved party for fear
that this may become equivalent to interest’ (p.72).
The
latest response to the challenge posed by this issue seeks to strike a balance.
It makes a penalty for default/delay automatic, but the proceeds of the penalty go to charity. As
regards compensation for harm done the issue is left to courts of law. In its
guidelines relating to murabaha, the State Bank of Pakistan says: ‘It can be
stipulated while entering into the agreement that in case of late payment or
default by the client he shall be liable to pay penalty calculated at percent
per day or per annum that will go to the charity fund constituted by the bank.
The amount of penalty cannot be taken to be a source of further return to the
bank (the seller of the goods) but shall be used for charitable purposes….The
bank can also approach competent courts for award of solatium
which shall be determined by the courts at their discretion, on the basis of
direct and indirect costs incurred, other than opportunity cost’ ( State Bank of Pakistan,2004. p. 3).
One
of the peculiarities of a market economy is to press for efficiency. This is
done largely through competition. Unfortunately the market has no such
mechanism to ensure justice and fairness. That is left, in the first instance,
to the conscience of the players, the economic agents, themselves and then to
the regulatory authorities. In other words, the market works for the private
interests of the participants whereas the public interest (which includes the
interests of non-participants also) has to be taken care of largely by the
state, the guardian of public interest. Islam works on the conscience of the
economic agents through moral orientation. Also, Social Authority is empowered
to take steps necessary to protect public interest, a principle enshrined in
the traditional Islamic institution of hisbah. Since the prohibition of riba/interest
is directed at ensuring justice, the jurists rightly insist that no provision
should involve interest/riba. But can they stop
there? If they do, as they seem to have done till now, can the market stop
pressing for an efficient solution to the problem under scrutiny?
The
second issue we take up is the sale of debt, bai
‘al-dayn. Prohibition of interest almost
eliminates the direct lending of money for business. So there is no bond market
in an Islamic economy whose liquidity should become an issue. Direct lending of
money is replaced by murabaha and similar credit transactions, effectively
tying the expansion of credit with the growth of the economy. In place of
conventional treasury bonds Islamic financial markets have bonds based on Ijara
(leasing), Salam (prepaid orders) or Istisna‘ (manufacturing orders on a pay as
you get basis). But there also is a huge debt created by installment sales and
murabaha. To some, making all these wait till maturity implies waste. This
waste occurs at two levels. Firstly, those holding IOUs will need credit to
command real resources in order to continue producing, having presumably
exhausted their own resources in producing what they already sold on credit.
This means the society will always carry lots of illiquid assets, the IOUs.
Secondly, this may force sellers/producers to refuse selling on credit,
demanding cash instead. A society in which all IOUs must await redemption by the
original debtor cannot economize on the use of cash. This is rather inefficient
(but not a big deal in a fiat currency regime!).
It
may rightly be pointed out that somebody must await maturity of debts incurred
in the process of acquiring command over real resources on credit. As Keynes
pointed out commenting on the ‘liquidity fetish’, not everybody can be liquid
all the time. It is, however, more efficient to provide opportunities for
exchange between those who are willing to wait and share the risks involved (as
the Islamic framework does not reward pure waiting) and those who seek
liquidity. One way to do so is to allow IOUs as collaterals for fresh
credit---a practice already in vogue in the Islamic financial market. It is
also permissible to exchange these IOUs for goods and services. But some want
more, let us see if they can have it.
The
juristic objection to sale of debts resulting from murabaha, etc. is the same
as in case of selling a debt created by a money loan. If I buy for 90 an IOU
worth 100 after a year, I am doing so in order to earn 10 as interest. They see
no reason to distinguish between IOUs created by murabaha and IOUs created by
lending money. This seems to be underlying the latest Islamic Fiqh Academy
resolution on the subject that states: ‘It is not permissible to sell a
deferred debt by the non-debtor for a prompt cash, from its type or otherwise,
because this results in Riba (usury). Likewise
it is not permissible to sell it for a deferred cash, from its type or
otherwise, because it is similar to a sale of debt for debt which is prohibited
in Islam. There is no difference whether the debt is the result of a loan or
whether it is deferred sale’ (Islamic Fiqh Academy, 2000, p.234). However, the
view equating, in this context, money loans and debts resulting from credit has
been challenged. There are reasons to treat the two differently, say Chapra and Khan : ‘The debt is created by the murabaha mode of financing
permitted by the Shariah and the price, according to the fuqaha
themselves, includes the profit on the transaction and not interest. Therefore,
when the bank sells such a debt instrument at a discount, what it is
relinquishing, or what the buyer is getting, is not interest but rather a share
in profit’ (Chapra and Khan, 2000, p.78). In other
words, a debt resulting from murabaha has an element absent from a debt arising
from borrowing money-- the mark up on spot price.
The
problem with this proposition is that what was a profit margin for the seller
of goods and services (on a murabaha basis) may not necessarily remain so when
the same seller ‘sells’ the IOU arising from that transaction. Some of the
factors involved in the determination of the mark up on spot price in murabaha
may be different from those involved in the sale of the resulting IOU at a
discount. Furthermore, the extra profits earned in murabaha sale, over and
above those earnable on selling for cash, are still against sale of goods and
services. But the part of it that goes to the buyer of the murabaha based IOU
(according to the above mentioned rationalization) has no goods and services
corresponding to it. It is money for money, with a difference of dates.
The
authors go on to argue that there is hardly any gharar
involved in the sale of debt-instruments under discussion, a point we may
ignore because of the limited purpose of this paper. What interests me is their
plea that the fuqaha reconsider the
case of asset-based debt instruments and allow their sale as it would lead ‘to
the accelerated development of an Islamic money market’ (ibid, p. 79) They
proceed to emphasize the need for such a market by pointing out that Islamic
banks may face a liquidity crunch in its absence, paralyzing the whole system.
They also believe ‘it is difficult for banks to play effectively their role of
financial intermediation, without being able to securitize their receivables’ (Chapra and Khan, 2000, p.79). After discussing alternative
avenues of raising large funds required by client companies through banks, they
conclude that ‘it would be preferable to allow banks to rely on the sale of
their own assets to raise liquidity.’( ibid, p.80 )
So
it is efficiency that is at stake, in an environment where the inefficient may
not long survive. Once again the same story: the jurists bent on ensuring
justice by avoiding anything similar to riba/interest
and the economists keen to maintain efficient markets. Do they understand each
other’s concerns? Is the rationale
(hikmah) of prohibiting riba also applicable to sale of debts resulting from
murabaha so that it must be blocked to ensure justice? What about a trade-off
between the two objectives of Shariah, justice and wealth creation? Is such a
trade off acceptable under certain circumstances? Does it become unavoidable
sometimes? Can we agree on some formula that ensures a reasonable degree of
fairness with a reasonable level of efficiency? These questions have yet to be
thoroughly examined. Those arguing in favor of legitimizing sale of debt have
to demonstrate that no alternative methods of ensuring liquidity are available.
They have also to meet the objection that once sale of debt is allowed insofar
as asset based IOUs are concerned, prohibiting the sale of IOUs based on money
lending will be difficult, if not impossible, to sustain.
Bai‘ al-dayn is approved by Malaysian
Shariah scholars (Securities Commission, 2002). It has a place in Islamic
banking as practiced in
Does
not sound very convincing, as a shareholder does not hold a claim to a definite
sum of money to be paid in future. But
there
is no need for me to evaluate these arguments in analogical terms. What I am interested
in is their focus on distancing sale of debt from riba/interest
and trying to show it is fair trade, free of injustice as symbolized by riba/interest. Hence the claim that asset based securities
are like share certificates and necessary for the well being of people. This is
evidenced by Ishak’s appeal to the
‘syari‘ah (
It
would be far better to conduct the debate openly in the framework of ease
versus hardship, efficiency versus fairness, growth versus distribution. The
trade-offs could then be openly examined, sometime even measured. At the
macroeconomic level, we need to know why liquidity cannot be guaranteed without
legitimizing the sale of debt. It has to be discussed how giving debt-financing
a greater role is likely to change the nature of Islamic economy which
emphasizes risk sharing and participatory finance. Alas! That is not the way
legal issues are handled, especially in an industry in a hurry, as the Islamic
financial industry currently seems to be, under tremendous pressure from its
more ‘efficient’ competitors. While the Shariah scholar sitting on an Islamic
bank’s advisory board may have barely the time to check the relevant texts and
whether a particular analogical reasoning is acceptable, the task of the social
scientists/moral philosophers is more contemplative, time taking. An appeal to maqasid al-shariah (objectives of
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