Islamic Banking Primer

A Basic Guide to Contemporary
Islamic Banking and Finance
Mahmoud Amin El-Gamal1

Rice University
June 2000
1 2000
c by Mahmoud El-Gamal, All rights reserved. The author is Professor of
Economics and Statistics, and holder of the Chair in Islamic Economics, Finance
and Management, at Rice University, Houston, TX 77005. [email protected].
http://www.ruf.rice.edu/∼elgamal
Preface

In the Name of Allāh, The Beneficent, The Merciful
I was asked by ISNA to produce a short guide to Islamic Banking and Finance
for the Muslims of North America. To keep this guide short, we had to define
our target audience rather carefully. This introductory guide is meant to
address the Muslim who is familiar with the fundamental tenets and sources
of legislation in Islam. The reader is not assumed to have elaborate prior
knowledge of Islamic financial contracts, but a certain degree of financial
sophistication will be required.
This is not a full survey of the field, and it is not a religious guide. It is the
work of a single individual, who does not claim any religious authority beyond
that which is derived from quoted texts. I tried my utmost to steer away
from issues which are or may become controversial. Therefore, I have been
careful to limit the discussion of recent fatwās and decisions of jurists and
juristic councils. In that sense, this guide falls short of providing the reader
with full information about “state of the art” Islamic financial instruments.
This apparent shortcoming is intentional. The field of contemporary Is-
lamic finance is rather young, and marred by a number of shortcomings of its
own. It is easy for an economist such as myself to fall prey to the temptation
of claiming religious authority from translated texts and quoted opinions. It
is also easy for specialized jurists to assume that they understand both the
religious and the financial aspects pertaining to a specific contract or trans-
action. In both cases, there is a great danger for scholars of religion as well
as students of economics and finance to speak falsely in the name of Islam.
ii
iii
I hope to succeed in minimizing this danger by speaking generally about

the basic types of contracts used by “Islamic financial institutions” in North
America and elsewhere. The generic forms of those contracts have been sub-
jects of extended study by traditional jurists. My goal is to provide a concise
summary of the nature of those contracts, and their Islamic foundations in
Qur’ān, H . adı̄th , Sunnah, ’ijmā‘, and – where necessary – qiyās. The primary
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objective of this introductory guide is to explain to the non-specialist curious
Muslim the difference between the forbidden financial transactions commonly
used in conventional finance, and their Islamically permitted counterparts.
It is important for me to make it clear that I am not endorsing any par-
ticular institution or industry which labels itself “Islamic”. There are many
honest, sincere, and hardworking Muslim men and women who are currently
struggling to make it easier for Muslims in North America to lead their lives
in accordance with the Sharı̄‘ah, without having to make unreasonable finan-
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cial sacrifices. Such individuals and groups deserve our support and du‘ā’.
However, prudence also dictates that we recall that religion has often been
used by individuals with sick hearts to exploit the gullible.
The humble educational aims of this work are two-fold:
1. By alerting the North American Muslims to the differences between

conventional and Islamic finance, we may be able to boost the efforts
of the sincere Muslims developing or dealing with Islamic financial in-
stitutions.
2. By providing a clear basic understanding of the underlying contracts,

Muslims may become less prone to making inadvertent errors, as well
as less likely to fall prey to the inevitable exploitative efforts of some
unscrupulous individuals.
I beg the forgiveness of Allāh for the mistakes I make, and pray that He
makes this effort a fruitful one.
Why “Islamic Finance”?
I would like to preempt two opposing reactions that many readers may have
once they recognize that “Islamic finance” is in many ways very similar to
(and at times identical with) conventional finance. Some may feel that this
similarity is an attempt to dilute the Islamic teachings to simplify our lives,
while others may feel that the Islamic Legal distinctions between Islamic
and regular finance are artificial means of creating an industry where none is
needed. I will be among the first to admit that the terms “Islamic banking” or
“Islamic finance” can be quite misleading given the many similarities between
Islamic and conventional financial contracts. To explain my point of view
about this issue, let me use a good analogy: the issue of “Islamic marriage”.
There are no obstacles that prevent Muslims in North America from hav-
ing an Islamic marriage, a contract that adheres to the legal requirements of
the state as well as the Islamic legal requirements. In certain respects, “a
marriage is a marriage”, but in other respects, to abide by all the require-
ments of the Islamic marriage contract, the Muslim man and woman need to
do some extra work. Local Islamic centers, as well as continent-wide organi-
zations like ISNA, provide information and contract-forms to help potential
Muslim families abide by both sets of laws (e.g. providing local religious
“marriage services”, providing forms for an “Islamic will” to ensure abidance
by Islamic inheritance laws, etc.).
Similarly, the notion that “a marriage is a marriage” may be applied in
the realm of finance, e.g. “a lease is a lease”. In this domain also, the Muslim
needs to ensure that the contract he signs with the lessor or lessee agrees with
the conditions of the lease contract (‘aqd al-’ijārah or ‘aqd al-’ı̄jār) in Islamic
jurisprudence. Those conditions are put in place to ensure that the contract
would not contain elements of Ribā or Gharar, which are forbidden in Islam.
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In this sense, “Islamic banks” or “Islamic financial institutions” try to
ensure that all their contracts adhere to Islamic legal requirements as well as
iv
v
state requirements. As with marriage, the outer form of an Islamic lease may
seem to a casual observer to be identical to a regular lease. Recognizing the
differences requires alertness to some of the legal requirements that may seem
subtle to the casual observer. I hope that this primer will wet the readers’
appetites to educate themselves regarding those important Legal financial
requirements of Islam.
Abuses of the terms “Islamic banking and finance” in a number of Is-
lamic countries have precipitated a degree of skepticism among the Muslim
population. The view that the field consists of nothing more than mere
nomenclature has become too deeply rooted in the minds of many sincere
Muslims because of those abuses. That skepticism turned cynical when edu-
cated Muslims examined careless statements by early proponents of the field
of Islamic banking in those countries. Those statements suggested that the
differences between the Islamic model of finance and its conventional (west-
ern) counterpart should be obvious without any need for further education.
Since the behavior of early Islamic banks seemed to casual observers to be
very similar in function and form to conventional banks, the field was sum-
marily dismissed as window-dressing.
Those early tactics were particularly ill-advised given the fact that Allāh
(swt) did not deny the similarity between Islamic and conventional (or west-
ern) finance. When the Arabs argued that “trade is but like ribā” [2:275],
Allāh (swt) did not deny that apparent similarity, but decisively informed
that “but Allāh has permitted trade and forbidden ribā” [2:275]. The le-
gal differences between the two are clear, and have been detailed over the
centuries by capable Muslim jurists. However, the fact remains that the
sophisticated Arab traders of Makkah did not at first see any discernible dif-
ference between the Islamic model and the one based on ribā.1 Therefore, the
reader seeking to understand this difference should expect that understand-
ing the difference is a non-trivial process. My hope – as stated in the preface
– is to dispel some of the misconceptions about this area, and encourage the
reader to seek more requisite Islamic knowledge.
1
Al-’Imām Al-T.abarı̄ (1992, vol.3, p.104), Al-Q
. urt.ubı̄ (1996, vol.3-4, p.230) report in
the exegesis of [2:275] that the Arabs before Islam knew only one type of ribā: Once a
person’s debt was due for payment, the creditor gave him the choice “either you pay, or you
increase the debt”. They argued that there is no difference between this type of increase
and the increase in the price of a credit sale over the price of a cash sale is identical to
what they were doing. However, Allāh (swt) made the fundamental distinction, which was
later explained by the Prophet (pubh) and analyzed by Islamic scholars.
Contents
Preface ii
Why “Islamic Finance”? iv
1 Prohibitions of Ribā and Gharar 1

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1.1 The prohibition of Ribā . . . . . . . . . . . . . . . . . . . . . . 2
1.1.1 Debt re-sale . . . . . . . . . . . . . . . . . . . . . . . . 5
1.2 The Prohibition of Gharar . . . . . . . . . . . . . . . . . . . . 6
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1.3 Obeying the Law . . . . . . . . . . . . . . . . . . . . . . . . . 8
2 Permissible Financing Methods 9

2.1 Cost-plus sales (murābah.a) . . . . . . . . . . . . . . . . . . . . 10
2.2 Credit sales (bay‘ bi-thaman ’ājil) . . . . . . . . . . . . . . . . 11
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2.3 Leasing (’ijārah or ’ı̄jār) . . . . . . . . . . . . . . . . . . . . . 13
2.4 Partnerships (mushāraka and mud.āraba) . . . . . . . . . . . . 15
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2.5 Islamic forwards (salam and ’istis.nā‘) . . . . . . . . . . . . . . 17
3 Permissible Investment Vehicles 18

3.1 Investing in equities . . . . . . . . . . . . . . . . . . . . . . . . 18
3.2 “Fixed income” funds . . . . . . . . . . . . . . . . . . . . . . . 21
4 Permissible Insurance Alternatives 23

4.1 Prohibition of financial insurance . . . . . . . . . . . . . . . . 24
4.2 Cooperative insurance . . . . . . . . . . . . . . . . . . . . . . 26
5 Answers to Commonly Asked Questions 27

5.1 Trading in stocks . . . . . . . . . . . . . . . . . . . . . . . . . 27
5.2 Interest on bank deposits . . . . . . . . . . . . . . . . . . . . . 29
5.3 Lending . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
vi
CONTENTS vii
5.4 What is the difference? . . . . . . . . . . . . . . . . . . . . . . 34
A Translation & transliteration 37

A.1 Abbreviations . . . . . . . . . . . . . . . . . . . . . . . . . . . 37
A.2 Transliteration table: . . . . . . . . . . . . . . . . . . . . . . . 38
A.3 Glossary of used Arabic terms . . . . . . . . . . . . . . . . . . 39
viii CONTENTS
Chapter 1
Prohibitions of Ribā and Gharar

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It is commonplace in Islamic discourse to stress the positive injunctions to
do good and forbid evil before discussing prohibitions and other negative
injunctions. However, in the interest of saving the reader’s time, we go
directly to the need for having an “Islamic finance”. In this regard, financial
tools, like all other tools of social and economic interaction, can be used for
good or for evil. Using the tools of finance for good rather than evil is – of
course – of primary concern in the “Islamic” vs. “un-Islamic” distinction.
However, those aspects of the distinction – important as they are – lie beyond
the scope of this basic guide.
Our primary concern, instead, is the Muslim individual, group, or busi-
ness, with a legitimate and good financial objective (e.g. purchase a home to
house his family, purchase real estate to establish a Masjid or school, invest
available funds in productive and permitted ways, etc.). As we shall see,
many of the conventional financial tools currently available in North Amer-
ica (and most of the rest of the world) are legally prohibited in Islam. In
this chapter, we shall review the two fundamental Islamic prohibitions which
render financial contracts invalid (bāt.il) and forbidden (h.arām).
Before proceedings to the specific prohibitions, I must reiterate that we
are here concentrating on the Islamic legal aspects pertaining to the contract
itself. Needless to say, an Islamically permissible contract may still be un-
Islamic for other reasons. For instance, a legal contract for purchasing an
automobile may be permissible, but the buyer may intend to use the car for
evil rather than good. Concentrating on the legality of the sale contract does
not imply that it is more important than the other considerations. It simply
means that it is one important consideration.
1
2 CHAPTER 1. PROHIBITIONS OF RIBĀ AND GHARAR
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1.1 The prohibition of Ribā
Most probably, the reader is familiar with the verses of prohibition of Ribā in
the Qur’ān. Unfortunately, negligent interpretations of the meaning of those
verses has led many individuals to assume that the prohibition only relates
to situations where the creditor is likely to charge exploitatively high rates of
interest. One of the most popular translations of the meaning of the Qur’ān,
Yusuf ‘Ali (1991), translates the meaning of verses [2:278-279] thus:
278. O ye who believe! Fear Allah, and give up what remains of

your demand for usury, if ye are Indeed believers.
279. If ye do not, take notice of war from Allah and His Messen-
ger: but if ye turn back, ye shall have your capital sums; Deal
not unjustly, and ye shall not be dealt with unjustly.
Thus, the English reader who is not familiar with the end of verse 279 “lā
taz.limūna wa lā tuz.lamūn”, reads this translation as a proof that the (sole?)
objective served by the prohibition of Ribā is the avoidance of injustice (in the
sense of exploitation of the poor debtor by the rich creditor). However, the
meaning of the ending of the verse – as explained by ’Abū Ja‘far, ’Ibn ‘Abbās,
and others (c.f. Al-’Imām Al-T.abarı̄ (1992, vol.3, pp.109-110)) – is much
closer to: “if you turn back, then you should collect your principal, without
inflicting or receiving injustice”. The exegetes (ibid.) then explain “without
inflicting or receiving injustice” as “without increase or diminution”, where
both an increase or a decrease of the amount returned relative to the amount
lent would be considered injustice.
Understanding the Objectives of the Law is important for students of
Islamic Law.1 However, laymen and religious scholars alike must abide by
the Law. Therefore, what we need to understand is: what constitutes the
forbidden Ribā, and how can we avoid it? In the remainder of this section,
we shall cite H. adı̄th s and jurists’ analyses which explain the forbidden Ribā.
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Later chapters will deal with the Islamic alternatives to Ribā.
There are numerous H . adı̄th s which detail the prohibition of Ribā. In the
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interest of brevity, I list only two here:
1
In this regard, Islamic scholars have long debunked the explanation of the prohibition
of Ribā solely on the basis of its exploitative nature. The interested reader my refer to
Al-Nawawı̄ (continuation by Al-Subkı̄) (1995, vol.9: “far‘ fı̄ madhāhib al-‘ulamā’ fı̄ bayān
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‘illat al-ribā fı̄ al-’ajnās al-’arba‘ah”).
1.1. THE PROHIBITION OF RIBĀ 3
1. Muslim narrated on the authority of ’Abū Sa‘ı̄d Al-Khudriy; The Mes-

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senger of Allāh (pbuh) said:
“Gold for gold, silver for silver, wheat for wheat, barley for
barley, dates for dates, and salt for salt; like for like, hand to
hand, in equal amounts; and any increase is Ribā.”
2. Muslim narrated on the authority of ’Abū Sa‘ı̄d Al-Khudriy:

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Bilāl visited the Messenger of Allāh (pbuh) with some high
quality dates, and the Prophet (pbuh) inquired about their
source. Bilāl explained that he traded two volumes of lower
quality dates for one volume of higher quality. The Messenger
of Allāh (pbuh) said: “this is precisely the forbidden Ribā!
Do not do this. Instead, sell the first type of dates, and use
the proceeds to buy the other.”
The first H . adı̄th enumerates six goods which are eligible for Ribā. Since
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barter trading (e.g. dates for dates, as in the second H . adı̄th ) is rarely of
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concern today, we shall mainly be concerned with Ribā as it pertains to gold
and silver, the monies (Roman and Persian, respectively) used during the
Prophet’s (pbuh) time. With the exception of juristic schools which denied
the use of reasoning by legal analogy (qiyās) as a source of legislation (e.g.
the Z.āhirı̄s), and a few contemporary detractors, most Islamic schools of
jurisprudence accepted gold and silver in the first H . adı̄th to signify money
2 ¯
in general, including contemporary monies. In this regard, the Islamic Fiqh
Council of the Organization of Islamic Conference (OIC), in its third meeting
in 1407 A.H., ruled as follows:
After reading the studies presented to this Council regarding

this topic, the Council has determined – regarding the legal status
of paper currency – that it is a form of independent money, for
which apply all the legal rulings which apply to gold and silver,
including the rulings regarding Ribā, Zakāh, and salam. The legal
reason for this ruling is the use of such monies as monetary nu-
meraires, in terms of which prices are specified (al-thmaniyyah).
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2
The interested reader may consult ’Ibn Rushd (1997, vol.3, pp.183-184) for a summary
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of the major Sunni school generalizations based on this H
. adı̄th .
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The first cited H . adı̄th makes it clear that there are two conditions for
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exchanging money for money: hand-to-hand, and in equal quantity. This is
what is known as a currency exchange contract (‘aqd al-s.arf), where money
is traded at the current exchange rate. However, any violation of the H . adı̄th
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will result in one of two forms of forbidden Ribā:
1. Ribā al-fad.l: where money is exchanged for money hand-to-hand, but
in different quantities, or
2. Ribā al-nası̄’ah: where money is exchanged for money with deferment.
The latter form (Ribā al-nası̄’ah) is the one upon which most of western
finance has been built. In the conventional financial sector, financial in-
termediation is effected through lending, and the time value of money is
reflected in interest payments. As we have seen, this is unequivocal Ribā, the
devourer of which was warned of a war from Allāh and His Apostle. Indeed,
’Abū Dāwūd narrated on the authority of ’Ibn Mas‘ūd (mAbpwh) that
The Messenger of Allāh (pbuh) cursed the one who devours Ribā,
the one who pays it, the one who witnesses it, and the one who
documents it.
Similar traditions with slightly different language were narrated in Muslim,
Al-Bukhārı̄, and Al-Tirmidhı̄. Another most damning H . adı̄th was narrated
¯ ¯ ¯
by Ibn Mājah and Al-H. ākim on the authority of ’Ibn Mas‘ūd (mAbpwh) that
the Prophet (pbuh) said:
There are seventy three different types of Ribā, the least of which
is equivalent [in sin] to committing incest, and the worst of which
is equivalent [in sin] to destroying the honor of a Muslim.
Notice that unlike the prohibition of Gharar (risky or ambiguous sales),
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to which we shall turn shortly, the prohibition of Ribā is unequivocal. The
jurists have been more lenient to varying degrees with the prohibition of
Gharar since no contract can ever be totally devoid of uncertainty. However,
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as we shall see shortly, most of the financial needs that can be served with
contracts containing Ribā can be met without the need for Ribā. In partic-
ular, Muslims do not need to deprive themselves of credit to avoid paying
Ribā, nor do they need to forego the time value of their wealth to avoid
receiving Ribā.3
3
The notion that there is no time-value for wealth in Islam is false, as we shall see in
Chapter 2. The notion that money is sterile (does not grow by itself) and has no time
1.1. THE PROHIBITION OF RIBĀ 5
1.1.1 Debt re-sale

As we shall see in the following chapter, Islamic financial contracts (e.g.
leases and credit sales) result in debts or liabilities (duyūn) on the party
for whom the acquisition of an asset is financed. Charging an increase for
further deferment of the payment of such debts as a function of time (e.g. a
late rental payment in a lease, or a late installment payment in a credit sale)
would constitute Ribā al-jāhiliyyah, the worst form of Ribā condemned in the
Qur’ān. ’Ibn Rushd labeled such increases the rule of “defer and increase”
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(’amhilnı̄ ’azidka) and condemned it thus. The opposite rule, in which the
amount of the debt is reduced due to prepayment, was also listed by ’Ibn
Rushd (ibid.) among the types of Ribā, under the title “prepay and reduce”
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(d.a‘ wa ta‘ajjal). The prohibition of the latter rule has been controversial
historically, and it was relaxed in recent years by various juristic bodies.4
Those opinions were recently used to develop so-called “Islamic credit cards”,
where purchases are automatically financed over a fixed period (usually 12
months), and earlier payments result in reduced charges. Despite the almost
unanimous acceptance of the juristic backing of this rule by contemporary
juristic bodies, some of its various financial applications remain controversial.
The two rules discussed above can be encompassed under the more general
topic of trading in debts. The “defer and increase” rule is in fact selling the
current debt to the debtor, where the price is an even larger debt with a
longer deferment period. As stated above, this is Ribā al-jāhiliyyah, and it
is strictly prohibited. The sale of a debt to the debtor, therefore, must be at
face value (unless part of the debt is forgiven).
More interesting, on the other hand, is the potential of selling debts
to third parties. In conventional “asset-backed securitization”, a mortgage
company or bank sells its “accounts receivable” from its mortgages or other
value is – in fact – part of the traditional doctrine of the Catholic church, and rather alien
to Islam. In fact, it was argued in Al-Qarad.āwı̄ (1999, vol.1, pp.37-8, 139-149) that the
growth potential (namā’) for wealth (māl) is one of the conditions of eligibility for Zakāh.
The term is derived from zakā which means “to grow”. The word Ribā is derived from
rabā which also means “to grow”. The reader is encouraged to contemplate the constant
conjunction of Qur’anic verses of the prohibition of Ribā with verses encouraging charitable
payments.

4
See, for instance, the recent rulings by

,

(

, !"

#$, and % & ' ) *& ' +&, (c.f.,

resp., Sakhr (1996, fatawa #50,1291,265,740,536).
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financing instruments to third parties. In fact, if the reader currently has a
mortgage with any given company, it is almost certain that this mortgage was
securitized and sold to others (e.g. Fannie Mae, etc.), even though payments
continue to be made to the originator mortgage company.
The reason I mention this issue will become apparent in Chapter 3 be-
low. Islamic banks will have “accounts receivable”5 corresponding to lease or
installment payments (in leases and credit sales, resp.). In principle, those
accounts receivable may be “sold” to the public as a fixed-income investment
vehicle with minimal risk (the risk that the debtor will default, and the re-
possessed asset sells for less than anticipated). Debt re-sale has been used
extensively in the Islamic financial market in Malaysia, following a Shāfi‘ı̄
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ruling which permits such trading. The practice remains controversial since
the H. anafı̄s and H
. anbalı̄s (with the exception of ’Ibn Al-Qayyim) render such
transactions prohibited, and the Mālikı̄s permit it only under very stringent
conditions. While a variety of “tricks” (h.iyal) under various guises have been
suggested and used in various “Islamic countries”, I shall restrict attention
in Chapter 3 to the most obviously uncontroversial alternatives which do not
include such tricks.
1.2 The Prohibition of Gharar

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There are numerous H . adı̄th s forbidding Gharar sales, and specific instances
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thereof. One commonly cited H . adı̄th was narrated by Muslim, ’Ah.mad, ’Abū
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Dāwūd, Al-Tirmidhı̄, Al-Nasā’ı̄, Al-Darāmı̄ and ’Ibn Mājah on the authority
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of ’Abū Hurayra (mAbpwh) (translation of the version in Muslim) that
The Prophet (pbuh) prohibited the pebble sale and the Gharar
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sale.
A good translation of Gharar is “risk” or “uncertainty”.6 Professor
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Mus.t.afā Al-Zarqā’ defined it as follows:
5
An “account receivable” is any amount owed to a business by a customer as a result
of a credit sale.
6
The term risk (Italian: risco, French: risque) is derived from the Latin roots re = back
and secare = cut, thus reflecting the potential for a sailor to have his ship cut by hitting
a rock. In other words, “risk” means “danger of loss”. This is precisely the meaning of
the Arabic term Gharar. The literal meaning of the term Gharar according to Qād.ı̄ ‘Iyād.
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(c.f. Al-Qarāfı̄ (n.d., vol.3, p.266)) is: “that which has a pleasant appearance and a hated
essence”.
1.2. THE PROHIBITION OF GHARAR 7
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Gharar is the sale of probable items whose existence or charac-
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teristics are not certain, due to the risky nature which makes the
trade similar to gambling.
Many classical examples of Gharar were provided explicitly in the H . adı̄th .

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They include the sale of fish in the sea, birds in the sky, an unborn calf in
its mother’s womb, a runaway animal, the semen and unfertilized eggs of
camels, un-ripened fruits on the tree, etc. All such cases involve the sale of
an item which may or may not exist. In such circumstances, to mention but
a few, the fish in the sea may never be caught, the calf may be still-born,
and the fruits may never ripen. In all such cases, it is in the best interest of
the trading parties to be very specific about what is being sold and for what
price. For instance, ’Ah.mad and ’Ibn Mājah narrated on the authority of
’Abū-Sa‘ı̄d Al-Khudriy (mAbpwh):
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The Prophet (pbuh) has forbidden the purchase of the unborn
animal in its mother’s womb, the sale of the milk in the udder
without measurement, the purchase of spoils of war prior to their
distribution, the purchase of charities prior to their receipt, and
the purchase of the catch of a diver.
The last prohibition in this H . adı̄th pertains to a person paying a fixed price
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for whatever a diver may catch on his next dive. In this case, he does not
know what he is paying for. On the other hand, paying a fixed price to hire
the diver for a fixed period of time (where whatever he catches belongs to the
buyer) is permitted. In this case the object of sale (the diver’s labor for – say
– one hour) is well defined. In many cases, Gharar can be eliminated from
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contracts by carefully stating the object of sale and the price to eliminate
unnecessary ambiguities.
In contemporary financial transactions, the two areas where Gharar most
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profoundly affects common practice are insurance and financial derivatives.
Jurists often argue against the financial insurance contract, where premia are
paid regularly to the insurance company, and the insured receives compen-
sation for any insured losses in the event of a loss. In this case, the jurists
argue that the insured may collect a large sum of money after paying only
one monthly premium. On the other hand, the insured may also make many
monthly payments without ever collecting any money from the insurance
company. Since “insurance” or “security” itself cannot be considered an ob-
ject of sale (c.f. Al-Zuh.aylı̄ (1997, vol.5, pp.3415-3420) for more details), this
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contract is rendered invalid because of the forbidden Gharar. Of course, con-
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ventional insurance also suffers from prohibition due to Ribā since insurance
companies tend to invest significant portions of their funds in government
bonds which earn them Ribā.
The other set of relevant contracts which are rendered invalid because of
Gharar are forwards, futures, options, and other derivative securities. For-
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wards and futures involve Gharar since the object of the sale may not exist
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at the time the trade is to be executed. As we are going to see, Islamic Law
permits certain exceptions to this rule through the contracts of salam and
’istis.nā‘. However, the conditions of those contracts make it very clear that
contemporary forwards and futures are not permitted under Islamic law.
Classical jurists called such contracts where both the price and the goods
were to be delivered at a future date al-bay‘ al-mud.āf, e.g. “I sell you this
car for so-much at the beginning of the next month”, and considered them
non-concluded and thus invalid. Contemporary options were also discussed
by traditional jurists, e.g. “I sell you my house for so-much if my father
returns”, and called it a suspended conditional sale (al-bay‘ al-mu‘allaq).
They have also rendered such sales invalid due to Gharar (c.f. Al-Gharar wa
¯ ¯
’Atharuhu fı̄ Al-‘Uqūd by S.iddı̄q Al-’Amı̄n (pp.137-149) for a full discussion).
¯
1.3 Obeying the Law

I hope that the reader will find that the questions which justify the develop-
ment of an “Islamic financial” industry are well motivated:
1. If a Muslim does not possess enough cash to purchase a house, car, of-
fice equipment, etc., does he have any options other than borrowing to
finance such a purchase (which will no-doubt include Ribā), or refrain-
ing from making the purchase (which will no-doubt affect his quality
of life and future financial prospects)?
2. Can a Muslim (perhaps a retiree) invest his savings in a way which will
earn him a h.alāl income without exposing himself to too much risk?
3. Is there a permissible alternative to commercial insurance?

Chapter 2
Permissible Financing Methods
Most types of trade (buying and selling) are permitted in Islam, where pro-
hibition is the notable exception. Yusuf ‘Ali (1991) translated the meaning
of [2:275] thus:1
Those who devour usury (ribā) will not stand except as stands
one whom the Evil One by his touch hath driven to madness.
That is because they say: ‘trade is like usury’, but Allāh hath
permitted trade and forbidden usury.
Thus, “Allāh has permitted trade” (bay‘) is the general rule, with Ribā sales
being a strictly forbidden exception.
A valid trade is concluded in Islam if the seller and buyer exchange an
offer and acceptance which specify the object of sale and the price, and they
both agree. Yusuf ‘Ali (1991) translates the meaning of [4:29] thus:
But let there be among you traffic and trade by mutual good will.
Al-Bayhaqı̄ and ’Ibn Mājah narrated on the authority of ’Abū-Sa‘ı̄d Al-

Khudriy that the Messenger of Allāh (pbuh) said (translation of the language
¯
in ’Ibn Mājah):
I shall meet Allāh before I give anyone something owned by an-

other without his consent, for a trade requires mutual consent.
1
The English reader may take the term “usury” to mean exorbitant interest, as most
contemporary dictionaries would indicate. As seen in the previous chapter, Ribā (a term
for which no contemporary English translation would be accurate) is strictly forbidden
regardless of how small or large the interest rate may be.
9
10 CHAPTER 2. PERMISSIBLE FINANCING METHODS
Not only is trading permitted, it is encouraged. Al-Suyūt.ı̄ mentioned in

Al-Jāmi‘ Al-S.aghı̄r, a H
. adı̄th on the authority of Rāfi‘ that:
¯ ¯
The Prophet (pbuh) was asked: “which are the best forms of
income generation?” He (pbuh) replied: “A man’s labor, and
every legitimate sale”.
Therefore, any financing conducted through valid trading by mutual con-

sent is permissible. However, since most Muslims (myself included) lack
sufficient knowledge regarding the various conditions for a sale to be valid,
contemporary jurists and financial practitioners have limited Islamic banking
and finance to a few “named” contracts. Those are contracts that have been
studied extensively by jurists over the centuries, and whose validity is well
established through the Prophet’s (pbuh) own actions (Sunnah), or consen-
sus of the early Muslim communities and jurists (’ijmā‘). To further add
credibility to the industry, the Arabic names for those contracts are often
used instead of their English counterparts (e.g. the term ’ijārah is often used
instead of its English counterpart “lease”). In what follows, I shall review
the most commonly used contracts in Islamic finance, utilizing both their
Arabic and English names.
2.1 Cost-plus sales (murābah.a)

In this sale, the buyer knows the price at which the seller obtained the object
to be financed, and agrees to pay a premium over that initial price. It
was narrated that ’Ibn Mas‘ūd (mAbpwh) ruled that there was no harm in
declared lump-sum or percentage profit margins. Thus, one may approach an
Islamic financial institution and say “purchase this item on my behalf at this
price, and I shall give you a profit (’urbih.uka) margin of $10”, or “purchase
this item on my behalf at this price, and I shall give you a profit (’urbih.uka)
margin of 10%”. The fact that the latter statement may be perceived to
make explicit a percentage2 payment should not be of concern, since it is
not Ribā if the sale satisfies the conditions of murābah.a.3 Notice that in this
2
Or “interest rate”, if a time factor is present as we shall see in the next section.
3
The faulty use of the contemporary term “interest” as a translation of the term Ribā
has led to many misconceptions. Bank interest is certainly the forbidden Ribā (please see
the long discussion of this point in Section 5.2 below). However, just because a profit
margin in a valid sale is stated as a percentage does not mean that it is Ribā. Stating
2.2. CREDIT SALES (BAY‘ BI-THAMAN ’ĀJIL) 11
¯
contract, the Islamic bank or financial institution must own the item at the
time the customer buys it from them with the specified profit margin.
2.2 Credit sales (bay‘ bi-thaman ’ājil)

¯
Very rarely is murābah.a used by Islamic banks with the price paid immedi-
ately by the customer. In such cases, there would be no financing included,
and the Islamic bank would simply be a middle-man or broker-agent (simsār).
When a customer approaches an Islamic bank to finance a purchase through
murābah.a the payment of the price is usually deferred, and most commonly
paid in installments.4
In such cases, it is easy to look at the end result and assume that this
is simply a juristic “trick” to circumvent the prohibition of Ribā. However,
this is certainly not the case. Indeed, the murābah.a component determines a
profit margin (even as a percentage of the original price), and the deferment
ensures that this profit is collected over a period of time. The rate of return
is thus guaranteed (up to the risk of default on payments by the buyer) over a
fixed period of time. Twenty-some year-old misconceptions in the literature
on Islamic banking would argue that this makes the banks’ profits a form of
Ribā. However, it is curious to note that some of the proponents of this view
in the 1970s were themselves the pioneers of the field of Islamic banking in the
Arab Islamic countries and elsewhere. Those banks dealt almost exclusively
in the early years in instruments such as the one considered here (and leases
to which we shall turn shortly). It was only a matter of time for sophisticated
observers to note that those banks’ rhetoric contradicted their actions. This
early confusion about Islamic banking and finance continues to plague the
immigrant Muslim community in North America to this day.
Perhaps the source of the confusion is precipitated by the conjunction of
the deferment of the price payment and the profit rate. A seventh grader
can calculate the implicit annual interest rate in such a contract. However,
traditional Islamic jurists over the centuries have indeed permitted such a
conjunction of increase with deferment. In fact, they have explicitly justified
it as a percentage only requires simple division of the profit margin by the original price,
followed by multiplication by 100! In fact Jordanian law on murābah.a, dating back to
Ottoman Law in 1903, explicitly states a maximal interest rate of 9% in murābah.a.
4
For Arabic readers, I recommend the excellent short manuscript by Al-Mis.rı̄ (1997)
for all the relevant juristic details of the permission of such sales.
the increase by the deferment. Al-Mis.rı̄ (1997, pp.39-44) lists a number of

quotes by traditional jurists of various schools, illustrating the permissibil-
ity of increasing the price based on deferment. Some jurists qualified this
permissibility with conditions to ensure that other reasons for prohibition
(e.g. two sales in one, a sale and a condition in one contract, etc.) were not
present.
I shall only list a few of the quotations included in the above text to
illustrate that increasing the price due to deferment is indeed permissible:
• Al-Kāsānı̄ in Badā’i‘ Al-S.anā’i‘ (H

. anafı̄ masterpiece) said: “the price

).
may be increased based on deferment” (
• H
. āsh
iyat ’Ibn ‘Abidı̄n (compendium of H
. anafı̄ jurisprudence): “a price

).
¯
is increased if it is deferred” (

• ’Ibn Rushd (Mālikı̄) in Bidāyat Al-Mujtahid wa Nihāyat Al-Muqtas.id:
!
“He has given time a share in the price” (
¯

"#).
• In Al-Majmū‘ by Al-’Imām Al-Nawawı̄ and Taqiyuddīn Al-Subkı̄ (Shāfi‘ı̄
¯
masterpiece): “deferment earns a portion of the price”, also in H
. āsh iyat
¯
¯ ¯
El-Gamal ‘alā Sharh. Al-Manhaj (Shāfi‘ı̄), and Fatāwā ’Ibn Taymiya

. anbalı̄), ( $#
).
(H
The contemporary confusion is hardly new. In ’Ibn Al-‘Arabı̄’s ’Ah.kām

Al-Qur’ān, he reports a specific argument given by the Arabs during the
time of Prophet Muh.ammad (pbuh) to support their statement that “trade
is like Ribā” [2:275]. They argued as follows: Consider a credit sale, with a
price of 10 payable in a month. After a month, the buyer and seller agree
to postpone for one more month, and increase the price to 11. The latter
is forbidden Ribā. They then argued: is this not the same as an initial sale
with the price of 11 deferred for two months? The answer in [2:275] was a
decisive “but Allāh has permitted trade and forbidden Ribā”.
The legal difference between the two is very clear: one is a sale in which
price is increased for deferment, and the other is an increase in the amount
of a debt for deferment. The first is permitted, and meets almost all the
financing needs which can be met through forbidden Ribā-based lending. The
second, however, is strictly forbidden. The permissibility of the first and the
2.3. LEASING (’IJĀRAH OR ’ĪJĀR) 13
prohibition of the second are both quite clear and unequivocal.5 Therefore,
we may use credit sales as a form of finance, and we must categorically avoid
interest-bearing loans. Why one is permitted while the other is forbidden
can only be fully known by Allāh and whomsoever he gave such knowledge.
As a practical matter, we should know what is permitted and use it to our
advantage, and what is forbidden and avoid it.
2.3 Leasing (’ijārah or ’ı̄jār)

Legally, the lease contract is not a sale of the object, but rather a sale of the
usufruct (the right to use the object) for a specified period of time. The sale
of usufruct is permissible in Islam, as evidenced by the verses (translation of
meaning by Yusuf Ali (1991)):
And if they suckle your offspring, give them their recompense.
[65:6]
Said one of them: ‘O father, hire him on wages, for truly the best
to employ is a strong and trustworthy man’. He said: ‘I intend to
wed one of my daughters to you, on condition that you work for
me for eight years, and if you complete ten full years, that will
be a grace from you’. [28:26-27]
It is also established by the following H. adı̄th narrated by ’Ah.mad, ’Abū
¯
Dāwūd, and Al-Nasā’ı̄ on the authority of Sa‘d (mAbpwh):
The farmers during the time of the Prophet (pbuh) used to pay
rent for the land in water and seeds. He (pbuh) forbade them from
doing that, and ordered them to use gold and silver (money) to
pay the rent.
Also, ’Ah.mad, Al-Bukhārı̄ and Muslim narrated on the authority of ’Ibn
¯
‘Abbas (mAbpwh) that the Prophet (pbuh) hired a man to cup [water] for
him, and paid him his wages.
There are a number of conditions for lease-financing to be valid (the in-
terested reader may refer to M. Taqi Usmani (1998, pp. 157-174) for a partial
5
The non-Arabic readers, who may not have access to the above referenced manuscript
by Al-Mis.rı̄ (1997), may refer to M. Taqi Usmani (1998, pp.104-109) for clear legal distinc-
tions between the increased price in credit sales and the forbidden interest on loans/debts,
as well as some of the technical legal conditions for murābah.a financing to be valid.
list). The most important financial difference between Islamically permitted

leasing and conventional financial leasing is that the leasing agency must own
the leased object for the duration of the lease. Therefore, while leasing an
automobile from a car manufacturer or dealership may in principle be permit-
ted (if the contract satisfies the other conditions), Muslims should be careful.
In many cases, the dealership will in-fact use a bank or other financial inter-
mediary to provide a loan for the present value of lease payments, and charge
the customer an interest on this loan. This would constitute the forbidden
Ribā. Careful Islamic financial institutions ensure that the contract abides
by all the restrictions set in the Sharı̄‘a (e.g. sub-leasing requires the per-
¯
mission of the lessor, late payment penalties must be handled very carefully
to avoid the forbidden Ribā, etc.).
Recently, Muslim jurists have also provided an Islamic alternative to con-
ventional lease-purchase agreements (called in Arabic ’ijārah wa ’iqtinā’).
In this contract, a lease is written as discussed above, with an additional
promise by the lessor that he will agree to sell the leased object at the end
of the lease at a pre-determined residual value. This promise is binding on
the lessor only, and the lessee has the option of purchasing the item at the
end of the lease, or returning it to the owner-lessor (c.f. ibid. (pp.175-6)).
A common model for equipment, auto and home financing in North Amer-
ica is based on leasing or lease-purchase. The Islamic financial institution
buys the financed object, and retains the title through the life of the con-
tract. The customer makes a series of lease payments over a specified period
of time, and may have the option at the end to buy the item from the lessor
(and owner) at a pre-specified residual value. The period of the lease and the
rent payments may be made such that the final payment is only symbolic.
It is no secret (at least it should not be a secret) that the Islamic bank
or financial institution will take into consideration the same factors when
determining the rental payments and residual value that a regular bank would
consider: the value of the financed item, its depreciation value, inflation, the
credit-worthiness of the lessee, the opportunity-cost value of the money (as
reflected by market interest rates), etc. Of course, an implicit “interest rate”
can trivially be calculated from the price, residual value, term of the lease
and the lease payment. There is no need to hide this fact, and indeed,
the intelligent Muslim customer (as Muslim customers should always be)
must be encouraged to “shop-around” and ensure that the Islamic financial
institution is not implicitly charging an interest rate which is not in line with
the conventional market. However, in the final analysis, the difference will
2.4. PARTNERSHIPS (MUSHĀRAKA AND MUD
. ĀRABA) 15
¯
be in the form of the contract. If the lease is structured in accordance with
the various conditions detailed in books of jurisprudence, it will contain no
Ribā and will ensure that it cannot contain such forbidden Ribā in the future
(e.g. in terms of late payment fees, etc.).
2.4 Partnerships (mushāraka and mud.āraba)

¯
Various forms of partnership can be direct financing methods. In the early
days of Islamic banking and finance, those forms were commonly grouped
under the banner “profit and loss sharing”, to be contrasted with the above
listed debt-based forms of financing. It was assumed by some that the profit
and loss sharing methods were somehow more ideal from an Islamic point
of view. The fact that most Islamic banking practice concentrated on credit
sales and leases was thus often lamented as re-labeling of the forbidden inter-
est. As we have already seen, if the Islamic banks and financial institutions
are careful to abide by the rules of Sharı̄‘a, there is no reason to think that
¯
credit sales are any “less Islamic” than a silent partnership (mud.āraba) or full
partnership (mushāraka).6 There are a number of rules in Sharı̄‘ah regarding
¯ ¯
the language of the various partnership contracts, the rights and obligations
of various parties, and the sharing rules for profits and losses.
Most of the users of such partnership contracts will require the services
of legal experts in any case, and therefore should also consult Islamic legal
experts on the legitimacy of any specific contract. Therefore, there is no need
to spend much time on those general contracts.
However, one model of financing which has been used in North America is
6
Still, respected jurists as well as many Islamic economists, while admitting the permis-
sibility of debt-based financing, continue to echo such sentiments. For instance, M. Taqi
Usmani (1998, pp.239-240) states: “The ideal instrument of financing according to the
Shariah is Musharakah where the profits and losses both are shared by both the parties
according to equitable proportions”. This opinion is not based on any solid juristic or re-
ligious evidence, but rather based on the jurist’s economic reasoning (ibid): “Musharakah
provides better opportunities for the depositors to share actual profits earned by the busi-
ness which in normal cases may be much higher than the rate of interest. Since the
profits cannot be determined unless the relevant commodities are completely sold, the
profits paid to depositors cannot be added to the cost of production, therefore, unlike
the interest-based system the amount paid to depositors cannot be claimed back through
increase in the prices”. It is important for the sophisticated reader to distinguish be-
tween the jurists’ opinions which are based on solid religious grounds, and those based on
inadequate economic reasoning.
based on a form of mushāraka, where the financing agency and the customer
¯
share the ownership of real estate. This contract is known by many names,
most prominent among them is the name mushāraka mutanāqis.ah (diminish-
¯
ing partnership). In contrast to the leasing model, where ownership of the
financed item remains with the lessor for the entire lease period, ownership in
a diminishing partnership is explicitly shared between the customer and the
Islamic financial institution (legally, what is established is an Islamic sharikat
¯
al-milk). The periodic payments of the customer in this model contain two
parts: (i) a rental payment for the part of the property owned by the Islamic
financial institution, and (ii) a buy-out of part of that ownership. Over time,
the portion of the asset which is owned by the customer increases, until he
owns the entire asset and needs to pay no more rent. At that time, the
contract is terminated.
Examining the periodic payments, the customer will find that they look
very much like a conventional mortgage schedule. Early-on, a large portion of
the payment is “rent” (corresponding to “interest payment” in conventional
mortgage), and a small part is “buy-out” (corresponding to the “principal
payment” in a conventional mortgage). As time progresses, the first com-
ponent gets smaller, and the latter component gets bigger, until the rent
becomes zero when the customer owns 100% of the asset. Given this one-
to-one correspondence between the two components of the payments, it is
again trivial to calculate the equivalent interest rate which would make the
conventional mortgage payments identical with the diminishing partnership
payments.
Again, this should not be cause for concern, as long as the partnership
contract is written in full accordance with the rules of Sharı̄‘a (for a partial
¯
list and general discussion, see M. Taqi Usmani (1998, pp. 31-92)). For in-
stance, there is a fundamental difference between a mortgage company which
holds a lien on a financed house, and the actual joint ownership of the house
between the client and the Islamic financial institution. There are a variety
of issues which such institutions need to resolve to operate in compliance
with Sharı̄‘a as well as government regulations, and the intelligent Muslim
¯
customer is again encouraged to ensure that both sets of regulations are met.
As for the correspondence of the “rental” portion of payments to what would
be an interest payment on the principal balance in a conventional mortgage,
this should afford the intelligent Muslim customer an opportunity to ensure
that he is not being charged excessively relative to the conventional market.
As far as compliance with the Islamic Sharı̄‘a is concerned, the form of the
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2.5. ISLAMIC FORWARDS (SALAM AND ’ISTIS.NĀ‘) 17
contract is what matters. To keep the Islamic financial industry from reep-
ing excessive profits at the expense of devout Muslims with few alternative
sources of financing, this comparison to conventional market trends is very
valuable.
2.5 Islamic forwards (salam and ’istis.nā‘)

Those forms of financing are very rarely used, and hence will be mentioned
only in passing. In general, the sale of non-existent objects is forbidden due
to Gharar. However, to facilitate certain types of business, exceptions were
¯
given through those two contracts. The six major books of H . adı̄th narrate
¯
on the authority of ’Ibn ‘Abbās (mAbpwh):
The Messenger of Allāh (pbuh) came to Madı̄nah, and found

its inhabitants entering salam contracts (with the price paid in
advance) in fruits for one, two, and three years. He (pbuh) said:
“whoever enters into a salam contract, let him specify a known
volume or weight, and a known term of deferment”.
Thus, he (pbuh) permitted this trade, where the price is paid in full, and
the well-defined object of the sale is delivered after a specified time. This
pre-payment of the price allowed the farmers to buy seeds, spend for their
own sustenance, etc., in order to be able to produce the fruits.
Most jurists reasoned by analogy (qiyās) and preference (’istih.sān) from
the permissibility of salam to the permissibility of ’ists.nā‘, which may be
translated as “commission to manufacture”. In the latter contract, the price
is paid in installments as the work progresses in manufacturing or building an
otherwise non-existent object. The price pre-paid in installments in this case
will often be lower than the cost of purchasing the finished product (if it were
to exist), and can therefore be a useful tool for building schools, Masjids, etc.
Those two contracts are permitted as exceptions to the general rules of
sale. As such, there are many conditions which must be met for salam or
’istis.nā‘ contracts to be valid. Those considering the use of such contracts
are advised to consult an Islamic Legal expert along with their other lawyers
to ensure that they abide by Sharı̄‘a as well as government regulations.
¯
Chapter 3
Permissible Investment
Vehicles
The previous chapter dealt with permissible vehicles that would allow Mus-
lims to acquire capital to finance purchases of equipment, homes, automo-
biles, etc. We now turn to the other side of the coin: what permissible
investment vehicles are available for Muslims? Of course, there are many
direct investment vehicles. A Muslim can invest directly in any legitimate
business, possibly earning some profits. However, it is useful to focus on
relatively passive investment vehicles such as equities, mutual funds, etc., as
well as “fixed-income” alternatives to forbidden interest-based instruments
such as bonds and money-market funds.
3.1 Investing in equities

Common shares in a listed company are – as the name suggests – “shares” in
the assets of the company. Thus, if the company’s business is legitimate, and
its conduct is in compliance with the rules of Sharı̄‘a, Muslims are allowed
¯
to own such common shares (stock). Common stock may thus be bought
and sold, as the potential owner sees fit. While the common stock is held,
it earns a portion of the total profits of the firm, part of which may be
distributed to the shareholders in the form of dividends, and the other part
may be reinvested in the company. Thus, the first part of the profit-share
is given directly to the shareholder, while the second part is given back
implicitly by the increase in the company’s capital, a fixed proportion of
18
3.1. INVESTING IN EQUITIES 19
which is claimed by the held share. Other common means of investing in

claims on companies’ capital are not allowed: bonds are explicitly a claim on
a portion of the company’s interest-bearing debt, and preferred stock are a
hybrid stock/bond.
Since common stocks of Islamically appropriate companies may thus be
bought and sold, it is also possible to create mutual funds in such stocks. A
mutual fund would group the funds of a number of investors, and “man-
age” those funds by investing in a portfolio of permitted stocks, buying
and selling them as they see fit. The mutual fund managers collect a fee
for their efforts in studying the market conditions as well as the prospects
of each given company. In some Islamic countries, some “Islamic mutual
funds” also calculate and pay the appropriate Zakāh on shares on behalf of
their investors, in addition to screening the various stocks and choosing the
portfolio weights according to their best judgment. Within the Islamically
permitted pool of companies approved for trading by the Sharı̄‘ah boards
¯
of such fund-managing companies, a variety of funds may be created (tech-
nology, high-growth, blue-chip, regional, etc.). Most “Islamic funds” of this
sort have had a consistent record of outperforming “the market” in most
categories. This guide is intended to give general information on trends in
Islamic banking and finance, and therefore, I refrain from giving any specific
information on fund management firms.
One point which should be understood by the reader of this primer, how-
ever, is that a number of compromises were made by jurists to make it pos-
sible for “Islamic stock indices” and “Islamic mutual funds” to exist. If the
strict Sharı̄‘a rules were applied, the pool of permitted stocks will be too
¯
small for any reasonable diversification to be possible. Here’s a particular
dilemma: the strict rules of Sharı̄‘a will dictate that the individuals (and
¯
hence the company in which they are shareholders) should neither borrow
nor lend with interest. However, most listed companies fall in one of two
categories: either they tend to face occasional liquidity shortages, in which
case they borrow (with interest – of course), or they are cash-rich, in which
case they tend to put their excess liquidity in interest-bearing instruments
(e.g. government bonds, etc.). This, together with legal structures in the
U.S. and elsewhere favoring debt financing (e.g. due to tax deductions on
interest payments), make it very difficult to find companies which neither
pay nor receive interest. This difficulty motivated the jurists’ compromises
discussed below.
Sharı̄‘ah boards are employed by “Islamic fund management” firms as
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20 CHAPTER 3. PERMISSIBLE INVESTMENT VEHICLES
well as “Islamic index” generating companies. The jurists serving on those

boards determine a set of rules for selecting the eligible pool of companies
whose stocks may be held by Muslims. Some of those rules are clear-cut,
while others require each investor to search his own conscience for answers.
While the opinions of prominent jurists on “Sharı̄‘ah boards” add a signifi-
¯
cant measure of respectability and credibility to the enterprise, Muslims are
ultimately responsible for their own decisions. If the reader finds some of
those rules unconvincing, he or she should attempt to learn more by contact-
ing the various firms and information sources. No matter how prominent the
issuers of a fatwā may be, they are human. We ask Allāh to reward them for
their best efforts, but we cannot absolve ourselves of our most basic religious
responsibilities by following their opinions if we are convinced otherwise.
The first set of filters is straight-forward: exclude all companies whose
primary business involves forbidden products (e.g. alcohol, pork, tobacco, fi-
nancial services, weapon production, and “entertainment”). A typical screen
given by the Dow Jones Islamic Index (DJII) Sharı̄‘a board can be found on
¯
the web at: http://www.dowjones.com/corp/index products.htm (pp. 8-
10). The second set of filters, based on “financial ratios”, is significantly more
dubious. The rules recently adopted by the DJII board are virtually identi-
cal with those adopted in earlier years by other fund management company
Sharı̄‘a boards in Islamic countries. Those rules relate to the above men-
¯
tioned compromises on three prohibitions due to the inherent Ribā and other
impurities:
1. Carrying interest-bearing debt.
2. Receiving interest or other impure income.
3. Trading in debts at a price other than their face values.
The Sharı̄‘a boards of most Islamic fund managers and equity indices have
¯
reached very similar compromises. The following is the list of rules/compromises
(ibid, p.10) used by DJII:
1. Exclude companies with a debt to total asset ratio of 33% or more.
2. Exclude companies with “impure plus non-operating interest income”
to revenue ratio of 5% or more.
3. Exclude companies with accounts receivable to total assets ratio of 45%
or more.
3.2. “FIXED INCOME” FUNDS 21
Those rules are virtually identical to those used by other indices, e.g. the
FTSE Global Islamic Index Series, http://www.ftse.com/ebox/TII.html.
The first compromise is based rather loosely on a famous H. adı̄th where Sa‘d
¯
(mAbpwh) asked the Prophet (pbuh) how much of his wealth to give in
charity, and the Prophet (pbuh) said: “one-third, and one-third is plenty”

(

). This is clearly an out-of-context use of the Hadı̄th, and
. ¯
jurists do not claim that it is
used as a legal proof, but rather as a comforting

rule of thumb ( ). The third compromise is based on

the view that if the majority of the company’s assets are illiquid, then the
total assets may inherit the status of that majority (c.f. M. Taqi Usmani
(1998, pp.208-210)). The second compromise assumes that 5% is a negligible
amount. I have not been able to find any source which would mention the
origin of that rule.
I do not have the pre-requisite religious knowledge to debate whether or
not compromises on issues related to Ribā can be justified in this manner.
However, I can point out that the cutoff-rules on financial ratios used in this
area seem extremely arbitrary, and potentially rigid. In this regard, even
if they are indeed justified, it is very unlikely that fixed cutoff ratios will
be appropriate for all circumstances and all pools of equities! The reader
will simply have to make his or her own mind. I cannot afford to bear any
responsibility for others’ decisions, and hope that the reader will recognize
that I am only providing information on recent developments in this area to
help him or her become better educated.
3.2 “Fixed income” funds

Many retirees and others need to invest in income generating vehicles with
minimal risk. Obviously, investing in common stocks carries significantly
more risk than most such people can tolerate. At the very least, a compo-
nent of their investment needs to be earmarked for so-called “fixed-income”
vehicles. Unfortunately, the vast majority of conventional fixed income in-
vestments (e.g. CDs, government bonds, money market accounts, etc.) in-
clude forbidden Ribā. How then can retirees and those nearing retirement be
able to get a lower risk source of income from their investments?
Consider a simple example first: the individual seeking the lower risk
investment vehicle may use his money to buy some real estate (e.g. an
22 CHAPTER 3. PERMISSIBLE INVESTMENT VEHICLES
apartment building, or a warehouse) that generate income in the form of

rent. This rent will naturally go up with inflation, as will the value of the real
estate, thus providing a reasonable inflation hedge and helping the investor
keep the real value of his or her wealth, while generating an income on which
to live.
Of course, any specific piece of real estate may still carry risks which
the more sophisticated investor can diversify without affecting the average
income stream. For instance, the particular area in which you buy an apart-
ment building may become less fashionable, and the value of the building as
well as the rent income may decline significantly. Also, any given building
may require substantial repair costs due to unforeseen damages, etc. There-
fore, it may be better for the investor to team-up with a group of similar-
minded investors and jointly own a collection of buildings in different areas.
Each individual’s share of the total rent income will be equal to his share in
the total value of the portfolio. This simple diversification can allow him to
have the same average rent income he could get on his own, but with much
lower risk (the chances that all the buildings will be adversely affected at the
same time is very small).
This is the concept behind an “’ijārah fund”. Recall that an Islamic
financial institution engaged in a number of lease contracts continues to own
the assets throughout the life of the leases. While some jurists restricted the
lessor’s ability to sell the leased asset or parts thereof during the lease period,
most others permitted such a sale as long as the lease continues. Therefore,
the Islamic financial institution can treat its portfolio of leased assets as a
company or fund, shares of which may be sold to investors. The investors
then earn a fixed income according to their shares in the fund. Like the
forbidden conventional fixed income investments (e.g. money market funds,
bonds, etc.), the fixed income from a lease fund will move up with inflation,
and the risks borne are minimal (default in the conventional contract vs.
default and repairs or losses of assets in the lease fund).1
1
It is becoming popular nowadays to propose also having “murābah.a funds” along
similar lines. However, in a murābah.a, the asset is no longer owned by the Islamic financial
institution, and what they can “securitize” and sell is therefore the cash flow generated
by the liability on the buyer. Such debts/liabilities may only be sold at par value, and
therefore cannot provide a source of income for the “investors”. Compromises along the
lines discussed above are constantly cropping-up, with a higher percentage of physical
assets being combined with some murābah.a accounts receivables in a single portfolio.
Chapter 4
Permissible Insurance
Alternatives
When thinking about reducing certain types of risk (one can never “elim-
inate” a risk in the sense of full “insurance”), one often thinks of “buying
insurance”. The typical financial insurance contract used in North Amer-
ica and elsewhere would entail signing a policy with an insurance company
whereby the insured makes periodic premium payments, and the insurance
company promises to compensate the insured for damages or part thereof
according to a well-specified formula. The majority of Islamic jurists have
concluded that this contract is invalid based on the prohibition of Gharar.
¯
Moreover, since many insurance contracts also include an investment compo-
nent (e.g. certain types of term and life insurance), the insurance companies’
investments in interest-bearing bonds render such contracts invalid based on
the prohibition of Ribā.
The first thing to notice is that “buying insurance” is not the only method
of risk reduction. We have already seen in the previous chapter how simple
diversification schemes can reduce risks. As a matter of fact, the endorsed
Islamic alternative to conventional insurance is the notion of cooperative or
mutual insurance,1 which is based precisely on the same logic of diversifica-
tion used in that chapter.
1
Jurists often use the Arabic term “takāful”, which means cooperative mutual insur-
ance, for this contract. However, since variations on this term have recently been “trade-
marked” in Europe and the U.S., I shall refrain from using it lest the reader assume that
I am endorsing any particular institution to the exclusion of others.
23
24 CHAPTER 4. PERMISSIBLE INSURANCE ALTERNATIVES
4.1 Prohibition of financial insurance

Let us abstract from the prohibition based on Ribā for a second, and consider
only the argument for prohibiting financial insurance based on the prohibition
of Gharar. This prohibition, unlike the prohibition of Ribā, is relative. Al-
¯
Bājı̄ Al-’Andalusı̄ (n.d., vol.5, h.āshiyah, under bay‘u al-Gharar) states:
¯ ¯
His (pbuh) prohibition of bay‘u al-Gharar renders such a sale de-
¯
fective. The meaning of bay‘u al-Gharar, and Allāh knows best,
¯
refers to sales in which Gharar was the major component (ghalaba
¯ ¯ arar.
‘alayhi) until the sale is justifiably described as bay‘u al-Gh
¯
This is the type of sale which is unanimously forbidden. On the
other hand, minor (yası̄r) Gharar does not render a sales contract
¯
defective, since no contract can be entirely free of Gharar. Thus,
¯
the [legal] scholars differ in determining which contracts are defec-
tive due to differences in opinion regarding the extent of Gharar
¯
inherent in each: sic. whether it is substantial and invalidates
the contract, or minor and retains the contract’s validity.
Taqiyyudīn Al-Subkı̄ explicitly summarizes the opinions of earlier jurists

thus (Al-Nawawı̄ (continuation by Al-Subkı̄) (1995, vol. 9)):
The scholars said that the criterion for invalidity of the contract
based on Gharar, or its validity despite the existence of Gharar,
¯ ¯
is thus: if necessity dictates committing Gharar which cannot be
¯
avoided without incurring an excessive cost, or if the Gharar is
¯
trivial (h.aqı̄r), the sale is rendered valid, otherwise it is rendered
invalid.... Thus, the differences among scholars are based on this
general principle, where some of them render a particular form
of Gharar minor (yası̄r) and inconsequential, while others render
¯
the same form consequential, and Allāh knows best.
’Ibn Taymiya (1998, vol. 4) makes the same point as follows:
In this regard, the corrupting factor in Gharar is the fact that it

¯
leads to (kawnuhu mat.iyyat) dispute, hatred, and devouring oth-
ers’ wealth wrongfully. However, it is known that this corrupting
factor would be overruled if it is opposed by a greater benefit
(al-mas.lah.ah al-rājih.ah).
4.1. PROHIBITION OF FINANCIAL INSURANCE 25
Thus, Al-D. arı̄r (1997, pp.44-51) lists four necessary conditions for Gh
¯
arar
to invalidate a contract:
1. It must be major.
2. The potentially affected contract must be a commutative financial con-

tract (this includes sales, but excludes gifts and charitable contribu-
tions, including “sharing” arrangements).
3. The Gharar must affect the principal components of the contract (e.g.
¯
the price and object of sale, language of the contract, etc.).
4. That there is no need met by the contract containing Gharar which

¯
cannot be met otherwise.
Many contemporary jurists, e.g. Al-Zuh.aylı̄ (1997, vol.5, pp.3415-3431),

have argued that commercial insurance satisfies all four conditions. This
opinion dates back at least to ’Ibn ‘Ābidı̄n (n.d., vol.3, p.273 onwards), who
issued a fatwā forbidding marine insurance.2 The Gharar, it is argued, results
¯
from the fact that the premium (price) is paid, where what is being bought
is not well defined. The proponents of this view say that the insured may
pay one small premium and collect a large sum if he can make a legitimate
claim, and he may pay many premia without ever collecting any sum of
money. Notice that “security/insurance” itself is not a valid object of sale
under Islamic jurisprudence. In commercial insurance, jurists argue:
1. The Gharar is argued to be quite substantial, since the amount to be

¯
collected from the insurance company may vary between zero and a
very large sum, depending on chance.
2. The commercial insurance contract is a sale contract, which is a com-

mutative financial contract.
3. The Gharar affects the object of sale, and therefore it is integral to the
¯
contract.
4. The cooperative insurance alternative can meet the needs that are met
by commercial insurance.
2
As we have seen, the origin of the term risk, re-secare, suggests that the origins of the
analysis of risk and insurance lie in this area.
26 CHAPTER 4. PERMISSIBLE INSURANCE ALTERNATIVES
4.2 Cooperative insurance

In cooperative insurance, a group of subscribers contribute to a pool of funds.
Whenever one of the members makes a legitimate claim (relative to the spe-
cific form of cooperative insurance to which they subscribed), they draw
money out of the pool. In the meantime, the funds in the pool are invested
in an Islamic manner, and without exposing the policy holders to any ex-
tra significant risk. Unclaimed profits are then distributed among the policy
holders. Notice that Al-Zuh.aylı̄ (1997, ibid.) argued that
The difference between commercial and cooperative insurance is

that the insurer in the former is not an institution separated from
the insured. Moreover, the members of the insuring organization
are not seeking to make profits, but only to reduce the losses
which affect some of them. In contrast, the insurance in exchange
for fixed installments is implemented by an insurer which is a
profit-seeking corporation. Such profits are made at the expense
of the insured...
In fact, this logic is exactly applicable to the distinction between mutual and
stock insurance companies as they exist in the U.S. The logic inherent in
the above quote (that stock insurance companies seek to make profits at the
expense of policy holders, while mutuals provide better insurance) in fact
agrees with our most sophisticated economic understanding of the structure
and operations of such companies.3
Unfortunately, most of the “cooperative insurance” companies established
in Islamic countries are in fact similar in ownership structure to stock insur-
ance companies. In principle, however, a mutual insurance company which
invests its funds in Islamically acceptable ways would satisfy all the condi-
tions put forth by the jurists as a valid alternative to commercial insurance.
While no Islamic cooperative insurance companies are currently operating
in North America, some efforts are underway both in the U.S. and Canada
to establish such organizations. Until such a time, Muslims may still re-
duce risks through direct diversification, and in the absence of permissible
insurance alternatives, most jurists agree that the use of available insurance
vehicles becomes temporarily permissible if needed or required by law.
3
The economically-oriented reader may consult Mayers and Smith (1988), Smith and
Stutzer (1995), and the references therein.
Chapter 5
Answers to Commonly Asked

Questions
5.1 Trading in stocks

Q: Is trading in stocks permissible, or is it forbidden “speculation” or gam-
bling?
A: There is a difference between speculation and gambling. Every trade

involves speculation: the purchased goods may go up or down in price.
As explained in Chapter 3, common shares in a company provide the
holder a claim to some portion of that company’s assets, and a cor-
responding claim to its profits. As long as the company’s business
and financial position are acceptable, there is no reason to believe that
trading in the company’s shares is not permissible.
Speculation in productive trade and investment creates value for soci-
ety, and therefore cannot be equated to gambling. In pure gambling,
money changes hands based on chance, without any underlying pro-
ductive activity taking place. On the other hand, trading in the shares
of companies, with potential profits derived from productive economic
activities, allows capital flows to allocate investments as productively
as possible. Of course, if a business’s primary activity is deemed un-
productive (e.g. a casino, or a beer brewery), then Muslims will not
be permitted to own shares in that company since owning such shares
constitutes an implicit participation in the business’s activity.
27
28 CHAPTER 5. ANSWERS TO COMMONLY ASKED QUESTIONS
There are a number of issues involved in determining which companies’

shares are “permissible” for Muslims. Please refer to Chapter 3 for
more details.
Q: How about “day trading”? Shouldn’t Islamic investment be “long term”

rather than “speculative”?
A: I repeat the above distinction between productive speculation which is
at the very heart of all permitted (and encouraged) trading on the one
hand, and forbidden gambling on the other. It is possible for careless
individuals to approach the stock market as a gambling casino, but
it is also possible for such individuals to use any other market in the
same manner. Following a “buy low and sell high” strategy is at the
heart of all profitable trading, including the caravan trades in which the
Prophet (pbuh) participated. If a profitable opportunity presents itself
sooner than anticipated, a good merchant or investor would be criti-
cized for foregoing such profits. Whether or not speculation amounts
to gambling depends on the intentions of the trader, and the nature of
the traded goods.
Assuming that intentions are good, and the proper screening of se-
curities is observed, we must now turn to the issue of whether “day
trading”, where the investor intends to liquidate all positions at the
end of each day, is particularly close to gambling as compared to other
investment strategies. There is no reason to believe that the term of the
trading activities influences whether or not it is considered gambling.
Tradition has it that ‘Abdul-Rah.mān ibn ‘Awf (mAbpwh) reached
Madı̄nah without any wealth (having left it all in Makkah), went to
the market with an axe, and returned at the end of the day with a
small fortune. His abilities to amass wealth were legendary, but that
did not reduce his religious status, as he was one of the shūra group to
¯
nominate the Khalı̄fah, and he was one of the ten companions of the
¯
Prophet (pbuh) to receive glad tidings of admission into paradise.
That being said, one must comment from the financial point of view
that most day-trading is – for lack of a better term – stupid wasting of
talent and wealth. While a few professional traders may be sufficiently
skilled to make modest profits on average in day-trading, the vast ma-
jority of those who engage in this activity are amateurs attracted by
irresponsible advertisement that over-emphasizes a few large profits
5.2. INTEREST ON BANK DEPOSITS 29
made by some lucky individuals. The fact of the matter is that for
most day-traders, they lose money on average, with very few making
large profits out of sheer luck of making the right trades at the right
time. Approached in this manner, it is definitely gambling. Viewed as
gambling, most individuals will have better odds at a Las Vegas casino.
If day-trading is approached in this manner, it wastes the trader’s time
in non-productive activities relative to his or her main professional ca-
reer, and wastes his or her wealth. While “day trading” per se may not
be easily condemned as h.arām, waste of time and talent certainly may
be condemned thus.
5.2 Interest on bank deposits

Q: There have been some “fatwās” in recent years permitting bank interest.
Can we collect interest on our bank deposits? If not, what can we do?
A: There have indeed been some such “fatwās”, especially by Egyptian

muftı̄s. However, the vast majority of jurists, today and in the past,
disagree with those expressed opinions. Intellectual honesty dictates
that we should present both the minority and the majority opinions.
The most famous of the minority fatwās, that of Dr. T.ant.āwı̄, was
characterized by the Federal Shariat Court of Pakistan in Judgment
on Interest (Ribā), Lahore Lawyers’ Book Club, 1992, as the “solitary
opinion of Shaykh Tantawi of Egypt”. It is also worthwhile noting that
the timing of this and later fatwās coincided with a political backlash
against a series of financial scandals for Egyptian savings and loans
operations that had characterized themselves as “Islamic”. The politics
behind those fatwās do not concern us in this guide. We care primarily
about the religious merits of the minority opinion against the opinions
of the majority of jurists around the world, including at Al-Azhar.
Dr. ‘Abd-Al-Mun‘im Al-Nimr, an ex-Minister of ’Awqāf in Egypt,
wrote an article in Al-’Ahrām (June 1, 1989), in which he argued that
the reason for the prohibition of Ribā (which he argued to be the harm
caused to the debtor) does not apply to deposits with banks. Therefore,
he argued, bank interest was not the forbidden Ribā. The past muftī
of Egypt, and current Shaykhu-Al-’Azhar, Dr. Muh.ammad Sayyid
¯ ¯
T.ant.āwı̄, issued a fatwa (Al-’Ahrām, 12 July 1989; November 1989)
permitting certain forms of interest, and in a series of five fatwas in the

same newspapers in May 1991, he permitted all banking interest. The
current Egyptian muftı̄, Sh. Nas.r Farı̄d Wās.il, reiterated this opinion
in the U.A.E. daily paper Al-Ittih.ād, August 22, 1997: “I will give you a
final and decisive ruling (fatwā)... So long as banks invest the money in
permissible venues (h.alāl), then the transaction is permissible (h.alāl)...
The issue is an investment from money. Otherwise, it is forbidden
(h.arām)... there is no such thing as an Islamic or non-Islamic bank. So
let us stop this controversy about bank interest”.
Those fatwās have been published, and ignoring or denying their ex-
istence is not the solution. We only point out that those new rulings
contradict many earlier and contemporaneous ones. For instance, the
’Azhar’s own Research Council ruled as follows in 1965:
Interest on all types of loans is forbidden Ribā. There is

no difference in this regard between so-called consumption
and production loans. Moreover, Ribā is forbidden (h.arām)
in small as well as large quantities, whether it is effected
through time deposits, demand (or checking) deposits, or any
interest-bearing loan contract. All such dealings are among
the forbidden Ribā.
Many similar rulings and fatwās forbidding banking interest have been
issued by different Fiqh Councils around the world.1 Moreover, earlier
Muftı̄s of Egypt have ruled of the prohibition. Thus Sh. Jād Al-H . aqq
‘Alı̄ Jād Al-H
. aqq, who served both as muftı̄ and as Sh aykh u-Al-’Azhar
¯ ¯
ruled in his book Al-Fatāwā Al-’Islāmiyyah:
Depositing monies to collect a fixed rate of interest is forbid-

den in Islām, and borrowing with interest from government
institutions or banks is forbidden Ribā.
In this regard, it has long been established that deposits (e.g. with a
bank) become loans as soon as they are used by the recipient of the
deposit. Thus, Jordanian civil law (item 889) stated: “if the deposited
1
The Arabic reader is referred to the books of Dr. Muh.ammad ‘Alı̄ Al-Sālūs, in which
he lists many prohibiting fatwās and debunks the foundations of those recent permitting
fatwās (e.g. Al-Sālūs (1998, vol.1)).
5.3. LENDING 31
item was an amount of money or something which perishes by usage,

and if the depositor allows the recipient to use the deposited items,
then the contract is considered a loan contract”. In loan contracts, any
increase, as we have seen, is forbidden Ribā.
Therefore, the vast majority of jurists (including those of Al-’Azhar in
Egypt) rule that bank deposits are loans, and that the interest incurred
on them is forbidden Ribā. However, if the question is asked: “assume
that the interest has already been accumulated, what would the Muslim
do with it?”. An answer was provided by The Islamic Fiqh Council in
Makkah (19-20 Rajab 1406 A.H./1985 C.E.):
All income collected through Ribā interest is forbidden prop-

erty ( ), and the Muslim may not use it for any per-
sonal benefit. Such money must be spent on infrastructure
projects such as schools, hospitals, etc. to benefit Muslims.

Such spending is not considered charity (
), but it is a
form of purification from the h.arām component. It is not
permitted for the Muslim to leave the interest monies with
the bank, since that would benefit the banks, especially if
they are non-Muslim and foreign banks that may use such
funds against Islam and Muslims directly or indirectly. This
is being said with the full understanding that continuing deal-
ings with Ribā-based banks, with or without interest, is not
permitted.
This same opinion was given earlier by the Fatwā Committee of Al-
’Azhar in the 1960s with regards to deposits with foreign banks which
were necessary to facilitate international trade.
5.3 Lending
Q: If I lend someone $10 for 10 years, how can it be fair for him to return
to me the same $10 when that amount of money buys a lot less than
it did 10 years earlier?
A: There is a continued fundamental misunderstanding among many Mus-

lims about the legal status of loans in Islamic Jurisprudence. This
confusion gives rise to questions regarding how to deal with inflation,

and to faulty suggestions for how to build an Islamic banking system
on “interest free loans”.
Lending in Islam is a charitable contract, which differs from sales con-
tracts in three fundamental ways (c.f. Al-Qarāfı̄, Al-Furūq, beginning
of vol.4)
1. Loans may be conducted with ribawı̄ goods (those measured by

weight or volume for the Hanafı̄s, monetary numeraires and food-
. anbalı̄s). Since a ribawı̄ good
stuffs for the Mālikı̄s, Shāfi‘ı̄s, and H
¯
is exchanged for an equal amount of that ribawı̄ good in a loan,
this would constitute “Ribā al-nasā’” Thus, this is permitted in
loans but forbidden in sales.
2. For non-ribawı̄ goods, a loan may result in exchanging a known
good for an unknown compensation later to be accepted. This is
forbidden in sales but permitted in loans.
3. For a loan of fungibles, the equivalent sale would include the for-
bidden sale of what one does not have. However, this third rule
is also relaxed for loans.
Al-Qarāfı̄ proceeds to explain that those rules are relaxed in loans since
the loan is primarily a charitable contract. According to Al-Shı̄razı̄ in
¯
Al-Muhadhdhab (vol.1), and Ibn Qudāmah in Al-Mughnı̄ (vol.4, p.313),
¯ ¯
it is narrated that ’Abu Al-Dardā’ (mAbpwh) said:¯ “I prefer to lend
two Dinārs, get them back, and lend them out again, to giving them
away in charity”, and Ibn Mas‘ūd and Ibn ‘Abbās are narrated to have
said “two loans are better than one charitable payment”.
Another fundamental difference between lending and financing methods
is that the lender has the right to request repayment of the loan at any
point in time. If the debtor is capable of paying, he must do so (ibid).
Therefore, any form of loan, “interest free” or otherwise, is unsuitable
as a basis for any form of finance!
Therefore, the loan contract is a form of charity since the lender is
giving away the usufruct of the lent money or goods for the period of
the loan. This charitable contribution includes the “time value” of that
money or good. If that time value is higher due to inflation, then the
lender has given a larger charity. Notice that if the debtor cannot pay
5.3. LENDING 33
(as per the verses of Ribā in Sūrat Al-Baqarah [2]), the creditor must
give him extensions until he is able. In fact the debtor may never be
able to pay back, in which case the entire lent sum is considered charity.
In a recent ruling, the Fiqh Academy of the Organization of the Islamic
Conference, in a Seminar on indexation held in Bahrain (September
22-23, 1999) distinguished between two cases: whether or not the infla-
tion was anticipated. If the inflation was anticipated, then the reduced
purchasing power of the lent money was indeed paid charity, and the
lender may not demand any compensation. In the case where the in-
flation was not anticipated, the Academy recommended resorting to
arbitration. If arbitration was not possible, the Academy devised rules
of compensation depending on whether the loss due to inflation was
major (over 33%) or minor (less than 33%). The arbitrariness of this
rule is quite apparent, especially since this rule could not possibly be
adequate independently of the term of the loan!
Most interesting, however, is the fact that the Academy categorically
ruled out as strictly forbidden the commonly-suggested solution of in-
dexation of a lent amount of money to cost of living, interest rates,
GNP growth rates, the price of gold or some other commodity, etc. Of
course, that opinion by the Academy does not rule out the possibility
of lending gold instead of dollars, if the latter indexation was desired.
The best way to summarize the status of lending and Ribā in Islam is
this:
In Islam, one does not lend to make money, and

one does not borrow to finance business.2
Loans are a charitable contract, and therefore if inflation causes the
lender to lose more than he anticipated (with or without the OIC Fiqh
Academy’s compensation scheme), then the charitable part of the loan
is larger. Demanding compensation for such an increase in charity
would be unwise and insolent in Islam, since only Allāh can and will
determine the appropriate reward. If the purpose of extending the
2
Of course, the second part of this slogan is not based on a religious prohibition.
However, since the lender is not entitled to any part of the profits of the investor, he would
only be exposed to the negative possibility of losses without a corresponding potential for
gains. This is not a good or sustainable way to finance business.
loan was making profits or engaging in a business project, then the

parties should not have selected the loan contract as the vehicle for such
transactions. Please review Chapter 2 for a summary of appropriate
contracts that are intended for such purposes.
5.4 What is the difference?

Q: It seems to me that all you’re doing is re-labeling interest as “rent” or
“profit”, but dollar-for-dollar, I don’t see any difference between what
you call an Islamic contract and what is done by banks and mortgage
companies.
A: Islamic law puts many restrictions on contracts to attain maximal justice

in financial transaction, minimize the potential for legal disputes, and
build a healthy and stable financial and economic system. Of course, all
those goals are shared by secular governments as well, and they utilize
their best human effort to attain them. The fact that there is a great
deal of similarity between the two systems should therefore come as no
surprise. To draw an analogy, many rational non-Muslims share the
Muslims’ recognition of the evils of intoxicants and drugs, and attempt
to avoid them in the same manner.
The fundamental difference from a legal point of view is the central
role of Revelation in Islamic Law. Islamic jurists, like legal experts
of other system, exercised and continue to exercise their best judg-
ment in light of the extant body of Islamic Law. The main differ-
ence is the general rule: “no ruling based on legal reasoning is allowed
where a ruling exists in a Legal Text (Nas..s) [in the Qur’ān or H . adı̄th ]”

¯
(
). Therefore, the fine legal distinctions between

Islamic jurisprudence and man-made laws will normally be based on
the existence of a Canonical Legal Text (Nas..s).
Obviously, the great Islamic legal scholars of the past rarely, if ever,
wrote extensive discussions to justify legal injunctions that are directly
derivable from a Nas..s. Such justification would not change the appli-
cability of the law, and may be harmful if later proven wrong.3
3
A case in point is the wrong justification of the prohibition of ribā purely on the
grounds of preventing exploitation. See footnote 1 of Ch. 1 for a reference.
5.4. WHAT IS THE DIFFERENCE? 35
On the other hand, we have very few glimpses of the legal understand-
ing of those scholars when they discussed how to generalize the impli-
cations of a Legal Nas..s. One very illuminating instance is provided
by ’Ibn Rushd (1997, vol.3,pp.183-184). When discussing the differ-
¯
ent generalizations of the prohibition of ribā in the six commodities
(gold, silver, dates, wheat, barley, salt) mentioned in the first refer-
enced H. adı̄th , ’Ibn Rushd reasoned as follows:
¯ ¯
“It is thus apparent from the law that what is intended by
the prohibition of Ribā is what it contains of excessive in-
justice (ghubn fāh.ish). In this regard, justice in transactions
¯
¯ by approaching
is achieved equality. Since the attainment
of such equality in items of different kinds is difficult, their
values are determined instead in monetary terms (with the
Dirham and the Dı̄nār). For things which are not measured
by weight and volume, justice can be determined by means
of proportionality. I mean, the ratio between the value of one
item to its kind should be equal to the ratio of the value of
the other item to its kind. For example, if a person sells a
horse in exchange for clothes, justice is attained by making
the ratio of the price of the horse to other horses the same as
the ratio of the price of the clothes [for which it is traded, tr.]
to other clothes. Thus, if the value of the horse is fifty, the
value of the clothes should be fifty. [If each piece of cloth-
ing’s value is five], then the horse should be exchanged for 10
pieces of clothing.
”As for [fungible] goods measured by volume or weight, they
are relatively homogenous, and thus have similar benefits
[utilities]. Since it is not necessary for a person owning one
type of those goods to exchange it for the exact same type,
justice in this case is achieved by equating volume or weight
since the benefits [utilities] are very similar...”
This quote cannot be treated fully in this short guide.4 However, the
reader can immediately see one major difference between the finance
4
For a fuller economic analysis, see my paper “An Economic Explication of the
Prohibition of Ribā in Classical Islamic Jurisprudence”, available on the web at
http://www.ruf.rice.edu/∼elgamal/riba.pdf.
payments in an Islamic contract and those in a Ribā-based contract.

The “equality” of compensations, which ’Ibn Rushd lists as the fun-
¯
damental reason for prohibiting Ribā, guarantees a certain degree of
marking to market in an Islamic financial contract. For instance,
if a home purchase is financed through an Islamic lease-purchase or
diminishing partnership, there is a “rental” payment in place of the
“interest” payment in a conventional mortgage. This distinction is
not simply verbal window-dressing. The going market rent for similar
properties in similar areas can be used as a benchmark to gauge the
appropriate financing charges.
Of course, as we have seen previously, the interest payments in a con-
ventional mortgage may just happen to be exactly equal to the rent
component in an Islamic contract. Even if the conventional mortgage
contract had agreed with all the other Islamic ’ijārah or sharika re-
¯
quirements enumerated by the jurists (it does not!) this would not
mean that using the latter is mere window dressing. The Islamic con-
tract forces the two parties to link the finance charges to a specific
tangible asset, and thus forces comparison (if not equalization) with
the time value of money invested in that asset.5 It also enforces all the
other legal conditions associated with the lease-purchase or declining
partnership contract.
The fundamental difference between the two cases cannot be over-
emphasized. From a religious point of view, writing a contract that
intentionally abides by Islamic Legal injunctions is very different from
writing one which does so by mere coincidence or based on human rea-
soning. Moreover, from a legal and practical point of view, the first
contract is guaranteed to continue to abide by Islamic Law, while the
latter may change with circumstances. Such change can impose a sig-
nificant cost on the Muslim who has to seek refinancing to abandon
Ribā and live in accordance with the Sharı̄‘a.
¯
5
Those educated in contemporary economics and finance will recognize the importance
of this rule in effecting desirable economic efficiency and fairness.
Appendix A
Translation & transliteration
For the benefit of the reader, I have included three tables in this appendix to
simplify the reading of transliterated terms throughout the text. The second
table shows the standard Library of Congress transliteration key which I used
in this document. The third table provides the reader with a handy glossary
of terms which I have used often in this document, and which are commonly
used in the language of Islamic banking and finance.
A.1 Abbreviations
Abbreviation Full phrase Corresponding Arabic

swt Transcendent is He

pbuh peace be upon him

s.allā Allāhu ‘alayhi wa sallam

mAbpwh may Allāh be pleased

with him (her) rad.iya Allāhu ‘anhu (‘anhā)

mAbpwt may Allāh be pleased !" #

with them rad.iya Allāhu ‘anhum (‘anhumā)
37
38 APPENDIX A. TRANSLATION & TRANSLITERATION
A.2 Transliteration table:

Transliteration Arabic letter letter name
Short vowels illustrated with consonant “b”

ba, bi, bu

fath.a, kasra, ..damma

Long vowels illustrated with consonant “b”

bā, bı̄, bū

’alef, yā’, wāw

Consonants

’a, ’i, ’u

hamza
b

bā’

t tā’, tā’ marbūt.a

th thā’
¯ ¯
j jı̄m
h. h.ā’
kh khā’
¯ ¯
d dāl

dh dhāl
¯ ¯
r rā’
z zāy
s sı̄n
sh shı̄n
¯ ¯
s. s.ād
d. d.ād
t. t.ā’
z. z.ā’
‘ ! ‘ayn

gh ! ghayn
¯ ¯
f " fā’
q # qāf
k $ kāf
l % lām
m & mı̄m

n ' nūn
h hā’
w ( wāw
y ) yā’

A.3. GLOSSARY OF USED ARABIC TERMS 39
A.3 Glossary of used Arabic terms

Transliteration Translation Arabic

Sharı̄‘ah The Islamic Way/Law
¯

‘aqd contract

’ı̄jāb offer

qabūl acceptance

thaman price

¯

wakı̄l legal proxy; agent
!

‘aqd bāt.il invalid contract "

ribā usury #

Gharar risk and uncertainty #
¯

murābah.a cost-plus sale $% &

dayn debt or libability '

Æ

bay‘ bi-thaman ’ājil credit sale (
) *
¯
’ijāra lease +# (

s.arf currency exchange , -

salam Islamic forward sale ./ 0

’istis.nā‘ commission to manufacture 1 2 0

mud.āraba silent partnership # 3 &

mushāraka partnership # 4&
¯

faqı̄h, fuqahā’ jurist, jurists 5 6 7

’ijmā‘ consensus 1 89:

qiyās inference by analogy ;

fatwā (pl. fatāwā) Islamic legal opinion(s) < = ! > ? =

madhhab (pl. madhāhib) school(s) of jurisprudence < @A
& > ? @A
&

¯ ¯

h.alāl permissible B(

h.arām prohibited C D

h.iyal contemptible legal tricks D

Bibliography
Al-Bājı̄ Al-’Andalusı̄. n.d. Al-Muntaqā Sharh. al-Muwat.t.a’. Dār Al-Kutub Al-

¯
’Islāmiyyah.
Al-D
. arı̄r, S. 1997. Al-gharar in contracts and its effects on contemporary transac-
tions. IDB Eminent Scholars’ Lecture Series, No. 16. Jeddah: IDB, IRTI.
Al-Q
. urt.ubı̄, A. 1996. Al-Jāmi‘ li-’Ah.kām Al-Qur’ān (Tafsı̄r al-Qurt.ubı̄). Beirūt:
Dār Al-Kutub Al-‘Ilmiyyah.
Al-’Imām Al-T.abarı̄. 1992. Jāmi‘ Al-Bayān fı̄ Ta’wı̄l Al-Qur’ān (Tafsı̄r Al-T
. abarı̄).
Beirūt: Dār Al-Kutub Al-‘Ilmiyyah.
Al-Mis.rı̄, R. 1997. Bay‘ Al-Taqs.ı̄t.: Tah.lı̄l Fiqhı̄ wa ’Iqtis.ādı̄. Damascus: Dār

Al-Qalam.
Al-Nawawı̄ (continuation by Al-Subkı̄). 1995. Al-Majmuū‘ Sharh. al-Muhadhdhab.

¯ ¯ ¯
Dār ’Ih.yā’ Al-Turāth Al-‘Arabı̄. verified and completed by Muh.ammad Najı̄b
¯
Al-Mut.ı̄‘ı̄.
Al-Qarad.āwı̄, Y. 1999. Fiqh al-Zakāh. Beirut: Mu’assasat Al-Risālah.
Al-Qarāfı̄, A. n.d. Al-Furūq. Beirut: ‘Alam Al-Kutub.
Al-Sālūs, A. 1998. Al-’Iqtis.ād Al-’Islāmı̄ wa Al-Qad.āyā Al-Fiqhiyyah Al-

Mu‘ās.irah. Al-Dawh.ah: Dār Al-Thaqāfah.
¯
Al-Zuh.aylı̄, W. 1997. Al-Fiqh Al-’Islāmı̄ wa ’Adillatuh. Damascus: Dār Al-Fikr.
Fourth revised edition.
’Ibn ‘Ābidı̄n. n.d. H

. āsh iyat radd al-muh.tār. Egypt: Mat.ba‘at Al-Bābı̄ Al-H
. alabı̄.
¯
’Ibn Rushd, M. 1997. Bidāyat Al-Mujtahid wa Nihāyat Al-Muqtas.id. Beirut: Dār
¯
Al-Ma‘rifat. verified by ‘Abd Al-Majīd T
. u‘mat H
. alabı̄.
40
Bibliography 41
’Ibn Taymiya, A. 1998. Al-Fatāwā Al-Kubrā. Cairo: Harf (reprod.): Dār Al-Kutub
Al-‘Ilmiyyah. in Encyclopedia of Islamic Jurisprudence (CDROM).
M. Taqi Usmani. 1998. An introduction to Islamic finance. Karachi: Idaratul

Ma‘arif.
Mayers, D. and C. Smith. 1988. Ownership structure across lines of property-

casualty insurance. Journal of Law and Economics 31:351–78.
Sakhr. 1996. Al-fatāwā al-’Iqtis.ādiyyah. Heliopolis, Cairo: Sakhr Software Co.,

and Dallah Al-Barakah. 2nd edition, (on CDROM).
Smith, B. and M. Stutzer. 1995. A theory of mutual formation and moral hazard
with evidence from the history of the insurance industry. Review of Economic
Studies 8(2):545–77.
Yusuf ‘Ali, A. 1991. The Meaning of the Holy Qur’an. Brentwood, MD: Amana
Corporation.
Some information on the Internet

This is a partial list of some of the general information websites that focus
on issues in Islamic Banking and Finance. This list excludes many excellent sites
developed by providers of Islamic financial services. The reader can find those sites
linked to the ones listed here, or by using a web search engine. I do not vouch
for the accuracy of all the information on those sites. This list is not exhaustive.
It is provided to give the reader a starting point for searching the web for more
information on the subject.
• http://www.muslim-investor.com
• http://www.islamiQ.com
• http://www.hifip.harvard.edu
• http://www.irti.org
• http://www.islamic-banking.com
• http://islamic-finance.net
• http://www.muslimsonline.com/ief

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A Basic Guide to Contemporary

Islamic Banking and Finance

Mahmoud Amin El-Gamal1

I hope to succeed in minimizing this danger by speaking generally about

1. By alerting the North American Muslims to the diﬀerences between

2. By providing a clear basic understanding of the underlying contracts,

Why “Islamic Finance”? iv

1 Prohibitions of Ribā and Gharar 1

2 Permissible Financing Methods 9

3 Permissible Investment Vehicles 18

4 Permissible Insurance Alternatives 23

5 Answers to Commonly Asked Questions 27

5.4 What is the diﬀerence? . . . . . . . . . . . . . . . . . . . . . . 34

A Translation & transliteration 37

Prohibitions of Ribā and Gharar

278. O ye who believe! Fear Allah, and give up what remains of

1. Muslim narrated on the authority of ’Abū Sa‘ı̄d Al-Khudriy; The Mes-

2. Muslim narrated on the authority of ’Abū Sa‘ı̄d Al-Khudriy:

After reading the studies presented to this Council regarding

1.1.1 Debt re-sale

        

1.2 The Prohibition of Gharar

Many classical examples of Gharar were provided explicitly in the H . adı̄th .

1.3 Obeying the Law

3. Is there a permissible alternative to commercial insurance?

Permissible Financing Methods

Al-Bayhaqı̄ and ’Ibn Mājah narrated on the authority of ’Abū-Sa‘ı̄d Al-

I shall meet Allāh before I give anyone something owned by an-

Not only is trading permitted, it is encouraged. Al-Suyūt.ı̄ mentioned in

Therefore, any ﬁnancing conducted through valid trading by mutual con-

2.1 Cost-plus sales (murābah.a)

2.2 Credit sales (bay‘ bi-thaman ’ājil)

the increase by the deferment. Al-Mis.rı̄ (1997, pp.39-44) lists a number of

• Al-Kāsānı̄ in Badā’i‘ Al-S.anā’i‘ (H

The contemporary confusion is hardly new. In ’Ibn Al-‘Arabı̄’s ’Ah.kām

2.3 Leasing (’ijārah or ’ı̄jār)

list). The most important ﬁnancial diﬀerence between Islamically permitted

2.4 Partnerships (mushāraka and mud.āraba)

2.5 Islamic forwards (salam and ’istis.nā‘)

The Messenger of Allāh (pbuh) came to Madı̄nah, and found

3.1 Investing in equities

which is claimed by the held share. Other common means of investing in

well as “Islamic index” generating companies. The jurists serving on those

3.2 “Fixed income” funds

apartment building, or a warehouse) that generate income in the form of

4.1 Prohibition of ﬁnancial insurance

Taqiyyudīn Al-Subkı̄ explicitly summarizes the opinions of earlier jurists

’Ibn Taymiya (1998, vol. 4) makes the same point as follows:

In this regard, the corrupting factor in Gharar is the fact that it

2. The potentially aﬀected contract must be a commutative ﬁnancial con-

4. That there is no need met by the contract containing Gharar which

Many contemporary jurists, e.g. Al-Zuh.aylı̄ (1997, vol.5, pp.3415-3431),

1. The Gharar is argued to be quite substantial, since the amount to be

2. The commercial insurance contract is a sale contract, which is a com-

4.2 Cooperative insurance

The diﬀerence between commercial and cooperative insurance is

Answers to Commonly Asked

5.1 Trading in stocks

A: There is a diﬀerence between speculation and gambling. Every trade

There are a number of issues involved in determining which companies’