Applied Islamic Banking

By:
Prof. Dr. Mohd. Ma’sum Billah
masum@applied-islamicfinance.com
masum2001@yahoo.com
+6019-3699542

The discipline of Islamic finance concept has been exist decade ago but now it still in the academic sense. Although the guidelines are provided, the level of theories and models still needs the expansion and implementation. In the Islamic financial system, one of its components is financial market, which comprises of money market and capital market. In the respective market itself, contained the instruments and products that available to provide and support the easiness of the transaction activities.

Both of the market plays the important role as the means to the economic activities. Via these markets, Muslim may help each other as the business parties and they are able to transact each other in much comfortable way. This shows that the Islamic way of life is actually to promote the welfare of people by safeguarding their faith, life, intellect, property and their posterity.

As a Muslim, there are many responsibilities shall be undertake and one of these responsibilities is management of wealth. By existence of the instruments or products in the financial markets, the Muslim may manage the wealth in the proper way. Such business transactions are allowed in Islam as long as the ground and the foundation are not contradicted with the Shariah and the elements inside those transactions is free from the prohibited elements such as riba (interest), maisir (gambling) or gharar (ambiguity).

The instruments exist in such market capable to allow the investors to make the investment in the respective market. This activity will allow the invested company to enhance its business activities and thus expanding the economic growth in general. One of the instruments available in the financial market is the stock or equity. This paper is written with intention to discuss the Islamic investment in the stock market.

An investment can be defined as current commitment of resources for a period of time in the expectation of receiving future resources. These future resources will reimburse the investor for the time the resources are committed, compensate the expected rate of inflation and pay off the risk, which is uncertainty of future payment.

In the context of investment, people or organization will put the fund (a sum of money resources) in the financial markets in different form of securities (such as bonds, preferred stock, common stock etc). Commonly, they make investments due to certain reasons including expecting to generate extra income, to preserve the capital (because of the inflation) and/or to get gain when there is appreciation of capital.

To obtain the extra income, the investors are interested to have the securities that able to give them high rate of return in term of dividend. Meanwhile, the investors who would like to preserve the capital or original value of the investment, their concentration is towards the securities with low risk because this people do not willing to take the risk, as they would rather like to preserve the capital. On the other hand, the investors with the intention to increase the initial investment, their curiosity are the securities with high risk criteria (risk taker) because their desired returns is based on the growing amount of the price of the securities.

Actually, there are many different types of financial markets developed in the economy. The types of the markets can be divided in the term of physical asset markets, spot markets and future markets, money markets and capital markets, primary markets and secondary market, etc. In each of the markets itself, there are different types of the instruments offered and the main different exist in each of the instruments is its riskiness. For instance, the money market has the treasury bills, banker’s acceptance, commercial paper etc and the banker’s acceptance is riskier than the treasury bills.

In the investment there is a direct relationship between the risk and return. There is a tradeoff between them, where the security with the high-risk criteria will always give the higher return. The relationship of the instruments in the financial market with regard to the risk and return can be demonstrated by following exhibit

Basically, capital market and money market are different in the term of the liquidity of the securities where the instruments in the capital market usually less liquidate than the instrument in the money market. Besides, the capital market offers the immediate or long-term debt and corporate stock where it takes long time of maturity as compared to the money market.

In Islam, making an investment is allowed but it is restricted to certain circumstances. Islamic Investment can be defined as investment in financial services and investment products that adhere to principles established by the Shari'ah or the Islamic law as revealed in the Qur'an and Sunnah. In Islam, it is required that all investments made shall be from the ethical sectors or in other words, the investment made or the profits gained shall not be in or from the prohibited activities. These prohibited activities include alcohol production, gambling, pornography, interest-base (riba) sector etc.

Instead of having the halal securities, the invested funds also should be free from the interest-based debt. The investor does not allowed to borrow on interest to finance his investments. It is stated in the Holy Qur’an:

… ﺍﻮﺑﺮﻠﺍ ﻢﺭﺣﻮ ﻊﻳﺑﻠﺍ ﻪﻟﻟﺍ ﻞﺣﺃﻮ …

Before making the investment, the investors should think of certain essential questions: What is the investing "time horizon"? What type of investments will you make? How much money will you need to reach your goals? Do you have short-term financial needs? Will you need to live off the investment in later years? By providing answers to these questions, the investors may have the safety-investing journey.

In the Islamic investment, the concept of Mudarabah can be applied. Under this concept, Rab-ul-Maal ( ﻞﺎﻣﻟﺍﺏﺭ ) will provide the fund or investment to the Mudarib ( ﺐﺭﺎﻀﻣ ) the management. Rab-ul-Maal then will permit the Mudarib to organize the investment in appropriate manner with no intervention from his side. However, the Rab-ul-Maal has the right to keep an eye on the Mudarib’s activities and he may work with Mudarib (with the consent from Mudarib).

Stock is actually issued by the corporations to the individuals and the institutional investors. This stock can be divided into the preferred stock and common stock. Usually only the common stock is traded at the bulletin board in the stock market. In return of the financing and providing the capital to the corporation, the investor will get the yield, proceeds (if the stock is sold) and becomes part of the owner of the company. In short, the stock or in specialized term is the financial “securities” may represent the ownership of the company.

The investors can have the stand-alone common stock (only one types of securities) or in the portfolio (the collections of investment securities). After possessing the ownership of the common stock the investors will be the shareholders of the company, which is a part of the owner of a business. Being shareholders will allow the investors get one vote per share of stock to elect the board of directors.

When the company acquires more assets and generates more cash revenue, the value of the business increases. This increase in the value of the business will drive up the value of the stock in that business. However if the reverse condition occurs, the shares of stock may decrease in value or even the worst is the company goes bankrupt.

There are many opinions with regard to the Islamic investment in the stock market. Almost all the contemporary scholars agreed that that it is halal and permissible to invest in the stock markets with the condition that the company invested in does not engaged in a business not permitted by Shari'ah. The forbidden companies include the interest-based companies, conventional insurance companies, and manufacturers of liquors, casinos, nightclubs, etc.

Meanwhile the other view think that the investment in any matter even if the nature of business is halal is still not permissible, because these businesses (especially publicly listed joint stock companies) obtain finances on the basis of interest to establish and run their business.

It should be bear in mind that the investing in the stock market is same as in the conventional system except that the Shari'ah prohibits any return on debt and does not consider lending to be a legitimate profitable activity.

The investment in the stock market or equity represents an investment exposed to all kinds of business risks and sharing in the profits of the business. It may be in form of permanent nature, i.e. redeemable is made upon liquidation of the business or earlier by mutual agreement but not on demand.

Differed than conventional investors, Muslims are prohibited to make the investment decisions based on the short-term speculation. Being a Muslim, make a man to use the logic of sound analysis before making an investment decision. Same as the trading, the market price is also important and these considerations should be mind together with the fundamental value of the companies in before determination of investment in the stock market

Islamic Filters is a tool that would assist an individual to determine whether a company is eligible for investment from the Islamic point of view or not and also the reason why it is not eligible. In order to know the qualifications of a company, the most essential criteria are that they must comply with the Shariah principles which will be discuss later.

Before we discuss on the Shariah principles, we would like to discuss on the role of Shariah Board.

Shariah Board is a committee of ulama, established to make sure that the financial institution's practices and products the institution’s offers are in compliance with the Shariah.

The ulama, of Islam have played a crucial role in the contemporary movement of Islamic finance and investment. Their duties are interpret and analyze the sources of Islamic law and constitute a link with the vast body of work on commerce in the Islamic legal practice. This is important in deriving the principles of Islamic finance and investment. As a group, they also arrive at collective positions on contemporary financial issues in representative bodies such as the OIC Islamic Fiqh Academy.

The Shariah advisors or Shariah Boards are in continuous discussion with the bankers and economist in order to develop new financial products in compliance with Shariah principles. This is required in order to ensure that Islamic finance stays abreast of the latest developments in financial markets and also to help Muslim investors to have access to proper Shari'ah advice on these markets. Recognizing this necessity, all credible Islamic financial institutions today have a Shariah advisor or Shariah board, for example, BIMB has Shariah Advisory Board.

Islamic scholars refer to the sources of Islamic law in order to establish new financial products and fatwas. The sources refer are in sequence as below:

The Qur'an
The hadith texts (the words, actions, recorded statements and practices of Prophet Muhammad (pbuh) and this include hadith Qudsi )
Ijma (consensus of the ulama) and qiyas (drawing analogies deduction and reasoning from the Qur'an and hadith texts)
Ijtihad (the scholar's own reasoning)

Note that a scholar's ijtihad only comes after the analysis of the other sources, and remains within the parameters established by them.

In classifying the stocks as approved stocks, the Shariah Advisory Council (SAC) applies a standard criterion which focuses on the core activities of the companies listed on Board.

Hence, companies whose activities are not contrary to the Shariah principles will be classified as approved securities/stocks. Stocks will be excluded from the list of approved stocks based on the following criteria:

4:161. “ And their taking of Ribâ (usury) though they were forbidden from taking it and their devouring of men's substance wrongfully (bribery, etc.). And We have prepared for the disbelievers among them a painful torment.”

2: 275. “ Those who eat Ribâ (usury) will not stand (on the Day of Resurrection) except like the standing of a person beaten by Shaitân (Satan) leading him to insanity. That is because they say: "Trading is only like Ribâ (usury)," whereas Allâh has permitted trading and forbidden Ribâ (usury). So hosoever receives an admonition from his Lord and stops eating Ribâ (usury) shall not be punished for the past; his case is for Allâh (to judge); but whoever returns [to Ribâ (usury)], such are the dwellers of the Fire - they will abide therein.”

2:219. “ They ask you (O Muhammad

) concerning alcoholic drink and gambling. Say: "In them is a reat sin and (some) benefit for men, but the sin of them is greater than their benefit." And they ask you what they ought to spend. Say: "That which is beyond your needs." Thus Allâh makes clear to you His Laws in order that you may give thought."”

5:90. “ O you who believe! Intoxicants (all kinds of alcoholic drinks), gambling, AlAnsâb, and AlAzlâm (arrows for seeking luck or decision) are an abomination of Shaitân's (Satan) handiwork. So avoid (strictly all) that (abomination) in order that you may be successful.”

2:261. The likeness of those who spend their wealth in the Way of Allâh, is as the likeness of a grain (of corn); it grows seven ears, and each ear has a hundred grains. Allâh gives manifold increase to which He pleases. And Allâh is All-Sufficient for His creatures' needs, All-Knower.

Operations containing element of gharar (uncertainty) such as conventional insurance business;
Entertainment activities that are non-permissible according to Shariah ;
Manufacture or sale of tobacco-based products or related products;
Stock broking or share trading in Shariah non-approved securities; and
Other activities deemed non-permissible according to Shariah

As for the companies whose activities comprise both permissible and non-permissible elements, several additional criteria are applied:

the core activities of the company must be activities which are not against the Shariah as outlined in the first four criteria;
public perception or the image of the company must be good; and
The core activities of the company have importance and maslahah (benefit) to the Muslim Ummah (nation) and the country, and the haram element is very small and involves matters such as 'umum halwa (common plight), 'uruf (custom) and the rights of the non-Muslim community which are accepted by Islam. This will be discussing in detailed later.

One of the implications of Islamic investment principles is in the selection of the type of financial instrument among those available in global financial markets today. Interest based securities (e.g. bonds, bank deposits etc.) are not acceptable as Shariah compliant investments, since these securities provide returns that are predetermined, and unrelated to the underlying performance of the asset that is generating the returns. By the same reason, equity securities (shares) are considered permissible by an agreement of contemporary scholars (e.g. the Islamic Fiqh Academy), because the profits an investor makes on equity securities are tied to returns of the underlying company and hence are risk related.

Investment in common stock of companies engaged in permissible activities is allowed under Islamic Shariah. However, preferred stocks are prohibited in Islam as they guarantee the amounts paid out as dividends to holders of preferred stock. There are two ways of Islamic screening criteria; which are qualitative (permissible activities) and quantitative (financial ratios).

Qualitative screens are part of the the general rules followed by Shari'ah scholars in determining what is halal and what is haram for investment. There are two types of qualitative screens:

Industry screening: Is the company in an industry prohibited in Islam? Examples of industries that are haram (or are necessarily involved in haram activities) include: alcoholic drinks, riba/usury based financial institutions, gambling, sales of haram products and entertainment such as pornography.
Business practices: Is the company bias in its relationship with customers, suppliers and employees or is the company unethical in its trade practices?

Quantitative screens are part of the the general rules followed by Shari'ah scholars in determining what is halal and what is haram for investment. There are three types of quantitative screens and they are:

Debt/asset ratio: Has the company borrowed funds on interest? It is clear that there should ideally be no interest-based debt, but based on the Islamic legal principle "li al-akthar hukm al-kul" (to the majority goes the verdict of the whole) and subsequent scholarly opinions, a company is not a permissible investment if debt financing is more than 33% of its capital.
Interest-related income: Does the company generate any interest or interest-related income? This includes those companies who do not make earning interest their business, but place their surplus funds in investments that yield interest income. As in the previous case, ideally no income should come from interest-related sources. According to some scholars, however, up to 10% of a company's total income can be derived from interest sources.

Monetary assets: Items such as accounts receivables and liquid assets such as bank accounts and marketable securities should be review. Various minimums have been set for the ratio of illiquid assets (assets that are not in the form of money) necessary to make an investment permissible. Some set this minimum at 51% (again, according to the principle of "to the majority goes the verdict of the whole"). A few cite 33% as an acceptable ratio of illiquid assets to total assets.

There are also some opinions that classifying the permissibility of transactions of investment into four types:

It is necessary that companies which business activities are prohibited should be excluded. This rule also applies to the subsidiaries of such companies if they deal with unlawful activities, such as conventional banks, insurance companies, alcoholic beverages companies and gambling, pork, brothels, pornographic related companies and other similar companies.

It is in Islamic Shariah that debt can’t be sold to the third party (Bay-al-Dayn). The contemporary scholars stipulate that the equities of the company which the business activities are lawful may be traded if the total cash and debts do not exceed the total value of other assets that is real assets (fixed assets). Contemporary scholars differs on this percentage, but most of them agreed that it is prohibited if it is exceeds half the assets (50%) as stated in fatwas issued by the 2nd Al Baraka Seminar, Fatwa No. 5.

This guideline requires that the debt ratio to the shareholders equity should be as low as possible. The Religious Supervisory Board argues that a percentage of not more than 30% is considered to comply with this requirement. The scholars have adapted the rule that what are less than one third are the criteria of a small percentage as what has mentioned by the Prophet s.a.w: One third and one third is too much.

It is necessary that the ratio between the interest or unlawful earned income (or combined both interest and unlawful income) to the company’s total income should be negligible and should be as low as possible for two basic considerations:

As what has been discussed, the Shariah Council has put a high effort on putting the Islamic investment as one of the financial products that comply with the shariah. Most of the investors, mostly the Muslim investors will try to seek for the Islamic stocks that are approved by the Shariah, and these investors rely 100% on the Shariah Council so that they invest in the halal investment.

It is hard to separate the illegal activities from the investment, if the investors want to obtain high profit. For example, Genting stocks with BIMB stock, Genting have a higher profit rather than BIMB. Although, the activities done in Genting are prohibited, we cannot just see on the profit side however, we have to look at the activities they have done in order to get the profit. As what mentioned in the Quran;

2:219. “ They ask you (O Muhammad

) concerning alcoholic drink and gambling. Say: "In them is a great sin and (some) benefit for men, but the sin of them is greater than their benefit." And they ask you what they ought to spend. Say: "That which is beyond your needs." Thus Allâh makes clear to you His Laws in order that you may give thought."”

In order to support Shariah approved stocks and to strengthen Islamic investment, Muslims need to unite and purchase Shariah approved stocks rather than the conventional stocks.