Product Development and Shariah Issues in Islamic Finance

M. Kabir Hassan

Mervyn K. Lewis

This is the second of two special issues of this journal on Islamic finance. The first issue (Volume 49, No. 2) contained articles on the Islamic ban on riba (interest), mutual ownership as a counter to the practice of replicating conventional banking techniques in Islamically acceptable ways (Shariah arbitrage), the analysis of risks in sukuk (Islamic bond) structures, leasing (hire purchase) with special reference to the situation in Malaysia, and the regulation and performance of Islamic banks in Bangladesh. The articles in this particular issue deal with Shariah concerns related to product development in Islamic finance. Islamic banks, like other banks operating in a much more competitive environment, seek to boost their performance and profitability, but unlike their competitors they must do so in a way that complies with Shariah. New products and service innovations by an Islamic financial institution must be approved by its Shariah committee, comprising a panel of scholars versed in fiqhthat is, Islamic jurisprudence or the science of interpreting religious law. However, fiqh is far from an exact science and, in the absence of a uniform interpretation of Islamic

M. Kabir Hassan is a tenured professor in the Department of Economics and Finance at the University of New Orleans, Louisiana, and currently holds a visiting research professorship at Drexel University in Philadelphia, Pennsylvania. He is editor of the Global Journal of Finance and Economics. Dr. Hassan has edited and published many books along with articles in refereed academic journals, and is coeditor (with Mervyn K. Lewis) of Islamic Finance: The International Library of Critical Writings in Economics (Edward Elgar, 2006). A frequent traveler, Dr. Hassan gives lectures and workshops in the United States and abroad, and has presented over 100 research papers at professional conferences. He can be reached via e-mail at mhassan@uno.edu. Mervyn K. Lewis is a professor of banking and finance at the University of South Australia. Previously, he was the Midland Bank Professor of Money and Banking at the University of Nottingham, a consultant to the Australian Financial System Inquiry, and visiting scholar at the Bank of England. He was elected a fellow of the Academy of the Social Sciences in Canberra, Australia, in 1986. Professor Lewis has authored or coauthored 18 books and over 100 articles or chapters. The latest volume, edited with M. Kabir Hassan, is Islamic Finance (Edward Elgar, 2006). Other recent coauthored books include Islamic Banking (Edward Elgar, 2001), Public Private Partnerships (Edward Elgar, 2004), The Economics of Public Private Partnerships (Edward Elgar, 2005), and Reforming Chinas State-Owned Enterprises and Banks (Edward Elgar, 2006). Professor Lewis is a foundation member of the Australian Research Council Islam Node Network. He can be reached via e-mail at mervyn.lewis@unisa.edu.au.
Thunderbird International Business Review, Vol. 49(3) 281284 MayJune 2007 Published online in Wiley InterScience (www.interscience.wiley.com). 2007 Wiley Periodicals, Inc. DOI: 10.1002/tie.20144

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law, what is viewed as a permissible activity varies from one location to another, and from one time to another. Some argue that this need to obtain Shariah approval is a hurdle in the path of Islamic product innovation (Benaissa, Parekh, & Wiegand, 2005). Others have argued, perhaps on the basis of controversial developments such as tawarruq and sukuk, that Shariah boards have become rather too there needs to permissive and accommodating to the bankers in recent years (Nienbe a standardhaus, 2007).
ization of the processes involved in advising, supervising, and monitoring Shariah compatibility, including how a ruling should be determined.

M. Fahim Khan, in the first article in this issue, examines why this diversity in Shariah opinion exists and what can be done about it. After considering the reasons for diversity in fiqh rulings, he argues that any attempt to harmonize or codify fiqh opinions is not the answer. Rather, there needs to be a standardization of the processes involved in advising, supervising, and monitoring Shariah compatibility, including how a ruling should be determined. Such standardization of processes is desirable because divergences in fiqh rulings are not likely to go away, and it is important for all participants in the system to understand the basis on which decisions have been reached. These initiatives might occur at a national level (and Khan cites the Sudanese model, the Bahraini model, and the Malaysian model as examples) or at the international level, through bodies such as the Islamic Development Bank, the International Islamic Ratings Agency, the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), and the International Islamic Centre for Reconciliation for Commercial Arbitration for Islamic Finance. He sees that there would be considerable benefit from the existence of an international benchmark for quality management in the application of Shariah and the creation of standards for good practice in selecting and applying fiqh opinion. Benchmarking against such standards would enable outsiders to make informed judgments as to the Shariah processes in an institution, while providing Islamic bankers with a way of differentiating themselves vis-vis competitors in terms of the Islamicity or purity of their activities. A study of Shariah opinion in the particular case of commodity futures is provided in the second article by Mohammad Hashim Kamali, which illustrates very clearly the differences in fiqh opinion on the topic. The legitimacy of futures under Islamic law has been questioned on five grounds: (1) the goods do not exist at the time of contract; (2) the goods are not owned at the contract date; (3) there is no physical delivery (in most cases), with open positions invariably closed out; (4) deferment in the transaction is tantamount to the sale of one debt for another; and (5) futures involve speculation. Kamali

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Product Development and Shariah Issues in Islamic Finance

examines each of these contentions in detail, especially the hadith sell not what is not with you which is often cited in the case of fiqh rulings on the subject. He finds each argument to be wanting or, at least, contestable. On this basis, and after considering the potential benefits of futures trading for hedging and other licit purposes, he advocates that commodities futures transactions should be ruled as valid, on the grounds that they are not in violation of any decisive fiqh principle and are, in his opinion, free of riba, gambling (maysir), and excessive gharar, all of which are prohibited activities. Important fiqh issues are involved in the validity of combining two or more contracts to structure Islamic financial products. In conventional financing, securities such as preference shares, convertibles, and bonds with warrants can be seen as combinations of contracts, while creating synthetic securities by combining underlying securities (bonds, foreign exchange) with swaps, options, and forwards has been a major source of financial innovation in the case of derivatives. Strict juristic rules govern the extent to which product development in Islamic markets can proceed by combining Islamic financial contracts. These rules are outlined and assessed by Mohammed Burhan Arbouna in the third article. In general, the validity of combining contracts is not an issue under Islamic law because of the general principle of freedom of contracting in Shariah. Rather, what is at issue is the nature of the contracts involved. This means that parties can conclude whatever contracts, or deals consisting of a number of contracts, they deem desirable, so long as there is not an explicit source of law prohibiting their actions and the combination serves a valid purpose. Each component of a hybrid structure has to be examined to identify the possibility of a prohibited feature existing, while the overall combination needs to be assessed on the basis of terminology, objectives, and the degree of uncertainty and ambiguity. These principles are illustrated in the article with some practical examples of permissible and nonpermissible combined contracts. From this vantage point, Dr. Arbouna warns that the search for competitive financial products in global finance ought not undermine the purpose and principles of Islamic law. The final article in this issue focuses on Islamic insurance (takaful). Relative to the Islamic financial sector as a whole, the takaful industry is a mature one. The first two companies were founded in 1979, and since then these two have been joined by over 50 others, operating in 22 countries. Yet despite this relative longevity (Islamic commercial banking dates from 1975), the industry as a whole has not obtained a market presence that parallels that of other Islamic finanThunderbird International Business Review DOI: 10.1002/tie MayJune 2007

In general, the validity of combining contracts is not an issue under Islamic law because of the general principle of freedom of contracting in Shariah.

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cial institutions, although this position is beginning to change as conventional insurers have begun to display an interest in the market. Part of the reason for the more subdued growth of Islamic insurance is that the concept of takaful is not widely understood. While takaful is an important part of the Islamic financial system, the idea itself and the nature of the operations of takaful companies is a topic that has been relatively neglected compared with Islamic banking. It must also be said that the idea of insurance business, with its emphasis on uncertainties and risk of loss, does not appear to conform well to the Islamic ethic, and many types of insurance have long been discountenanced within the Muslim community. While most jurists argue that the problem is not insurance per se but conventional insurance operations, and that a system of insurance can be worked out that avoids the presence of gharar, riba, and maysir that is said to bedevil conventional insurance and render it unacceptable from an Islamic point of view, there are still some question marks over the way the concept of takaful is actually applied. It is from this starting point that Wahab, Lewis, and Hassan outline the basic principles that underlie the takaful system and then examine some of the business models that have been employed in the industry to implement the vision. For many years the mudarabah system was the only one in common use, although in the last few years some new takaful companies have been launched that have adopted the wakala approach. The differences between them revolve around the relationships between the operator and the participants, as well as the nature of the reward and remuneration system. However, the development of the wakala model has raised fresh issues and concerns from a Shariah perspective. After reviewing these Shariah matters, the authors outline an alternative business modelwakala with waqf fundwhich they argue meets some of the concerns of the Shariah scholars while remaining within the wakala context and retaining the essential features of this approach. In general, like other articles in this collection, the authors point to the need for a closer dialogue between the Shariah scholars and the industry practitioners to work on the unresolved problems.

REFERENCES
Benaissa, N.-E., Parekh, M. P., & Wiegand, M. (2005, October). A growth model for Islamic banking. McKinsey Quarterly, Web exclusive. Retrieved from http://www.mckinseyquarterly.com/article_abstract_visitor.aspx?ar=1694 Nienhaus, V. (2007). Governance of Islamic banks. In M. K. Hassan & M. K. Lewis (Eds.), Handbook of Islamic banking (Ch. 9, pp. 128143). Cheltenham, UK: Edward Elgar.

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