Principles of Islamic banking and finance/PIBF201/Rationale for Islamic finance/''Riba'', ''gharar'' and ''mysir''

The Basic Principles of Islamic Finance

In every economy almost all production and commercial units require financial resources which may not be readily available from their own (internal) sources. On the other hand many economic units (households and businesses) have surplus funds that they would like to invest for earning additional income. The financial system of an economy provides a framework of financial intermediation by different institutions to help these deficit and surplus economic units to meet their needs. Commercial and investment banks, markets for stocks and bonds, insurance companies, pension funds, etc., are financial intermediaries that constitute financial system of a capitalist economy. The performance of a financial system and its various components could be measured in terms of its relative efficiency, stability, its ability to solve problems of different groups involved in the system, fairness, and the nature of the attitudes it nurtures among different participants of the system. It may not be very difficult to observe that an economic doctrine that absolves itself from making any value judgments will naturally assign relatively lower importance to the last two measures just described. Like other areas of social life, Islamic teachings require that transactions in trade, commerce, production of goods and services and financial intermediation should follow some basic principles. For example, trade or financial dealings of forbidden goods and services (such as pork, pornography, gambling) is clearly prohibited. The most important of them that are relevant for banking and finance is to refrain from riba, gharar and mysir. Avoidance of Riba, Gharar and Mysir

Islamic scholars emphasize that riba (usury and/or interest), gharar (uncertain or unclear elements in business contracts) and mysir (transactions tantamount to be gambling) should be avoided in trade and financial dealings. The issue of riba is of paramount importance for Islamic banking and finance and will be discussed thoroughly. In the context of financial transactions, gharar could be thought of as looseness of the underlying contract such that one or both parties are uncertain about possible outcomes or obligations. Alternatively, there could be an element of gharar if a contract could be read in a number of ways such that one party could easily deceive the other party.1

The issue of gharar in our time has been most frequently mentioned in the context of insurance. Many religious scholars had initially claimed that dealings in conventional insurance involve gharar. They argued that it was not known in advance who would benefit from insurance claims in a particular period and what amount would be eventually paid in claim settlements. Furthermore, it was also contended that insurance seemed to have an element of mysir as it was possible for someone to claim a huge amount for which only a small premium was paid.

A number of Muslim economists convincingly refuted both these claims. However, one of the objections that has remained valid to this date with respect to conventional insurance is that most of the proceedings of insurance premiums are kept in interest bearing instruments. It is also being argued that, instead of allowing some individuals or group to insure others, people facing similar calamities in future should somehow get together, form their own insurance companies and share the cost and benefits collectively. Alternatively, an individual or group could offer to establish and run such companies / organizations on behalf of the subscribers who would be the actual owners of such companies. The establishment of Islamic insurance companies commonly known as takaful, is to make them conforming to the teachings of Islam.

The issue of mysir has been often referred in the context of the working of modern day stock markets, and markets for options, futures, etc. It is claimed that these markets are mired with excessive speculative activities. For example, in stocks markets people trade in stocks for making quick capital gains rather than focusing on dividend payments. Apart from the issue of mysir, it could also be argued that the basic goal of a stock market is efficient financial intermediation, which can be better realized if dividend payments are directly made the focal point of the market. The same may apply to forward and future markets for commodities where the primary rationale for their establishment was to reduce risk and uncertainty about future prices for both consumers and producers. It is questionable if these markets generally achieve this ultimate goal. Apparently they have become places for excessive speculation or mysir and evaluation by Muslim economists and financial experts for their acceptability, or to come up with possible reforms to make them conform to Islamic teachings. It is argued that even if these markets do provide some useful services, their acceptance, should be linked with the acceptance of the general behavior it creates among the participants.

One should also contemplate to see if the perceived benefits could also be achieved through other means. Some risks in investments and businesses are inherent. Providing opportunities to individual investors and businesses to reduce or avoid risk may appear sensible. However, it would be difficult to reduce the total inherent risk of a sector of the economy; one individual or business can only try to shift risk to other. The solution lies in a risk sharing mechanism that is efficient, achieves the underlying goals, avoids excess speculation tantamount to mysir, and is fair to all parties involved.

The primary reason for establishing Islamic banking was to avoid interest, the main apparatus of conventional commercial banking. Interest being one of the most important element of many financial dealings in the contemporary world, we now turn to have a deeper look into the issues related to Islamic banking and its modus operandi to avoid interest.