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Principles and Sources of Islamic Institutions

1. Business framework
Islamic banking system is based on Shariaa laws Shariaa scholars ensure adherence to
Islamic laws and provide guidance. 1While the conventional financial system is based only on
man-made laws and no religious laws or guidelines.

2. Interest (Riba)
Riba (interest) in Islam is forbidden. Hence, all banking activities must avoid interest. Instead of
interest, the Bank earns profit (mark-up) and fees on financing facilities it extends to customers.
Also, depositors earn a share of the Banks profit as opposed to interest. 2Within Islamic financial
institutions, it is not allowed to charge for the mere use of money. Whereas conventional
financial institutions trade in money (buying money from depositors and selling money in the
form of loans), Islamic financial institutions must trade in real assets or services. Most of the
activities of the conventional financial institutions are interest-based financing.
3. Prohibited activities/commodities

Shariaa prohibits using or dealing in certain commodities or activities. Islamic financial system
must encourage and develop the application of Islamic principles and law (Shariaa) to
transactions of finance, banking and business affairs. It controls the tolerable and consistent with
the Shariaa law thus preventing the occurrence of activities forbidden by Islam. Only halal
1 http://www.aaoifi.com/keypublications.html accessed on November 11,2009.
2 www.albalagh.net/Islamic_economics/riba_judgement.shtml, accessed on February
18, 2009.

activities are allowed. 3Islamic financing will, therefore, be inappropriate in financing any
enterprise involved in any type of activities/commodities that is unlawful in Islam or harmful to
mankind. The Islamic Bank, for example, does not finance liquor manufacturing, transportation,
storage or distribution companies. Shariaa scholars screen the suitability of investments on an
ongoing basis and provide guidance on products to the Banks management.
4. Uncertainty (Gharar)
Any contract based on a future uncertain event, within Islamic banking, is not generally
allowable, e.g. hedging, dealing in derivatives, etc. 4Conventional financial system allows trading
and dealing in derivatives of various forms is allowed.

5. Contractual Relationship
Contractual relationship is Islamic financial institution depends upon the nature of transaction. It
could be a seller-buyer relationship (Murabaha), a lessor lessee relationship (Ijara), a
partnership (Musharaka), or a creditor-debtor relationship (Qard Hassan). This relationship has
only one form in the conventional financial institution which is only a creditor-debtor
relationship.

6. Participation and risk sharing

Another principle of Islamic finance is based on partnership and the sharing of risks. Islamic
financial institutions offer investor/depositors participation in risk sharing type packages rather
than fixed interest on deposits. Any risk-bearing instruments reflecting a real asset and earning a
variable rate of return tied to the performance of the assets is considered to be consistent with
3 http://www.sbp.org.pk/ibd/Handbook-IBD.pdf accessed on November 9, 2009
4 http://www.sbp.org.pk/about/speech/governors/dr.shamshad/2007/IslamicBanking-11-Sept-07.pdf accessed on June 16, 2009

Islamic law. In contrast to conventional banking principles what is condemned is Islamic banking
is the notion of a risk free reward or return. 5The Islamic Financial system employs the concept
of participation in the enterprise, utilizing the funds at risk on a profit-and-loss sharing basis,
thus encouraging better resources management. Management of the enterprise can be in one of
several forms depending on whether the financing is through Mudarabah, Musharaka, etc. The
relation of investors to the institution is that of partners whereas that of conventional banking is
that of creditor-investor. The Islamic financial system is based on equity whereas the
conventional banking system is loan based.
7. The Islamic ethics and behavior
The Islamic financial institution and its staff must behave and act within the framework of
Islamic teachings in its broadest sense so that any person approaching an Islamic institution
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should be given the impression that he is entering a distinguished place not only in the types and

quality of its products but in the way the customer is treated-with care, respect and the eagerness
to help him and facilitate his matter.
8. Contributes to the socio-economic goals of the Islamic society
The Islamic financial system should contribute to achieving the major socio-economic goals of
the Islamic society. While conventional finance focuses solely on economic transactions and
markets, Islamic financial system stresses the ethical, social and moral dimensions of wealth
creation that enhance equality and fairness for the society as a whole. Islamic financial institution
is socially responsible towards the poor, and needy in the Islamic society, and must contribute in
the efforts of poverty alleviation and people empowerment through creating social funds for poor
and needy and providing education scholarships to students. The Islamic bank is required to
remind his customers of Zakat payments on the clients assets which have not been used
throughout the period of one year.
5 (http://www.ifsl.org.uk/output/ReportItem.aspx?NewsID=32, accessed on February
11, 2009
6 http://www.dawn.com/2005/04/12/ebr4.htm accessed on 16th June 2009

9. Shariaa Supervisory Board (SSB)

Islamic banks are supervised by a Shariaa Supervisory Board (SSB) which allows the bank to
conduct its financial transactions in accordance with Shariaa. 7The transaction structured and
supporting documentation approved by a Sharia Supervisory Board and for the transaction
Offering Document to include a copy of their FATWA. This board will generally be comprised
of three or more of scholars who are well versed in Islamic jurisprudence. There is no existence
of such Board in the conventional bank which aiming to attain profit without considering Sharia
precepts.
Sources of Islamic Financial Institution
PRIMARY AND SECONDARY SOURCES
There are various sources of Islamic legal knowledge. The rst one of course is the
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Quran itself, which, Muslims believe, was revealed to the Prophet Muhammad, also called the

Messenger of God (Rasulullah), by the angel Jibril (Gabriel). The second one is the sunna, that
is, the deeds, utterances and tacit approvals of the Prophet, as related in the a hadith or traditions
(the singular hadith is also used for tradition in general), handed down through a dependable
chain of transmitters. Sometimes, the term sunna is used in a wider sense, including the deeds of
Muhammads Companions and successors. Note that this is not a critical study of the origins of
Islamic law.
Eminent Islam scholars such as Joseph Schacht (190269), following Ignaz Goldziher
(18501921), argued that the sunna is in reality the practice of the Umayyad rulers of Damascus,
7 http://www.scribd.com/doc/34853985/Shariah-Supervisory-Board
8 http://ourworld.compuserve.com/homepages/ABewley/usul.html)

only supported by ahadith of dubious authenticity. More recent scholarship, however, tends to
concentrate on the authenticity of individual a hadith, rejecting wholesale branding of the ahadith
as forgeries. All this, however, lies outside the purview of this book. The Quran and the sunna are
the primary sources. They are thought to contain Gods infallible and immutable will, or sharia in
a narrow sense. Of course present-day Muslims, living some 15 centuries after the time of
Muhammad, see themselves confronted with problems on which the Quran and the sunna are
silent.
The Hadith dwells at great length on such subjects as the sale of gold necklace studded
with pearls and the selling of the camel and stipulation of riding on it, but contains precious
little on, say, corporate government, public utilities or intellectual property, let alone complex
nancial products. Furthermore, the Quran and the sunna leave room for dierent interpretations.
Muslims therefore often have to resort to secondary sources of law. Sharia in a wide sense
includes all Islamic legislation. In so far as this is based on secondary sources, it is not
necessarily valid for all times and all places.

SECONDARY PRINCIPLES
1. IJMA
Ijma means consensus. The underlying idea of 9ijma as a source of law is that truth is safe with
the community of believers. Support is provided by a hadith according to which Muhammad said
that my community will never agree on an error. Thus, after Allah and the Prophet, the Muslim
community or umma can also be a source of law. The trouble is that there is no consensus about
what consensus consists of. Some, following al-Shafii, define consensus as agreement among the
entire community of believers whereas others restrict ijma to agreement among the scholars.
Some political modernizers in the Muslim world give a liberal twist to consensus and see it as a
foundation for democracy, with parliament as the body that produces ijma.

2. QIYAS
9 http://www.studylecturenotes.com/social-sciences/law/412-secondary-sources-ofislamic-law-ijma-ijtehad-qiyas-a-urf

Qiyas or analogy is the second important secondary source, or the fourth root, of Islamic law.
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The idea is that, if a ruling is required on a situation not covered in the Quran or the sunna, a

comparison can be made with situations which the Quran or the sunna did provide for. If, for
instance, the Quran prohibits the use of wine, the use of other toxicants, with similar deleterious
eects, can be assumed to fall under the prohibition as well.The classication is not logically
watertight, in the sense that it covers all sources of law without overlap. Ijma, for instance, may
use qiyas, and other sources of law are also accepted by many Muslims. It is not surprising,
therefore, that al-Shais classication has not been universally followed. Many scholars, down
from al-Ghazali.
3. IJTIHAD
Ijtihad is the independent reasoning by a qualied jurist leading to new legal rules. Such a jurist
may, or rather should, use qiyas. 11There is no unanimity on the question of whether there is still
a place for ijtihad in the modern world. Some Muslim scholars opine that the door of ijtihad or
gate of ijtihad was closed early in the tenth century, as at about that time scholars of the law
schools felt that all important questions had been settled. Others say it took place in the thirteenth
century. A modern case of (collective) ijtihad, according to Yaqubi (2000), are the accounting
standards developed by the Accounting and Auditing Organization for Islamic Financial
Institutions (AAOIFI) In Sudan ijtihad was reintroduced in 1983 by the military dictator Jafar alNumayri when he established Islamic law as the law of the state. In cases not foreseen in statute
law, the Sudanese civil court may apply the sharia as it interprets it and if necessary exercise
ijtihad. It is in the character of ijtihad laws that they can be changed if circumstances change,
which allows many economic laws to be adapted to new circumstances.
4. RAU
Rau is expert private interpretation or personal reasoning. Ray was involved in the instructions
that the Prophet and the early Caliphs gave to the people responsible for the administration of
justice in conquered territories and in their ex post sanctioning of it. It did not use qiyas, as there
10 https://www.academia.edu/526760/Principals_of_the_Islamic_finance
11 www.library.columbia.edu/content/dam/libraryweb/.../islamic_law_isrr.doc

were not yet rules or examples that could be used as an analogy. According to Schacht, by the
ninth century ray was no longer acceptable.

OTHER PRINCIPLES
1. ISTIHSAN
Istihsan means juristic preference and points to exceptions that a jurist can make to strict or
literal legal interpretations. Istihsan can be applied when qiyas, or any other method, does not
provide a denite answer, or when a ruling based on qiyas would put unreasonable burdens on
the believers. Istihsan is concerned with equity.
2. ISTISLAH
Istislah literally means seeking the good,or taking the public interest, maslaha, into account.
Jurists have diered over the scope of istislah or maslaha as a source of law.Some see no place
for it, others want to consider it as legal only to the extent that it can be seen as part of another
source of law, such as qiyas, but still others accept istislah or maslaha as an independent source
of law, even in cases where it cannot be based on quotations from the Quran or the sunna. The
principle of istislah can be invoked, for instance, in decisions about blood transfusions and organ
transplants, where there are no historical precedents and qiyas therefore cannot show the way.
3. URF
Urf is custom. 12It can be an argument behind istihsan and istislah. Custom can also function as a
supplementary source of law in contract law. It will determine the rights and duties of contracting
parties in cases where no conditions have been stipulated.
4. DARURA
12 www.arzim.blogspot.com/2010/01/secondary-sources-of-shariah-uruf-or.html

Darura or necessity. The principle of necessity says that a law need not be followed in cases
where it would be unreasonable to demand strict obedience to the laws and rules. This is simply
the old adage that necessity knows no law. It can be seen as a kind of source of law,even if it is a
principle that is not used to formulate laws, but only to determine when laws should not apply.
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A ruling under the heading of darura may be based on custom. In the Quran itself a case of

darura can be found in Chapter, or Sura, 2:185, where it is said about travellers and the ill, who
are not able to observe the rules of fasting, whoever is ill or upon a journey shall fast a similar
number of days later on. Allah intends your well being and does not want to put you to hardship.
To those for whom fasting is under any circumstances dicult, such as the old and inrm, Quran
2:184 oers a choice: For those who can not endure it, there is a ransom, the feeding of one
poor person for each missed day. The message is that Islam does not demand the impossible
from the believers

13 www.law.richmond.libguides.com/content.php?pid=286369&sid=2357003