Islamic Finance 101
Islamic Financial Instruments &
Mahmoud A. El-Gamal Department of Treasury
Rice University Washington, DC
April 26, 2002: 1 p.m.
More thorough explanations at:
Two main prohibitions
• Ribā: (lit. increase, Hebrew: Ribit)
– Superficial translations: “interest”, “usury” (exorbitant interest).
– In fact: there is Ribā without interest (or time), as well as interest
without Ribā (embedded in most Islamic banking instruments).
– Islamic Law recognizes the time value of money.
– Correct definition: The unbundled sale of credit, e.g. an interest-
bearing loan, interest being the price of credit.
• Bay`u l-Gharar:
– The unbundled sale of risk, e.g. gambling, insurance, derivatives,
payment or premium being the price of unbundled risk.
IF 101: April 26, 2002 © Mahmoud A. El-Gamal Slide #2 of 10
History of Usury and Ribā prohibitions
• Non-Abrahamic prohibitions of “usury”:
– Code of Hammurabi (ca 2100 BC): interest ceilings of 33% and
20% on loans-in-kind.
– Hindu law: total interest may not exceed principal.
– Plato,…: Capital not viewed as a valid “factor of production”.
• Judeo-Christian-Islamic prohibition of “Ribā”:
– Exodus [22:25], Leviticus [25:35-7], Deuteronomy [23:19-20],
Bava Metzia, Chapter 5, Mishna 2.
– Luke [6:27-36], Benedict XIV (De Synodo Diocesana, X.iv, n.6),
First Council of Carthage (345)-until-Fourth Council of the
– Qur’an [30:39], [3:130], [2:275-279], various Prophetic traditions.
IF 101: April 26, 2002 © Mahmoud A. El-Gamal Slide #3 of 10
Universality of prohibitions of Ribit
• Interpretations of Exodus [22:25], later Canonical Texts
– Rare: “Ami” (my people) interpreted to mean poor debtors.
– Commonly (Ami = children of Israel) interpreted to apply prohibition of
Ribit only to inter-faith loans; c.f. Talmud (Bava Metzia 70b – 71a).
– Maimonides (Laws of Loans, Ch. 5, Law 2) restricted permission of
charging moderate interest to cases of necessity.
– Fourth Council of the Lateran (1215) allows Jews to charge interest at
non-usurious (non-exorbitant) rates.
– Distinguish consumption loans (to the needy) from productive loans.
• Sixteenth Century – modern day:
– Heter ‘Iska: replaced loan-financing with silent partnership investment.
– Moral hazard problems led to refinements of HI to allow for fixed interest.
– Calvin permitted moderate interest on loans.
– Modern debates on interest rate ceilings (as in the code of Hammurabi).
IF 101: April 26, 2002 © Mahmoud A. El-Gamal Slide #4 of 10
Islamic Sharīca: Prohibition of Ribā
– Lit.: “The Way” … to a water hole … in the desert! (comp. Halakhah).
– Revealed Law in Canonical Texts: The Qur’an and Prophetic traditions.
• Islamic Law: A mixture of canon and common law
– Fiqh (jurisprudence): (lit.) understanding of the Sharīca
– Canon Law: All rulings must be referred back to the Canonical Texts.
• Unanimous interpretations are raised to the same authoritative level.
– Common Law: Jurists rely on precedents in opinion, interpretation, etc.
• Universal Prohibition of Ribā (interest on loans):
– Explicit in Canonical Texts. Virtually no dissent on interpretation.
– Islamic finance avoids loans as finance contracts: loans are for charity.
IF 101: April 26, 2002 © Mahmoud A. El-Gamal Slide #5 of 10
Neither a borrower nor a lender be …
• Finance without interest-bearing loans:
– Equity finance:
• Obvious “profit/loss-sharing” rules in partnerships, silent
partnerships, and (contemporary) ownership of common shares.
• Recent trend: Islamic mutual funds, VC, private equity funds, etc.
• Silent partnerships used to generate Islamic banks’ “liabilities-side”.
– Debt finance (Islamic banking “assets-side”):
• Form: initiate debt (including implied interest) through cost-plus
sales (Murabaha), leasing (’Ijara), etc.
– OCC #867 (1999) & OCC #806 (1997) recognized respective
contracts as “secured lending within the business of banking”.
• Substance: Enforcement of closer ties to “real” transactions,
marking collateral value and implied rate of return to market.
IF 101: April 26, 2002 © Mahmoud A. El-Gamal Slide #6 of 10
“Sharīca Compliant Finance”
• Islamic financial institutions appoint religious scholars to serve on
“Sharīca boards”, approve contracts and monitor operations.
• Efforts are underway to “harmonize Sharīca and accounting
standards” (e.g. AAOIFI, etc.).
• What do Sharīca boards consider to check for Sharīca compliance?
– Real and legitimate transactions underlying financial contracts.
– Absence of Ribā (interest on a “loan-like” contract) and Gharar.
– A contract form that ensures the above.
– A contract wording that ties the contract form to historical forms
known in classical jurisprudence (hence the Arabic names).
– In the tradition of Canon Law, the names imply permissibility.
– In the tradition of Common Law, the names and contract
specifics ensure derivation from precedents and valid analogies.
IF 101: April 26, 2002 © Mahmoud A. El-Gamal Slide #7 of 10
“Sharīca Compliant Finance”
• Example 1: Home financing
– Object to the “mortgage loan” language, since interest-bearing
loans (secured or otherwise) clearly constitute Ribā.
– First step: The Islamic financing firm “acquires” the property.
– Second step: The firm typically finances the customer’s purchase
of the property in one of three ways:
• Cost-plus credit sale (Murābaha): Customer buys the property from
firm on credit, amortization schedule calculated in similar manner to
conventional mortgage (often LIBOR+ used as benchmark).
• Lease-to-own (‘Ijāra wa qtinā’): Customer pays rent for portion
owned by firm + buys back part of firm’s equity. Rent determined
by market rental rate of comparable properties, or LIBOR+.
• Rolling partnership (mushāraka mutanāqisa): similar to lease,
different treatment of taxes, insurance, capital gains sharing, etc..
IF 101: April 26, 2002 © Mahmoud A. El-Gamal Slide #8 of 10
“Sharīca Compliant Finance”
• Example 2: Investing in stocks (Islamic mutual funds)
– Eliminate companies with primary or substantial businesses that are
illicit in Islam (e.g. liquor, tobacco, gambling, pornography, etc.).
– Eliminate companies with excessive debt-to-assets (highly leveraged).
– Eliminate companies with excessive interest income (idle capital).
– Within the resulting universe of securities, apply standard portfolio
management techniques to provide a variety of risk-return profiles under
different business conditions (e.g. sectoral bias, growth, value, …).
– Some have argued for regional, developmental, and ethical biases being
incorporated in the portfolio selection methodologies (ethical investing),
but such considerations seem currently to be secondary at best.
IF 101: April 26, 2002 © Mahmoud A. El-Gamal Slide #9 of 10
Growing pains of Islamic Finance
• Contemporary Islamic finance is a only a few decades-old.
• Its emergence and growth coincided with (and resulted from) increased
degrees of adherence to explicit Islamic forms (from ritual worship, to
dress-codes, to social processes, to economic life).
• This explains the focus on contract forms and names.
• There is an ongoing effort to bridge a centuries-wide gap of
jurisprudence development to meet today’s Muslims’ needs within
various national legal/regulatory frameworks.
• This often puts form above substance, and results in higher (legal and
other) short-term transactions costs (in this instance, including your
time… Thank you!).
IF 101: April 26, 2002 © Mahmoud A. El-Gamal Slide #10 of 10