Lender-of-Last-Resort Facilities Structuring Shariah-Compliant Instruments and Mechanisms

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2. 2 .1. Issues under Study Islamic banking has evolved to the extent that the industry is now able to compete with conventional banks in fulfilling the needs of individuals, businesses and governments by offering a full range of banking services and innovative financing modes that are no less efficient than the alternatives provided by their conventional counterparts and at the same cost. However, the relationship between central banks and Islamic banks remains passive and devoid of any developments even though urgent need dictates otherwise. It would be of no use to lay the blame on central banks and accuse them of resisting any attempt to adopt special programs that take into account the specificities of Islamic banking. Rather, it can be more fruitful to put forward useful proposals that take into account the parameters within which central banks operate and offer alternatives that can improve some of the central banks’ functions that are related to Islamic banking, particularly in regards to the issue of lender-of-last-resort (LOLR) facilities. All of this must be pursued within the scope of what is permissible in Sharīʻah. This paper presents a proposal in this regard; which can be a starting point for the formulation of a structure that enables Islamic banks to utilise LOLR facilities provided by central banks, without breaching the principles of Sharīʻah. 2.2. Significance of the Study Developing mechanisms and structures that could enable Islamic banks to benefit from the facilities provided by the central bank in the event of financial shocks is a matter of absolute necessity. Whoever delves into the history of banking will come to realise that the central bank’s support of commercial banks is an intrinsic component of the banking system without which that system is doomed to fail. Suffice it to say as evidence of the above that the phrase “lender-of-last-resort” dates back to the year 1797 when Francis Baring1 mentioned it in one of his writings about the best policy to be adopted by the Bank of England to protect the banking system in the event of a financial shock. This fact shows that the great development that took place in the banking system would not have occurred without the existence of such support from the central bank. Therefore, the role of the LOLR is one of the most significant functions of the central bank due to its considerable importance in achieving the stability of the banking system in particular and the national economy at large. 1 28 Sir Francis Baring (1797). Observations on the Establishment of the Bank of England and on the Paper Circulation of the Country, (Swell, Cornhill, and Debrett: London).
3. If we truly aspire to a day when all banks in Muslim-majority nations become Islamic , we have to keep in mind the fact that such a dream would be impossible unless an effective and legitimate formula is developed for the function of LOLR, which is why this issue is so vital. 2.3. Importance of the LOLR in the Realm of Banking Liquidity is to the economy what the circulatory system is to the human body, and as we know, banks are the main source of liquidity in the economy. It is true that the national currency is issued by the central bank; however, banks remain the source of liquidity. This feature is due to what is called the “fractional reserve system”,2 which enables banks to generate liquidity. Banks retain a limited fraction of their deposits in the form of cash in their vaults or accounts at other banks or with the central bank. As for the most important part of deposits, which may amount to over 90% of total deposits, it will be used for financing, which would generate liquidity since this process will be repeated by all the banks collectively. The role of banks in generating liquidity is irreplaceable and highly essential for achieving economic growth and stability. Thus, the role played by banks in the national economy is extremely vital. On the other hand, the aforementioned fractional reserve system exposes banks to the risk of default by being unable to fulfil their obligations towards their depositors at all times. At the institutional level, each bank should ensure on a daily basis that the available amount of liquidity is equivalent to the expected amount of withdrawals by its clients on that day. If demand exceeds supply, the bank resorts to “interbank lending”, a method by which it can obtain liquidity from other banks having surplus liquidity on that day. At the system-wide level, the aggregate supply of liquidity must equal the aggregate demand for liquidity for all banks. The interbank lending system serves the purpose of transferring liquidity from one bank to another within the banking sector to achieve the objective of aggregate demand for liquidity equalling the aggregate supply. However, if aggregate demand at the system-wide level exceeds the aggregate supply of liquidity, the only way out of the crisis is to resort to the central bank for the supply of the necessary liquidity. Therefore, to ensure the soundness of the banking system in the jurisdiction, the central bank must be prepared for such instances at 2 A system where a bank covers a small portion of its liabilities towards its depositors, while lending the larger portion of deposits based on the law of large numbers, which assumes that the volume of liquidity the bank is expected to require on a daily basis would be no more than 5% or so of its total liabilities. 29
4. all times . This is applicable in the short term, but in the long term, banks can resort to other sources of funding such as issuing securities of various kinds. Without these measures, banks would face the risk of failure and collapse at the slightest financial shock. This is because the fractional reserve system depends entirely on the confidence of account holders that they can withdraw, at any time, their deposited money. If this confidence is shaken for any reason, or if depositors have doubt that a certain bank does not have sufficient funds, such uncertainty will turn into panic and will result in a bank run contagion. Consequently, each depositor would expect the worst and fears that if he delays the withdrawal of his deposit he may never be able to retrieve it, as other depositors may have withdrawn their deposits first. When the assets of a bank can cover all of its liabilities, the bank is solvent. However, most of a bank’s assets are illiquid and cannot be sold quickly unless they are sold at a large discount due to the deterioration of their quality because of the stress conditions caused by depositors who are demanding to withdraw their deposits. If a bank buckles under such pressure and sells its assets for low prices, its financial position would worsen and would eventually cause it to fail, as the shortage of liquidity no longer becomes its only problem. Moreover, in such cases the banking sector suffers from contagion, which means the critical situation of one bank (shortage of liquidity) will spread to other banks unless the issue is immediately treated. If depositors of a certain bank lose confidence in it, they will rapidly influence the depositors of other banks, which would put the entire banking system at the risk of collapse. Collapse of the banking system leads to the collapse of the national economy. Consequently, this would mean the affected jurisdiction losing its economic fundamentals, which in turn would result in halting economic growth and could even result in deflation, as well as the consequent social unrest, rise of problems of every kind, and so forth. Therefore, it is natural that central banks strive to prevent such an eventuality from happening, by being ever ready to support any bank that is unable to stand its ground, so that its collapse would not result in the collapse of the entire banking system. 2.4. Mechanisms for Performing the LOLR Function The central bank provides LOLR facilities to banks using various mechanisms, the most important of which are through: 30
5. (a) direct lending, which is the preferred mechanism, and collateralising the highquality assets of the bank to document the loans, which carry relatively high interest rates; and (b) repurchase agreements (repo), which is a contract for the spot sale of securities combined with a deferred contract to repurchase the same securities by the seller at a price higher than the sale price. The difference between the sale and repurchase prices is the interest on the loan and is called the “repo rate”. The securities that are the subject matter of the aforementioned transaction are debt bonds with a short-term maturity that varies from one day to several days, or possibly weeks.3 A custodian holds the securities to facilitate the transaction and specify any due taxes.4 2.5. Why Is It Called “Lender-of-Last-Resort”? In the normal course of their business, banks always lack liquidity, which they obtain under normal conditions through multiple methods and from different sources. The obtained liquidity is usually sufficient as long as the aggregate supply of liquidity equals the aggregate demand in the economy. Therefore, the primary source of liquidity under normal conditions is the market, whereby a bank can obtain financing through the issuance of long-term securities or by relying on short-term interbank borrowing. If these two avenues are not available, only then does the role of the lender-of-last-resort come into the picture. The central bank is the institution that plays the LOLR role. However, being ever ready to provide loans may entail a moral hazard, as it may create an incentive for banks to bear more risk than they should and to rely on the willingness of the central bank to lend to them. Therefore, the central bank does not provide liquidity to a bank suffering from illiquidity unless two conditions are satisfied. First, the loans must be guaranteed by collaterals of good quality, which are often the best assets of the bank. 3 Another type that could be available is open repo, which has no maturity date and it can remain in effect till both parties agree to end it. 4 There is also what is known as reverse repo, which is used by the central bank to absorb liquidity from the banking system. However, it is not used when performing the role of the lender-of-lastresort, but for liquidity management by central banks. 31
6. Second , the liquidity facilities are offered at a considerably high cost to ensure that the bank demanding liquidity has tried all other possible means before resorting to the central bank. This is because the central bank does not want to be an alternative for interbank lending or any other sources of liquidity, nor does it want to compete with other banks in providing liquidity for each other. This is why it is called the lender-of-last-resort, since only a destitute bank would seek it. 2.6. Sharīʻah Issues Surrounding the Conventional LOLR Scheme Central banks provide liquidity to banks only through interest-bearing loans, documented by collaterals, or through repurchase agreements (repo) which make use of some of the bankʼs tradable assets. (a) The issue in the first method is the fact that they are interest-bearing loans. Such loans are the exact replica of usury (ribā) of the pre-Islamic era of ignorance, which is explicitly prohibited. Islamic banks came into existence specifically to eradicate it. Therefore, Islamic banks cannot be involved in such loans for any reason whatsoever. (b) The issue in the second method of repurchase contracts is less severe than the interest-bearing loans, especially if the subject matter of the transaction is permissible shares instead of interest-bearing bonds. However, the two issues of appending the sale transaction to a future date and purchase of the subject matter on condition of its repurchase remain unresolved. These issues will be discussed further later. Meanwhile, central banks in most jurisdictions find it difficult to adopt alternative schemes dedicated to Islamic banks because they lack a structure that can provide liquidity at the same level of the risk–return spectrum and with the same efficiency in application while at the same time not requiring additional procedures for monitoring and follow-up. Designing special schemes for Islamic banks that meet all of the above-mentioned requirements is by no means an easy task. The difficulty arises especially from the fact that the circumstances that require quick intervention by the central bank are always very critical, to the extent that they do not allow the involved parties to enter into complex procedures or contracts that need lengthy negotiations, or time to study and assess the potential risks. All these issues are associated with the use of transactions such as cost-plus sale (murābaḥah) or joint venture (mushārakah). 32
7. It is well-known that lending with interest is the easiest way of funding , with the least required procedures and the clearest contract provisions. Therefore, these requirements must be taken into consideration when proposing an acceptable mechanism for Islamic banks. 2.7. Alternative Mechanisms in Islamic Banking Literature for LOLR Facilities Many studies have discussed the issue of the relationship between the Islamic bank and the central bank, particularly with regard to the LOLR function. Many mechanisms have been proposed, the aim of which is to provide the necessary protection for Islamic banks by creating an appropriate source of liquidity to be resorted to in the event of a financial shock. The most important of those proposed mechanisms are discussed next. 2.7.1. Entering into a Profit-Sharing/Loss-Bearing (Muḍārabah) Contract between the Central Bank and the Islamic Bank A number of researchers have suggested the profit-sharing/loss-bearing mechanism of muḍārabah as a way for Islamic banks to obtain liquidity from the lender-of-lastresort. Muḍārabah is a profit partnership contract between the provider of capital (rabb al-māl) and the entrepreneur (muḍārib). Both partners agree to share the profit according to an agreed-upon ratio, while losses are incurred by rabb al-māl unless the loss is due to any misconduct or negligence on the part of the muḍārib. In the proposed structure, the central bank acts as the rabb al-māl, while the Islamic bank acts as the muḍārib. Accordingly, if an Islamic bank needs liquidity (in the case of a financial shock), it needs only to sign a muḍārabah contract with the central bank whereby it receives the capital of the muḍārabah and uses it to meet its liquidity needs. The generated profit is divided between both parties based on an agreedupon ratio, and the muḍārabah would be liquidated at the end of its prescribed term. Even though this proposed structure is acceptable from the Sharīʻah perspective, it has inherent operational shortcomings that would make its application almost impossible. For example: (a) The nature of the LOLR function requires that funds provided by the central bank be guaranteed by the beneficiary bank, since the provided funds are considered a debt on its liability. Moreover, the debt must be collateralised. This arrangement is not applicable to the profit-sharing/loss-bearing contract of muḍārabah, since the muḍārib is not allowed to guarantee either the capital or the profit for the benefit of rabb al-māl. 33
8. (b) The rate of return on the liquidity provided by the central bank is usually high. This rate of return is measured in relation to the prevailing interest rates or those that are expected to prevail. However, the muḍārabah contract requires sharing of the profit. 2.7.2. The Use of Reciprocal Loans by the LOLR The proposed mechanism is that the central bank would provide a loan to any Islamic bank that is in need of liquidity. However, the central bank will not be entitled to receive any interest on the loan, since it will be an interest-free loan. At the same time, the Islamic bank is required to extend an interest-free loan similar to the one it has received in terms of amount and duration to the central bank. In some mechanisms, the loan extended by the Islamic bank would be for a longer duration or higher amount than the original interest-free loan. Nevertheless, this mechanism has inherent Sharīʻah and practical issues. In terms of the Sharīʻah issues, the mechanism has the following shortcomings: (a) The consensus of jurists is that conditional reciprocal loans are impermissible, while those who did permit such loans stipulated that they should not be conditional. Some Sharīʻah boards, such as Al-Baraka Bank Sharīʻah Board, deemed the use of reciprocal loans permissible, provided that they are based on a promise (waʻd). (b) The mechanism of reciprocal loans cannot be applied unless a condition for increasing the duration of the loan or its amount is stipulated. Especially taking into consideration the fact that the point in time at which the Islamic bank receives the first loan would be different from the point in time at which the central bank receives the second loan. This requires taking into account the new circumstances that may entail a request to increase the amount of the loan. Therefore, stipulating a condition that the second loan must be of a higher amount or for a longer duration than the first loan is considered a conditional increment that falls under the definition of ribā and no jurist has deemed this permissible. (c) Even if we assume that the amount of the second loan equals the first one and the duration of both loans are the same, this will not meet the requirement of the central bank that a high return on the loan be given to the Islamic bank. This requirement is needed to ensure that banks will not resort to such a facility except when no other sources of liquidity are available and, as a result, such a requirement cannot be met under this proposed mechanism. 34
9. (d) Usually the central bank provides liquidity to an Islamic bank under stressed conditions, which means it is unfathomable for the Islamic bank that has just received the liquidity injection to have a surplus of liquidity within a reasonable period of time, which can be lent to the central bank for the same duration of the loan it received from it. 2.7.3. The Use of Commodity Murābaḥah for the LOLR Function Under this proposal, the central bank purchases commodities from the market on a deferred payment basis, then sells them to the Islamic bank that needs liquidity on a deferred payment basis. The Islamic bank would then sell the commodities in the market on a spot payment basis to obtain cash to meet its liquidity needs. In fact, this method is applicable and has already been applied in one central bank. However, it is not expected to be used extensively by other central banks because of the following shortcomings: (a) It requires relatively long procedures, while the need for liquidity in the event of a financial shock cannot endure any delays. (b) Commodities markets do not have the depth necessary to conduct large operations, which is what the banks usually need. Furthermore, the occurrence of a financial shock in financial markets would also affect the commodities markets. (c) A murābaḥah contract has a fixed duration, and in cases where a bank needs liquidity for an unknown duration, such a mechanism cannot be applied. However, it is argued that the mechanism can be renewed with a new tawarruq transaction. However, the procedures for the new tawarruq transaction would be more complex, especially for large amounts of money. 2.8. Proposed Mechanism for the LOLR Function Certain characteristics must be met in the proposed mechanism for the LOLR function so that it can be an alternative for the conventional mechanism: (a) The facility must be efficient, so that it can be applied quickly and using easy procedures. 35
10. (b) The facility must be of a higher cost than other alternatives to ensure that the use of such a facility will not result in any «moral hazards» in the sense that it would tempt the bank to take more risk than it should. The only way to determine the cost of the facility would be to compare it with the cost of the other alternatives, which are usually based on interest rate. Accordingly, we will present below the proposed structure and explain its juristic basis. 2.8.1 New Proposed Mechanism for the LOLR Function The new proposed mechanism is based on the muḍārabah contract. This contract was not given adequate attention in Islamic banking due to the belief that it involves high risk. On the contrary, the muḍārabah contract should form the backbone of Islamic banking. It is based on profit sharing between a capital provider rabb almāl and a muḍārib, who conducts and manages the business. Scholars of Islamic jurisprudence have defined it as: “A contract whereby an individual gives another a sum of money for the latter to utilise it in trading activities, provided that the profit is shared between them based on what was agreed between them.” 5 There is no text in the Qurʼān, or the Sunnah of Prophet Muhammad, peace be upon him, that explicitly mentions the contract of muḍārabah. However, people used to practise it, so the jurists took great pains to regulate it and set conditions for its validity so it can be conducted in compliance with the rules and principles of Sharīʻah. Furthermore, jurists have dedicated entire chapters in the books of Islamic jurisprudence to the subject of muḍārabah. Its famous mechanism is what has been commonly practised in the past, and it has been said that the Companions of the Prophet Muhammad, peace be upon him, had practised this kind of profit-sharing contract since the dawn of his prophethood. This proposed mechanism is based on entering into a muḍārabah contract between the central bank and the Islamic bank that needs liquidity. The mechanism will serve its purpose without the need to resort to interest-bearing loans. At the same time, the muḍārabah contract will be designed in a way that would reduce the risks associated with it so that it can be applicable in the current banking system and meet the conditions of the central bank in regards to the function of the lender-oflast-resort. 5 36 Authored by a group of Sharī‘ah scholars (1995). Al-Mawsūʻah al-Fiqhiyyah al-Kuwaytiyyah, (Dār alṢafwah: Egypt). Vol. 33, p. 112.
11. 2 .8.2 The Muḍārabah Contract Has a Large Degree of Flexibility The contemporary juristic thinking surrounding the contract of muḍārabah, which is reflected in the resolutions of fiqh academies and the pronouncements of Sharīʻah boards, did not confine itself to the original mechanism of the muḍārabah contract. Rather, it was based on the opinion of Imām al-Shawkānī and what he narrated from Ibn Ḥazm whereby they stated: “No authentic ḥadīth of Prophet Muhammad, peace be upon him, mentioned muḍārabah contract, except for one weak ḥadīth in which he said it has blessing.” 6 Furthermore, Ibn Ḥazm also stated in his book, Marātib al-Ijmā‘: “All the chapters of jurisprudence have origins in the Qurʼān, and Sunnah except qirāḍ [muḍārabah] which we could not find any origin of it in the Qurʼān and Sunnah.” The contemporary juristic thinking surrounding the contract of muḍārabah is best reflected in the following: (a) One of the basic principles of the muḍārabah contract is that it cannot be limited to a specific duration. Accordingly, the opinion of the Shāfiʿī and Mālikī jurists and one of the opinions of the Ḥanbalī jurists is that fixing a duration for the muḍārabah contract would invalidate it.7 However, contemporary jurists adopted the opinion of Abū-Ḥanīfah that permitted such a practice and it has become the norm for the muḍārabah contract to have a fixed duration. (b) Another basic principle of muḍārabah is that it is a permissible, non-binding contract. Almost a consensus is held on this point, as stated in Al-Mughnī: “Muḍārabah is one of the permissible contracts that can be terminated by any of the two parties … whether before or after work has commenced.”8 However, contemporary jurists adopted the opinion of the Mālikī jurists, which considers the muḍārabah binding if the entrepreneur commences the work. Moreover, they made it binding if a condition to this end is stipulated. Therefore, on this basis the muḍārabah contract that is being practised by the Islamic banks is binding on both parties from the moment of signing it. (c) Another basic principle of muḍārabah is that the capital provider must provide the capital to the entrepreneur in the form of minted dirhams and dinars. In this regard, the classical jurists said: “If the capital provider sets a condition that he will hold the money in his possession and he would pay the price of any item purchased by the entrepreneur, the contract would still become invalid.” However, contemporary jurists approved constructive possession by 6 Al-Shawkānī, Muḥammad bin ‘Alī (1993). Naīl al-ʼAṭwār, (Dār al-Ḥadīth: Egypt). Vol. 5, p. 300. 7 Ibn Qudāmah, Abū Muḥammad Muwafaq al-Dīn (1968). Al-Mughnī, (Maktabat al-Qāhirah: Cairo). Vol. 5, p. 50. 8 Ibid., Vol. 5, p. 46. 37
12. considering the amount of money held in a bank account to be constructively possessed by the bank . (d) Another basic principle is that distribution of the profit is juristically valid only after liquidation of the muḍārabah venture. Therefore, the entrepreneur does not own a share of the profit unless the profit is distributed. This is in line with what Ibn Qudāmah stated in his book Al-Mughnī when he said: “The muḍārib is not entitled to receive any portion of the profit until he delivers the capital to the capital provider.”9 Nevertheless, the contemporary formula of muḍārabah depends entirely on what is called “constructive liquidation” by considering the accounting books in the bank as an acceptable form of evidencing the recognition of profit or loss and whether the capital of muḍārabah is impaired or not. This approach relies on a statement that Imām Aḥmad was reported to have said and was quoted by the author of Al-Mughnī Ibn Qudāmah who said: “[The outcome of muḍārabah can be] calculated as [if the capital] is in the possession [of the capital provider].”10 (e) Another principle is that it is impermissible for the capital provider to instruct the muḍārib to carry out the muḍārabah venture using the debt owed by the muḍārib to the capital provider. Such a scenario is impermissible and the muḍārabah venture based on it would be voidable. Ibn Rushd stated in his book Bidāyat al-Mujtahid: “The majority of jurists such as Mālik, Shafiʿī, and Abū Ḥanīfah are of the opinion that if someone is a creditor of another, it would be impermissible for the creditor to give away his debt to the debtor on the basis of muḍārabah.” The author of Al-Mughnī also says, “It is impermissible to inform a debtor to trade in the debt owed by him on a muḍārabah basis.”11 However, all the muḍārabah contracts conducted by Islamic banks for the purpose of investment are based on transforming funds to the investment account from the current account, which is a debt owed by the bank to the customer. Thus, it is as if the customer is saying: “Conduct muḍārabah using the amount of debt you owe me”, which contradicts the above-mentioned basic principle and deviates from the consensus of the jurists. The evidence for adopting this opposing view is a juristic opinion of the Ḥanbalī jurists, which was quoted by the author of Al-Mughnī when he was discussing the view that prohibited such approach: “Some of our companions stated that the muḍārabah could be deemed valid.” 12 9 Ibid., Vol. 5, p. 41. 10 Ibid., Vol. 5, p. 45. 11 Ibid., Vol. 5, p. 53. 12 Ibid., Vol. 5, p. 53. 38
13. From all of the above , it is evident that the muḍārabah contract has a great deal of flexibility and broadness, which makes it a convenient answer to the contemporary needs of people. The muḍārabah remains permissible unless its inherent nature is affected, which is something that would deem it invalid such as stipulating the guarantee of the capital, since such a condition would turn the muḍārabah into qarḍ and, as a result, profit from such an arrangement would be a form of ribā. Another issue that could affect the legitimacy of muḍārabah is when one of the partners claims all of the profit at the expense of the other party despite having a profitsharing agreement. 2.8.3. The Proposed Muḍārabah Structure An Islamic bank can enter into a muḍārabah agreement with the central bank that has the following description: (a) The agreement must involve entering into daily muḍārabah contracts that enable the Islamic bank to obtain liquidity from the central bank in cases where such liquidity is needed. Whenever the Islamic bank withdraws an amount to cover its shortage of liquidity, this amount is to be considered the capital of a one-day muḍārabah contract to be invested by the Islamic bank in its financing activities via the use of Sharīʻah-compliant modes of financing. Any profit generated will be shared in accordance with what is stipulated in the agreement. For example, the central bank may have one-third of the profit and the entrepreneur (the Islamic bank) two-thirds, or each party is to have half of the profit, and so on. The percentage of profit sharing may be changed on a daily basis. Moreover, there is no objection to increasing the central bank’s share of the profit to prevent the Islamic bank from requesting liquidity unless it is urgently in need of it and cannot obtain it by any other means. (b) The aforementioned capital of muḍārabah is to be added to the overall working capital of the Islamic bank, which entails the establishment of mushārakah in the investment pool of the Islamic bank. Hence, the muḍārabah capital is entitled to receive a share of the profit equivalent to its percentage in the total mushārakah capital on that day, which refers to the total investment pool of the Islamic bank. (c) At the close of business, the muḍārabah is constructively liquidated and profits are shared accordingly. It must be stipulated in the agreement that if the term of the muḍārabah, which is one day, expires, the relationship between the central bank and the Islamic bank is turned into a debt-based relationship because the capital of muḍārabah becomes a loan on the liability of the Islamic bank. Thus, the amount liquidated on that day, which represents the 39
14. capital of mu ḍārabah and any generated profit, would be guaranteed by the Islamic bank. (d) Both parties enter into a new muḍārabah contract on the next day with the same conditions, and the new capital of muḍārabah would be the amount resulting from the constructive liquidation of the muḍārabah contract of the previous day. In other words, it would be the capital of the first muḍārabah in addition to the profit of the first day, if any. It is also possible for both parties to agree not to distribute the profit on a daily basis, which means the capital of the new muḍārabah contract would be the same as that of the first muḍārabah contract. Moreover, the central bank may change the conditions of the agreement in regards to the profit-sharing ratio or terminating the agreement at the end of any day. (e) At the end of each year (or each quarter), or when the bank is no longer in need of liquidity, and where the agreement between the two parties includes a clause not to reinvest the daily profits, the Islamic bank would calculate the daily accumulated profits and the central bank would receive its capital plus its share of the accumulated profits. 2.8.4. The Profit-Sharing Method The entrepreneur in the above-mentioned muḍārabah contract is the legal personality of the Islamic bank, and such a legal personality comes under the same rules and provisions that apply to a natural person. Therefore, the legal entity of the Islamic bank, its fixed capital, and employees constitute an intrinsic part of it, similar to the case where a man acts as a muḍārib by relying on his physical ability, intelligence, shrewdness, and other tools of the business, etc. The working capital of the Islamic bank (the legal personality that is acting as a muḍārib) consists of what it spends to accomplish production operations in its field of specialisation, which is financing, and this is the subject matter of the partnership. This is because the muḍārabah contract results in the entrepreneur commingling the capital of the muḍārabah with his own working capital to enhance its financing activities. Therefore, both parties become partners in the overall investment pool where all the funds are collected. The share of the muḍārabah in the realised profit is determined based on the percentage it constitutes of the overall mushārakah pool. For example, if the muḍārabah capital constitutes 10% of the overall mushārakah pool, the profit to be divided between the capital provider and the entrepreneur (i.e. the muḍārabah profit) would be 10% of the overall profit of the mushārakah pool. Accordingly, the entrepreneur may get two-thirds and the central bank one-third of the said percentage, or based on any agreed-upon profit-sharing ratio. 40
15. In this regard , the International Islamic Fiqh Academy, in its resolution no. 30 (304/), stipulated the following: “The amount to be divided is the profit in the juristic sense of the word, which is the amount over and above the capital and not the revenue or yield. The amount of profit is determined by either liquidation or valuation of the project’s assets in cash. Whatever is above the capital at the point of liquidation or valuation is considered the profit, which is to be distributed between the ṣukūk holders and the entrepreneur.” Thus, the entrepreneur has to hand over the capital to its provider and whatever amount over and above the capital is considered the profit in the juristic sense of the word that has to be divided between the partners. 2.8.5. Profit Sharing in Contemporary Companies How can we apply the profit-sharing rule mentioned above when using the muḍārabah contract, bearing in mind that the calculation of profit and other items related to it is governed by the accounting standards and the perception of accountants and auditors to the financial position of companies and the way their accounting books are managed? According to contemporary accounting standards, there are three stages for profit calculation – namely, the calculation of gross profit, operating profit and net profit. Thus, to which one of these three types of profit does the definition of profit according to the rules of muḍārabah apply? Gross Profit Gross profit (also called “gross margin” or “added value”) equals the total revenues minus cost of sales, or, in other words, the surplus of sales revenues after deducting the cost of production. Accountants consider it the best method for measuring a company’s profitability, ability to optimise the use of its financial resources, and the extent of its power in the face of its competitors. This is because the higher the gross profit is, the stronger it reflects the company’s ability to reduce the prices of its products. On the other hand, a low gross profit indicates the vulnerability of the company’s financial position. Moreover, when the gross profit continues to fall, it would be an indication of the increasing cost of production due to the increase of salaries and wages, or the decline in product quality, or the increase in the prices of raw materials in a faster pattern as compared with the increase in the prices of the product. 41
16. Operating Profit If , for example, the gross income is 420,000 and the cost of sold goods is 210,000, the gross profit would equal 210,000. The gross profit after deducting fixed expenses such as the shop rental, electricity bills, salaries of staff, and so on, would be called the “operating profit”. Therefore, if the gross profit, as in the example above, is 210,000 and fixed expenses equal 100,000, then the operating profit would be 110,000. Net Profit Net profit is the operating profit after deducting taxes and interests on loans. After analysing the types of profit as defined by the accounting standards, we find that the type of profit, which is in line with the resolution of the International Islamic Fiqh Academy and the consensus of classical and contemporary jurists, is the gross profit. It is the total working capital minus the costs of production. The muḍārabah capital would be commingled with the entrepreneur’s own working capital, and the realised profit would be the subject of distribution between the entrepreneur and the capital provider. Thus, the muḍārabah contracts can be applied within the scope of accredited accounting standards. 2.8.6. Objections and their Refutations It is Not Permissible for the Entrepreneur to Guarantee the Capital of Muḍārabah In order for the proposed mechanism to be suitable for performing the LOLR function, the capital of muḍārabah must be guaranteed by the entrepreneur at the end of every day. It may be argued that it is impermissible for the muḍārib to guarantee the capital or profit for the benefit of the capital provider and that there is a consensus prohibiting such a guarantee. Nevertheless, there are still cases where stipulating the guarantee of capital is permissible. For example: (a) If the capital provider stipulates that the entrepreneur must hand over to him the capital, or the part of it that remained after liquidation, yet the entrepreneur does not fulfil this condition, then he would be considered a usurper and, on this basis, he has to guarantee the capital. This is the basic ruling with regard to any trustee who breaches the conditions set by the party entrusting him, such as a trustee refusing to return a deposit. Accordingly, the muḍārabah agreement may include a condition that the entrepreneur must hand over the 42
17. capital to its provider at the end of each business day , and if the entrepreneur fails to do so, he would be held liable for the capital that he failed to return. On the next day, both parties may enter into a new muḍārabah agreement and, as a result, the capital guarantee would no longer stand. In this regard, jurists, may Allah have mercy on them, have stated that it is permissible for a man to inform the usurper of his money to conduct business with the money on the basis of muḍārabah according to the profit-sharing ratio agreed between them. The author of Badāʾiʿ al-Ṣanāʾiʿ said: “If [the capital provider] adds a guaranteed asset under the possession [of a usurper] such as usurped dirhams or dinars, by saying to the usurper: work with what is under your possession on the basis of muḍārabah provided the profit is shared equally. [Then such a practice] is deemed permissible according to Abū Yūsuf and AlḤasan Ibn Ziyād, whereas Zufar deems it impermissible.”13 Ibn Qudāmah, in his book Al-Mughnī, also stated: If someone has a usurped wealth under the possession of a usurper and he [asked the usurper to utilise it] based on muḍārabah, such an arrangement would be permissible. This is because [the usurped wealth] is that of the capital provider and it is permissible for him to sell it to whoever is able to take it from the usurper, which makes it similar to a deposit… However, whenever [the owner of the usurped wealth requests the usurper] to utilise it based on muḍārabah, the guarantee of the usurped wealth will cease to exist the moment they enter into the muḍārabah contract, and this is the juristic view of Abū Ḥanifah.»14 (b) It may be argued that the assumption of usurpation is somewhat farfetched in a way that could affect the proposed structure and it is, therefore, preferable not to resort to such an assumption. However, we can still achieve our purpose in another way. It is known that a capital provider is permitted to stipulate a condition requiring the entrepreneur to invest the muḍārabah capital for a specific period of time and, once the agreed-upon period is over, the capital would turn into an interest-free loan on the liability of the entrepreneur. Therefore, the central bank may offer the needed liquidity to the Islamic bank in the form of muḍārabah capital for a one-day duration. Once the day is over, the amount turns into an interest-free loan under the guarantee of the muḍārib since it is a form of debt established on his liability. Evidence for the permissibility of such an arrangement can be obtained from the sayings of several jurists. For example, Ibn Qudāmah says in AlMughnī: “Muhannā said: ‘I asked Imām Aḥmad about a man who has given 13 Al-Kāsānī, ‘Alā al-Dīn (1986). Badā’i‘ al-Ṣanā’iʻ fī Tartīb al-Sharā’i‘, (Dār al-Kutub al-‘Ilmiyyah: Beirut). Vol. 6, p. 83. 14 Ibn Qudāmah, Abū Muḥammad Muwafaq al-Dīn (1968). Al-Mughnī, (Maktabat al-Qāhirah: Cairo). Vol. 5, p. 54. 43
18. another a thousand to invest it on a mu ḍārabah basis for a month provided that once the month elapses, the amount would become a loan. He said: it is permissible. Then I asked him if the month elapsed and the amount is in the form of goods, he said: when the goods are sold, the money would become a loan.’”15 This statement proves that stipulating such a condition would achieve the intended purpose and it does not have any objections from the Sharīʻah perspective. It is not Permissible for the Capital under this Structure to be in the Form of Debt An opponent of such a structure may say that such a mechanism is objectionable since the muḍārabah capital turns into a debt by the close of business, which would result in the central bank not being able to enter into a new muḍārabah on the following day. This is because the capital of muḍārabah would be in the form of debt on the liability of the muḍārib and it is known that the capital of muḍārabah cannot be a debt. However, this issue has been debated among classical jurists, and the Kuwaiti Encyclopedia of Jurisprudence cited some of the books of the Ḥanbalīs in regards to this issue. Among these citations are the following: “Ḥanbalis are of the opinion that if a capital provider instructed his debtor to utilize the debt he owes on the basis of muḍārabah, such an arrangement would be invalid and this is the predominant view of the Ḥanbalī jurists. However, Imām Aḥmad permitted such a practice. Moreover, al-Qaḍī also permitted it on the basis that it takes the form of an agent purchasing the debt from himself on behalf of the principal. He later amended his view, deeming it permissible on the basis that it takes the form of an agent possessing the debt from himself on behalf of the principal. Two narrations have been cited in respect to this issue.”16 Furthermore, ibn Qudāmah says in Al-Mughnī: “It is impermissible to instruct someone who has a debt on his liability to utilise it on the basis of muḍārabah. This is the view of Imām Aḥmad and the majority of jurists. Nevertheless, some of our companions are of the opinion that the muḍārabah could be valid. This is because if the debtor [who is acting as a muḍārib] purchases an item for the muḍārabah, he would have purchased it with the consent of the capital provider. In other words, by doing so he would be using the debt as payment to whomever he was permitted to pay it. Hence, the debtor’s liability will be cleared in regards to the debt obligation. It would be similar to the capital provider providing him with an asset and instructing 15 Ibid., Vol. 5, p. 50. 16 Authored by a group of Sharī‘ah scholars (1998). Al-Mawsūʻah al-Fiqhiyyah al-Kuwaytiyyah, (Dār alṢafwah: Egypt). Vol. 38, p. 50. 44
19. him to sell it and invest the proceeds on the basis of mu ḍārabah.”17 The author of Al-Inṣāf, in elaborating the following statement of Ibn Qudāmah: “If the creditor instructs the debtor to invest the debt owed by him on a muḍārabah basis, the arrangement would be invalid”, stated the following: “This position is affirmed by Al-Khiraqī… A contrary opinion is that: such an arrangement is valid. Its validity is based on an analogy mentioned in Al-Muḥarrar and it is also a possibility attributed to some of the companions [within the Ḥanbalī school of jurisprudence].”18 All of the above shows that the issue has a certain level of flexibility and if we ascertain the legal reasoning (ʻillah) of the prohibition, we will realise that it does not materialise in our case and as we know any ruling revolves around its legal reasoning in its presence and absence. Those who explicitly mentioned the legal reasoning behind the prohibition of such an arrangement have said that it is because they fear that the debtor could be insolvent. In this regard, Ibn Rushd in Bidāyatul al-Mujtahid said: “If someone is indebted to another, it is impermissible for the creditor to ask the debtor to invest the amount of the debt unless this amount is repaid to the creditor. The argument Mālik provided for this view is that the creditor may know the debtor is insolvent, so he resorts to this trick to defer repayment of the debt provided that the debtor should invest it to increase its amount, which falls under the category of prohibited usury.” However, this concept of insolvency is not applicable to Islamic banks. 2.8.7. The Proposed Structure is Not New and is the Backbone of Islamic Banking Activities The daily muḍārabah, which is liquidated constructively at the end of the day, is present and applied in Islamic banks even though this relationship is practised between the client and the Islamic bank. All we have done is to transfer the application of the aforementioned structure to be between the central bank and the Islamic bank, which became its client. 2.9. Repurchase Agreements The repurchase agreement (repo) is a tool frequently used by central banks to manage the money supply and promote the function of the lender-of-last-resort. We have previously discussed this tool and elaborated on the Sharīʻah issues it raises. However, some modifications can be applied to the structure to make it a 17 Ibn Qudāmah, Abū Muḥammad Muwafaq al-Dīn (1968). Al-Mughnī, (Maktabat al-Qāhirah: Cairo). Vol. 5, p. 53. 18 Al-Mardāwī, ‘Alā al-Dīn (No date). Al-Inṣāf, (Dār Ihyā’ al-Turāth Al-‘Arabī: Beirut). Vol. 5, p. 431. 45
20. successful tool in implementing the LOLR function . These modifications are as follows: (a) The central bank may buy Sharīʻah-compliant securities from the Islamic bank such as ṣukūk or shares, if any, or units in investment funds, or other forms of assets for a spot price that can benefit the Islamic bank in strengthening its liquidity position. (b) The Islamic bank may give a binding promise to repurchase the assets sold to the central bank for a price to be determined on the same date that includes a profit, which is the difference between the selling and repurchase prices. This arrangement can also be in the form of a bilateral binding promise between the two parties, as stipulated in the resolution of the International Islamic Fiqh Academy no.157 (17/6), which stated the following: “Third: In cases where a sale contract cannot be effected because the subject matter is not possessed by the seller, and there is a general need to obligate both parties to execute the contract in the future by virtue of the law or international trade norms, as in the case of opening a letter of credit to import goods. In such cases, it would be permissible to make the promise binding on both parties either by legislating it in a law or by both parties agreeing to insert a clause in the agreement making the bilateral promise binding on both parties.” “Fourth: The bilateral binding promise mentioned above does not fall under the ruling of a sale appended to the future bayʿ al-muḍāf. Therefore, the ownership of the subject matter will not be transferred to the purchaser, nor does its price turns into a debt due on him. Rather, the sale contract will be effected on the agreed upon date via an offer and acceptance.” “Fifth: If one of the parties fails to fulfil the obligations he undertook to perform under the bilateral binding promise, such a party would be legally obliged to fulfil his obligations or bear the actual damages incurred by the other party as a result of not fulfilling his promise (without considering the opportunity cost).” In this manner, a central bank can provide liquidity to an Islamic bank facing a shortage of liquidity within the scope of permitted transactions and at the same level of efficiency as in conventional transactions. 46
21. 2 .9.1. Objections and their Refutation The Proposed Structure is a Form of a Redemption Sale (Bay‘ al-Wafā’) According to the Kuwaiti Encyclopedia of Islamic Jurisprudence, bay‘ alwafā’ is defined as follows: “The sale [of an asset] provided that whenever the seller repays the price [of the sold asset], the buyer would return the subject matter to the seller.”19 It may be argued that the proposed structure resembles bay‘ al-wafā’. However, whoever contemplates the inner workings of the proposed structure will find it clearly different from bay‘ al-wafā’, which is an arrangement that involves two sale contracts that are not effected at the same time, but one of the two parties gives a unilateral promise of sale or purchase. The Proposed Structure is a Form of the Prohibited Bay‘ al-‘Īnah According to the consensus of the majority of jurists, it is impermissible for someone to purchase a commodity on a deferred basis and to collude with the seller to repurchase it on a spot basis, which is a practice known as bay‘ al-‘īnah (a sale and repurchase contract). Whoever contemplates the inner workings of the proposed structure will find that it falls under the category of unconditional sales that does not involve any deferment of payment, which makes it different from bay‘ al-‘īnah. 19 Authored by a group of Sharī‘ah scholars (1987). Al-Mawsūʻah al-Fiqhiyyah al-Kuwaytiyyah, (Dhāt al-Salāsil: Kuwait). Vol. 9, p. 48. 47
22. References Authored by a group of Shar ī‘ah scholars (1995). Al-Mawsūʻah al-Fiqhiyyah alKuwaytiyyah, (Dār al-Ṣafwah: Egypt). Authored by a group of Sharī‘ah scholars (1998). Al-Mawsūʻah al-Fiqhiyyah alKuwaytiyyah, (Dār al-Ṣafwah: Egypt). Authored by a group of Sharī‘ah scholars (1987). Al-Mawsūʻah al-Fiqhiyyah alKuwaytiyyah, (Dhāt al-Salāsil: Kuwait). Al-Kāsānī, ‘Alā al-Dīn (1986). Badā’i‘ al-Ṣanā’iʻ fī Tartīb al-Sharā’i‘, (Dār al-Kutub al‘Ilmiyyah: Beirut). Al-Mardāwī, ‘Alā al-Dīn, (No date). Al-Inṣāf, (Dār Ihyā’ al-Turāth Al-‘Arabī: Beirut). Ibn Qudāmah, Abū Muḥammad Muwafaq al-Dīn (1968). Al-Mughnī, (Maktabat alQāhirah: Cairo). Al-Shawkānī, Muḥammad bin ‘Alī (1993). Naīl al-ʼAṭwār, (Dār al-Ḥadīth: Egypt). Sir Francis Baring (1797). Observations on the Establishment of the Bank of England and on the Paper Circulation of the Country, (Swell, Cornhill, and Debrett: London). 48