Islamic finance: Grasping with price and profit theory

Prof. Saiful Azhar Rosly, INCEIF  

 

The Halal industry comprising of bank and non-banking firms is hardly visible in theoretical rigor except for the Shariah rules it promotes to exert religious labelling. While Islamic banks pay greater attention the elimination of riba, gambling and ambiguities in financing contracts to claim Shariah legitimacy, non-banking companies are more concerned about halal slaughtering, avoidance of pork in the production process, prevention of food adulteration, promoting hygiene in food preparation and many more.

While both businesses aspire to promote Islamic values in their product line, less has been discussed about their main objective, which is to earn profit, and this can be quite challenging at times. One is due to the fact that profit from Islamic banking transactions is a product of time value of money (TVM) while non-banking firms realize profit from the risks and uncertainties of business outcomes.  Both look considerably hard to synchronize but interestingly enough it is not difficult to see the congruence of both.

In general, the Islamic theory or principle of profit is explained by the Mejelle which is the complete code of Islamic law of the Ottoman Empire according to which the “legality of profit is determined by property (mal), effort (kasb) and liability (daman)”.  Modern theories of profit have in fact recognized the Islamic theory of profit in many ways. In Islam, property (mal) partly indicates the taking of risks and uncertainty of its (ie property) ownership as traders can make a loss when market price falls below cost.

Hence, the merchant deserves to earn profits from the risks and uncertainties that he assumed. F.W. Hawley’s theory of profit considered risk-taking as an important function of an entrepreneur where the riskier the business, the higher is the profit. Nobel Laurette Frank Knight went a little bit further, that it is not the taking of risk but uncertainties that deserve the entrepreneur to earn profits as the former is insurable while the latter is not. The Islamic legal maxim al-ghorm bil ghonm i.e risk accompanies gain, is actually built from this conception of risk-taking in ordinary business where goods (i.e. properties) are traded in exchange for money.

Properties or mal mutaqawim refer to halal goods that serve to generate benefits (manfaat) in fulfilling the needs of consumers. Since money as a medium of exchange is not accepted as al-mal in Islam, any profits earned from the money lending business is deemed unlawful. It also means that shares of conventional banks are unlawful as it arises from the retained earnings of interest income which is riba

Islam also places great importance to the role of labour in business as work and effort (kasb) exerted from labour generally add value to production. The wage theory of profit made known by Taussig and Davenport said that profits accrue to the entrepreneur on account of his special ability. Joseph Schumpeter 1932 further associated profit with innovation from labour that emerges from vision, foresight, originality and boldness to bear high risks in new business.

Daman or liability, as the final determinant of profit is the assumption of responsibility over what is sold (ie property) through the warranty/guarantee system. This is related to the legal maxim al-kharajbil daman (ie. benefit goes with liability) where the trader who is held liable for damages of asset sold deserves to take profit as compensation. This factor is also explained by J.B. Clark’s dynamic theory of profit where profit is the difference between the price and cost of production of the commodity. Costs of providing warranty is usually added on to the cost of production.

When the above justification of profit is destined for ordinary non-financial business, less is clear about Islamic finance, banking in particular. This is due to the fact that the banking business is based on lending and borrowing of monies and profits arising from loans are derived from the financing charges i.e. interest collected from borrowers. While Islamic banking does not make loans, it uses the principle of sale of assets or properties with deferred payments in generating profits. To some extent both systems involves future payment obligations, hence TVM, especially in Islamic finance cannot be undermined.

The charging of profit from delayed payments of goods is a real challenge for Shariah scholars to agree on. Halal companies may have utilized murabaha facilities and pay financing charges which become profits to the Islamic banks. In this way, both industries are connected to each other such that position of TVM in Shariah cannot be tackled by the Islamic banks alone. While this journal may not be the right forum to debate on status of TVM in Islam, early Islamic jurists such as Ibn Taimiyya, Ibn Rushd, Al-Ghazali and Al-Kasani have in fact permitted traders to set higher prices from a sale with deferred payment. 

For example, a silver cup is sold for 5 dollars on cash payment, but can be sold for 7 dirhams on credit terms. It means that profit from the cost-plus contract, say murabaha is partly derived from deferment of spot payment to the future.If the cost price of the silver cup is 3 dollars, then the merchant earns 2 dollars from the cash sale and 2 dollars from the credit sale. The former can be explained by property, work & effort and liability, as we have discussed earlier, but the latter is hardly investigated by Islamic jurists. In fact, there is no theory associated with profits derived from credit sale.

Early Muslim jurists are rather silent on this matter which is not surprising as most early trading exchanges were made on spot basis, say at the market bazaars and some trading posts, hence the theory of profit embodied in the Mejelle is a direct consequence of cash sale, which most halal business is based on. It therefore constitutes a general theory of profit in Islam, while those associated with credit sale is considered to be a special case, hence not much theoretical concern is put on this issue by early Islamic jurists. For example, the early caravan traders who travelled from one continent to another, say from Mecca to Palestine, would have demanded cash payments from all sales made. It would be hard to sell on credit as they have to come back a long way to look for the debtors. But now as most Islamic banking contracts are based on credit sale, it is highly critical for Shariah scholars and jurists alike to provide the Shariah justification for the profit earned from debt financing as it (ie murabaha credit sale) is now considered a general case.

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