What Legal Codification means for Islamic Finance

Throughout history, Islamic finance law (fiqh al-muamalah) has been very fluid, allowing room for scholastic disagreement. There has consistently been an array of opinions and interpretations from the different madhahib and schools of thought, creating a diverse scholastic and legal landscape in the realm of contract law in particular. As modern Islamic finance further establishes itself vis a vis its conventional counterpart, we are seeing a trend of legal codification.  

Codification is defined as the creation of codes, which are compilations of written statutes, rules, and regulations that inform the public of acceptable and unacceptable behaviour. It is a relatively modern phenomenon in Islamic law. The Machelle (Majelle), the civil code of the Ottoman empire established in the late 19th century, is the first known attempt at codifying or canonizing shariah law. In the contemporary context, the establishment of the AAOIFI standards and the Islamic Fiqh Academy resolutions as guiding principles for Islamic finance practices are embodiments of codification of Islamic finance law.  

Codification creates ease of application, unity, and establishes a status quo and standard operating procedures, all of which benefit the booming Islamic finance sector. However, it raises some serious concerns; first, it minimizes diversity in the application of law. Second, canonized law is susceptible to protecting one party above and beyond the other. This is especially true in the case of Malaysia where Bank Negara Malaysia’s (BNM) guidelines and standards on Islamic finance have binding legal effect and are not open to scholastic interpretation. 

The problem of justice is the primary concern in Malaysia. It can be argued that BNM has a greater vested interest in the protection of Islamic financial institutions (IFIs) than the protection of IFI’s customers. The financial implications of IFIs are greater than those of its customers. It could be argued that BNM has a disproportionate interest in maintaining the financial success of IFIs while simultaneously, it sets the laws and guidelines for IFIs. The use of the complimentary wa’d (unilateral promise) contract plays a major role in the arguably unfair protection of the rights of IFIs. 

The use of binding wa’d to protect the rights of the IFI above and beyond the customer can be demonstrated with a hypothetical commodity murabahah facility. Consider this scenario, Customer A approaches an IFI for business financing and enters into a wa’d to purchase assets from the IFI for an amount equivalent to the total business financing facility. The IFI agrees to offer business financing based on the commodity murabahah principle worth rm200,000 to Customer A with an effective profit rate of BFR + 3% per annum. The IFI proceeds to undergo the purchase of the commodities. However, once the IFI has purchased the commodity, Customer A breaches their wa’d to purchase the commodity from the IFI.  

From a classical scholastic perspective, the majority opinion would be that the customer, upon breaching wa’d, is not liable for the costs incurred by the IFI for purchasing the commodity. However, BNM has defined this wa’d as a binding promise (wa’d mulzim), thus protecting the rights of the IFI at the expense of the legal definition of wa’d. This creates injustice in the transaction. 

The IFI has access to the commodity market and could easily sell the commodity once the customer breaches their wa’d to purchase it. Thus, the use of binding wa’d in this case simply acts as a tool to make the customer financially liable to the IFI. A fairer approach would be for the customer to be liable of and only if the IFI resells the commodity at a financial loss. Given the scenario where the IFI resells the asset to the commodity market at a lost, the customer would then be liable for the financial losses incurred.  

A more nuanced observation:

A more nuanced critique and observation, on the other hand, could be that it is not the case that BNM protects the rights of IFIs above and beyond the rights of customers. Rather, it can be argued that BNM is seeking to mimic the outcome of conventional banks in IFIs by strictly defining Islamic contracts and closing the doors to interpretation and diversity. A secondary effect of this is the unfair protection of IFIs over those of the customers in some cases. This argument is supported by the fact that BNM allows for conditional ibra (rebate) which makes giving ibra a legally binding obligation for IFIs. Arguably, conditional ibra is more beneficial for the customers than the bank. The determinant here, then, is the mimicking of conventional banking practices.  

Thus, it is arguable that in the case of Malaysia, codification of Islamic finance law is done as an effective tool to mimic the outcome of conventional financial instruments, whether the codified unfairly protects the IFI or the customer. The binding nature of BNM's Islamic finance standards can be argued to be a means for BNM to ensure that mimicking conventional banking practices is done by all IFIs within the jurisdiction rather than an option banks can choose to opt into. This raises major concerns over the inherent integrity of Islamic finance in Malaysia.