QUESTION 2 (30 MARKS) A. Malik b. Aus b. al-Hadathan reported: I came saying who was prepared to exchange dirhams (for my gold), whereupon Talha b. Ubaidullah (pbuh) (as he was sitting with 'Umar b. Khattib) said: Show us your gold and then come to us (at a later time). When our servant would come we would give you your silver (dirhams due to you). Thereupon 'Umar b. alKhattib (pbuh) said: Not at all. By Allah, either give him his silver (coins) or return his gold to him, for Allah's Messenger (SAW) said: Exchange of silver for gold (has an element of) interest in it. Except when (it is exchanged) on the spot; and wheat for wheat is an interest unless both are handed over on the spot: barley for barley is interest unless both are handed over on the spot; dates for dates is interest unless both are handed over on the Spot.

 a. By referring to the hadith, elucidate the business transaction model as proposed by Prophet SAW. (10 marks) b. Justify why riba is prohibited in the Quran and it is judged differently from legitimate trade. (10 marks) 

B. Risk is defined as uncertainty about a future outcome. Risk also can be classified based on market risk, business risk, financial risk and others risk. Evaluate the implications of credit risk and Shariah non-compliance risk in Islamic bank. Support your answer with appropriate examples. (10 marks)

From this hadith, this is a consumer to consumer business transaction model. These are those parties that are equal in power and they are transacting in equal grounds. That is to say that there is no party that is above the other or gains from the other. According to the Quran, interest is illegal. The reason is that charging interest will only enrich the party earning the interest while the party paying the interest will remain poor.

The Islamic banks are exposed to high credit risks because of the fact that there is a possibility that a client could default making its payments. Additionally, the Islamic banks are exposed to non-compliance risk if they fail to comply with the sharia laws. In general, the mode of operations used by the Islamic banks is different from the conventional ways of other businesses.

Step-by-step explanation

a. By referring to the hadith, elucidate the business transaction model as proposed by Prophet SAW.

From this hadith, this is a consumer to consumer business (C2C) transaction model. For example, a consumer will give another one goods that are equal in value. In this case, the consumer is exchanging their goods directly. None of these consumers are gaining from the other. For example, wheat for wheat means that there is no interest that either of these parties will get or benefit from in any way.

This means that there is no interference of any other party in between. For this case, if the bank takes the gold and asks the client to come back at a later date, then the element of interest because the company can benefit in some way. Similarly, the exchange for gold and silver could lead to differences in value. But for the consumer to consumer (C2C) business model, the exchange is direct and there is no interest earned.

b. Justify why riba is prohibited in the Quran and it is judged differently from legitimate trade.

Riba is prohibited because it will enrich one party who is charging it. On the other hand, the person paying the interest will be impoverished. This means that there is only one party that is getting rich and richer while the other party is continually getting poorer. For example, a bank could be getting richer and richer but the borrower will continue to be poor because of the fact of paying such high interest rates.

For example, a bank charging an interest rate of 8% on loans would mean that a client that borrowed $1,000,000 would end up paying $1,080,000. That is another $80,000 on top of what such a client borrowed. In this respect, the bank or other party charging the interest is gaining profits at the expense of the borrower. This means that there is one party that possibly is made poor.

B. Risk is defined as uncertainty about a future outcome. Risk also can be classified based on market risk, business risk, financial risk and others risk. Evaluate the implications of credit risk and Shariah non-compliance risk in Islamic banks.

Credit risk: This is a risk that arises as a result of borrowers defaulting to pay their debts when they fall due. For example, the customers may face financial challenges and therefore they can default their payments leading to losses to the bank. Given that the Islamic bank is NOT charging interest, it means that the bank is likely to make huge losses as it may NOT recover the losses that arises from customer defaults.

Compliance risk: As Islamic banks are prohibited from engaging in business activities that attract interest, some of the employee or management decisions could fail to comply with the recommended standards. For example, if the decisions fall outside the law, then lawsuits could be imminent. In the UAE Supreme Federal Court, Decision dated. 06.09.1983, the court ruled that an Islamic bank can pay for interest if it borrows money from another bank.