Accepted Manuscript

Title: Uncertainty and risk management from Islamicperspective

Author: Ghassen Bouslama

PII: S0275-5319(15)30060-XDOI: http://dx.doi.org/doi:10.1016/j.ribaf.2015.11.018Reference: RIBAF 472

To appear in: Research in International Business and Finance

Received date: 31-5-2015Revised date: 16-10-2015Accepted date: 23-11-2015

Please cite this article as: Bouslama, G.,Uncertainty and risk management fromIslamic perspective, Research in International Business and Finance (2016),http://dx.doi.org/10.1016/j.ribaf.2015.11.018

This is a PDF file of an unedited manuscript that has been accepted for publication.As a service to our customers we are providing this early version of the manuscript.The manuscript will undergo copyediting, typesetting, and review of the resulting proofbefore it is published in its final form. Please note that during the production processerrors may be discovered which could affect the content, and all legal disclaimers thatapply to the journal pertain.

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UNCERTAINTY AND RISK MANAGEMENT

FROM ISLAMIC PERSPECTIVE

Abstract

Most decisions are taken in very uncertain contexts and all objective economic behavior is

dictated by the efforts of different agents to protect themselves against uncertainty. So, how to

act in the face of uncertainty to minimise the harmful consequences of recurrent financial

crises? The purpose of this article is to answer this question by highlighting the ethical aspect

of investments and finance from the Islamic perspective, which notoriously, forbids excessive

uncertainty, gharar. Islamic law proposes a legal framework that specifies the rules by which

risk is understood, managed, taken or shared. The way the Islamic financial system resisted

the recent crisis leads us to study its unusual interpretation of risk. We also investigate

whether Islamic ethics as an alternative could help to prevent the disaster of repeated financial

crises.

*Manuscript, excluding Author DetailsClick here to view linked References

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1. Introduction

The study of recent or older financial crises always raises the same question: why do such

crises recur? We can always learn from previous crises, but we can be almost certain that they

will reoccur in the future. From a post Keynesian perspective, the feature shared by the recent

subprime crisis and those that preceded it – such as the American savings and loan crisis at

the beginning of the 1980s or the Japanese bubble economy at the end of the 1980s – is our

inability to deal with “uncertainty.”

The consequences of current individual actions come about in the future. To take rational,

objective decisions, it is first necessary to draw up congruent forecasts. However, in the real

world, most decisions are taken in very uncertain contexts. According to the Keynesian

approach, all objective economic behaviour is dictated by the efforts of different agents to

protect themselves against uncertainty. This raises the question of how to act in the face of

uncertainty to minimise the harmful consequences of recurrent financial crises. This article

attempts to answer this question by highlighting the ethical aspect that distinguishes

investment and finance in the Islamic approach, which notoriously forbids excessive

uncertainty (gharar).

Islamic finance came to prominence in the 1960s thanks to renewed interest in religion in

Muslim countries and the accumulation of large foreign exchange surpluses in the Gulf

countries. It has internationalized rapidly due to migration but also to the increasingly urgent

need for moral attitudes and practices at a time when financial excesses are too often the

cause of economic crises (Warde, 2010). Indeed, many people asserted during the last

financial crisis that the aim of Islamic finance is to make ethical finance available for the real

economy. Therefore, the principles underpinning this type of finance are that it could be an

ethical alternative to conventional finance, the limitations of which have become clear during

the recent crisis.

The aim of this article is to analyse the notion of risk from an alternative angle, using

Islamic financial and economic principles. Islamic law proposes a legal framework that

specifies the rules by which risk is understood, managed, taken or shared. The way the

Islamic financial system resisted the recent crisis (Ben Khediri et al., 2015) leads us to study

its unusual interpretation of risk. We also investigate whether Islamic ethics as an alternative

could help to prevent the disaster of repeated financial crises.

First, the article describes the principles of Islamic economics and finance. The second

section investigates the Islamic approach to risk in individual decision making. In the third

section, we discuss the Islamic approach to uncertainty, gharar, in bilateral and multilateral

transactions. Finally, the article illustrates the Islamic conception of risk management.

2. Foundations of economic and financial principles in Islam

To the extent that all economic and financial transactions involve a more or less significant,

more or less fleeting degree of more or less implicit trust, Algan and Cahuc (2010) show that

distrust can have an extremely negative impact on economic and financial activities. This

makes it useful and/or necessary to resort to theological and religious values in that they allow

the establishment of trust between individuals. In this sense, Islam is a religion that embraces

all aspects of life and does not restrict itself to religious worship. Indeed, through its two

principal sources, the Koran and the Sunnah (the words and action of the prophet of Islam, set

down by his companions), Islam guides Muslims and frames every area of their existence on

earth (worship, interpersonal relations, organisation of society, economy, civilization, way of

life, etc.), which is by definition limited and transitory. Its initial aim is earthly wellbeing, and

its ultimate goal is salvation and eternal happiness hereafter.

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The Islamic approach to economics and finance aims to guarantee the interest and long-

term development of human being by making the most of the earthly resources that God has

created for us. This endeavour to steward and develop the earth is based on the pursuit of

good, equity, solidarity, cooperation, mutual help and sharing, and on the proscription of evil,

individualism, excess and exploitation of the weak or of those in precarious or vulnerable

situations. Islam takes into account the overall, lasting dimension of people’s interests,

including personal, social, political, economic, environmental and civilizational aspects

(Sabiq, 1999; Warde, 2010; Charkaoui Malqi, 2000).

Whilst the leading scholars in Islamic law have not developed genuine economic and

financial theory, the Islamic approach in this area nonetheless favours solidarity, as

mentioned, but is also liberal and non-monetarist. Indeed, it approves of private property,

individual initiative and free pricing without using currency price adjustments. Moreover, the

Islamic conception promotes economy regulation to encourage progress and sustainable

development and, more generally, economic activities with positive collective value

(investment in infrastructure, human capital, innovation, technology, etc.).

2.1. Islam and private ownership of capital

According to Koranic texts, the absolute and highest right to property belongs only to God.

On earth, the Muslim only holds the usufruct of this property. This religious conception is not

opposed to the earthly practice of property rights, whose limits are defined by Sharia: goods

legitimately acquired (purchase, inheritance, exchange, gift, etc.). Sharia sanctions private

property and full enjoyment of this property, as long as this does not harm society or public

interests. Muslims must make good use of their resources and develop them in harmony with

the principles of Islam, for their own benefit but also to share a part of his wealth and allow

society to profit from it.

2.2. Islam and work

The right to private property, which is sacred in Islam, encourages the Muslim to work and be

productive. The importance of work is so great in Islam that it is raised to the level of

worship. The vision of work covers all lawful activities that are genuinely useful for human

being and for the satisfaction of his legitimate needs. Fundamental to production and wealth

creation, all work deserves an adequate and equitable reward.

2.3. Islam and redistribution of wealth

Whilst differences between individuals exist and can lead to both conflict and

complementarity, Islam seeks to reduce their extent by promoting solidarity and social justice.

Indeed, the enjoyment of wealth is only authorised if it is reasonable and balanced, and

insofar as a proportion of it is given to the needy. Thus, wealth must be used first to satisfy

personal needs1 and then to help others. Zakat, obligatory almsgiving, is one of the five pillars

of Islam; it constitutes what may be described as an annual solidarity tax to help the needy,

whoever they may be2. Furthermore, the Waqf, or houbous, enables to dedicate a productive

asset permanently in favour of a specifically designated cause, person or group of persons.

Thus, Zakat and Waqf can be seen as the instruments of intra- and inter-generational solidarity

within the Islamic framework.

1 Needs should be satisfied according to a number of priorities: first necessities, then utilities and

finally refinements. 2 Zakat is not the same as Sadaqa, optional almsgiving that is, nonetheless, strongly recommended.

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2.4. Islam and finance

The Islamic approach sees finance as serving the real economy. More precisely, Islam

considers that money is only the measure of wealth, not wealth itself. Money is thus not a

good in itself, it is intrinsically unproductive and as such, there is no reason to pay for it. As a

general rule, excessive, unavoidable risk, uncertainty, the use of interest (riba)3, speculation

(maysir), monopolies (ihtikar), hoarding wealth (iktinaz), gain without work and/or

appropriate risk-taking, deception and investment in unlawful activities or assets such as

gambling and alcohol, are prohibited4. The Islamic alternative is that capital and work should

be linked in participatory operations. It is important in this context to note that given the

principle that everything that is not contrary to the precepts of Sharia is considered as lawful

and that of "easing" (yusr), Islamic finance intrinsically promotes strong innovation. This

means that the range of possible Islamic financial solutions and contracts is very wide.

Indeed, the main standard contracts (Mudaraba, Mucharaka Salam, Istisna'e, Murabaha,

Ijara, etc.) should not be considered an exhaustive list of Islamic contracts but only those that

are currently most used by a still very young Islamic financial industry (Foster, 2007)5, acting

at present as a “processing” industry rather than a pure “innovation” industry6.

3. Risk in individual decision making

The definition of risk varies, depending on its application or the discipline. It also has

different connotations and suggests different meanings to different people.

3.1. Definitions and origins

In microeconomics, risk refers to uncertainty over the consequences (positive or negative) of

a decision. For financial economists, its connotation is generally negative, referring to

potential losses. Despite the apparent ambiguity around the definition of the word risk, it is

possible to consider risky situations as characterized by the possibility of identifying various

future situations and the ability to assign to each of them a probability of occurrence7.

If we study the etymological roots of the word risk, we find that it comes from the Italian

term rischio (Magne, 2010). This refers to the possible damage or negative consequences

resulting from unforeseeable circumstances. The connotation here is clearly negative. The

origins of the word rischio are to be found in the terms risico and risco. These expressions

3

Beyond divine prohibition, it is possible to advance two main explanations for the prohibition of the

use of interest. First, it is like asking the borrower (deficit agent) to increase the lender's resources

(surplus agent), which is illogical and unreasonable, and can be seen as a form of morally

reprehensible exploitation. Second, the cost to the borrower entrepreneur is more important, ceteris

paribus, than that of an entrepreneur with no debt. This difference in cost may, in some cases, lead the

indebted entrepreneur, under pressure (legal and contractual commitments and obligation of project’s

success), to fraudulent practices (sale of poor quality products or services, infringement of

professional ethics, etc.) that can harm not only the entrepreneur himself but also other parties (clients,

institutional partners, population, environment, etc.) not concerned by the original loan agreement. 4 These prohibitions are counterbalanced by the obligation to remunerate lawful work and legitimate

risk taking. 5 Indeed, Islamic finance is around forty years old, compared with more than four centuries in the case

of conventional finance. 6 Indeed, the Islamic financial industry is currently mainly a “processing” industry attempting to make

conventional financial paradigms, solutions and products Sharia compliant. 7 As opposed to uncertainty, which characterizes a situation where, because of its complexity and/or

opacity, the future is unknown.

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were common among traders as early as the thirteenth century. They were used to refer to

companies that could make a profit or a loss. Before this, the terms had been used to refer to

the results of hazardous, uncertain situations. The Latin root is unclear, but they might be

related to the term resecare (re = back and secare = cut) which means to cut away or to

remove. According to Magne (2010) and El-Gamal (2000), the meaning of the word may

originate in sea transport, referring to the possibility for a ship’s hull to be holed by a rock or

a reef. More widely, it could refer to the “risk shared by two contracting parties” and therefore

“the risk of losing merchandise at sea.” In other words, risk means “danger of loss.”

However, the origins of risico and risco are not quite clear. The most frequent hypothesis

links the Italian risico to the Arabic word rizq. The modern conception of this Arabic word

refers to “a thing from which a person profits” or “something that is loaned to someone

without gain.” Rizq therefore has generally neutral connotations. In its religious sense, the

term rizq means “the daily provision allotted by God to each man.” At the beginnings of

Islam, rizq referred to “the regular wages soldiers are entitled to.” The word rizq entered

Arabic via Syriac Aramaic, originating in the Pahlavi (a Persian language spoken between

300BC and 950AD) rôcik, which means daily bread, from Roc "day" (-Ruz in modern

Persian). This term is related to the Avestan (spoken before 400BC) term raocah “light” and a

Sanskrit (after 1800BC) term meaning “brilliant, radiant.” The Pahlavi term rôcik entered

Arameic as “daily provisions”, and then changed its meaning to become “bread.” It then

entered Syriac (third to seventh centuries AD), where it signified “daily portion.” From there,

it became part of Arabic. Until mediaeval times, the word risk had apparently neutral

connotations, referring to the future, Man’s “income,” which is subject to uncertainty.

Thereafter, the term seems to have been restricted to negative results compared to its sense in

mediaeval Italian. What is clear is that the word risk has a long and fascinating history, which

may well explain the ambiguity surrounding its definition today.

3.2. Risk in Islamic approach

Islam distinguishes clearly between two different forms of risk. Although there can be cases

when it is difficult to distinguish between them, the general frame is nonetheless clear. The

two types of risk are:

Risk linked to economic transactions, in other words activities that create value added or

wealth;

Risk associated with gambling “eating wealth for nothing” or, according to Al-Suwailem

(2002) referring to zero sum activities, where no additional wealth is created.

According to Al-Suwailem (2002), associating risk with the possibility of losing is

unacceptable to the Islamic approach, given that its principles clearly call for the conservation

and development of wealth. Risking a loss of wealth cannot be an aim in itself. This can be

considered in the same way as difficulties. Many actions involve difficulties that are not

desirable in themselves. According to Sabiq (1999), the reward for such actions is based on

their usefulness and not on the difficulty of carrying them out. A good action may be difficult,

but if it is considered good, this is not because of its intrinsic difficulty but because of its

usefulness and its impact. More precisely, the reward for an action can be significant if it is

difficult; not because the difficulty is the aim, but because the action involves difficulties. In

other words, when determining the value of an action, difficulties are a secondary

consideration. The principal concern is its usefulness. Consequently, the value of the action is

a reflection of its difficulty, but only if the action is useful.

According to Al-Suwailem, (2006), the same reasoning applies to risk, since it is a form of

difficulty. Risk is not in itself desirable, even if it is an intrinsic part of almost all economic

activity. However, the value of an economic decision is not mainly determined by the risk it

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involves, but by the wealth and value added it creates. Consequently, the value reflects the

risk, but the risk does not determine the value. Hence, risk taking is permitted for the value it

adds and wealth it creates, not because the risk is desirable. This distinction creates a

fundamental difference between legitimate risk and forbidden risk. Risk is legitimate when it

is necessary for the creation of value. However, when no value is created, risk is considered as

a form of gambling. The question that arises here is how to differentiate between legitimate

and forbidden risk in the context of the Islamic approach?

Three principal criteria are generally used to determine whether the risk is acceptable: its

degree of inevitability; its importance; and finally the degree to which it is intentional.

The first criterion implies that value cannot be created without the risk of loss or

bankruptcy. Risk is inseparable from real transactions and value creation. In the Islamic

context, separating risk from real transactions would create more risk and would lead to

greater instability in the economy. For example, trading debt for a specific price is forbidden

(conventional securitisation). More generally, all derivative products in finance, whose

structure is based on separating risk from ownership, and hence from operating activities are

forbidden in Islamic finance.

The second criterion concerns the degree of risk. According to Islamic thought, for the risk

to be acceptable, the possibility of failure must be lower than that of success. Thus, gambling,

which is based on a strong possibility of losing, is forbidden in Islam. This type of behaviour

is correctly described as a deception and an illusion. The decider is fooled by the size of the

prize to be won, and so behaves as if the probability of obtaining the prize was high, whereas

in fact, the possibility is tiny, and the risk of losing your stake is very high.

The third criterion follows on from the other two. The purpose of normal economic activity

is the value that it creates, and not the risk that it involves. This risk cannot therefore be

planned as part of the transaction. An agent’s decision should be motivated by an intention to

succeed and to create value, and not based on a strong possibility of losing. This rule makes it

possible to distinguish between investment and gambling. The principal difference between

the two is the probability of success. An entrepreneur launches a project because he is

convinced that it will succeed. A gambler knows in advance that he will probably lose, but the

size of the prize to be won persuades him to commit himself to a project that will probably not

succeed. Thus, an action that more often leads to failure than to success cannot be considered

as a cause of success; it is a cause of failure.

3.3. Risk approach and financial crises: main stability factors of the Islamic framework

Conventional finance has suffered from its own excesses whose climax was reached at the

last crisis of end of 2007 (Warde, 2010). Indeed, excessive risk taking, systematization of

information asymmetry situations and unbridled financial technicality are engines of out-and-

out private profit maximization which has shown its dangers. Excessive use of derivatives

before during and even after the last financial crisis had negative consequences on the

stability of banking system (Keffala, 2015). Similarly, past research has shown some resilience

of Islamic banks during the last crisis. In this sense, Ben Khedhiri et al. (2015) found that the

risk level is lower for Islamic banks than for their conventional peers. In this context, it is

possible to identify in Islamic approach some stability factors, in particular:

The materialization through the backing of funding to a related specific real assets makes

that yield can only come from a real asset,

The proscription of the total or partial transfer of liabilities and short sales that are

intrinsically speculative transactions providing no real added value to the economy.

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Furthermore, financial techniques such as securitization disconnect the assets created

from their underlying particularly in terms of risk assessment which accentuates

information asymmetry situations, catalyst of all-around speculation,

The specific approach to risk and the coupling of the asset funding cost with its actual

performance. Indeed, unlike conventional finance, which seeks to separate the risk from

its underlying asset8, Islamic finance emphasizes risk to better understand and control it

9

and requires it to be an unavoidable part of lawful productive activities. Specifically, the

Islamic approach extols the pooling of risk and therefore the equitable sharing of profit

and loss (Haberbeck, 1987)10

between the parties in a balanced agreement where one

person’s gain is not based on another’s loss11

. In these conditions, the risk of an asset or

project (which is the basis for determining the cost of the funds that have financed it) is

genuinely linked to its yield. The excessive use of financial leverage is thereby

considerably limited, since the remuneration of the capital lessor depends directly on the

real operating profitability of the asset, as opposed to financial profitability, which can be

“boosted” through high gearing,

The screened and responsible process of assets selection, taking into account the intrinsic

nature of the project, its quality, its viability, its profitability but also the implied risk and

not only the quality of the entrepreneur and guarantees he brings. The compliance with

Sharia is another important selection criterion, which excludes all assets and activities

that are unlawful, unethical and directly or indirectly harmful to people, their integrity

and their environment. Islamic financial institutions are therefore more protected against

loss of assets than their conventional counterparts, and in doing so, at least in theory,

enjoy greater capacity to absorb shocks.

4. Risk in bilateral and multilateral decisions: concept of gharar

While the previous section discusses risk in individual decision making, this section

concentrates on the Islamic approach to risk in bilateral and multilateral decisions formalized

through contracts12

.

8 The concept of risk-free assets, techniques such as securitization, structuring and financial

derivatives respectively aim to minimize, mitigate or break free of risk by transferring it to others. 9 However, it is necessary for the risk taken to be identifiable and not excessive.

10 Specifically, it is possible to consider different profit-sharing rules for different risk profiles. This

would lead investors to become more involved in choosing the projects they intend to participate in

and of which ultimately they bear the related risks. 11

This describes the zero-sum games situations regarded as morally weak or reprehensible. 12

A contract allows two pledges to be linked and leads to legal obligation in favor of a single party in

the case of unilateral contracts such as donation contracts, or for the benefit of all parties in the case of

bilateral and multilateral contracts, such as sales contracts, rental contracts, company contracts, etc.

For the latter type of contracts, the presence and consent of the parties are required for validity (Sabiq,

1999; Noor, 1988). According to their purpose, it is possible to distinguish two main types of

contracts:

- Contracts aiming at capital fructification, through which each party seeks what belongs to the other

party. In doing so, each contracting party gets a counterpart to what it offers, such as the sale or lease.

These contracts give rise to reciprocal obligations to contracting parties. Besides the legal ability of the

parties to contract and discernment, the validity of this type of contract is dependent on the lawfulness,

precise specification and availability of its object and on the determination of the transaction price

(Noor, 1988),

- Contracts aiming to perform charity work (unilateral or donation contracts) are contracts that give

rise to liabilities for a single party, namely the donor who agrees to deliver the object of the donation

to the recipient of the donation.

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4.1. Presentation and Analysis of the Concept of Gharar

In general way, the word gharar means risk (El-Gamal, 2000, 2006). It can also mean

deception and illusion. The two meanings are quite similar in contexts where there is a high

probability of failure of winning a very large prize, such as in lotteries or forms of gambling

where the size of the prize encourages the agent to take part in a competition he is almost

certain to lose (Al-Suwailem, 2006).

After the ban of riba, that of gharar is the second most important Islamic prohibition in the

area of economic transactions. It has been very widely studied by Islamic contract law

scholars (Sabiq, 1999).

Etymologically, the word gharar means trickery, deception or imposture and describes

everything that appears attractive, but behind which danger is hidden (Sabiq, 1999). It comes

from the verb "gharrara" or "gharra" which means to profit from a person’s naivety or

ignorance and expose him or his property to danger or loss. We see from this that the most

important feature of gharar is deception, and giving the victim erroneous or partial

information that hides the truth. Used as a verb, the term means to deceive, but as a noun, it

can have other meanings such as danger or unknown quantity.

According to Sabiq (1999), gharar had been defined in various ways. Three principal

points of view have emerged. First, gharar applies to cases of uncertainty such as when an

event may or may not occur. A second point of view considers gharar as the trading of an

unspecified object. Thus, in sales contracts, gharar occurs when the buyer (seller) does not

know what he has bought (sold). The third approach is a combination of the first two. Thus,

gharar covers both what is unknown and what is uncertain, and occurs when the

consequences of a contract are unknown. Gharar is thus one of the most difficult Islamic

legal concepts to define. It can cover various aspects such as unknown quantities or

contingence, uncertainty, excessive, avoidable risk, speculation, ambiguity and information

asymmetry.

A bilateral or multilateral contract tainted by gharar is a contract whose consequences are

uncertain, and which aims to wrongfully gain possession of another’s property. More

specifically, gharar can concern either the legal formulation or the subject matter of the

contract. Gharar in the legal formulation refers to the existence of ambiguous, opaque terms

or clauses leading to contingency or ignorance, such as making two transactions in one, sales

contracts with circumstantial conditions and so on. Gharar in the subject matter of the

contract might be due to incomplete information or ignorance of key features of the contract,

such as the identity, nature, type and features of the principal goods or services covered by the

contract, the quantity, the date, or delivery conditions and procedure.

The prohibition of gharar in the Islamic approach is based on several factors:

In its sense as the unknown, contingency or chance, which is close to the concept of

"maysir"13

: on the immorality of gains that are not justified by work,

In its sense as uncertainty or risk: on excessive avoidable risk taken by the parties to a

contract and the need to protect them from this14

. Conditional contracts, due to the

uncertainly that they entail, are generally considered invalid since the parties do not know

whether or when the contract will be executed,

13

Risk taking prohibited by Islam is related to uncertainty that is not part of everyday life. Taking such

risk, for example that which is inherent in gambling, is unnecessary both at the microeconomic level,

since individuals who do not take part do not have to bear the risk for those who do, and at the

macroeconomic level, since it adds no real value to the economy. 14

However, entrepreneurial risk, inherent to legal activity, is not included in this prohibition.

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In its sense as speculation: on the danger to society represented by speculation and by

monopolizing goods and services,

In its sense as ambiguity or information asymmetry: on the need to prevent parties from

deceiving, profiting from or exploiting others fraudulently and dishonestly. Zero-sum

trading sums up exactly what is to be avoided: these are transactions in which one party

makes a profit at the expense of the other, which results in a win-lose situation. The

prohibition thus aims to prevent injustice, animosity and hatred between individuals.

4.2. Quantification of Gharar

Since it is impossible for contracts to be absolutely watertight, a certain degree of risk and

uncertainty is almost always involved. Thus, the evaluation of gharar varies from one

situation to another. It is almost impossible to quantify it exactly using precise criteria. It is

therefore a relative concept, and it prohibition is not as generalised and systematic in every

situation as, for example, riba. Gharar is prohibited in cases where uncertainty or vagueness

gives rise to the possibility of iniquitous or unwarranted consequences or gains that benefit

one party at the expense of the other. The degree of gharar is evaluated by a rigorous analysis

of the costs and benefits.

According to Sabiq (1999), scholars identify two principle types of gharar:

Major or excessive gharar: invalidates bilateral contracts in which it is present insofar as

it cannot be avoided without causing significant prejudice to one of the parties and

leading to a possibility of conflict in the long term. Legal experts identify four different

criteria for excessive gharar: uncertainty over availability of the principal goods or

service covered by the contract; uncertainty over delivery and obtaining the goods or

services; uncertainty over the quality or value of the goods or services (the amount of

compensation in case of accident or loss for example) or uncertainty over the term (date

of compensation payments in the case of an insurance policy, for example),

Minor or trivial gharar: the presence of this type of gharar is tolerated in bilateral

contracts, since it does not prevent execution of the key features of the contract. The

principal features of this type of gharar are:

It’s extremely limited significance to the main purpose of the contract. For

example when hiring an object for one month, the exact number of days can be

more or less than 30 days. In this case the cost of the uncertainty is very limited

(3.33%) relative to the monthly hire charge,

Its subsidiary and unpremeditated character; it is unrelated to the main purpose of

the contract. It is often ancillary to this purpose and independent of the parties’

wishes. This is the case, for example, when one sells a house without knowing

how solid the foundations are,

Its unavoidable nature; if this gharar is forbidden it may well result in significant

danger for one or both of the parties. In cases of forward sales – salam and

istisna’e – the goods covered by the contract does not yet exist when the contract

is signed, which implies the existence of excessive gharar. However, since this

type of contract funds industrial and agricultural activity that could not be carried

out without such funding it is considered valid despite the gharar that is involved.

Similarly, whilst conventional insurance activity involving excessive gharar is

prohibited due to the existence of alternative lawful forms namely takaful

insurance companies, the latter may use conventional reinsurance methods since

alternative legal reinsurance companies do not exist, at least at the present time.

According to Sabiq (1999), excessive gharar invalidates bilateral and multilateral contracts

since it implies that one of the parties will not obtain part or all of the compensation that he

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. Concerning minor gharar, it is deemed that it does not invalidate bilateral,

multilateral or unilateral contracts.

Finally, whilst intermediate gharar (midway between major and minor gharar) does not

invalidate unilateral contracts, its impact on bilateral or multilateral contracts depends on the

opinions of different legal schools.

4.3. Principal Exceptions

Islamic Sharia allows a certain number of exceptions to the prohibition of gharar in contracts,

firstly due to the type or nature of certain contracts and secondly due to consideration of the

notion of necessity (Sabiq, 1999; Charkaoui Malqi, 2000).

Exceptions due to the type or nature of certain contracts: Gharar inherent in the

mechanism of specific contracts is allowed when it does not result in prejudice for either of

the parties, and in particular:

Uncertainty in a profit-sharing contract is not illicit, since the purpose of the contract is to

share the profits. However, the risk must be shared between all the associates, following

the principle of “gain against guarantee” (al kharaj bi damane). Indeed, unlike bilateral

contracts based on competition between buyers and sellers, company contracts are

contracts involving cooperation and complementary activity. Moreover, in this type of

contract, uncertainty (making a profit) is not the principal aim but is ancillary and

inherent in the activity. Moreover an economy cannot exist without companies which are

the basis for production and the distribution of goods and services. They are useful for the

community and therefore in the general interest,

The Jiala contract (reward): this contract involves more or less uncertainty. It consists in

giving a predetermined compensation for a task or a service to be accomplished, such as

finding lost property, mining or water table exploration, debt recovery and so on. The

work that will be necessary in such cases cannot be precisely predetermined 16

,

Muzara’a and Musakat contracts: in these contracts, one party farms land belonging to

the other, and receives part of the harvest. By its nature, this part cannot be

predetermined17

.

Exceptions due to necessity (darura): Ardent or imperious necessity18

or darura, makes it

possible to deviate from the general rule of prohibition and gives scholars some room for

15

Sabiq (1999) stipulates that the Maliki legal school of Islamic thought considers that excessive

gharar does not invalidate unilateral contracts since the beneficiary offers nothing to deserve

compensation. He has thus no reason to fear for the loss of that which he offers as in the case of

bilateral or multilateral contracts, since he has not given anything up. The fact that the donation is

large or small, or that it is to be made immediately or later, is therefore of no importance. 16

In the case of the jiala contract, the exception to the prohibition of gharar is also based on the need

for the party offering the reward (ja’il) to have the licit task or service carried out by another, without

being able to so using a work contract because of the uncertain nature, importance and place of the

task or service. Note that this uncertainty is not necessarily disadvantageous to the worker; since the

result may be attained by more or less work. Moreover, this type of work can be terminated without

prejudice by either of the parties except when the worker has already begun work or when the worker

undertakes not to break the contract for a predetermined period (Wahidul Islam, 1998). 17

The validity of this type of contract is based on the fact that the imprecise nature of the

compensation is dependent on the very nature of the contract, which can be seen as a profit-sharing

contract by which the profit is shared between the associates, the owner of the land and the farmer.

Moreover, this uncertainty is not organised and does not benefit one of the parties at the expense of the

other. The compensation is indeed dependent on the quality of the work provided by the farmer, but

also on the weather conditions.

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manoeuvre. It results from the important principle of “easing” or “avoiding difficulty”. Thus,

in cases of necessity, the presence even of excessive gharar in certain contracts does not

automatically invalidate them.

5. The Islamic approach to risk management: the case of Islamic insurance

This section is divided into two points. The first deals with the Islamic attitude towards risk

management, while the second offers a comparative approach to risk management in Islamic

and conventional frameworks.

5.1. Islam and Risk Management

The conservation of capital, goods and property is one of the aims of Sharia. Similarly,

Sharia strongly recommends solidarity, cooperation and mutual assistance to circumvent the

risk individuals may encounter. However, the purpose of risk management must not be profit,

and must not take the form of bilateral or multilateral trading contracts, given the high degree

of uncertainty inherent to contracts transferring risk from one party to the other in exchange

for compensation. The core principle in this context is that everything possible must be

undertaken individually and/or collectively to avoid or reduce risk. Muslims are required to

use all available means even when insufficient to attain their objectives. Indeed, the end result

of the actions they undertaken depends on a huge number of factors that human being cannot

totally control, and ultimately on the will of God.

Thus, Islam encourages us to manage risk as long as it does not involve any practices

prohibited by gharar, chance, the charging of interest or injustice. Nor must it be carried out

merely for reasons of profit.

5.2. Risk Management: Conventional Approach Vs Islamic Approach

Generally speaking, risk management consists in identifying and analysing it before

attempting to control it, understand its limits and assess its potential impact. Controlling or

funding risk is most often split between controlling material risk, which involves making

every effort to reduce it in terms of frequency and impact, and controlling financial risk,

which can be undertaken within physical or corporate entities or externally. Internal control is

possible when the entity has sufficient resources of its own to deal with the potential impact

represented by the risk. This is the case in particular for risk involving potentially very

frequent events resulting in low levels of loss. For high-level risk, which entities do not have

sufficient available internal resources to tackle, two principal approaches are possible. The

first conventional approach is to transfer the risk to exogenous entities, i.e., insurance

companies or financial markets. This makes it possible to exchange the uncertainty inherent in

potential risk for the payment of a premium or a price. Note that insurance companies only

cover non-systematic risk and pure risk subject to variables whose behaviour is dictated by a

law that can be described and anticipated, commonly known under the term probability

distribution. Pure risk only results in loss, unlike speculative risk,19

which arises from

individual behaviour and can result in loss or gain. However, it is important to stress that the

main purpose of the entity to which the risk is transferred, the insurance or financial market, is

18

The ardent or imperious necessity must be effective and must have no legal alternative. It occurs

particularly when the life and/or property of an individual are seriously threatened or may be lost if he

respects the prohibition. 19

Financial markets offer financial products known as derivatives, which enable speculative risk to be

covered.

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to make a profit, which is not necessarily in any way to the advantage or benefit of the entity

that faces the initial risk.

Alongside this first conventional approach, an alternative approach consists in sharing or

mutualising20

comparable risk face by different entities within an ad hoc organisation. This

ethical perspective is typical of risk management in the Islamic context. Indeed, as well as

attempting purely and simply to avoid gharar and/or to reduce it to a bearable level, this type

of management can involve using Islamic insurance services, or takaful, based on the

principles of solidarity and mutual assistance, to deal with material, and in particular financial

risk (Khorshid, 2010; Haberbeck, 1987)21

.

Takaful insurance consists of an agreement between the Islamic insurance company, as

representative of the members, and an individual or company who wishes to be insured.

Under this agreement, the latter undertakes to pay an insurance policy in the form of a

donation (principal and income) to the insured members’ account. In return for this, the

member receives compensation from the company in the event of accident or loss, in

accordance with the technical clauses of the insurance contract and the statutes of the

insurance company (Khorshid, 2010). Unlike conventional insurance companies, the

policyholder insures himself in a takaful scheme. Furthermore, the moral hazards are low in

takaful insurance, and more generally in schemes based on sharing, cooperation and

solidarity. Indeed, since it is in the members’ interest to reduce potential risk as much as

possible, since they pay the cost of this risk, and not a third-party insurance company. Their

aim is not to make money but to cooperate to overcome the accidents and loss that each of

them can suffer from.

The accounts of the takaful company are separate from the members’ account. The

insurance company has a mandate to manage the account of the policyholders, to collect

premiums and to pay compensation. It invoices the members’ account for administrative costs

and reinsurance, as well as fixed management charges or a percentage of any surpluses on the

account. If premiums and payments by reinsurance companies are not enough to cover

compensation, the Islamic insurance company does not cover this deficit as is the case for

commercial insurance companies, but makes an interest-free loan to the members’ account,

which it recovers gradually over a period of time. If it makes a profit, the takaful company

distributes all or part of it, after setting aside a reserve, to members who have not benefited

from compensation, in proportion to their premium payments.

The directors of the takaful company must ensure that the activity is properly managed:

identification and precise analysis of risk; management of subscriptions to enable

compensation payments but maintain members’ payments at an acceptable level; balanced

participation and risk sharing. They are simply “agents” for the members, responsible for

taking care of members’ interests. They must take care to increase the value added of their

work, which means they firstly must constantly improve their work by analysing risk and

subscription assessments ever more finely and secondly have to justify their decisions to the

members. These two factors make takaful a totally integrated risk management system, since

the risk is not transferred to a third party (insurance company or financial market). Moreover,

takaful is completely in line with good organisational management practices, notably

transparency and the obligation to justify decisions.

20

Statistically, insulated high intensity risks grouping allows, at the aggregate level, reducing them

individually. 21

In theory, given the prohibition of gharar and maysir, derivatives are illegal. However, in certain

conditions, the use of certain derivatives is authorised and has been standardised as part of the

Tahawwut agreement signed in 2010 between ISDA and IIFM (Causse Broquet, 2012; Foster, 2007).

Moreover, to manage risk, Islamic institutions may, as well as building up reserves, use contracts such

as arbun and waad, which are similar to options contracts.

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6. Conclusion

Whilst risk and its management are one of the fundamental areas of conventional modern

finance, the Islamic approach to this subject is unique, and its characteristics are worthy of

note. First, Islam forbids gharar as it involves deception and iniquity, which are inadmissible.

Second, reasonable risk taking is authorised in a context of legal, productive, economic or

financial activity. Specifically, operational risk is inherent to commercial, industrial or

services activities and therefore unavoidable. Moreover, it justifies the profit made. This type

of risk is allowed as long as the probability of making a profit is predominant, in other words

if mathematically there is more chance of a positive result.

Further, since the conservation of capital and goods is one of the principal objectives of

Sharia, Islam encourages risk management as long as the ultimate aim is not purely and

simply to make money and it does not involve prohibited practices such as riba or gharar.

The use of solidarity, cooperation and mutual assistance in particular are strongly

recommended in this area.

Whilst it is permissible to circumvent one of the principles of Sharia in exceptional cases,

for example necessity (darura), in order to manage exceptional or complex situations

involving a high degree of danger and/or difficulty, the use of such concessions must be

managed to prevent them becoming the rule. Indeed, the danger is that unfounded exceptional

situations will be claimed by the use of trickery (hiyal), leading to large-scale reorientation

towards conventional practices. The risk is that the potential of the Islamic economic and

financial approach as an alternative model will be artificially curbed, in a context where there

is an ever-greater need for ethics, morals and equity to counter the greed, abuse and excesses

that too often lead to economic and financial crises.

Specifically, Islamic finance appears as a source of diversification with respect to the

abundant liquidity it can afford and also to high ethical asset class it offers.

Moreover, Islamic finance is also able to offer an alternative approach that can make a

significant contribution to economic and financial recovery and stability, due to the

accessibility and compatibility of its financing and investment solutions with all actors,

without exception.

However, the effective development of Islamic finance remains heavily dependent on

political will and that of the corporate managers and customers, not simply on technical issues

that can be more or less easily solved.

Furthermore, the implementation of any system or approach is always a human experience,

with its advantages and drawbacks, which remains more or less distinct from the system as

such, depending on the degree to which its spirit and aims are faithfully observed, rather than

its rules alone. Islam is an inseparable whole, a genuinely integrated system covering all

aspects of life. It will not achieve its full potential unless the paradigm underlying its vision,

values and principles is sincerely applied.

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UNCERTAINTY AND RISK MANAGEMENT

FROM ISLAMIC PERSPECTIVE

Abstract

Most decisions are taken in very uncertain contexts and all objective economic behavior is

dictated by the efforts of different agents to protect themselves against uncertainty. So, how to

act in the face of uncertainty to minimise the harmful consequences of recurrent financial

crises? The purpose of this article is to answer this question by highlighting the ethical aspect

of investments and finance from the Islamic perspective, which notoriously, forbids excessive

uncertainty, gharar. Islamic law proposes a legal framework that specifies the rules by which

risk is understood, managed, taken or shared. The way the Islamic financial system resisted

the recent crisis leads us to study its unusual interpretation of risk. We also investigate

whether Islamic ethics as an alternative could help to prevent the disaster of repeated financial

crises.

*Graphical Abstract