RESEARCH ON ACCEPTABILITY OF SHARIAH NON-COMPLIANT ASSET AS COLLATERAL
by Ahmad Mukarrami Ab Mumin and Afiqah Nur Yahya
- Overview on Rahn and Regulations Governing Rahn Contract in Malaysia
Rahn is an Arabic term that refers to collateral, security as well as mortgage. The use of rahn in a financing facility arrangement is by tying an asset to a debt so that in the case of default, the asset or its value can be used for repayment. The type of asset used as rahn varies from real asset, such as property, land buildings, or machineriesto financial asset like shares, bonds and unit trust. It may also include intellectual property and future assets.
The issuance ofRahn Exposure Draft (Rahn ED) by Bank Negara Malaysia (BNM) is aimed to strengthen the Shariah-compliance practice amongIslamic financial institutions (IFIs), and to provide a comprehensiveguidance to the Islamic financial industry with respect to end-to-end compliancewith Shariah, in particular on rahn contract. In stipulating the condition for the subject matter of rahn, it is stated that it shall be a collateral (marhun) that is recognized by Shariah.Rahn ED also allows for the collateral to be partially Shariah-compliant (referred to as mixed financial asset) or Shariah non-compliant. However it is stipulated that where a Shariah non-compliant financial asset is used as a collateral, the collateral value must be limited to the principal amount of the financial asset.
This is in line with the resolution issued by the Shariah Advisory Council (SAC) of BNMthat allows for the acceptance of rahn of asset which comprised of both Shariah-compliant and Shariah non-compliant assets. The SAC of BNM in its 160th meeting on 30th June 2015 ruled the shares of companies with mixed asset may be accepted as collateral provided that the core business of the company is recognized as Shariah compliant; and a mixed asset may be used as collateral provided that the Shariah compliant assets and Shariah non-compliant can be segregated. The value of the collateral is limited only to the portion of the assets that are Shariah compliant. In this respect, the collateral value of interest bearing debt based asset such as conventional fixed deposit certificate and conventional bonds is limited to the principal amount of the instrument; and the collateral value of Shariah non-compliant unit trust is limited to the value of the investor’s initial and subsequent/additional investment. Based on this ruling, there are two conditions for acceptance of mixed financial asset as follows:
- The Shariah-compliant asset and Shariah non-compliant asset of that instrument can be segregated; and
- The collateral is accepted only up to the value of the portion of the assets that are Shariah-compliant
It is interesting to note that the SAC of BNM has later, in its 170th meeting on 30 August 2016, allowed the IFIs to accept the whole principal amount of conventional fixed deposit although such principal amount contains previous interest portion which has been recapitalized by the conventional fixed deposit certificate holder. This ruling is in line with previous SAC of BNM rulings which allow the principal amount of the conventional fixed deposit to be used as collateral and SAC of BNM rulings that allow IFIs to accept funds from customer without ascertaining its source.
In addition, the SAC of Securities Commission Malaysia(SC) has, at its 188thmeeting held on 25 August 2016, deliberated on an enquiry from the industry in relation to collateral for Islamic share margin financing (SMF) for Islamic stockbroking services. The current practice by Islamic Participating Organizations (POs) is to accept only Shariah-compliant securities as collateral for SMF. However, when such securities are subsequently reclassified as Shariah non-compliant securities (SNCS) by the SAC of SC in its bi-annual review, the Islamic POs would automatically exclude such securities as collateral resulting in margin call and/or forced selling of such securities. After due deliberation, the SAC has resolved that it is permissible for the Islamic POs to maintain Shariah-compliant securities, which have been reclassified to SNCS, as collaterals until the end of the Islamic SMF tenure.
- Challenges in Segregating a Mixed Financial Asset
The Rahn ED and the SAC of BNM ruling is clear on the requirement for the Shariah-compliant asset and Shariah non-compliant asset of the instrument to be able to be segregated before it can be accepted as collateral. However, we can see exceptions given on the requirement of segregation from the latest SAC of BNM’s ruling that allows the acceptance of the whole principal amount of conventional fixed deposit although it contains previous interest portion which has been recapitalized, as well as from the SAC of SC’s ruling that permits Islamic POs to maintain securities that have been reclassified to SNCS.
Segregating Shariah-compliant asset and Shariah non-compliant asset of a mixed financial asset is challenging due to several reasons as follows:
- Recapitalization of interest: For certain instrument like bond, it is easy to determine the principal value of the instrument by just referring to the face value of the bond certificate. However, for financial instrument like fixed deposit, it involves recapitalization of interest that resulted in the principal amount to contain as well the previous interest. It will be difficult to segregate the principal amount from the interest amount if the investor does not remember the initial deposit that he made.
- Growth of Value: Certain financial assets like shares and unit trust unit represent the value of the underlying asset. This asset normally will grow or decrease in value without any limitation depending on market demand and performance of the business. If the underlying business activities for these shares and unit trust are mixed between Shariah-compliant and Shariah non-compliant business activities, it is hard to determine after the growth of value of such shares which portion is Shariah-compliant and which portion is not.
There are various financial instruments available in the modern financial markets with complicated and diversified structure, and many of them are hard to segregate between the Shariah-compliant portion and Shariah non-compliant portion. The IFIs as a part of the whole financial system are exposed to these instruments. Even though the intention of not accepting Shariah non-compliant collateral is to disallow the inflow of funds that are based on Shariah non-compliant activities to the Islamic financial systems is praiseworthy, it is not incumbent of the IFI to identify, examine and segregate these instruments to ensure that the collateral value is accepted up to the Shariah-compliant value only.
- Importance of Collateral for Credit Enhancement
Collateral plays a very major role in terms of credit enhancement in the provision of financing facility by bank. Through credit enhancement, the bank is provided with reassurance that the customer will honour the obligation through collateral, insurance or third party guarantee. Credit enhancement reduces credit or default risk of a debt, thereby increasing the overall credit rating and lowering the financing rate that will be offered by the bank.
If a mixed financial asset cannot be accepted as collateral due to inability to segregate between the Shariah-compliant asset and Shariah non-compliant asset of that instrument, the following could be the consequences:
- To IFI: exposure to credit risk should the Shariah-non-compliant asset be not accepted as collateral, and as such the financing given is not secured.
- To customer: It reduces the credit rating of the customer and as such increasing the profit rate offered by Islamic bank for the financing facility. Alternatively, the customer can resort to a cheaper alternative of financing such as conventional loan that accepts mixed financial asset as collateral.
- Shariah Deliberation
Based on the above,this paper tries to explore on possible Shariah justifications to allow the acceptance of mixed financial asset that cannot be segregated as collateral. This will be based on the following Shariah deliberation:
- Categories of Shariah non-compliant asset (المالالحرام)
There are two categories of Shariah non-compliant assets (المالالحرام) as follow:
- Al-haram lidzatihi (الحراملذاته) (asset which is prohibited due to its own essence) such as alcohol and swine.
- Al-haram lighairihi (الحراملغيره) (asset which is prohibited due to external factors). This kind of asset is not prohibited due to its fundamental essence but itsassociationwith external factor or character(sifah ‘aridhah/صفة عارضة) that is prohibited by Shariah. The example is ill-gotten wealth through cheating, theft, or interest-based transaction. The money itself in its essence is not prohibited, but the illegal act or prohibited transactions caused the money to be treated as prohibited.
- Shariah Views on Pledging al-Haram Lidzatihi as Collateral
The discussion on acceptance of al-haram lidzatihi as collateral can be found in kutub al-turath (classical fiqh books) when the jurists discussed on the pledging of al-khamr (liquor) and al-khinzir (swine). The views can be categorized as follows:
- Pledging of liquor or swine amongst Muslims
It is not permissible to pledge or accept alcohol or swine as collateral if the contracting parties are Muslims. This is because a Muslim has no capacity to transact in alcohol or swine. 
- Pledging of liquor or swine amongst non-Muslims
The pledging of collateral amongst non-Muslim is valid in all items that are permissible for them to transact which include liquor and swine.
- If the pledgor is a non-Muslim and the pledgee is a Muslim
It is not permissible for a Muslim to accept liquor or swine as collateral since a Muslim does not have capacity to transact in these prohibited items. This is because the pledging of such prohibited items as collateral requires the keeping of that collateral and in a situation that needs repayment of the debt by utilizing the collateral, it will require the Muslim to deal with the prohibited item by selling it off, and such is not allowed in any way by Shariah.
Al-Kasani in his book Badai` al-Sanai` stated that if a Muslim accepted liquor as collateral from a non-Muslim, he will be liable (dhamin) for such collateral because liquor is a valuable asset (mal mutaqawwim) to the non-Muslim pledgor. As such, if anything happened to the liquor whereby it is in the hand of the Muslim pledgee, he will be liable to it.
IbnQudamah in his book al-Mughnistated that it is not permissible to accept a pledge from a non-Muslim whether or not the collateral is placed in the hand of the non-Muslim or others. However, he views that if the non-Muslim pledgor or his agent keeps the collateral and later sells the collateral and bring the price/value to the Muslim, the Muslim is obliged to accept that as payment. If the Muslim refused to accept, he has to waive his right from receiving payment.
- If the pledgor is Muslim and the pledgee is non-Muslim
Al-Kasani stated that if a Muslim pledged liquor or swine to a non-Muslim, neither party will be liable (dhamin) to the other. Al-Sarakhsi viewed that if the pledgor is a Muslim, if he settled his debt by using the prohibited collateral to the non-Muslim pledgee, he has to channel to charity the same value of that collateral because he has no ownership or legal capacity to deal with the liquor.
It is clear from the above that it is not permissible for a Muslim to deal with al-haram lidzatihiby any means.
- Shariah Views on Pledging al-Haram Lighairihi as Collateral
Interestingly, the discussion on acceptability of Shariah non-compliant assets as rahn in classical fiqh books is limited to al-haram lidzatihi, whereas for al-haram lighairihi, there is no specific discussion.
The examples of al-haram lighairihi are financial assets like fixed deposit, bonds and shares. These assets are considered as Shariah non-compliant due to external factors such as its association with interest based activities. Nevertheless there is a component of that instrument that represents permissible element, which includes the principal value that was initially invested by the holder as well as any return that is generated as a result of Shariah-compliant business activities.
The possible Shariah justifications to allow acceptance of mixed financial asset that cannot be segregated are as follows:
- Nature and implication of prohibition due to external factor (al-haram ligharihi)
Nature of al-haram lighairihi is different from al-haram lidzatihi. The ruling on prohibition ofal-haram lighairihiis not due to the essence of the asset. The attribution of haram is given due to external factors. For example, on the prohibition of silk for men, the silk itself in its essence is not haram, but the man who wears the silk. The same goes to money received as a result of interest-based transaction. Money in its essence cannotbe described as halal or haram but the act of the mukallaf.
Thus, the prohibition shall be limited to the external factor that causes the asset to turn as haram, andshall not be extended to the essence of the asset. This is because the prohibition is a character related to the action of the mukallaf and has no relation at all with the essence of asset(أن الحرمة وصف يثبت في ذمة المكلف لا علاقة بالمال به).This is the view of Imam IbnArabiy in discussing the ruling on dealing with a person who has mixed asset of halal and haram. He views that if such dealing is ruled as haram it will be an exaggeration in religion. Other scholars view that the ruling of haram in dealing with a person who has mixed asset could only bring difficulty, dispute and doubt (waswasah). 
From another point of view, the effect and obligation arising from prohibited transaction shall remain with the one who does the act. The obligation arises is to channel the SNC income from such prohibited transaction to charity and such obligation will not be transferred just simply because the SNC income is transferred to or pledged with another person. For example, as a result of riba transaction, the one who received the riba has the obligation to channel to charity the amount of riba received. If he uses the riba money to pay his debt to a creditor, the obligation to channel the riba money to charity remains with him until he channels the same value of the riba amount to charity. Such obligation will not be transferred to the creditor who received the money as debt settlement since he does not know which portion is halal and which portion is riba.
The same shall be applied in accepting mixed financial asset as collateral. The mixed financial asset shall not be attributed as halal or haram because it is the underlying contract behind that asset that is prohibited and such prohibition has no relation at all with the contract of rahn or the murtahin. If the collateral is a fixed deposit instrument, the murtahin has no relation at all in the interest-based contract between the lender and borrower. If the collateral is shares of a company that runs mixed business activities, the murtahin has nothing to do with the business of the company or any investment interest by the investor in that business. In any situation, the murtahin will just benefit from the monetary value of the collateral only upon default of payment by the pledgor or rahin. The transfer of the monetary value to the murtahin, be it from Shariah-compliant asset or Shariah non-compliant asset of that instrument, will not discharge the obligation of the parties to the Shariah non-compliant contract to purify their Shariah non-compliant income by channeling to charity.
- Hajah (need) for mixed financial asset as collateral
The different implication between al-haram lidzatihi and al-haram lighairihi is further supported by fiqh maxims as follows:
- Necessity will render al-haram lidzatihi permissible (الحراملذاتهتبيحهالضرورة); and
- Need ormaslahahrajihahwill render al-haram lighairihipermissible
It is also an established qa’edah(principle) in deriving hukm (ruling) that hajah(need) is not sufficient to render prohibited item or action permissible. However, hajah can be used to render permissible on the occurrence of any of the following:
- There is akhilaf (dispute) in the impermissibility ruling
- It is prohibited as a sadd al-zari`ah (a blocking means to prohibited things)
- The ruling on haram is dha`if (weak) in general.
In any of the above situation, hajah can be used as a justification to render the prohibition permissible subject to the following conditions:
- The ruling of permissibility is issued by a prominent scholar; and
- There is a maslahahmu`tabar (accredited maslahah)
As such, we need to determine whether there is any hajah or maslahah in allowing the acceptance of Shariah non-compliant collateral. Such need is established based on the following considerations:
- Exposure of the Islamic bank to credit risk if the financing facility is not secured due to the non-acceptability of mixed financial instrument that cannot be segregated; and
- The possibility of the customer to turn to cheaper financing offered by conventional bank and as such they will get involved in the greater sin of riba.
- No explicit prohibition on the usage of al-haram lighairihi as collateral
It is noteworthy that the prohibition of using al-haram lidzatihi is very explicit and it is due to theessence of the asset such as liquor or swine that cannot be benefited in any way and cannot be dealt with by any means by a Muslim.A Muslim has no capacity at all in dealing with that kind of assets. Such prohibition in dealing with al-haram lidzatihi such as liquor and swine cannot be equalized to dealing with al-haram lighairihi because there is no explicit prohibition on dealing with al-haram lighairihi. This is also in line with the maxim “Permissibility is the original rule for all things” (الأصل في الأشياء الإباحة). This maxim is supported by a number of hadiths, amongst them, the Prophet Muhammad (peace be upon him) said:
الحلال ما أحل الله في كتابه، والحرام ما حرم الله في كتابه، وما سكت عنه فهو مما عفا عنه.
The halal is what Allah has made lawful in His Book, and the haram is what Allah has prohibited in His Book; and whatever He has remained silent about is part of what He has excused.
- Fiqhmaxims which conclude that for matter which their true status are hard to determine, it is adequate for the appraisal to be based on its external appearance
The difficulty to determine the Shariah-compliant asset and Shariah non-compliant asset of a mixed financial instrument should be tolerated based on several fiqh maxims which conclude that for matter which their true status is hard to determine, it is adequate for the appraisal to be based on its external appearance. The fiqh maxims are as follows:
- الأحكام على الظاهر والله ولي المغيب
“Ruling of something is based on the external appearance, whereas internalmatter is left to Allah the All Knowing.”
- الأحكام تجرى على الظاهر فيما يعسر أو يتعذر الوقوف على الحقيقة
“Ruling of something is based on the external factor, should it be impossibleto comprehend the actual meaning”
- فمن محاسن الشرع ضبط الأحكام بالأسباب الظاهرة وإقامتها عللا يدور الحكم معها وجودا وعدما
“Hence, among the beauty of Shariah is the determination of legal ruling based on the external factors, and deemed (these external factors) as an effective cause (`illah), a ruling exists if the `illah exists and vice versa.
- المعاملات على الظواهر والمعلوم الباطن خفي لا يعلق عليه الحكم
Mu`amalah (financial transactions) is based on the external factors, undoubtedly internal matters arehidden and ruling cannot be based on the latter.
- Analogy to the transactions with or receipt of gifts from someone who has mixed source of halal and haram assets/income
There is also a Shariah discussion on the issue of dealing with or accepting gift from someone who has mixed source of halal and haram assets/income. The preferred view on this issue is that it is permissible to deal with or accept gift from someone who has mixed assets if the haram elements cannot be identified.Should this view be extended to the acceptability of mixed asset that cannot be segregated as collateral, it may allow the acceptance of such asset. The detail on juristic views on the issue of dealing with or accepting gift from someone who has mixed asset is as follows:
- Views on Permissibility:
The followings are juristic views on permissibility in dealing with or accepting gift from someone who has mixed asset:
- Hanafiah view it as permissible but not recommended (makruh), if the halal portion is larger than the haram portion.
- Shafi’iah, Hanabilah and Malikiah view it as permissible but not recommended in general whether or not the haram portion is smaller or larger than the halal portion.
The authorities (istidlal) on permissibility to benefit from mixed asset is based on the followings:
- Legal maxim: original ruling of wealth and its related transactions are permissible, and the prohibition is an incoming element which is not recognized unless with full certainty (أنالأصلفيالمالوالتعاملبهالإباحة،والتحريمعارضلايثبتإلابيقين).
- It is derived from the actions of Holy Prophet Muhammad (peace be upon him) eating the food of Jews, and the Prophet had also conducted sale and purchase with them, even though it is known that their wealth is mixed with haram element which is riba.
- B) Views on Impermissibility:
The followings are juristic views on non-permissibility in dealing with or accepting gift from someone who has mixed asset.
- Hanafi views it as unlawful in dealing with a person who has mixed asset if the haram portion is greater than halal portion.
- For some maliki, it is totally unlawful whether haram portion is bigger or smaller because when it is mixed, the haram portion will be widespread and becomes wholly haram, thus need to be purified.
Based on the above juristic point of view, the preferred view is that it is permissible but makruh to accept gift from a mixed source of wealth, based on the dominant (rajih) opinion, in the event the haram element cannot be precisely identified. If the haram element can be identified, it is unlawful to accept the haram portion. 
- Uncertainty (Gharar) in Rahn Contractis Tolerated
It is an established principle that requires the pledged asset to be Shariah-compliant based on the maxim thatanything that is permissible for sale is permissible for collateral (كلماجازبيعهجازرهنه), and that all conditions for arahn contract to be similar with all conditions in a sale contract. However there is an exception to that whereby Maliki views that uncertainty is tolerated in rahncontract even though it is not tolerated in a sale contract. This is the basis that is used in allowing future asset to be pledged as collateral as resolved by the SAC of SC. Moreover, rahn is just a supporting contract to secure the financing.
The uncertainty in a mixed financial asset in this issue is the Shariah non-compliant portion of that asset that cannot be segregated from the Shariah-compliant portion. Should this portion be known, it is easy to extract it and remove it from the collateral value. When it is unknown, it gives uncertainty to the status of the collateral. For such uncertainty, tolerance should be given following the above Maliki views.
- Maxim: The Greater Harm is to be Removed by Lesser Harm
((يزال الضرر الأشد بالضرر الأخف/ أخذ أخف الضررين
On one hand there is a harm of taking or consuming something doubtful (syubhah) should the mixed financial asset be accepted as collateral and later used for the purpose of repayment, since the financial asset contains Shariah non-compliant elements. The occurrence of this harm is not certain since it is subject to customer’s failure in repaying the debt. Moreover, based on nature of haram ligharihi as stated above, the haram ruling falls only on the one who acquired the asset through and the obligation to cleanse the impermissible asset. Such ruling and obligation shall not be transferred or extended to other person who was not involved at all in the impermissible transaction.
On the other hand, if the mixed financial asset is not accepted ascollateral, there is a harm of not securing payment even though that collateral contains Shariah-compliant portion. This will pose the bank to a higher credit risk. That also triggers another harm in terms of credit rating as stated earlier whereby it may reduce the credit rating of the customer and hence increasing the profit rate which eventually may cause the customer to resort to a cheaper alternative of financing which is conventional loan.
Weighing between the two harms, it is obvious that it is more harmful if the bank refuses to accept the mixed financial asset as collateral.
The pledging of a mixed financial asset which is prohibited due to external attributes, not to its own essence, had not been discussed by past jurists and there is no clear prohibition on it by contemporary scholars. Based on the Shariah justifications provided above, we humbly believe that mixed financial asset shall be accepted as collateral without any need to segregate the Shariah-compliant and Shariah con-compliant asset of that instrument. The acceptance of mixed financial asset as collateral in securing Islamic financing facilitywill enhance the creditworthiness of the debtorthat consequentlywill reduce the financing cost. On the side of the IFIs, this will widen the types of collateral that may be acceptedto secure Shariah compliant financing.
This article is exclusively submitted for 14th Kuala Lumpur Islamic Finance Forum (KLIFF) 2017 held on 3rd to 5th October 2017.
 Ahmad Mukarrami Ab Mumin is the Head of the Shariah Division and Afiqah Nur Yahya is the Section Head of Shariah Research at RHB Islamic Bank Berhad. They can be contacted at firstname.lastname@example.org and email@example.com, respectively.
 Paragraph 13.1(a) of Rahn ED, issued on 15 May 2017
 Paragraph 14.1(b) of Rahn ED
 Paragraph 14.2(b) of Rahn ED
 BNM Shariah Resolutions in Islamic Finance, 2nd Edition, page 197 (Deposit or Customer’s Investment Fund from Doubtful Sources)
Jami`Fiqh: al Sarakhsi, al Mabsut, KitabarRahn.
Al-Sarakhsi, Al-Mabsut, Chapter of Collateral by Non-Muslims.
 Jami`Fiqh: al Kasani, Badai` al-Sanai` fi Tartib al Sharai`.
 Jami`Fiqh: ibnQudamah, al Mughni, Chapter: A Non-Muslim Request Loan from a Muslim and Pledge Liquor as Collateral; and Al Buhuti, Kasyaf al Qina“an Matn al Iqna`
 Jami`Fiqh: al Kasani,ibid
 Jami`Fiqh: al Sarakhsi, al Mabsut, KitabarRahn
Dar al Ifta’ al Misriyyah, al fatawa: هديةمناختلطمالهالحلالبالحرام, الفتاوى يالتاريخ : 28/09/2015, http://dar-alifta.org/AR/ViewResearch.aspx?sec=fatwa&ID=255&LangID=1 (extracted on 15th Sept 2017)
 Abdullah ibnBayyah, Sinaah al-Fatwa.
 Al-Tirmidzi, hadith no. 1726; IbnMajah, hadith no. 3367; Al-Hakim (4/129); and graded as hasan by al-Albani in SahihSunanIbnMajah (Beirut:al-Maktab al-Islamic, 1997).
Al-Syafii, Al-Umm, Bait al-Afkar al-Dawliyyah, (n.d.), p. 720
 Ali Ahmad al-Nadwi, Jamharah al-Qawa`id al-Fiqhiyyah fi al-Mu`amalat al-Maliyyah, Syarikah al-Rajhi
al-Masrafiyyah li al-Istithmar, 2000, v. 1, p. 4334.
 Al-Subki, Al-Ashbahwa al-Nazha’ir, Dar al-Kutub al-`Ilmiyyah, 1991, v. 2, p. 190.
IbnuHajar al-`Asqalani, Fath al-Bari SyarhSahih al-Bukhari, Dar al-Ma`rifah, 1959, v. 4, p. 302.
Dar al Ifta’ al Misriyyah, ibid
 Al-Hattab, Mawahib al-Jalil fi SyarhiMukhtasar Khalil