Applications of security instruments and assets in Islamic project financing : a shari’ah perspective analysis

Abstract

Security or collateral plays a pivotal role in mitigating credit risk in banking, functioning as a safeguard against customer default. While its application is widespread in both conventional and Islamic banking systems, there remain persistent questions concerning the Shari’ah compliance of various security instruments and the underlying assets used. The absence of a standardized framework for Islamic security arrangements has led to inconsistent practices across jurisdictions, resulting in legal uncertainties and a heightened risk of Shari’ah non-compliance, particularly in Islamic project finance. This study aims to fill this critical gap by evaluating the Shari’ah compatibility of security instruments and asset classes commonly employed in project financing. Employing a qualitative comparative methodology, the study undertakes doctrinal legal analysis of statutory provisions, case law, and secondary literature, while complementing it with Shari’ah analysis grounded in classical and contemporary juristic discourse. Particular emphasis is placed on rahn and ʿuqud al-tawthiqat (security contracts). Field interviews with industry practitioners, legal experts, and Shari’ah officers provide practical insights and validation of theoretical interpretations. Findings reveal that the rahn shares some resemblance with charge, mortgage, pledge, and lien in terms of providing security to the creditor, but it differs in key characteristics. The rahn closely parallels the collateral instrument of a charge, meeting flexible rahn requirements of possession and asset diversification. Unlike a mortgage, which transfers ownership of the asset to the creditor, rahn does not require such a transfer. Similarly, pledge and lien require delivery and possession of the asset by the creditor, which is not mandatory in rahn. Furthermore, common law quasi-security arrangements, such as guarantee contracts, and assignments, have comparable Islamic counterparts in kafālah/ḍamān and ḥawalah contracts, despite some differences. The study also evaluates the Shari’ah permissibility of various asset classes used as collateral in project financing. Real estate, Islamic cash-based assets (e.g., deposits, reserves), and Islamic financial assets (e.g., sukuk, Islamic unit trusts) are fully Shari’ah -compliant and acceptable as collateral. Conventional assets like fixed deposits and bonds are only allowed up to the principal, excluding any interest (riba). For conventional insurance, only the premium paid is permissible. Shares of companies engaged in non-compliant core activities are strictly impermissible. However, shares that breach Shari’ah benchmarks due to non-compliant income may be accepted as collateral, limited strictly to the ḥalal portion of their value. Book debts are permitted due to constructive possession. Future assets under floating charges are conditionally accepted based on the Maliki view if safeguards against gharar are in place. Intellectual property is also allowed, being recognized as ḥaqq mall with tradeable and lasting value. This research contributes a clearer understanding of Shari’ah -compliant security instruments and assets for Islamic project financing stakeholders and regulators.