The Application of Maslahah in Justifying Ta’widh and Gharamah in Islamic Finance: A Malaysian Perspective

The Application of Maslahah in Justifying Ta’widh and Gharamah in Islamic Finance: A Malaysian Perspective

Nur Adibah Zahra Binti Amirul Shazli., Ruzian Markom^* & Mohd Izzat Amsyar Mohd Arif

Centre for International Law and Siyar, Faculty of Law, Universiti Kebangsaan Malaysia

DOI: https://dx.doi.org/10.47772/IJRISS.2025.908000568

Received: 13 August 2025; Accepted: 20 August 2025; Published: 20 September 2025

ABSTRACT

The application of maṣlaḥah (public interest) plays a vital role in justifying the use of taʿwidh (compensation) and gharāmah (penalty) within Islamic finance. This study examines how maṣlaḥah addresses contemporary challenges in Islamic finance in which the primary sources of Islamic law may not provide explicit guidance. Malaysia, through its Shariah Advisory Council (SAC) of Bank Negara Malaysia (BNM), has determined that taʿwidh and gharāmah may be imposed as late payment charges to safeguard maṣlaḥah and to uphold justice among the financiers and customers. The problem addressed in this study is the justification and acceptance of taʿwīdh and gharāmah in Islamic finance remain debated due to differing interpretations of Shariah principles as calculating precise losses from late payment is often complex and subjective and also there is limited clarity on how maṣlaḥah is applied to legitimize these concepts within the Malaysian Islamic finance context as some scholars argue these fees help maintain financial stability and justice, while others see potential conflict with Shariah prohibitions, leading to inconsistent application. The main purpose of this study is to explain the concept of maṣlaḥah, taʿwidh, and gharāmah, to analyse how the application of taʿwīdh and gharāmah is justified through maṣlaḥah in Islamic finance, and also to recommend a guideline on the application of taʿwīdh and gharāmah and its impact on Shariah compliance and regulation in Malaysian Islamic finance. This study adopts a qualitative research design by focusing on library research and doctrinal research, and thus, it is found that the concept of maṣlaḥah is applied in the application of taʿwidh and gharāmah in Malaysia. This study agrees that ta’widh and gharamah are introduced by Islamic banks in Malaysia to safeguard the interests of both financiers and the customers, hence the concept of maṣlaḥah is impliedly applied.

INTRODUCTION

The application of maṣlaḥah (public interest) plays a vital role in justifying the use of taʿwidh (compensation) and gharāmah (penalty) within Islamic finance. Maṣlaḥah was addressed as one of the contemporary challenges in Islamic finance, in which the primary sources of Islamic law, Al-Quran and the Sunnah, did not provide explicit guidance. Malaysia, through its Shariah Advisory Council (SAC) of Bank Negara Malaysia (BNM), has determined that taʿwidh and gharāmah may be imposed as late payment charges to safeguard maṣlaḥah and to uphold justice among the financiers and customers.

The Concept Of Taʿwidh And Gharāmah

The concepts of taʿwidh and gharāmah have sparked extensive debate among scholars, given the prohibition of riba’ (interest) and the ethical considerations surrounding punitive charges. In this context, maṣlaḥah serves as a foundational tool to reconcile these mechanisms to meet the standard of Shariah objectives (maqāṣid al-sharīʿah), which are preserving justice, preventing harm, and promoting economic stability. Taʿwidh is imposed as compensation for genuine loss after the repayment period, and its income is recognized by Islamic banks, whereas gharāmah is strictly channeled to charitable bodies to avoid benefiting the banks directly. These measures reflect the maṣlaḥah of ensuring fairness, transparency, and viability in Islamic finance, balancing the financier’s operational sustainability and customers’ rights.  Maṣlaḥah is crucial in legitimizing taʿwidh and gharāmah because it allows Islamic finance scholars and regulators to adapt the law for contemporary needs, balancing public interest and Shariah principles without opening the door to prohibited riba.

In Malaysia, the Shariah Advisory Council (SAC) has progressively refined its stance on the application of taʿwidh for delayed payments in Islamic finance in its meeting on 14 July 1999. Later, at a meeting held on 28 January 2010, SAC reaffirmed that both taʿwidh and gharāmah are allowable as a deterrent mechanism against cases of default by customers.

Bank Negara Malaysia’s (BNM) Policy Document on Hajah and Darurah plays a crucial role in addressing issues related to taʿwidh and gharāmah in Islamic finance by providing clear and procedural guidance for applying these Shariah concepts. This Policy Document clarifies the concepts of Hajah (Need) and Darurah (Dire Necessity) in a contemporary Islamic finance context, recognizing these principles as justifications for allowing exceptions to strict Shariah rules when needed to prevent mafsadah (harm) and achieve maṣlaḥah. Taʿwidh and gharāmah, which can raise Shariah compliance concerns due to potential resemblance to riba, may be reconsidered under this framework as permissible under hajah or darurah if certain conditions are met to avoid hardship and maintain fairness.

The justification and acceptance of taʿwīdh and gharāmah in Islamic finance remain debated due to differing interpretations of Shariah principles, as calculating precise losses from late payment is often complex and subjective; and limited clarity on how maṣlaḥah is applied to legitimize these concepts within the Malaysian Islamic finance context as some scholars argue these penalty fees help maintain financial stability and justice, while others see potential conflict with Shariah prohibitions, leading to inconsistent application.

The article aimed to explain the concept of maṣlaḥah, taʿwīdh, and gharāmah. Analyse how the application of taʿwīdh and gharāmah is justified through maṣlaḥah in Islamic finance. Finally, recommend a guideline on the application of taʿwīdh and gharāmah and their impact on Shariah compliance and regulation in Malaysian Islamic finance.

METHODOLOGY

This study adopts a qualitative research design focusing on library research and doctrinal research to explore the application of maṣlaḥah in justifying taʿwidh and gharāmah within Islamic finance in Malaysia. The qualitative approach allows for an in-depth understanding of theoretical concepts, jurisprudential debates, and regulatory frameworks. Doctrinal research involves the analysis of primary Islamic legal sources, including the Qur’an, Sahih al-Bukhari and Muslim Hadith collections, and classical jurisprudential texts from the Hanafi, Maliki, Shafi’i, and Hanbali schools, and classical jurisprudential texts, to understand the theoretical foundations and principles underpinning the concept of maṣlaḥah in justifying taʿwīdh and gharāmah. Complementing this, library research examines contemporary scholarly debates, regulatory frameworks, and legal instruments such as the Islamic Financial Services Act 2013 and rulings from the Shariah Advisory Council of Bank Negara Malaysia. The analysis will specifically examine the operationalization of these concepts in Malaysian case law and compare them with standards from other jurisdictions like the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI). This qualitative approach facilitates an in-depth understanding of the jurisprudential reasoning, ethical considerations, and practical implementation of maṣlaḥah, taʿwidh, and gharāmah, enabling the study to critically assess their legitimacy and application in the Malaysian Islamic finance context.

LITERATURE REVIEW

In Islamic finance, the concepts of taʿwidh and gharāmah are crucial for addressing late payments while adhering to Shariah principles. The application of these charges, particularly taʿwidh, often relies on the Islamic legal principle of maṣlaḥah.

It is commonly acknowledged that in Islamic finance, the prohibition of riba restricts banks from charging interest on delayed payments. Nevertheless, Islamic banks function as financial intermediaries, channeling funds from surplus units such as depositors, investors, and public institutions requires substantial capital. The absence of late payment penalties threatens the financial stability of Islamic banks, which are highly dependent on timely repayments in order to maintain their operations. Late payments by customers lead to increased operational costs, such as administrative and legal expenses. Therefore, to mitigate these adverse effects and safeguard institutional interests, Islamic finance permits the imposition of late payment penalties, which are known as taʿwiḍh based on the principle of maṣlaḥah, particularly in cases where delays are due to negligence or intentional non-compliance by the customers (Zameri et al. 2024).

Juristic Debates On Ta’widh And Gharamah

The justification for these charges is the subject of diverse scholarly opinions. A significant body of contemporary scholars, including those in the OIC Fiqh Academy, permit late payment penalties to compensate creditors for losses (Muneeza et al., 2019). Their justifications include: (i) preventing harm to creditors; (ii) viewing deliberate delay as a form of unlawful appropriation (ghasb); (iii) the necessity of financial compensation as the most effective remedy; and (iv) targeting only capable debtors as a deterrent (Sanusi, n.d. as cited in Muneeza et al., 2019). However, prominent scholars like Sheikh Taqi Uthmani offer a counter-argument. They contend that the hadith often cited (“The delay in paying debt by the rich who has money makes dishonouring and punishing him permissible”) does not contemplate financial punishment to be profited by the creditor, but rather a punishment meted out by a judge (hakim) for the state (Uthmani, 2002 as cited in Muneeza et al., 2019). This highlights the central debate: whether compensation is a private right or a public penalty.

According to Ishak (2019), based on the principle of maṣlaḥah, there is a need to standardize the taʿwiḍh rate to ensure the sustainability of the Islamic banking sector. However, Islamic banks must strictly exercise caution in applying taʿwiḍh, as late payment charges must not resemble riba. Although taʿwiḍh can be recognized as income, Islamic banks should only account for actual losses, directing any surplus funds to charitable causes to uphold Shariah compliance.

Regulatory Evolution And Practical Application In Malaysia

The historical context in Malaysia reveals that the adoption of ta’widh was driven by practical necessity. As noted by former Chief Justice Tun Abdul Hamid, the absence of post-judgment penalties initially placed Islamic banks at a financial disadvantage compared to their conventional counterparts, as they incurred legal costs without a mechanism for recovery (Mohamad, 2012 ). This practical challenge led the SAC to progressively refine its stance, culminating in the 2011 BNM Guidelines which streamlined the application of taʿwidh and gharāmah, differentiating them from the calculation of ibra’ (rebate) which was a source of earlier disputes.

In terms of regulations, the Islamic Financial Services Act 2013 reflects the government’s commitment to Shariʿah compliance. Central to this framework is the Shariah Advisory Council (SAC) of Bank Negara Malaysia, which was established in 1997,  serves as the highest Shariʿah authority and issues binding resolutions for Islamic financial institutions. The SAC introduced a late payment charge for Islamic banks based on the concept of taʿwidh and gharāmah in 1999 and later in 2010. This charge must fulfill three conditions: its amount cannot exceed the actual loss suffered by the Islamic bank, the compensation shall be determined by the central bank, and the default or delay of payment must be applied only to customers who have not paid despite having the ability to do so. The SAC also introduced gharāmah, which is a penalty imposed on customers who delay in financing/debt settlement, over and above the amount of ta’widh. Gharāmah is not allowed to be recognised as income, and it must be channeled to specified charitable bodies approved by the SAC.

Ishak (2017) investigates the Shariah issues surrounding taʿwidh in Malaysia, specifically its use by Islamic banks to address late payments. The study shows that taʿwidh serves as a Shariah-compliant alternative to interest-based late payment penalties, which are prohibited in Islam. While taʿwidh finds justification in  Al Sunnah and maṣlaḥah for sustaining the competitiveness of Islamic banking operations. It was pointed out that its practice remains debatable due to the determination of a special rate rather than the actual loss incurred. It was suggested that even though the BNM allows Islamic banks to consider a 1% charge as income, they should ideally claim only the actual loss, with any remaining amount used for charitable purposes. This highlights the reliance on maṣlaḥah to allow for taʿwidhto ensure the operational viability of Islamic financial institutions, while also emphasizing the need to uphold the spirit of justice and prevent excessive charges.

Norazlina and Ridzwan (2019) explore further into the maṣlaḥah approach towards the imposition of taʿwidh in Islamic finance. They assert that the permissible imposition of taʿwidh for delayed repayments is based on the ijtihad (independent reasoning) of Shariah advisors, grounded in maṣlaḥah. They both emphasize that the concepts of  Maṣlaḥah and mafsadah  (harm or corruption) are consistently employed by Muslim scholars to address contemporary issues and conclude that the late payment charges imposed by Islamic banking generally conform to the real maṣlaḥah concept. This is achieved by considering the interests of both the banks and the customers, thereby upholding the objectives of Islamic law. This paper also provides a direct link between the permissibility of taʿwidh and the principle of maṣlaḥah, illustrating how it facilitates practical solutions within the Islamic financial framework.

Zawawi and Hassan (2023) provide an analysis of issues arising from the application of taʿwidh and gharāmah by Islamic financial institutions (IFIs) in Malaysia, particularly in light of recently decided cases. They note that the concept of charging penalties for late repayments was introduced by BNM in 1999, with taʿwidh and gharāmah specifically introduced in 2010 and guidelines for their calculation in 2012. The authors highlight a crucial point, which is that taʿwidh is allowed by BNM to be included in profit distributable to depositors and investors. This practice necessitates utmost caution from IFIs, as errors in application could expose them to Shariah non-compliance risks. While not explicitly focusing on maṣlaḥah as the sole justification, this paper implicitly supports its role by examining the regulatory framework that permits these charges for the stability and functionality of Islamic financial institutions. The concerns raised regarding potential misapplication further emphasize the need for careful adherence to the underlying Shariah principles, including maṣlaḥah, to ensure fairness and prevent unjust enrichment.

Hence, the application of Maṣlaḥah is a fundamental justification for the imposition of taʿwidh and gharāmah in Islamic finance. These charges are seen as necessary tools to ensure the smooth operation and competitiveness of Islamic banks while remaining compliant with the Shariah principles. While maṣlaḥa provides the theoretical basis, the practical implementation of taʿwidh, particularly concerning the determination of the charge amount, remains a subject of ongoing discussion to ensure that the compensation genuinely reflects actual losses and avoids any semblance of riba’ or excessive charges, thereby upholding the broader objectives of Islamic finance.

The Concept Of Maṣlaḥah And Its Validity According To Muslim Jurists

Maṣlaḥah is recognized by Islamic jurists as one of the secondary sources of Islamic law. As a principle, maṣlaḥah reflects the dynamic capacity of Islamic law to accommodate societal needs and human development, thereby reinforcing its relevance and adaptability in the modern Islamic jurisprudence. The principle of maṣlaḥah can also be seen in the concept of Maqasid al-Shariah. In general, Maqasid al-Shariah is a combination of two Arabic words, which are maqasid, which means objectives or purpose, and al-Shariah, which can be defined as Islamic laws. Maṣlaḥah, which means public interest, is one of the core principles in Maqasid al-Shariah, and it reflects the essential elements of human life, including the exercise of one’s livelihood and the development of emotional and intellectual qualities that are needed to live an effective life.(Ishak, M. S. I., & Asni, F. 2020).

Many texts of the Qurʾan and the Sunnah impliedly point to the element of maṣlaḥah is the purpose of Islam. One example is related to the case of mercy: “And we have not sent you, (O Muhammad), except as a mercy for all creatures” (Qurʾan, 21:107). Another example is about avoiding difficulties: “Allah does not wish to place you in difficulty but, rather, to purify you and complete His favor to you” (Qurʾan, 5:6). At the same time, several rules hold an additional maṣlaḥah, such as the rule of qisos (proportional retribution): “Fair retribution saves life for you” (Qurʾan, 2:179). Furthermore, looking at the practices of the rightly guided caliphs, the first four successors of Prophet Muhammad (PBUH), it is noted that most of their policies were based on maṣlaḥah. These included compiling the Qurʾan as a single book, banning interfaith marriage, selling any lost camel, imposing a fine on craftsmen for the loss or damage to customers’ property, and many more.( Ishak, M. S. I. 2019).

While maṣlaḥah had been practiced since the time of the Prophet Muhammad (PBUH), his companions and the early generations, its theory was only systematically written about between the fifteenth and eighteenth centuries. The discussion has been expanded to cover the parameters of maṣlaḥah, dealing with possible clashes between various masalih (plural of maṣlaḥah), the issue of hiyal (legal stratagems), and the application of maṣlaḥah in Islamic jurisprudence. The main purpose of Islamic law is to realize maṣlaḥah for human life; it can be said that the establishment of Islamic law is closely related to the dynamics of maslahat that develops in society. The revolve of Islamic law, which always follows the events that occurred during the revelation, all are the signs which clearly show that the changes of law follow the alteration of the existing problems (Renie, E., Luth, T., & Hamidah, S., 2019).

In general, maṣlaḥah are divided into three types, namely: (Asni, F., Ishak, M. S. I., & Noor, A. M., 2024).

1. Masalahah al Mu ‘tabarah, are maṣlaḥah calculated by syara’, because there are instructions from syara’ both directly and indirectly, where the clue to the existence of this maṣlaḥah is the reason for establishing the law.
2. Maslahah AI-Mulghah, or rejected maslahah. It is maṣlaḥah that is considered good by reason, but it is not considered by syara’, and there are syara’ instructions that reject it. Here, the reason is considered a good thing, which is in line with what is demanded by the problem.
3. Maslahah Mursalah, or called istislah, is what is deemed good by reason, in line with the purpose of the law of Sharia, but no guidance calculates and rejects it to establish the law.

As the sources of maṣlaḥah mutabarah and maṣlaḥah mulghah came from the Quranic texts and the Sunnah, there is no argument from Muslim jurists to be used as a legal reference because they do so indirectly. However, maṣlaḥah mursalah is still argued among Muslim jurists, and the position of maṣlaḥah mursalah as a method of determining Islamic legal ruling has become a lengthy polemic among the classical ulama. Most of the Muslim jurists from the Hanafi, Maliki, and Hanbali schools of law accepted maṣlaḥah mursalah as a method of determining Islamic legal rulings in fiqh literature and in issuing fatwa. These scholars concluded that, based on the instructions in both the Qur’an and the Sunnah, Islamic Shariah aims to bring benefit and needs to mankind. These needs evolve, making it impossible for them to be detailed in the Qur’an as well as in the Sunna. Thus, scholars agreed that, as long as it does not bring conflicts with the Qur’an as well as the Sunnah, maṣlaḥah mursalah poses valid evidence.

Lastly, maṣlaḥah must be general: it should prevent harm or give benefits to the people as a whole and not to a certain specific person or group of persons. Due to this, legislating a rule based on maṣlaḥah must include the benefit of the majority of people. This is because the whole concept of maṣlaḥah is meant to ensure the well-being of the people at large. Finally, the maṣlaḥah must not be against the principle or value which is upheld by the Quran, Sunnah, or Ijma’.

Application Of Maṣlaḥah In Islamic Banking And Finance

General application of maṣlaḥah beyond taʿwidh and gharāmah

New developments in Islamic economics and finance create a need for clear legal Islamic rulings on how to apply the new ideas and products. This was especially challenging because there were no existing Shariah texts that directly addressed these novel situations. Therefore, determining maṣlaḥah mursalah became a vital alternative for establishing Islamic law on Islamic finance. As Islamic finance is an active financial market, Muslim jurists should practice ijtihad to ensure that the products are Shariah-compliant and not inconsistent with the principles provided in the Quran and the Sunnah by looking at the secondary sources of Shariah such as maṣlaḥah, ʿurf, and others.

There are situations where maṣlaḥah is applied. Firstly, establishment of Islamic Capital Markets: Maṣlaḥah applied in developing investment policies for Islamic capital markets that benefit society generally. This includes the establishment of Shariah-compliant stock and index screening methods, even though interpretations may vary among scholars due to the complex nature of modern capital markets. Secondly, the renewal in Mudarabah Transactions, whereby in mudarabah (profit-sharing) financing, Islamic banks require additional collateral to mitigate risks associated with non-performing financing. This practice is justified by maṣlaḥah to protect the bank’s funds and maintain customer trust, ensuring the stability of financial intermediation. Thirdly, Zakat Financing, which is proposed as a means to enhance zakat distribution and benefits, despite disputes among Shariah scholars. Modern scholars support its permissibility based on maṣlaḥah and hajah, arguing that it provides a benefit similar to utilizing other aspects of zakat items, and can help entrepreneurs repay financial obligations. It is seen as an alternative to microloans, which involve riba.

Application of maṣlaḥah on taʿwidh and gharāmah

In general, Islamic banks cannot charge interest on late payments as it constitutes riba and is hence prohibited in Islamic law. However, delays in repayments by the customers cause operational costs and risks. To protect the banks and depositors, taʿwidh, which is late payment penalties based on actual loss, and gharāmah, which is a penalty donated to charity, are allowed under the principle of maṣlaḥah.

Practical Challenges And Criticisms

A critical issue emerges in the practical application of ta’widh. Critics argue that the standardized 1% rate often charged by banks may not represent a genuine “actual loss” but rather an “opportunity cost” (Noor & Haron, 2016). Operational costs like sending reminders are often pre-existing overheads already priced into the financing product, questioning the “additional expenditure” justification provided by the SAC (Muneeza et al., 2019). Furthermore, Malaysian case law, such as MK Associates Sdn Bhd v. Bank Islam Malaysia Bhd [2015] 6 CLJ 97 and Maybank Islamic Berhad vs M-10 Builders Sdn Bhd [2015] 4 CLJ 526, has established that banks cannot claim ta’widh as an absolute right. Courts have ruled against banks that failed to provide customers with clear notice of these charges in the agreement or upon default, emphasizing principles of fairness and transparency (Kunhibava, 2016).

While riba’ is prohibited, late payment charges are permitted under the principle of maṣlaḥah to protect banks and their fund. This is because Islamic banks act as intermediaries, channeling funds from surplus units (depositors, investors) to deficit units (businesses, individuals). Without late payment penalties, banks face risks to their operations due to their reliance on these funds and incur higher expenses from delayed payments. To address this, various Islamic bodies allow late payment charges: the International Islamic Fiqh Academy (IIFA) permits ta’widh (compensation based on actual loss), which must not be treated as profit, while the Accounting and Auditing Organization for Islamic Financial Institutions (AAOFI) allows charging debtors for incurred expenses and also permits gharamah for delayed payments.

Late Payment Issues In Islamic Finance

Technically, there are two types of charges in Islamic banking that are imposed on customers who are late to repay the financing according to the jointly defined period, which are ta’widh and gharamah.

Concept and juristic views on taʿwīdh (compensation)

Taʿwīdh originates from the Arabic word ʿiwad, meaning “change” or “replacement.” It refers to compensating for something that has been taken or for harm caused. In the context of Islamic finance, taʿwīdh is understood as a form of agreed-upon compensation or a fine that a creditor (the bank) can claim from a debtor (the customer) when the debtor fails or delays in fulfilling their obligation to repay a loan. It serves as a form of property damages for financial harm caused by the debtor’s non-performance. Generally, Islam prohibits usury and legitimates buying and selling transactions. So, any additional form of repayment of the loan is considered usury. While generally, the Qurʾan (3:130) considers late payment charges as riba, eliminating these penalties in modern Islamic banking could negatively impact banks. Delays by customers lead to additional expenses for banks, like administrative and legal fees. Since Islamic banks act as financial intermediaries, customer defaults or late payments also affect the bank’s liabilities, including their deposit customers.

Supporting the allowance of late payment penalties, Islamic scholars argue that such penalties are permissible to compensate creditors for losses incurred due to delayed repayments. There are four key justifications for this stance:

1. Preventing Harm to Creditors: When a debtor withholds loan or financing payments without a valid reason, it directly harms the creditor. Such a debtor is deemed unjust and, therefore, is liable for all incurred losses.
2. Addressing Unlawful Appropriation (Ghasb): Unexcused late payments can be seen as an unlawful appropriation of property benefits, which falls under the category of ghasb (usurpation or wrongful taking of another’s property).
3. Necessity of Financial Compensation: The most effective, and often only, method to compensate for and mitigate damages resulting from payment delays is through financial compensation.
4. Targeting Capable Debtors and Deterrence: Late payment penalties are specifically aimed at debtors who have the financial means to pay but deliberately delay.

Therefore, this penalty is crucial for deterring debtors from intentionally delaying repayments. Simultaneously, by not charging a fee to those who pay promptly, it ensures fairness to obedient debtors. These penalties serve to restore justice and prevent financial detriment to creditors, while also encouraging timely repayment from those who are able.

Some Islamic legal scholars hold a different view on this matter. They argue that any penalty fees collected from late payments should not be considered income for the creditor or financier. Instead, these funds should be channeled to charity. This approach aims to prevent the penalty from inadvertently becoming riba (usury), which would occur if the bank profited directly from the delay.

In practice, many Islamic financial institutions maintain a dedicated charitable account for this exact purpose. By directing these fees to charity, the concern of the money accruing as riba is effectively resolved, ensuring the penalty remains Shariah compliant. The application of the maṣlaḥah in Islamic finance justifies the imposition of taʿwiḍh as a means to protect the interests of both banks and customers. Maṣlaḥah, which focuses on promoting public benefit and preventing harm, allows for flexibility in economic matters where direct textual evidence may not exist. This approach supports the idea that ta’widh is necessary to maintain fairness and prevent losses caused by delayed payments, thus safeguarding the financial stability of banks and ensuring justice for all parties involved.(Yaakub, E. et.al 2014).

Ta’widh is also distinguished from riba’ in which it serves as compensation for actual losses incurred by the creditor due to delayed payment, rather than an agreed-upon increase on the principal amount. Riba involves money-for-money transactions with an increment, which is forbidden in Islam, while ta’widh involves money exchanged for goods or services and is imposed only to cover harm caused by delay. Therefore, ta’widh acts as an alternative to usury, aiming to eliminate greater harm and uphold the Islamic legal maxim that “harm must be eliminated”.  The Prophet Muhammad’s statement that “Delay by a rich person (in payment of debt) is tyranny” further supports the need for such measures to uphold justice in financial dealings.

In summary, the maṣlaḥah approach justifies the imposition of ta’widh in Islamic banking as a necessary, just, and non-usurious means to prevent harm and maintain fairness between banks and customers in the context of late payment charges.

Concept and juristic views on gharāmah (penalty)

While ta’widh can be recognised as the bank’s income, gharāmah needs to be channelled to charitable organizations. Gharāmah is a penalty designed to prevent moral hazard, ensuring people take their financial obligations seriously. If defaulters only faced a court-ordered ta’widh (compensation for actual costs), customers might become more negligent with repayments, harming Islamic banks, their shareholders, and depositors. Gharāmah serves as a public lesson on fulfilling obligations, aligning with Islamic banking’s role as a da’wah (invitation to Islam) and educational institution that promotes good morals, discipline, and timely debt repayment (Abdullah, A. 2018).

In Malaysia, any funds collected from gharāmah must be directed to a third-party charity organization completely independent of the bank. This practice goes beyond simply affirming the Islamic bank’s role as a financial intermediary. It also highlights its commitment to safeguarding the interests of all market participants, fostering social harmony, upholding ethical standards, and fulfilling social commitments. These aspects are all in line with the overarching objectives of Shariah, known as Maqasid Shariah.

Gharāmah means Khasara (loss). However, when it is used with Mal (wealth), it means an obligation to pay something compulsory. Technically, Gharamah is interpreted as a “penalty imposed by the State because of an illegal act which requires the imposition of a financial penalty”. Gharamah is also referred to as a form of fine imposed on an individual for doing something illegal. It is not explicitly prescribed in Shari’ah, but is a fine for something done contrary to the country’s law or inconsistent with local customs. The fine can be either in the form of money or goods. Technically, Gharamah can be defined as a penalty/charge imposed on customers who delay in debt financing or debt settlement over and above the amount of Tawid (Hassan, R., Ali, J., & Noor, F. M., 2022).

From a Shariah perspective, Taʿwīdh and Gharamah serve distinct purposes as tools for debtor punishment or creditor compensation. Gharamah differs significantly from Taʿwīdh in several ways: it’s not limited to repayment delays but can be imposed for various offenses, and crucially, only the state has the authority to levy it, not individuals. Furthermore, Gharamah can manifest in various forms, including verbal reprimands, physical punishment, imprisonment, or monetary fines. It is exclusively applied to those who commit an offense, such as a debtor intentionally refusing or delaying payment. Critically, the proceeds from Gharamah must be directed to the Bayt al-Mal (public treasury) for public benefit, explicitly prohibiting the creditor from receiving any portion of these funds.

The justification for allowing compensation and penalties in Islamic finance stems from a well-known Hadith of Prophet Muhammad (PBUH), which states: “Delay by a solvent or rich person (in payment of debt) is a tyranny” (Sahih Al-Bukhari, Hadith no. 486). This Hadith, as narrated by al-Bukhari, unequivocally condemns the act of a financially capable individual deliberately delaying debt repayment, labeling it as an act of oppression or tyranny. While the Hadith itself does not specify a particular form of punishment, it intrinsically suggests that the authorities have the right to impose a penalty on such individuals. This principle is further supported by the Quranic verse: “And those who have wronged will be afflicted by the evil punishment of what they earned” (Al-Quran 39:51), which reinforces the concept of accountability and consequences for wrongful actions, including financial delinquency by those who can pay.

Some Islamic scholars interpret the Hadith, “The delay in paying debt by the rich who has money makes dishonouring and punishing him permissible” (Sahih al-Bukhari) as not advocating for financial penalties. Instead, they argue that any punishment should be determined by a judge, rather than through a pre-agreed arrangement between parties. Furthermore, they contend that any imposed fine or penalty should be paid to the government. However, this interpretation faces practical challenges within the context of modern governance and the operational realities of contemporary commerce and Islamic banking. Implementing such a system would likely prove impracticable due to the complexities of involving judicial processes for every delayed payment and the logistics of channeling fines to government entities in a timely and efficient manner.

Malaysian Legal And Regulatory Position On Taʿwīdh And Gharāmah

Relevant laws and regulations

In Malaysia, the SAC has addressed the issue of late payment charges for Islamic banks by introducing the concept of taʿwidh, which allows Islamic banks to levy a charge on defaulting customers, but with strict conditions to ensure it aligns with Islamic principles and avoids riba. Specifically, three crucial conditions must be met:

1. Limited to Actual Loss: The amount of the taʿwidh charge cannot exceed the actual financial loss incurred by the Islamic bank due to the late payment. This means the bank can only recover direct costs associated with the default, such as administrative expenses for sending reminders or legal fees if the case escalates. It explicitly prohibits charging a penalty that generates profit for the bank.
2. Central Bank Determination: The exact amount or methodology for determining this compensation must be decided and approved by the central bank, Bank Negara Malaysia (BNM). This ensures standardization, fairness, and adherence to regulatory guidelines across all Islamic financial institutions. It prevents individual banks from unilaterally imposing arbitrary charges.
3. Applicability to Able Defaulters: The late payment charge can only be applied to customers who have the financial capacity to make their payments but intentionally delay or default. This condition aims to differentiate between those who genuinely face financial hardship and those who are simply negligent or opportunistic. Islamic finance emphasizes leniency and support for those in genuine difficulty, while discouraging deliberate non-compliance.

These conditions, set by the SAC and documented by BNM, aim to strike a balance: allowing Islamic banks to mitigate losses from defaults while ensuring the charges remain shariah-compliant and do not resemble interest-based penalties.

According to the guidelines, the banks are allowed to impose either ta’wid alone or a combination of ta’wid and gharamah. Regarding how these funds are handled, taʿwīdh, being compensation for actual losses, is recognized as bank earnings and is therefore part of the profit distributed to depositors and shareholders.

However, if a combined rate (including both taʿwidh and gharamah) is applied, banks can only retain the taʿwīdh portion as income. The gharamah portion, conversely, cannot be treated as bank earnings; it must be channeled to charitable organizations approved by the bank’s Shariah Committee. To ensure proper oversight, guidelines mandate that banks maintain separate accounts for gharamah and taʿwīdh. This separation facilitates transparent monitoring of gharamah funds’ source and their distribution to charities. Given that gharamah closely resembles the prohibited riba, banks are required to be extremely meticulous in their administration. Banks must never be perceived, directly or indirectly, as benefiting from the management or distribution of gharamah funds.

In the case of Pan Northern Air Services Sdn Bhd v Maybank Islamic Bhd,[2020] MLJU 2206 (CA). The Court of Appeal discussed several issues concerning the ta’widh rate chargeable and reference to the SAC of BNM in relation to disputes concerning an Islamic financing facility. In this case, the Appellant (customer) who secured Islamic financing through several Al-Bai’ Bithaman Ajil agreements challenged their bank over the Ta’widh rates charged after a contract dispute was resolved. The bank demanded a RM42 million settlement, offering a RM1 million ta’widh waiver for early payment, which the customer paid “without prejudice.” Disputing both the rate and calculation of the ta’widh, the customer sued to recover alleged overpayments. However, the High Court dismissed the claim, ruling that the bank’s ta’widh rate and calculation were valid. In the Court of Appeal, when the Court decided the ta’widh rate, it examined the BBA Facility Agreements between the Customer and the Bank. These agreements stated that if installment payments were defaulted, the agreed Ta’widh rate was 1% per annum. The Court also noted that the Bank could change this rate at its discretion or based on advice from Bank Negara Malaysia (BNM), provided the Customer received written notification. The appeal by the Customer was allowed.

Role of the Shariah Advisory Council

The SAC has progressively refined its stance on the application of taʿwīdh for delayed payments in Islamic finance. It was resolved that taʿwīdh payments are permissible under two specific conditions: (i) for arrears, and (ii) for failure to pay after the due date. This ruling specifically applies to Islamic financing structures based on ʿuqūd muʿāwaḍāt (exchange contracts), which include Islamic debt securities. A critical condition for imposing taʿwīdh is the establishment of mumāthil, indicating a deliberate delay in payment by the issuer regarding the settlement of principal or profit.

Regarding the calculation of taʿwīdh, distinct rates apply to profit and principal arrears:

1. For late payment of profit, the taʿwīdh rate is set at one percent per annum of the arrears, and importantly, this amount cannot be compounded.
2. For failure to settle the principal payment, the taʿwīdh rate is determined by the current market rate in the Islamic interbank money market, and similarly, it cannot be compounded.
3. These resolutions underscore the SAC’s efforts to balance the need for compensation for deliberate payment delays with adherence to Shariah principles, particularly the prohibition of riba

In 2010, SAC of Bank Negara Malaysia  had decided ta’widh may be imposed on late payment of financial obligation arising from buy and sell and hire purchase and loan. Nevertheless, ta’widh may only be imposed upon the lapse of the repayment period agreed by both contracting parties. The amount of ta’widh received may be recognised as income by the seller/financier/creditor on the basis that it is imposed as compensation for actual loss incurred by the seller/financier/creditor. The rate of ta’widh shall be determined by the authority which is Bank Negara Malaysia.

Bank Negara Malaysia’s guidelines and practices

In Malaysia, Bank Negara Malaysia (BNM) plays a crucial role as a third-party regulator for the Islamic banking system. As the central bank, BNM ensures that Islamic banks comply with Shariah principles across their operations, from product development to processing and internal systems. BNM is also the authoritative body that sets the actual loss rate for calculating ta’widh. This rate is determined using the daily overnight Islamic Interbank Rate, which is published on the Islamic Interbank Money Market website. The calculation for ta’widh is based on the verdict date and is computed monthly using a daily balance method. In Malaysia, Islamic banks are prohibited from using proceeds from Gharamah. These funds must be held in a separate Gharamah account, distinct from taʿwīdh funds, to ensure proper oversight and administration. The SAC has authorized the Shariah Committees of Islamic banks to designate suitable charitable organizations or institutions, including the Islamic Treasury (Bayt al-Mal), as recipients for Gharamah proceeds. This measure serves as a safeguard, ensuring that Islamic banks do not derive any direct financial benefit from Gharamah collections. Furthermore, all institutions under BNM’s jurisdiction are required to submit regular Gharamah distribution reports.

While taʿwīdh is meant to compensate for actual losses and is considered bank income, Gharamah is a penalty that cannot be kept by Islamic banks; it must be channeled to approved charitable organizations to avoid resembling riba. This requires banks to maintain separate accounts for each and exercise extreme meticulousness in managing Gharamah to ensure no direct financial benefit is derived, given its close resemblance to prohibited interest. However, the exact determination of “actual loss” for Taʿwīdh remains a point of contention among scholars, especially when BNM’s standardized rate includes opportunity cost, leading to proposals for alternative methods like charging only direct costs or using a split-rate financing model with a rebate.

Current practice of Malaysian Islamic banks

The following table summarises the current practices of selected Malaysian Islamic banks regarding the imposition of taʿwīḍ (compensation) for late payment in financing facilities. These practices reflect the application of Shariah principles within the regulatory framework set by the Shariah Advisory Council (SAC) of Bank Negara Malaysia (BNM).

Table 1: Current Practices of Malaysian Islamic Banks on Taʿwīḍ Rate

This table delineates the operationalization of taʿwīḍ (compensation) charges across a selection of Malaysian Islamic financial institutions, revealing a regulatory alignment tempered by institution-specific procedural nuances. A standardized rate of 1% per annum on overdue instalments is universally adopted, in accordance with the cap prescribed by Bank Negara Malaysia (BNM). However, divergence emerges in the temporal application of these charges. For example, while Islamic Bank 1 employs a bifurcated approach—applying the fixed rate pre-maturity and transitioning to a variable rate pegged to the Islamic Interbank Money Market (IIMM) rate thereafter—other institutions exhibit less granularity in their policy disclosures. Furthermore, certain banks, such as Islamic Bank Berhad 3, explicitly extend the application of taʿwīḍ to post-judgment scenarios, subject to stipulated minimum and maximum thresholds. Common across all institutions is the conditional nature of the rate, which remains subject to variation by BNM directive and may be offset by ibrā’ (rebates) at the bank’s discretion. The observed variations in the specification of periods and enforcement conditions underscore the interplay between centralized regulatory compliance and the discretionary latitude afforded to individual institutions within the Shariah governance framework.

Challenges In Implementation

A central challenge in the Malaysian model is the widespread reluctance of Islamic banks to implement gharamah, despite its regulatory permission. This avoidance is primarily due to its perceived resemblance to riba and the administrative complexity of managing separate charitable accounts. Consequently, the industry relies de facto on ta’widh, which presents its own set of complications. The core issue is the inherent difficulty in proving actual loss, as banks struggle to distinguish genuine, additional costs incurred from a specific default from their standard, pre-priced operational overheads (Muneeza et al., 2019).

This challenge is compounded by the regulatory response. To circumvent the problem of quantifying loss, Bank Negara Malaysia (BNM) has standardized the ta’widh rate at 1% per annum. While this fixed rate upholds maṣlaḥa by preventing riba and avoiding customer exploitation, it creates a practical dilemma. The 1% cap may not cover the true extent of a bank’s losses, particularly significant opportunity costs or administrative burdens, thereby falling short of the Shariah objective (maqāṣid al-sharīʿah) of effective harm mitigation (dafʿ al-ḍarar).

Therefore, a critical tension exists between regulatory practicality and Shariah principles(Muhammad Shahrul Ifwat Ishak 2019). Treating the collected ta’widh as bank income risks conflating restitution with profit, raising serious questions about Shariah compliance. To resolve this, it is necessary to develop more precise mechanisms for determining actual loss. Achieving this alignment between regulatory practice and the maqāṣid al-sharīʿah is essential for enhancing the integrity and social justice foundation of Islamic finance in Malaysia.

CONCLUSION AND RECOMMENDATIONS

In conclusion, prioritising maṣlaḥah (public interest) through the standardisation of the taʿwīḍ rate remains essential for the long-term viability and credibility of the Islamic banking industry in Malaysia. While Bank Negara Malaysia (BNM) currently allows taʿwīḍ to be recognised as income by Islamic financial institutions, such practice warrants scrutiny. Islamic banks should exercise prudence by recognising only the portion of taʿwīḍ that reflects actual loss as income, while channeling any excess to charitable organisations.

Furthermore, to truly embody the maqāṣid al-sharīʿah, Islamic financial institutions must improve their assessment of customer default. A clear yardstick is needed to distinguish between negligent delinquent debtors and those in genuine financial hardship). For the latter, rather than imposing penalties, banks should consider exploring Shariah-compliant restructuring (Muneeza et al., 2019).

Moving beyond penalties, it is recommended that Islamic banks develop more innovative, forward-looking risk mitigation techniques rooted in Islamic finance principles. This includes enhancing the use of collateral (rahn), third-party guarantees (kafalah), thorough credit profiling, and risk-based pricing that incorporates potential default risks at the outset of the contract. Ultimately, a holistic and principled approach to taʿwīḍ rooted in transparency, fairness, and maṣlaḥah will not only strengthen Shariah compliance but also promote financial responsibility, social justice, and trust in Islamic banking institutions.

ACKNOWLEDGEMENT

The authors would like to thank the Centre for International Law and Siyar, Faculty of Law, Universiti Kebangsaan Malaysia, for the academic support and resources provided throughout the research process. Special thanks are also extended to colleagues and reviewers who offered constructive feedback that improved the quality of this paper. This research was supported by GUP 024-2023, funded by Universiti Kebangsaan Malaysia.

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