Scope of Standard

An overview of AAOIFI Standard Number Four is presented. It should be noted only a summary and overview of the standard is presented, the full standard is available from AAOIFI.

The aim of this standard is to outline rules governing the use of set-off in settling debts, the Shari’a requirements and conditions applicable to set-off, what is permissible or not permissible in this procedure and the most significant practices of Islamic financial institutions (institution/institutions) in this regard.

This standard shall apply to the settlement of debt by way of set-off. The standard shall not apply to discharge of liability by way of transfer, solving of obligation, composition, acquisition of a right payable or bilateral cancellation of a contract.

This standard is issued on 29 Safar 1422 H, corresponding to 23 May 2001.

Definition of set-off and its various forms

A set-off is the discharge of a debt receivable against a debt payable. It is divided into two main forms: mandatory set-off and contractual set-off.

Mandatory set-off

A mandatory set-off is a set-off that occurs without the need for bilateral agreement or consent of both indebted parties and, in some cases of mandatory set-off, it is one party that is forced to comply with the request of the other party for set-off. It is divided into compulsory set-off (on both parties) and set-off on demand (of the person with the superior debt whereby the other party is obliged to comply with the demand).

Contractual set-off

A contractual set-off is the discharge of two debts by the consent of the two parties to extinguish their obligations towards each other.

Bilateral exchange of promises to conclude a set-off in the future

It is permissible for the institution and its customers or other institutions to exchange bilateral promises that debts that may be created between them in the future will be settled by way of set-off, in which case all the conditions mentioned in the items 2/1 and 2/2 will be applicable at the time of actual set-off. However, if the currencies of the two debts differ, a bilateral exchange of promise of set-off should be concluded on the basis that a set-off will take place based on the current currency exchange rate at the time of actual set-off; this ruling is to prevent the practices of riba by roundabout methods or by implied agreement for practicing riba.

Application of the rules of set-off to some modern transactions

The followings are some rules of set-off to modern transactions:

• A conditional set-off between the customer and the institution in respect of debts to the institution arising out of deferred sales such as a deferred Murabaha transaction, or an Ijarah contract. The agreement on contractual set-off of future debts, commonly known as set-off and consolidation, is a practice employed by a large number of financial institutions. This form of set-off may take place either compulsorily or contractually depending on whether the state that gives rise to this set-off meets the conditions of compulsory set-off or the conditions of contractual set-off. Moreover, a pre-agreed contract of set-off of this kind would make it possible for the parties to dispense with any fresh agreement at the time of set-off when the two currencies are different or the two debts are not equal.
• A set-off may take place between a financial institution accepting a cheque and the drawer of the cheque, through the clearing-house. This form of set-off may also take place either compulsorily or contractually depending on whether the state that gives rise to this set-off meets the conditions of compulsory set-off or the conditions of contractual set-off.
• Set-off that is concluded among financial institutions through international or national networking systems, such as credit card or debit card organisations. This form of set-off may be either compulsory or contractual depending on whether the state that gives rise to this set-off meets the conditions of compulsory set-off or the conditions of contractual set-off or the conditions of contractual set-off.

Currency Swaps

The currency swaps that are concluded on the basis of riba are not permissible. This is because in this process it is the interest-based securities that are set-off against, interest-based securities.