FINANCIAL SYSTEM AND PRODUCTS

PRESENTATION: SECURITY ANALYSIS & PORTFOLIO

MANAGEMENT

TOPIC: ISLAMIC FINANCIAL SYSTEM AND PRODUCTS

CLASS – BBA(25)

AHMAD ALI 3499-FMS-BBA-S12

PRINCIPALES OF ISLAMIC FINANCIAL SYSTEM

Prohibition of Interest (RIBA)“An excess” Any unjustifiable increase of capital whether are loans or sales

in the central tenant of the system.

Islamic regulations encourage the earning of profit but forbid the charging

of interest.

Money as a potential capitalIt joins hands with other resources to undertake a productive activity.

Risk sharingWhen interest is prohibited, suppliers of fund become investors instead of

creditors.

Investors & financial intermediary relationship is based on profit & loss

sharing principals.

Prohibition of speculative behavior

Discouraging hoarding & prohibits transacting featuring extreme

uncertainties.

Sanctity of contracts

Upholding contractual obligations & the disclosure as a sacred duty to reduce

the risk of asymmetric information & moral hazard.

Sharing-approved activities

Only activities that don’t violate the rules of shariah qualify for investment.

Any business Dealing with alcohol, gambling or casinos is prohibited.

Social justice

In Principle , any transaction leads to injustice & exploitation is prohibited.

The concept of Shirkah & Musharakah

Terminology & Definition of Musharakah

“Musharakah ” means “Sharing” and in the terminology of Islamic Fiqh.

The word Musharakah has been derived from “Shirkah” which means

being a partner

Musharakah is basically a kind of partnership in which the partners join

together with different contributions, work or obligation for the common

objective of undertaking business and trade in accordance with the

principles of Shariah.

It is an ideal alternative for the interest based financing with far reaching

effects on the economy

Contract of Musharakah

The contract of Musharakah can take place between two or more persons

with the capital contributed by the partners/shareholders and the profit to

be distributed among them according to the rates agreed upon by the

shareholders.

SHIRKAH

SHIRKAT-UL-MILK SHIRKAT-UL-AQD

SHIRKAT-UL-WUJOOH

GAIR IKHTIARIIKHTIARI

SHIRKAT-UL-AAMAL

SHIRKAT-UL-AMWAL

Types of Musharakah

Rules of Musharakah

Musharakah means relationship established under a contract by the

mutual consent of the parties for sharing of profits and losses,arising

from a joint enterprise or venture.

Investments come from all partners / shareholders hereinafter

referred to as partners.

Profits shall be distributed in the proportion mutually agreed in the

contract.

The existence of Muta’aqideen(Partners):

Capability of Partners:

Must be sane & mature and be able of entering into a contract.

The contract must take place with free consent of the parties without

any fraud or misrepresentation.

Management of Musharakah

• Each partner has a right to take part in Musharakah

management.

• The partners may appoint a managing partner by mutual consent

• One or more of the partners may decide not to work for the Musharakah

and work as a sleeping partner.

• If one or more partners choose to become non-working or silent partners.

The ratio of their profit cannot exceed the ratio which their capital investment

bears so the total capital investment in Musharakah.

Asset of Musharakah

All assets of Musharakah are jointly owned in proportion to the capital of

each partner.

Rules of Musharakah

Rules of MusharakahCapital of Musharakah

All partners must contribute their capital in terms of money or species at an agreed

valuation.

Share capital in a Musharakah can be contributed either in cash or in the form of

commodities. In the latter case, the market value of the commodities shall determine

the share of the partner in the capital.

Distribution of Profit

• The ratio of profit distribution must be agreed at the time

of execution of the contract

• The ratio must be determined as a proportion of the actual

profit earned by the enterprise

- Not as percentage of partner’s investment

- Not in lump sum amount

• A sleeping partner cannot share the profit more than the percentage of his capital.

Profit Distribution

ILLUSTRATION

If A and B enter into a partnership and it is agreed between them that A

shall be given Rs. 10,000/- per month as his share in the profit, and the

rest will go to B, the partnership is invalid.

Similarly, if it is agreed between them that A will get 15% of his investment,

the contract is not valid.

The correct basis for distribution would be an agreed percentages of the

actual profit accrued to the business.

OBSERVATIONS

Profit Distribution

If a lump sum amount or a certain percentage of the investment has been agreed for any one of the partners, it must be expressly mentioned in the agreement that it will be subject to the final settlement at the end of the term, meaning thereby that any amount so drawn by any partner shall be treated as on account payment and will be adjusted to the actual profit he may deserve at the end of the term.

But if no profit is actually earned or is less than anticipated, the amount drawn by the partner shall have to be returned.

Rules for Loss

In the case of a loss, all the Muslim jurists are unanimous on the point that each partner shall suffer the loss exactly according to the ratio of investment.

There is a complete consensus of jurists on this principle.

Profit is based on the agreement of the parties, but loss is always subject to the ratio of investment.

Rules of Musharakah

Application

Musharakah can be successfully used to in the following areas:

• Project financing

• Working capital financing

• Import Financing

• Export Financing

• Running finance

• Saving/Deposit account

• Certificates of Investments

• Term finance certificates

• Inter bank financing

THE PROJECT

PARTNER BANK

1

Share in Capital Share in Capital

2

3

Accruing Profits

Share of profits

• In the case of project

financing, the

traditional method of

Musharaka can be

easily adopted.

Project Financing

Export Financing (Al Baraka Islamic

Bank)

Meezan Bank Musharaka

Product

Diminishing

Musharakah

In Diminishing Musharakah the financier and the client participate either in joint ownership of

a property or an equipment, or in a joint commercial enterprise

The share of the financier will be divided into a number of units

The client will purchase these units one by one periodically until he is the sole owner of the property

Diminishing Musharakah

Three components of Diminishing Musharaka

Joint ownership of the Bank and customer

Customer as a lessee uses the share of the

bank

Redemption of the share of the Bank by the

customer

Diminishing Musharakah

Mode of Fixed Asset Financing

Diminishing Musharakah is commonly used for the

purpose of financing of fixed assets by various Islamic

banks.

House financing

Car Financing

Plant and machinery financing

All other fixed Assets

Diminishing Musharakah

CUSTOMER

The Bank enters into a Musharakah (Joint

Ownership) agreement with the customer and

both of them pay their respective shares to the

seller of the asset.

Client promises to purchase Bank’s share (units)

over the tenure of transaction with the help of

Undertaking to Purchase

The customer approaches the Bank with the

request for Project/Machinery/House financing

BANK

Joint

Ownership

Musharaka

Rent

CUSTOMERBANK

Joint

Ownership

Musharaka

Gradual Transfer of Ownership

Client promises to purchase Bank’s share (units)

over the tenure of transaction with the help of

Undertaking to Purchase

Customer pays rent for the use of banks share

in the property

Client purchases the units every month via a

separate offer & acceptance every month and

will eventually become the owner of the

property.

CUSTOMER

Ownership of the asset is gradually transferred

to the customer upon payment of asset price.

(with the help of a Sale transaction between

bank & customer at the end of each period)

BANK

Joint

Ownership

Musharaka

Gradual Transfer of Ownership

• To create joint ownership in property is called Shirkat-ul-Milk and is expressly allowed by all schools of Islamic Jurisprudence.

• All Muslim Jurists agree on the permissibility of the Financier leasing his share in property to client and charging him rent i.e. the permissibility of leasing one’s share to his partner.

• There is difference of opinion among leasing one’s share to a third part But there is no difference on permissibility on leasing to a partner.

Shariah Principles

• Promise of client to purchase units of share of financier is also allowed.

• The Transactions cannot be combined in a single arrangementsand they have to be executed independently.

• This is because it is a well settled rule of Islamic Jurisprudencethat one transaction cannot be made a condition for another.

• Instead of making the transactions a pre-condition for one another there can be one-sided promises from one party to another

Shariah Principles

1. Customer request financing for a fixed Asset costing Rs. 300 million.

2. Islamic Bank agrees to provide financing up to 90% of the cost.

3. Joint Ownership Agreement is executed between the bank and the Customer.

4. Bank will purchase 90% share in the asset by paying Rs. 270 million to supplier.

5. Customers pays its share of Rs. 30 million.

Diminishing Musharaka - Illustration

6. Bank’s share is divided into five units.

7. Customer agrees to buyout Bank’s share (units) on yearly basis and the Undertaking is executed by the customer.

8. Customer pays the rent for the usage of the Bank’s units .

9. Rental reduces after purchase of each unit by the customer.

10.After five years ownership of the asset is completely transferred to the customer.

Diminishg Musharaka- Illustration

PRODUCT - Meezan Bank Easy Home

Albarak Islamic Bank

Diminishing Musharaka Products

Mudarabah

This is a kind of partnership where one partner gives money to another for investing in a commercial enterprise.

The investment comes from the first partner who is called “Rabb-ul-Maal” (Investor)

The management and work is an exclusive responsibility of the other, who is called “Mudarib” (Working Partner)

Profit is shared as per agreed ratio

In case of Mudarbah all losses are borne by Rabbul- Mal

Mudarabah

1. Al Mudarabah Al Muqayyadah

(Restricted Mudarabah)

2. Al Mudarabah Al Mutlaqah

(Unrestricted Mudarabah)

Types of Mudarabah

1. Al Mudarabah Al Muqayyadah

(Restricted Mudarabah)

Rabb-ul-Maal may specify a particular business or a particular place for the mudarib.

In which case he shall invest the money in that particular business or place.

Types of Mudarabah

2. Al Mudarabah Al Mutlaqah

(Unrestricted Mudarabah)

Rabb-ul-maal gives full freedom to Mudarib to undertake whatever business he deems fit.

Mudarib is authorized to do anything normally done in the

course of business

Types of Mudarabah

Rabb-ul-Maal has authority to:

a) Oversee the Mudarib’s activities and

b) Work with Mudarib if the Mudarib consents.

Rabb-ul-Maal

The capital in Mudarabah may be either cash or in kind.

If the capital is in kind, its valuation is necessary, without which Mudarabah becomes void.

Capital of Mudarabah

It is necessary for the validity of Mudarabah that the parties agree, right at the beginning, on a definite proportion of the actual profit to which each one of them is entitled.

They can share the profit at any ratio they agree upon.

However in case the parties have entered into Mudarabah without mentioning the exact proportions of the profit, it will be presumed that they will share the profit in equal ratios.

Some incentives my be given to the Mudarib.

Profit & Loss Distribution

Apart from the agreed proportion of the profit, the Mudarib cannot claim any periodical salary or a fee or remuneration for the work done by him for the Mudarabah.

The Mudarib & Rabb-ul-Maal cannot allocate a lump sum amount of profit for any party nor can they determine the

share of any party at a specific rate tied up with the capital.

Profit & Loss Distribution

EXAMPLE

If the capital is Rs.100,000/-, they cannot agree on a condition that Rs.10,000 out of the profit shall be the share of the Mudarib nor can they say that 20% of the capital shall be given to Rab-ul-Maal. However they can agree that 40% of the actual profit shall go to the Mudarib and 60% to the Rab-ul-Maal or vice versa.

Profit & Loss Distribution

If the business has incurred loss in some transactions and has gained profit in some others, the profit shall be used to offset the loss at the first instance, then the remainder profit, if any, shall be distributed between the parties according to the agreed ratio.

Profit & Loss Distribution

Musharakah

In Musharaka both of the partners invest

Both parties can work

Mudarabah

In Mudarabah one party invest (Rabbul- Mal) and other party work (Mudarib)

Profit is shared as per agreed ratio

In case of Mudarbah all losses are borne by Rabbul- Mal

Diff b/w Musharakah & Mudarabah

Mudarabah

• Medium/long - term financing

Project financing

Import financing

For Saving/mahana amdani/investment accounts (deposit giving Profit based on Mudarabah – with predetermined ratio )

Certificate of Investment

Inter- Bank lending / borrowing

Application

Mudarabah in Banking

Deposits - The Bank as Mudarib

• Profit from the Mudaraba activity is shared between the Bank (as Mudarib) and the investment account holder (as Rabb-ul-maal) in a pre-agreed ratio

• The Bank does not bear any loss but remains responsible for negligence

• The Bank may receive from its investors compensation (Mudarib fees) in return for management of their funds

• The Bank is bound to return the capital to the investors after deducting any losses or Mudarib fees at the time of winding up the contract

Mudarabah in Banking

Investments - The Bank as the Rabb-ul-maal

• Profit from the Mudaraba activity is shared between the Bank (as Rabb-ul-maal) and the Mudarib in a pre-agreed ratio

• The Bank will bear all the loss unless the Mudarib violates the agreement

• The Bank will pay to the Mudarib, compensation (Mudarib fees) in return for management of its funds

• The Mudarib is bound to return the capital to the Bank after deducting any losses or Mudarib fees at the time winding up of the contract

PRODUCT – Meezan Bank Karobari Munafa Account

Al Baraka Islamic Bank Mudaraba Products

Meezan Bank Mudaraba Products

Murabaha

• Murabaha is a particular kind of sale and not afinancing in its origin.

• Where the transaction is done on a “cost plusprofit” basis i.e. the seller discloses the cost to thebuyer and adds a certain profit to it to arrive at the

final selling price.

Definition of Murabaha

• The distinguishing feature of Murabaha fromordinary sale is:

- The seller discloses the cost to the buyer.

- And a known profit is added.

Murabaha

Basic rules for Murabaha financing:

Asset to be sold must exist.

Sale price should be determined.

Sale must be unconditional.

Assets to be sold:a) Should not be used for un-Islamic purpose.b) Should be in ownership of the seller at the timeof sale; physical or constructive.

Murabaha

Step by step Murabaha Financing

1. Client and bank sign an agreement to enterinto Murabaha (MMFA).

Agreement to Murabaha

Bank Client

Murabaha

2. Client appointed as agent to purchase goodson bank’s behalf

Agency

Agreement

Agreement to Murabaha

Bank Client

Murabaha

3. Bank gives money to agent/supplier forpurchase of goods.

Disbursement to the agent or supplier

Agency

Agreement

Supplier

Agreement to Murabaha

Bank Client

Murabaha

4. The agent takes possession of goods on bank’sbehalf.

Transfer of RiskDelivery of goods Vendor

Bank Agent

Murabaha

5(a). Client makes an offer to purchase thegoods from bank through a declaration.

Offer to purchase

Bank Client

Murabaha

5(b). Bank accepts the offer and sale isconcluded.

Murabaha Agreement+

Transfer of Title

Bank Client

Murabaha

6. Client pays agreed price to bank according toan agreed schedule. Usually on a deferredpayment basis (Bai Muajjal)

Payment of PriceBank Client

Murabaha

Application of Murabaha

Purchase of raw material; for meeting

working capital needs of trade and industry.

Medium to long term requirements for

purchase of land, building and equipment.

Trade finance products including imports,

exports and bill purchase.

Applications of Murabaha

Meezan Bank Murabaha Products

Meezan Bank Murabaha Products

Ijarah

• Ijarah is a term of Islamic Fiqh

• Literally, it means “To give something on rent”

• The term “Ijarah” is used in two situations:

1. It means ‘To employ the services of a person on

wages’ e.g. “A” hires a porter at the airport to carry

his luggage

2. Another type of Ijarah relates to paying rent for use

of an asset or property defined as “LAND” in Islamic

Economics

Ijarah

• Ijarah is an Islamic alternative of Leasing.

• Leasing backed by an acceptable contract is an acceptable

transaction under Shariah.

• The question of whether or not the transaction of leasing

is Shariah compliant depends on the terms and conditions

of the contract.

• Several characteristics of conventional agreements may

not conform to Shariah thus making the transaction un-

Islamic and thereby invoking a prohibition.

Ijarah as a mode of financing

• Risk and rewards of ownership lies with the owner i.e. any

loss to the asset beyond the control of the lessee should be

borne by the Lessor.

• Late payment penalty cannot be charged to the income of

the Lessor.

• Lease and Sale agreement should be separate and non

contingent.

Ijarah-Key Difference

Process of Ijarah

CUSTOMER

MECHANICS

ISLAMIC BANK

The Bank makes payment to the vendor

The Bank purchases the item required for leasing and receives title of ownership from the vendor

The customer approaches the Bank with the request for financing and enters into a promise to lease agreement.

VENDOR

. .Agreement-1

Ijarah

CUSTOMER

MECHANICS

ISLAMIC BANK

The customer makes periodic rental payments as per the contract

The Bank leases the asset to the customer after execution of lease agreement.

VENDOR

At the end of the tenure customer can purchase the asset from the bank with the help of separate Sale agreement.

. .Agreement-2

Ijarah as a mode of financing

Rules governing Ijarah

• Rules governing Ijarah are similar to the rules

governing sale.

• Because in both cases something is transferred from

one person to another

The only difference is:

• In case of sale, title of property is transferred to Buyer

• In case of Ijarah, title remain with the Lessor

• Only the use of the property is transferred to Lessee

Ijarah

Difference b/w Conventional Lease & Ijarah

1. In conventional lease the Lessor has the unilateral right to rescind the lease contract at his sole discretion, which is against the laws of Shariah,

2. Expenses under Ijarah are as follows:

• Lessor- expenses relating to the corpus of the asset i.e. insurance, accidental repairs etc. will be borne by the lessor

• Lessee- actual operating/overhead expenses related to running the asset will be borne by the lessee

Ijarah

Difference b/w Conventional Lease & Ijarah

3. Two contracts into one contract is not permissible in Shariah therefore, we cannot have the agreement of hire and purchase into one agreement, only we can undertake/promise to purchase the leased asset.

4. In conventional lease the lease starts even before the existence of assets, which is also not permissible in Shariah.

5. Penalty income is charged for late payments in Conventional lease.

Ijarah

APPLICATION

Unique Selling Proposition

• Pakistan’s first truly Shariah-compliant Car

Financing Scheme.

• Available in tenures of 3, 4 and 5 years.

• Available for locally assembled as well as

Imported cars.

• Also available for Used Cars

• No application Fee

MEEZAN BANK Car Ijarah

Application of Ijarah

For long and medium term fixed asset financing

Project Financing,Expansion

Retail products (Car Ijarah)

Applications of Ijarah

MEZAAN Bank - Ijara Products

MEZAAN Bank - Ijara Products

ISTISNA’

Istisna’a is a contract of sale of specified items to be

manufactured (or constructed), with an obligation on the part of

the manufacturer (or contractor) to deliver them to the Customer

upon completion.

Istisna’a is the second exception to the rules of sale where a sale

is allowed without immediate delivery of the goods sold .

ISTISNA’

ISTISNA’

If complete specifications (such as type, kind, quality and quantity) of the

subject matter have been given to the manufacturer along with the

contract price, then the manufacturer is bound to manufacture the Asset

and cannot terminate the contract unilaterally.

The ultimate purchaser cannot be regarded as the owner of the

materials in the possession of the manufacturer for the purpose of

producing the subject matter.

ISTISNA’

The time of delivery of goods does not necessarily have to be fixed in

Istisna’a however, a maximum time may be agreed upon between the

parties.

The delivery of the subject matter may take place through constructive

possession. At this point, the liability of the manufacturer in respect of

the subject matter comes to an end and the liability of the ultimate

purchaser begins.

ISTISNA’

It is necessary for the validity of Istisna’a that the price is fixed with the

consent of the parties.

The Istisna’a price can either be paid in advance, or in installments or at

the time of delivery of goods.

The price of Istisna’a transactions may vary in accordance with

variations in the delivery date.

ISTISNA’

It is permissible to amend the contract price of an Istisna’a contract

upwards or downwards, as a result of intervening contingencies (Force

Majeure).

It is permissible if it is agreed between the parties that in the case of

delay in delivery, the price shall be reduced by a specified amount per

day.

ISTISNA’

Unlike Murabaha where only raw material can be financed, Istisna’a’ can

be easily utilized to facilitate payment of overheads etc. in addition to the

purchase of raw material.

It is also to be noted that amount paid out as Istisna’a’ price to the

manufacturer can be used by the manufacturer anywhere he deems fit. It

doesn’t have to be utilized exclusively for the production process.

ISTISNA’

Sale on Cash Basis

1. After necessary credit and Shariah Approvals, MBL (Meezan Bank Limited) &

Customer will enter into a Master Istisna Agreement to manufacture goods

from time to time at an agreed price.

2. MBL would then enter into an Istisna transaction with the Customer for the

production of specific Goods. At this time quantity, price, specification and

delivery date of Goods will be agreed. The delivery of goods could be lump sum

or in trenches.

3. MBL could pay the Istisna price to the Customer either in full or in installments.

4. After manufacturing, the Customer will inform MBL and will request for

acceptance of delivery. A Bank representative will accept the delivery after

physical inspection of the goods at the site. This delivery could be through

identification and separate storage of MBL goods (so that they are not mixed

with Customer’s own goods). A Goods Receiving Note will be executed at this

moment to evidence the delivery of goods to MBL.

Prdouct Structure for ISTISNA’

5. MBL will also enter into a separate Agency Agreement with the

Customer for sale of goods on Cash basis to credible buyers on behalf

of MBL in a specified number of days. In this manner the Agent will be

responsible for recovery of Sale price and its payment to MBL.

6. MBL’s ownership and risk in goods remains until the Agent sells these

goods to the Buyer in the market. Takaful may be obtained to cover this

risk.

7. MBL Agent will sell the goods in the market and will pay the price to

MBL.

8. The Agent (Manufacturer) will be entitled to a specified Agency Fee for

providing such services. MBL may also give a certain incentive to its

Agent for timely selling and payment to MBL.

Prdouct Structure for ISTISNA’

In case of Credit Sale

The customer (as Agent of MBL) will sell the goods to Credible Buyers

on Credit (instead of Cash) and collect the sale proceeds in a specified

number of days.

At the time of entering into Agency Agreement, the Customer may be

asked to provide a separate / independent Guarantee to guarantee

payment obligations of the potential buyers.

Prdouct Structure for ISTISNA’

Manufacturer

1. Istisna’a Agreement

MBL2. Delivery of Goods

3. Agency Agreement

Local Buyer

4. Sale of

Goods

6. Sale Proceeds (net of Agency Fee)

5. Sale

Proceeds

Prdouct Structure for ISTISNA’

The package comprises of the following:

1. Master Istisna’a Agreement

1. Agency Agreement

1. Corporate Guarantee

Legal Documentation

1. Master Istisna’a Agreement

This agreement sets out the terms & conditions upon which the

Bank, from time to time, orders the Customer to manufacture the

Goods

Components :

A. Written Offer for Manufacture of Goods:

Description of Goods including quantity, quality, delivery date,

cost price, place of delivery etc.

B. Goods Receiving Note:

Legal Documentation in ISTISNA’

2. Agency Agreement

The Bank appoints the manufacturer (customer) its Agent to sell the

manufactured goods.

Components :

A. Notice of Appointment

The Bank authorizes the Agent to sell the Assets as its

undisclosed Agent details of which are mentioned.

B. Schedule of Agency Fee

Legal Documentation in ISTISNA’

3. Corporate Guarantee

The Customer guarantees payment obligation of the ultimate

purchasers if they default to make payment on time

Legal Documentation in ISTISNA’

RISKS MITIGANTS

1 Delivery RiskDelay in delivery of goods from the

manufacturer to MBL at maturity

Istisna’a price can be reduced on

daily basis to penalize the

manufacturer

2Non-

performance

The Manufacturer may not be able

to manufacture the goods during

assigned time and refuses to carry

on the responsibility further.

MBL can terminate the Istisna

agreement and demand the price

back from the manufacturer.

Alternatively, the price may be paid

by MBL in installments after being

satisfied with the performance.

3 Quality Risk

The Manufacturer delivers

defected/inferior goods, which is

realized by MBL only when the

ultimate purchaser points out to

that.

The manufacturer can be asked to

rectify the defect.

Risk Mitigation

4

Increased cost

of

Manufacturing

Cost incurred by manufacturer

turns out to be higher than

anticipated earlier causing

manufacturer to default on

performance

Increased cost will be borne by

manufacturer unless caused by

some force majeure events in

which case Istisna price may be

increased with mutual consent.

RISKS MITIGANTS

5 Storage Risk

The goods once delivered by

Manufacturer will be at MBL's risk

before the same are sold to the

ultimate purchaser

This may be covered through

Takaful of the goods and by

minimizing the time duration

between acceptance of delivery

under Istisna and delivery to the

ultimate purchaser. The Agent is

asked to procure Takaful as part of

his services

Risk Mitigation

6

Default by

ultimate

Purchaser

The ultimate purchaser

refuses to make payment on

time or goes bankrupt.

The Customer (in its

independent capacity) may be

asked to provide Corporate

Guarantee to guarantee

payment obligations of ultimate

buyers.

RISKS MITIGANTS

Risk Mitigation

Bank Islami Istisna Product

Al Baraka Islamic Bank Istisna Product

Islamic Mode of Financing Proportion in Pakistan