College of Business Administration Jazan University, KSA
Islamic Banking Course code : FIBA 387 6 th Level JAN 2013
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Prepared By Dr. Omer Ali Babiker Eltahir Assistant Professor
Finance & Banking Department Mr. Mohammed Yasin Lecturer
Finance & Banking Department Mrs. Amreen Lecturer Finance &
Banking Department
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Islamic Banking Course Code: FIBA 387 6 th Level - BBA Finance
& Banking Max.Marks : 100 Term End Exam : 50 Cont. Assessment :
50 COURSE CONTENTS Unit-I Islamic Banking: Historical Evolution and
Development, Why Islamic Finance? Riba and Gharar: Meaning and
Types. Principles of Islamic Banking: Riba (Interest) Free Banking
System; Profit-Loss Sharing. Governance in Islamic banking. The
Difference Between Islamic Banking and Conventional Banking.
Unit-II Wadea (Deposit) In Islamic Banking (Domestic Operations)
The Wadea: meaning, types, types of accounts, Operations and
journal entries. Teller(Treasury Section), Clearing House. Unit-III
Finance and Investment in the Islamic Banking (Domestic Operations)
Tools Of Finance And Investment (Permissible Financing Methods):
Musharakah (Joint Venture): Meaning, Types. Mudarabah
(Partnerships): Meaning. Murabahah (Cost-Plus Sales): Meaning,
Types. Ijarah(leasing) Investment In Fixed Assets: Meaning. Bai
Salam (Islamic forwards): Meaning. Bay be-Theman Ajel (Credit
sales) Meaning. Unit-IV ISSUES IN ISLAMIC BANKING Foreign
Operations: Letter of Credit (L/C); Letter of Guarantee ( L/G).
Final Accounts (Financial Statements: Income Statement, Balance
Sheet). Case study.
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Unit-I Islamic Banking
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INTRODUCTION The term Islamic banking refers to a banking
activity or a system of banking that is in consonance with the
basic principles of Islamic Shariah(rules and values set by Islam).
In Islamic banking system, a business that offers good interest
rates or services is strictly prohibited and it is in fact
considered Haraam(forbidden). Islamic banking offers the same
facilities as conventional banking system except that it strictly
follows the rules of Shariah or Fiqh al- Muamlat. Mirza
Basheer-ud-Din Mahmood Ahmad was perhaps the first person to
discuss Islamic Economics in detail in his books Nizame Nau (1942)
and Islam ka Iqtisadi Nizaam (1945). Later work included that of
Naeem Siddiqi and Maulana Maududi.irza Basheer-ud-Din Mahmood Ahmad
Shariah-compliant assets reached about $400 billion throughout the
world in 2009, according to Standard & Poors Ratings Services,
and the potential market is $4 trillion. ShariahStandard & Poor
Iran, Saudi Arabia and Malaysia have the biggest shariah-compliant
assets. IranSaudi ArabiaMalaysia
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WHAT IS ISLAMIC BANKING 1- Islamic banking has been defined as
banking in consonance with the ethos and value system of Islam and
governed, in addition to the conventional good governance and risk
management rules, by the principles laid down by Islamic Shariah.
2- Islamic banking is also known as interest free banking system as
the Shariah disallows the acceptance of Riba or interest rate for
the accepting and lending of money. 2- Banking encompassing Islamic
injunctions To avoid: i.Riba Earning returns from a loan contract
or Selling debt contracts at discount ii.Gharar Absolute Risk or
Excessive uncertainty in contracts, Gambling and chance-based games
(Qimar) iii.General Prohibitions iv.unethical practices Shariah
Compliance & Prudent Banking Achieving the goals and objectives
of an Islamic economy.
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EVOLUTION AND DEVELOPMENT OF ISLAMIC BANKING An early market
economy and an early form of mercantilism, sometimes called
"Islamic capitalism", were developed between the eighth and twelfth
centuries. market economymercantilism The monetary economy of the
period was based on the widely circulated currency the gold dinar,
and it tied together regions that were previously economically
independent.monetary economycurrencygold dinar A number of economic
concepts and techniques were applied in early Islamic banking,
including bills of exchange, partnership (mufawada, including
limited partnerships, or mudaraba), and forms of capital (al-mal),
capital accumulation (nama al-mal), cheques, promissory notes,
transactional accounts, loaning, ledgers and assignments.
Organizational enterprises independent from the state also existed
in the medieval Islamic world, while the agency institution was
also introduced during that time. bills of
exchangepartnershiplimited partnershipscapital
accumulationchequespromissory notestransactional
accountsloaningledgersassignmentsOrganizational
enterprisesstateagency Many of these early capitalist concepts were
adopted and further advanced in medieval Europe from the 13th
century onwards.medieval Europe
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origin of Islamic banking The origin of Islamic banking system
can be traced back to the advent of Islam when the Prophet himself
carried out trading operations for his wife. The Mudarbah or
Islamic partnerships has been widely appreciated by the Muslim
business community for centuries but the concept of Riba or
interest has gained very little diligence in regular or day-to-day
transactions. The first model of Islamic banking system came into
picture in 1963 in Egypt. Ahmad Al Najjar was the chief founder of
this bank and the key features are profit sharing on the non
interest based philosophy of the Islamic Shariah. These banks were
actually more than financial institutions rather than commercial
banks as they pay or charge interest on transactions. In 1974, the
Organization of Islamic Countries (OIC) had established the first
Islamic bank called the Islamic Development Bank or IDB. The basic
business model of this bank was to provide financial assistance and
support on profit sharing. By the end of 1970, several Islamic
banking systems have been established throughout the Muslim world,
including the first private commercial bank in Dubai(1975), the
Faisal Islamic bank of Sudan (1977) and the Bahrain Islamic
bank(1979). Islamic banking is now one of the worlds
fastest-growing economic sectors, comprising over 300 institutions
in over 75 countries. They are concentrated in the Middle East and
Southeast Asia (with Bahrain and Malaysia being the largest hubs),
but are also appearing in Europe and the United States. Total
assets worldwide are estimated to exceed $250 billion, and are
growing at an estimated 15 percent a year.
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History of Islamic Banking Local Islamic banks formed in the
1970s in Muslim countries Originally emphasized joint-venture
structures akin to private equity. Quickly evolved to provide
short-term credit facilities by using the murbaha structure With
increase in scale, Islamic banks began to branch out to more
complex financing schemes, including: Retail banking, including,
deposit taking and consumer lending Bonds (sukk) Medium- and
Long-term leases (ijra)
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History of Islamic Banking Impact of 11/9 Reverse Capital
Flight 1.Perception of hostile climate in many Western
jurisdictions, in particular, the United States, led to
repatriation of dollars by Arab investors to Middle Eastern banks
2.Islamic banks, along with conventional banks in the region,
benefited from this reverse flight of capital 3.Increase in Oil
Prices Led to Dramatic Increase in Liquidity in the Gulf
Conventional Banks Open Islamic Windows A.Conventional banks began
to respond to requests from Muslim clients to offer products that
complied with Islamic law B.As the size of the potential market
became clear, conventional banks responded with the creation of
divisions dedicated to Islamic banking
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History of Islamic Banking Conventional International Banks
with Islamic Windows: Citigroup HSBC Deutsche Bank UBS ABN AMRO
Standard Chartered Bank
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CONCEPT OF ISLAMIC FINANCE Although the concept of Islamic
finance can be traced back about 1,400 years, its recent history
can be dated to the 1970s when Islamic banks in Saudi Arabia and
the United Arab Emirates were launched. Bahrain and Malaysia
emerged as centres of excellence in the 1990s. It is now estimated
that worldwide around US $1 trillion of assets are managed under
the rules of Islamic finance. Islamic finance rests on the
application of Islamic law, or Shariah, whose primary sources are
the Qur'an and the sayings of the Prophet Muhammad. Shariah, and
very much in the context of Islamic finance, emphasizes justice and
partnership. The main principles of Islamic finance are that: 1.
Wealth must be generated from legitimate trade and asset-based
investment. (The use of money for the purposes of making money is
expressly forbidden.) 2. Investment should also have a social and
an ethical benefit to wider society beyond pure return. 3. Risk
should be shared. 4. All harmful activities (haram) should be
avoided.
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RIBA AND GHARAR - MEANING AND TYPES Riba means Interest. Riba
is forbidden in Islamic economic jurisprudence fiqh and considered
as a major sin. Simply, unjust gains in trade or business,
generally through exploitation.InterestIslamic economic
jurisprudencefiqh There are two types of riba discussed by Islamic
jurists: 1- An increase in capital without any services provided
and speculation (Maisir), which is prohibited by the Qur'anQur'an
2- Commodity exchanges in unequal quantities, also prohibited in
the Qur'an.Qur'an
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RIBA AND GHARAR - MEANING AND TYPES Gharar i. refers to any
transaction of probable items whose existence or characteristics
are not certain, due to lack of information, ignorance of essential
elements in the transaction to either party, or uncertainty of the
ability of one party to honor the contract. ii. The Prophet (S.A.W)
has forbidden the purchase of the unborn animal in the mothers
womb, the sale of the milk in the udder without measurement, the
purchase of spoils of war prior to distribution, the purchase of
charities prior to their receipt, and the purchase of the catch of
a diver. TYPES OF GHARAR 1. Gharar Yaseer (minor or slight) This
type of gharar is tolerated and will not invalidate a contract. 2.
Gharar Fahish (major or excessive) This type of gharar is not
tolerated and may result in contract void ability. All jurists
agree that gharar should be avoided in commercial exchange
contracts. As Islamic Sharia forbids riba (interest) because it
leads to exploitation and injustice in the society, it also forbids
gharar in any transaction to protect the two parties from deceit,
ignorance and uncertainty.
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DIFFERENCES AND SIMILARITIES BETWEEN ISLAMIC AND CONVENTIONAL
BANKING There are two major difference between Islamic Banking and
Conventional Banking: 1) Conventional banking practices are
concerned with "elimination of risk" where as Islamic banks "bear
the risk" when involve in any transaction. 2) When Conventional
banks involve in transaction with consumer they do not take the
liability only get the benefit from consumer in form of interest
whereas Islamic banks bear all the liability when involve in
transaction with consumer. Getting out any benefit without bearing
its liability is declared Haram in Islam.
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Major Differences between Islamic and Conventional Banking
System Islamic System 1- Real Asset is a product. Money is just a
medium of exchange. Conventional System 1- Money is a product
besides medium of exchange and store of value. Islamic System
2-Profit on exchange of goods & services is the basis for
earning profit Conventional System 2- Time value is the basis for
charging interest on capital Islamic System 3- Loss is shared when
the organization suffers loss Conventional System 3- Interest is
charged even in case, the organization suffers losses
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Major Differences between Islamic and Conventional Banking
System Islamic System 4- No expansion of money takes place and thus
no inflation is created. Conventional System 4- The expansion of
money takes place, which creates inflation. Islamic System 5- Due
to control over inflation, no extra price is charged by the
entrepreneur Conventional System 5- Due to inflation the
entrepreneur increases prices of his goods & services Islamic
System 6- Real growth in the wealth of the people of the society
takes place, due to multiplier effect and real wealth goes into the
ownership of lot of hands. Conventional System 6- Real growth of
wealth does not take place, as the money remains in few hands.
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DIFFERENCE BETWEEN ISLAMIC AND CONVENTIOANL BANKING Islamic
Banking 1) Functions and operations are based on Shariah principles
Conventional Banking 1) Functions and operations are based on fully
man made principles
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DIFFERENCE BETWEEN ISLAMIC AND CONVENTIOANL BANKING Islamic
Banking 2) Promote risk- sharing between provider of capital
(investor) and user of funds (entrepreneurs) Conventional Banking
2) Investor is assured of pre- determined rate of interest
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DIFFERENCE BETWEEN ISLAMIC AND CONVENTIOANL BANKING Islamic
Banking 3) Aim at maximising profit but subject to Sharia'h
restrictions Conventional Banking 3) Aim at maximising profit
without any restrictions
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DIFFERENCE BETWEEN ISLAMIC AND CONVENTIOANL BANKING Islamic
Banking 4) Partners, investor and traders, buyer or seller
relationship Conventional Banking 4) Creditor- Debtor
relationship
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DIFFERENCE BETWEEN ISLAMIC AND CONVENTIOANL BANKING Islamic
Banking 5) Encourage asset-based financing and based on commodity
trading Conventional Banking 5) Based on money trading. Money is a
medium of exchange and not a commodity, its sale and purchase is
prohibited in Islam.
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DIFFERENCE BETWEEN ISLAMIC AND CONVENTIOANL BANKING Islamic
Banking 6) No right of profit if there is no risk involved. The
profit and loss sharing depositor may lose money in case of loss.
Conventional Banking 6) It is almost risk free banking and
depositor has no risk of losing its money because interest is
guaranteed.
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PRINCIPLES OF ISLAMIC BANKING a) Prohibition of Interest : A.
Riba best translated today as the charging of any interest, meaning
money earned on the lending out of money itself. B. The prohibition
on paying or receiving fixed interest is based on the Islamic tenet
that money is only a medium of exchange, a way of defining the
value of a thing; it has no value in itself, and therefore should
not be allowed to give rise to more money, via fixed interest
payments, simply by being put in a bank or lent to someone else. C.
The human effort, initiative, and risk involved in a productive
venture are more important than the money used to finance it.
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PRINCIPLES OF ISLAMIC BANKING b) Profit and Loss Sharing : i.
While Islam employs various practices that do not involve charging
or paying interest, the Islamic financial system promotes the
concept of participation in a transaction backed by real assets,
utilizing the funds at risk on a profit-and- loss- sharing basis.
ii. Such participatory modes used by Islamic banks are known as
Musharakah and Mudarabah. This by no means implies that investments
with financial institutions are necessarily speculative. iii. The
concept of profit-and-loss sharing in an enterprise, as a basis of
financial transactions is a progressive one as it distinguishes
good performance from the bad and the mediocre.
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PRINCIPLES OF ISLAMIC BANKING c) Shariah Approved Activities A.
Islamic financial system encourages, performing only those business
activities which conform to Islamic Shariah. B. All the activities
which do not conform to the Islamic rules and laws are not
permissible and dealing in such activities will be dealt with
serious consequences.
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CRITICISM OF ISLAMIC BANKING I. Some Islamic banks charge for
the time value of money, the common economic definition of interest
(riba). These institutions are criticized in some quarters of the
Muslim community for their lack of strict adherence to Shariah.time
value of moneyinterestriba II. The concept of Ijarah is used by
some Islamic Banks to apply to the use of money instead of the more
accepted application of supplying goods or services using money as
a vehicle. III. A fixed fee is added to the amount of the loan that
must be paid to the bank regardless if the loan generates a return
on investment or not. IV. The reasoning is that if the amount owed
does not change over time, it is profit and not interest and
therefore acceptable under Shariah. V. Islamic banks are also
criticized by some for not applying the principle of Mudarabah in
an acceptable manner. VI. Where Mudarabah stresses the sharing of
risk, critics point out that these banks are eager to take part in
profit-sharing but they have little tolerance for risk.
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CRITICISM OF ISLAMIC BANKING I. The majority of Islamic banking
clients are found in the Gulf states and in developed countries.
II. The majority of financial institutions that offer Islamic
banking services are majority owned by Non-Muslims. III. With
Muslims working within these organizations being employed in the
marketing of these services and having little input into the actual
day to day management, the veracity of these institutions and their
services are viewed with suspicion.
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SCOPE OF ISLAMIC BANKING Islamic banking is one of the growing
domains of banking which shows promise for the future. Furthermore,
it has so far remained undeterred to a larger extent from the
current financial crises. It is about time to develop even more
innovative Islamic instruments which can meet the needs of the
customers in a religiously viable way. It is important that these
instruments do not defy the laws of Islam and the confidence of the
public at large is not shattered. Islamic banking is one beacon of
hope for all the conventional banks that have suffered the crunch
due to high speculation and ethical violations of business
norms.
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The Performance of the Islamic Banks Islamic banking has become
today an undeniable reality. The number of Islamic banks and the
financial institutions is ever increasing. New Islamic Banks with
huge amount of capital are being established. Conventional banks
are opening Islamic windows or Islamic subsidiaries for the
operations of Islamic banking.
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The Future of Islamic Banking Islamic banking is here to stay.
financial institutions predict that Islamic finance will be the
world's fastest-growing banking sector for years. with a predicted
modest estimate of 20 percent annual increase in deposits. bankers
are realizing that Islamic banking is big business that is only
getting bigger Japan is also planning to start Islamic banking
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Unit-II Wadiah (Deposit) In Islamic Banking (Domestic
Operations)
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Introduction There is no doubt that each bank needs financial
sources for funding, money bank rate is small relative to the total
funds used. In general Banking Deposits is one of the most
important sources of funds in banks, it has been offered through
Bank definition that has two ways borrowing from depositors, and
lending to borrowers. Bank Deposits have two types: 1) Deposits of
certain things like gold or documents at the bank where placed in
safes Pay. 2) Cash deposits, which is that we are talking about.
And cash deposits in Islamic banks vary in terms of recovery
time.
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Wadiah Wadiah is a contract ( Aqed ) between the owner of goods
and custodian of the goods. 1- To protect the goods from being
stolen, destroyed etc. 2- To ensure the safe custody of the goods.
3- Operates under the contract of Wadiah Yad Dhamanah (guaranteed
custody), The al-wadiah yad Amanh contract says that the bank will
provide deposits protection and honor all withdrawals on call
provided that it is allowed to use deposits to generate earnings.
4- The bank accepts deposits from its customers looking for safe
custody and convenience. 5- The bank requests permission to make
use of the customers funds for investment purposes.
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Wadiah 6- The customers may withdraw their balances at any
time. 7- Profit generated from the use of the customers funds
belongs to the bank. However, the bank may at its absolute
discretion rewards the customers by declaring profits to them.
Under the contract of Wadiah: 1- The custodian i.e. the Bank is not
allowed to mention or to promise any reward on the deposit
received. 2- The owner/depositors too cannot demand any rewards or
return from their Bank on their savings. 3-Wadiah is purely a
contract on safe custody of goods without any promise on rewards or
returns.
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Types of Bank Deposits in Islamic Banks Islamic banks provides
many types of deposits that meet the needs of the world, and fit
all segments of society from individuals and companies, including
(Islamic current account - Islamic Savings Account - Islamic
Investment Account), and is handled these types according to
regulations of Islamic law.
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Types of Bank Deposits in Islamic Banks Demand Deposits
(Current Accounts) Current accounts are based on the principle of
al-wadiah, and it defines that: The current account, a service
offered by Islamic banks to customers, and through the customer can
keep his money in the bank, with full warranty provided by the
bank, and can withdraw it at any time they want without notice and
without getting any benefit, or payment or any financial obligation
on it - through the bank - at any time, either through issuing
checks, or debit balance, or through the bank's branches, or
through automated teller machines (ATM), which operates throughout
the day, as a customer can pay for purchases through POS machines
(POS) deployed in the market.
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Demand Deposits (Current Accounts) 1- All Islamic banks operate
current accounts on behalf of their clients: individuals and
business firms. 2- These accounts are operated for the safe custody
of deposits and for the convenience of customers. 3-The bank
guarantees the full return of these deposits on demand and the
depositor does not gain any share of the profit or any other return
in any form. There are two dominant views about Current Accounts:
1- To treat demand deposits as Amanah. A "Trust Account" instead of
a current account. 2- The other view is to treat demand deposits as
Qard Hasan (or interest free loan). According to this view the bank
is free to utilize these funds at its own risk without return to,
or authorization from, the depositors.
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Current Accounts 1- Current accounts are based on the principle
of al-wadiah, whereby the depositors are guaranteed repayment of
their funds. 2- At the same time, the depositor does not receive
remuneration for depositing funds in a current account, because the
guaranteed funds will not be used for Profit and Loss Sharing (PLS)
ventures. 3- Current Accounts can be opened either in domestic
currency or foreign currency. 4- Current Accounts holders have the
right to draw cheques on their accounts. 5- This account consists
of several types, that are: Individual Account, Joint Account,
Partnership Account, Government Account, Private Company Account,
Company Account, Association Account.
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Current Deposits In Islamic Banks -Very Similar to standard
commercial banks - No return paid back to depositors - Checking
facilities 1- Are Current deposits a loan to the bank from
depositors ? 2- Are Current deposits a trust by depositors to banks
? 3- Use of Current deposits by the banks on their own risk.
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Islamic Savings Account Savings Account Islamic Savings Account
defines as that combines the advantages of the current account and
investment account, where the client can draw from the account
whenever he wants, from both branches or through automated teller
machines (ATM), or pay for purchases through POS machines (POS),
and at the same time the customer can get a return on the remaining
balance in the account, according to Mudaraba contract, which
includes distribution Ratios between the bank and the client at the
beginning of the contract, as a percentage of the profits resulting
from customer financing.
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Savings Accounts Savings accounts also operate under the
al-wadiah principle. Savings accounts differ from current deposits
in that: They earn the depositors income: depending upon financial
results, the Islamic bank may decide to pay a premium, hiba, at its
discretion, to the holders of savings accounts. Saving Deposits
Operates In Different Ways: 1- Saving deposits without
authorization to invest. In the Islamic Banks the depositors allow
the banks to use their money but they obtain a guarantee of getting
the full amount back from the bank, but no profits promised from
the bank.
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Saving Deposits 2- Saving deposits with authorization to
invest. In other banks saving accounts are treated as investment
accounts, the banks request a permission to use this funds so long
as these funds remains with the bank,but with less stringent
conditions as to withdrawals and minimum balance. Return to
depositors who provide authorization to invest. 3- Saving deposits
as a part of trust accounts. 4- Saving deposit as Notice
account.
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Investment Accounts Islamic Investment Accounts: is "money
deposited by their owners with Islamic banks in order to obtain a
return. These accounts subject to hold speculative legitimacy",
where the BID to invest these funds in the areas of work are
legitimate. Distributed profits generated between the bank and the
customer, depending on the proportions percentage to be determined
when the contract signed. The bank gets a share of the profits for
the effort, and the customer gets a share of the capital
return.
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Investment Accounts The subject of this investment accounts to
base legitimacy It means participation in the profits and losses,
and this does not mean that the client vulnerable to lose part of
its capital. Islamic banks provide funding to customers through
Murabaha or participation they get guarantees for the preservation
of funds depositors. Funding is granted to the customer after do
feasibility studies that show the success of the project.
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Investment Deposits 1- Investment accounts identify timed a
year - in most cases, and can add profits to the customer's
account. 2- Investment account is not entitled to the client
withdrawals from the investment account during that period. 3-
Investment account in emergency situations, the client can draw
with a discount portion of the profits for the amount that has been
withdrawn from the account. Investment Account An investment
account operates under the mudaraba al-mutlaqa principle, in which
the mudarib (active partner) must have absolute freedom in the
management of the investment of the subscribed capital.
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Investment Deposits Islamic Banking counterpart of Fixed
Deposits. Withdrawal allowed only in special cases Investment
deposits as Mudarabah Accounts. Depositor; Rabbal Mal; Bank: Aamil
Share profit on agreed basis, bear full loss. Investment pool
Distribution of profits on pro rata basis. Special investment
accounts Special investment accounts also operate under the
mudaraba principle, and usually are directed towards larger
investors and institutions.
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Bank Teller A Bank Teller is a member of the staff of a bank
who deals directly with the public and handles routine banking
transactions like deposits, withdrawals, and so forth. For many
people, bank tellers are iconic figures, since they represent the
face of the bank to the public.banking transactions 1. Employment
in this profession is actually shrinking, because some people have
turned to Automated Teller Machines (ATMs) and online banking since
they find these services more convenient.
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Bank Teller 2. The job requirements for becoming a bank teller
are fairly minimal. 3. He or she must have a University Degree,
diploma,high school and exhibit an ability to perform basic math
functions. diploma 4. Bank tellers must also be comfortable with
members of the public and with handling large amounts of money. 5.
They are also expected to be extremely attentive and discreet, and
in some regions a bank teller may need to pass a law enforcement
background check before he or she can be hired.
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Bank Teller 6. In a workday, a bank teller might accept cash or
checks for deposit, cash checks drawn on his or her bank, issue
funds like money orders and traveler's checks, and handle
transactions related to savings accounts.money orders 7. A bank
teller also usually promotes services offered by the bank, such as
loans, retirement accounts, and insurance; if a customer expresses
interest in these services, the teller refers him or her to another
bank employee who specializes in these offerings. 8. A bank teller
might also provide access to safe deposit boxes, if a bank offers
this service.
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Clearing House a place or institution where mutual claims and
accounts are settled, as between banks. or a central institution or
agency for the collection, maintenance, and distribution of
materials, information, etc. Development of clearing and settlement
arrangements (1) I. What banks clear and settle: claims on other
banks II. Can have banks without having interbank settlement! III.
Over time, banks increasingly redeemed claims on other banks I.
Differs according to payment instrument
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Clearing House Development of clearing and settlement
arrangements (2) Economic pressures for banks to accept claims on
other banks: i.Demand from customers to make bank money more liquid
ii.Accepting bank can issue its own money iii.Disciplines other
banks
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Clearing House Development of clearing and settlement
arrangements (3) But costs in accepting claims on other banks;
1.Credit risk 2.Clearing the payments 3.Holding the settlement
asset 4.Transferring the settlement asset
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Clearing House Development of clearing and settlement
arrangements (4) But costs in accepting claims on other banks:
A.Credit risk (frequent settlement rounds) B.Clearing the payments
(route payments via nodes) C.Holding the settlement asset (netting)
D.Transferring the settlement asset (exchange paper or book entry
claims)
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Automated Clearing House (ACH) Nationwide wholesale electronic
payments system Transactions not processed individually Banks send
transactions to ACH operators Batch processing store-and-forward
Sorted and retransmitted within hours Banks Originating Depository
Financial Institutions (ODFIs) Receiving Depository Financial
Institutions (RDFIs) Daily settlement Posted to receivers account
within 1-2 business days
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Automated Clearing House (ACH) I. High-volume, small value
payment orders between financial institutions II. largely recurring
payments: payroll, mortgage, car loan, Social Security III.
Automated Teller Machines (ATM) IV. Debit-card point-of-sale
payments V. Telephones or PC bill payments. VI. Direct deposit
(e.g. payroll) VII. Electronic benefits transfer
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Automated Clearing House (ACH) Wholesale Payments SWIFT
(Society for Worldwide Interbank Financial Telecommunications)
(non-profit, Brussels). Financial messaging system, not a payment
system, Settlement must occur separately Instructions between
financial institutions. 7125 institutions, 193 countries. 1.27
billion messages per year: $5 trillion per day. 2/3 are banks
trading for their own accounts. Settled through transfers in
respective currencies (must have accounts in both currencies).
Herstatt risk (pay out one currency before receiving the other --
cascading effect).
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Unit-III Finance and Investment in the Islamic Banking
(Domestic Operations)
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Permissible Financing Methods Cost-plus sales (murabaha).
Credit sales (bay bi-thaman-ajil). Leasing (ijarah or jar).
Partnerships (musharaka and mudaraba). Islamic forwards (salam and
istisna).
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Cost-plus sales (Murabaha) THE CONCEPT Murabaha is a contract
of sale where the seller discloses to the buyer the actual cost of
the item to be sold in addition to the profit margin (mark up)
added, to be mutually agreed upon with the buyer. It is important
to note that in classical fiqh, murabaha refers to sale (bay), with
all its implications and prescribed Sharia conditions pertaining to
sale, and has nothing to do with financing in the conventional
sense.
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Cost-plus sales (Murabaha) Murabaha financing is a widely used
contract in contemporary Islamic banking and finance; and it is
limited to cases where the customer actually needs to purchase some
commodity. Its used in modern day trade financing With regard to
Islamic banking, Murabaha is an agreement wherein the bank
purchases, at the request of a customer, a specified item, and then
sells it to him at a mutually agreed marked-up price.
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Cost-plus sales (Murabaha) In this sale, the buyer knows the
price at which the seller obtained the object to be financed, and
agrees to pay a premium over that initial price. Basic concept:
Sale on mutually agreed profit margin on the known cost of goods;
payment of sale price is deferred. Real, tangible goods to be
traded and not papers of debt or credit documents. Murabaha cannot
be used as mode in case no commodity is purchased by the client.
Buy-back arrangement: not allowed. MUAJJAL; Credit price may
include margin of mark-up, taking into consideration the deferred
payment. As a debt, no return can be charged on the amount of
Note/Bill.
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Cost-plus sales (Murabaha) 1. Thus, one may approach an Islamic
financial institution and say purchase this item on my behalf at
this price, and I shall give you a profit (urbihuka) margin of $10,
or purchase this item on my behalf at this price, and I shall give
you a profit (urbih.uka) margin of 10%. 2. The fact that the latter
statement may be perceived to make explicit a percentage payment
should not be of concern, since it is not Riba if the sale
satisfies the conditions of Murabaha.
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Cost-plus sales (Murabaha) 3. Notice that in this contract, the
Islamic bank or financial institution must own the item at the time
the customer buys it from them with the specified profit margin.
Examples of Murabahah Two contracts: I. A contract of intent to
conduct a Murabaha Sale. II. Another contract to buy the good
ordered in previous contract.
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Cost-plus sales (Murabaha) 1. The word MURABAHA is derived from
the word Ribh, meaning profit in Arabic. I. Sale with a profit. II.
Cost-plus financing. 2. Promise is not a legal binding. It
introduces an element of risk in the transaction. 3. The element of
risk justifies the profit in Murabaha sale : Fiqhi principle : Al
Kharaj bi Daman. 4. Applications of Murabaha: i.In domestic trade
ii.In foreign trade iii.In financing consumer durables iv.In
financing Real Estate
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Credit sales (bay bi-athamn aajil) Definition It is a sale
contract in which the payment of the price is deferred and payable
at a certain particular time in the future. and receipt the goods
immediately. Installments Sale permissible, even if the deferred
price exceeds the spot price. Deferred prices can vary so long as
price not finalised. Sale cannot take place until the parties agree
to a particular price & mode of payment. Not permissible to fix
the spot price on cash basis, then to charge interest expressly
tied with different periods. Commercial papers are lawful types of
authentication of a debt by putting it down in writing; - Treated
by Shariah near to mandatory.
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Credit sales (bay bi- athaman ajil) 1) Very rarely is Murabaha
used by Islamic banks with the price paid immediately by the
customer. 2) In such cases, there would be no financing included
and the Islamic bank would simply be a middle-man or broker-agent
(simsar).
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Leasing (ijarah or jar) 1) Legally, the lease contract is not a
sale of the object, but rather a sale of the usufruct (the right to
use the object) for a specified period of time. 2) The sale of
usufruct is permissible in Islam, as evidenced by the verses. 3)
The corpus of the leased asset should exist till the expiry of
lease period. 4) The corpus of the leased asset should remain in
the ownership of the lesser during the whole period of lease; in
case of Shirkah pro-rata ownership. 5) The lesser must accept
responsibility of any defect in leased asset (without negligence of
the lessee) which hinders the intended use of asset. 6) Sale
Separate and independent contractor
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Leasing (ijarah or jar) The most important financial difference
between Islamic permitted leasing and conventional financial
leasing is that the leasing agency must own the leased object for
the duration of the lease. i. Ijarah is emerging as a popular
technique of financing amongst the Islamic banks ii. Elements of a
lease contact: Lesser, Lessee, instrument and period of lease. iii.
The asset remains in the ownership of the lesser. Maintenance is
the responsibility of the owner. iv. Ijarah muntahi bit tamlik
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Partnerships (Musharaka and Mudaraba)
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MUDARABA Definition of Mudaraba Mudaraba is a partnership in
profit whereby one party provides capital and the other party
provides skill and labour. The provider of capital is called Sahib
al-maal while the provider of skill and labor is called
Mudarib.
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Types of Mudaraba Mudaraba Contracts are generally divided as
under: Unrestricted Mudaraba and Restricted Mudaraba. A.
Unrestricted Mudaraba: Unrestricted Mudaraba may be defined as a
contract in which the Sahib al- maal permits the Mudarib to
administer the Mudaraba fund without any restriction.
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Types of Mudaraba B. Restricted Mudaraba Restricted Mudaraba
may be defined as a contract in which the Sahib al-maal restricts
the actions of the Mudarib to a specified period or to a particular
location or to a particular type of business. Terms and elements of
Mudaraba: Contracting Parties There are two contracting parties in
Mudaraba: 1. The provider of the capital i.e. Sahib al-maal and 2.
The Mudarib.
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Terms and elements of Mudaraba Capital Capital is the amount of
money given by the provider of funds i.e. Sahib al-maal to the
Mudarib with the purpose of investing it in the Mudaraba business.
Profit & Loss Profit should be for both Sahib al-maal and
Mudarib as per agreed ratio. Loss should be borne by the Sahib
al-maal.
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The main features of Mudaraba a) There should be two parties:
Sahib al-maal (financer/Investor) and businessman is Mudarib (Who
provides skill and labor). b) There should be written
agreement/contract between the Bank and the businessman which
includes nature of business, period/time, sharing of profit etc. c)
Bank will finance and the businessman will run the business by
providing his labor & skill. d) The Bank will not interfere in
the business. e) The businessman will appoint employee(s) and he
will run the business independently. f) The Sahib al-maal
/Financier/Investor reserves the right to check/verify the accounts
of the business at any time.
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MUSHARAKA Definition of Musharaka Musharaka is a contract of
partnership between two or more parties in which all the partners
contribute capital, participate in the management, share the profit
in proportion to their capital or as per pre-agreed ratio and bear
the loss, if any, in proportion to their capital/equity ratio.
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Types of Musharaka In the context of Islamic Banking financing,
Musharaka may be of two types: A. Permanent Musharaka B.
Diminishing Musharaka Permanent Musharakah: partners can sell - as
in case of Shares of Joint Stock Companies. Temporary (Redeemable)
Musharaka: for limited time period, e.g After agreed time
period(s), Diminishing Musharakah: one partner promises to buy the
share of the other partner gradually until the title to the
property is completely transferred to him.
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Permanent Musharaka Permanent Musharaka may be defined as
contract of partnership business between the Islamic Bank and its
clients in which the Bank participates in the equity and share the
profit at a pre-agreed ratio or bear the loss, if any, in
proportion to the ratio of capital/equity where termination period
of the contract is not specified. This is also called continued
Musharaka.
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Diminishing Musharaka Diminishing Musharaka is a special form
of partnership in which one of the partners promises to buy the
share of the other partner gradually until the title to the equity
is completely transferred to him. In Diminishing Musharakah:- Loan
of Service Charges. Only administrative expenses can be charged.
Interest free loans are provided as a social service.
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Musharaka Contracting Parties There are two or more contracting
parties known as partners, It is a condition that all the partners
should be competent to give or be given power of attorney. 1.
Capital: Capital contributed by the partners may be in the equal or
unequal and in the form of cash or cash equivalent, goods &
commodities, assets or properties etc. 2. Distribution of Profit:
Profit should be distributed among the partners as per their ratio
of capital or as per agreement.
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Some Important Features of Musharaka 1) Capital should be
specific. 2) Equal share is not a must. 3) Nature of capital may be
money or valuables. 4) Active participation of partners. 5) Ratio
of profit prefixed. 6) Variation in share of profit permissible. 7)
Participation and sharing profit & loss. 8) Partners retains
the ownership and right to management.
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Musharakah Musharakah is from the word Sharikah. 1. More than
one partners: Partnership in capital proportion and project
supervision. A partner may waive his right of supervision or
delegate it to another partner. 2. Arrangements: Sharing of Profit
and loss in accordance with capital proportion agreed proportion.
3. Variant: Share of profit in agreed proportion, share of loss in
capital proportion. 4. Applications of Musharakah: i. in Import
trade ii. In Agriculture
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Difference between Mudaraba and Musharaka
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a)Mudaraba 1. The capital in Mudaraba is the sole
responsibility of Sahib al-maal. 2. In Mudaraba, the Saheb al-maal
has no right to participate in the management which is carried out
by the Mudarib only. 3. In Mudaraba the loss, if any is suffered by
the Sahib al-maal only, because the Mudarib does not invest
anything, His loss is his labor and skill.
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Difference between Mudaraba and Musharaka b) Musharaka 1. In
Musharaka it comes from all the partners. 2. In Musharaka, all the
partners can participate in the management of the business and can
work for it. 3. In Musharaka, all the partners share the loss to
the extent of the ratio of their investment.
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Salam and Parallel Contracts (Future Sale) 1) Prepayment of
price in full for goods to be delivered in future. 2) Allowed by
Holy Prophet (SAW) himself to meet farmers money need. 3) Banks
will receive contracted commodities, not money. 4) Parallel Salam:
a bank can sell a commodity purchased through Salam for even the
same date of delivery or the quantity; As long as the two contracts
are not made conditional on each other.
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Purpose of Salam i. To meet the need of farmers who need money
to grow their crops and to look after their family up to the time
of harvest. ii. To finance someone who is in need to grow something
or acquire something for further sale. iii. To meet the need of
traders for import and export business. iv. The buyer also enjoys a
lower purchase price, since he pays in advance. v. Acceptance of
Time. Value of Money through pricing of goods.
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Salam Conditions I. Fungible homogeneous goods II. not where
delivery has to be simultaneous, e.g. Gold, silver or currencies.
III. Date and place of delivery must be specified in the contract.
IV. In case of a number of commodities, the amount and delivery
period should be separately fixed. V. The bank can sell the Salam
Commodity through a parallel contract of Salam for the same date of
delivery. VI. For a parallel Salam, the two contracts should be
independent and separately enforceable. VII. Bank can also obtain a
unilateral promise to purchase from a third party. VIII. Agency IX.
To sell anywhere in the market
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Unit-IV ISSUES IN ISLAMIC BANKING
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The Concept of Letter of Credit in Islamic Banking 1. It is a
facility extended by the banks to the traders and the businessmen.
2. The purpose of opening letters of credit is to facilitate speedy
and simple payment and the transfer of money from one particular
spot to one more. 3. This facility, currently being a lawful
support, has to be effectively compensated in terms of Shariah. 4.
If the payment of compensation or remuneration is connected with
the quantity of services, the Shariah has no objection. 5. In this
case it will be a kind of service cost which has been already
thought to be and approved by nearly all the contemporary scholars
and learned bodies. 6. In this situation it will be necessary that
the rate of support charge is established maintaining in watch the
magnitude of the service, quickness of the payment and the stage of
credibility and performance of the lender concerned.
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Parties in Letters of Credit Can be summarized as follows: i.
The Applicant (Demanded opening credit) Demanded Opening Credit
that means the bank's customer (importer), which gives instructions
to the bank to open a letter of credit for the supply of certain
material for a demanded. ii. A Bank that Opens a Letter of Credit
Which is committed to the correspondent bank According to the
formula and terms of credit to pay the value when submitted
documents which required to be identical to the accreditation
requirements.
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Parties in Letters of Credit iii. (The beneficiary) or the
so-called (The seller) The beneficiary of the opening credit
(seller) be obliged to create the goods agreed with the buyer (The
buyer) within a specified period agreed upon in. iv. Confirming
Bank ) Advance Bank installer) This installation adds the Bank
(reinforcement) on the letter of credit for a commission obtained
from (buyer or seller) which in fact gives a true guarantee for the
vendor to receive the value of the documents provided by the
seller, even if the buyer does not pay for the value of those
documents.
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Types of Letter of Credit Irrevocable Documentary Credits can
be divided into two types :- 1/ Letter of credit is irrevocable and
is not installed The so-called ( Irrevocable unconfirmed L / C ).
2/ Letter of credit is irrevocable (enhanced) installed. 3/
convertible or Transferable L / C. 4/ Revolving credits are called
(Revolving L / C) can be divided into two types : a) (Cumulative
Revolving). b) (Non Cumulative Revolving).
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Types of Letter of Credit 5/ Back to back (L / C). 6/ Agreed
Documentary Credits, called (Standby credit) used only in American
banks. 7/ Prepayment Credits. 8/ Payment on Credit Allocations
called (deferred payment). 9/ Red Clause Credit.
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Mechanism to Open Letter of Credit Mechanism to Open Letter of
Credit How to open letter of credit can be summarized as follows:
A) Demanded letter of credit open a current account to the section
that deals with him. B) Financial Balance of the Account is
sufficient to cover the value of documents. C) The client requires
some special procedures for the purpose of opening a documentary
credit. Form open a letter of credit, which includes the following
information: - Name of the buyer. - The name of the beneficiary. -
Commercial lists. - Shipping documents. - The type of insurance. -
Shipping type (single shipment or multiple shipments). - Port
forwarding. - Final destination.
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Letter of Guarantees LETTER OF GUARANTEE is a written promise
issued by a bank to compensate (pay a sum of money) to the
beneficiary (third party, local or foreign) in the event that the
obligor (customer) fails to honor its obligations in accordance
with the terms and conditions of the guarantee / agreement /
contract. A bank guarantee is an undertaking by the bank at the
request of a party, whereby the bank in the event of default by the
principal in the fulfillment of his obligations to make payment to
the beneficiary within the limits of specified sum of money and
within the specified period of time. So, bank guarantees are
usually limited with respect to amount and time. As for as the time
is concerned - a grace period is usually granted to the beneficiary
to claim under the guarantee. This is basically given for the time
taken by the beneficiary to present his claim. Letters of Guarantee
can be in the form of Bank Guarantees, Performance Bonds, Bid
Bonds, Shipping Guarantees or Standby Letter of Credit.
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Types of Letter of Guarantees Types of Letter of Guarantees:
1.Conditional and Unconditional Guarantees. 2.Fixed and Fluctuating
Guarantees. 3.Financial Guarantees. 4.Performance / Non-financial
guarantees. Need for a Letter of Guarantee 1.To provide an
assurance of the intention of the principal to sign the contract.
2.To safeguard against the principal failing to meet his
obligations under such a contract 3.To protect interest of a party
awarding the contract (beneficiary) in respect of the repayment of
payments and advances made by him in the even of principal not
fulfilling the contract terms.
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Letter of Guarantee Parties and their differs interest 1. The
beneficiary: He is the party inviting the tender or He is the party
awarding the contract or He is the person who wants to receive a
compensatory sum of money incase the tendered fails to perform his
obligations or fails to perform the contract in accordance with its
terms or to secure repayment of any payment or advances made by him
if the principal fails to perform the contract. 2. The principal :
He is the party tendering the contract or He is the party to whom
the contract has been awarded. 3. Guarantor : Guarantor is a party
who will meet his commitment in terms of the guarantee, without
becoming involved in possible disputes between beneficiary and
principal. 4. The Instructing Party : The new rules recognize the
existing widespread practice whereby an instructing party may
forward to the guarantor instructions received from or on behalf of
the principal and counter-guarantee such instructions.
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General Aspects of Letter of Guarantees 1. Benefits to the
parties: 1. Benefits to the bank : It gets commission income. 2.
Benefits to the principal / Instructing party : (a) It enables
better liquidity by deferring payment and making it contingent on
non-performance. (b) Cheaper than fund-based facilities except
where it involves credit substitution. 3. Benefits to the
beneficiary : Certainty of payment, in the event of
non-performance, guaranteed by the bank. 2. Important points to be
noted before issuing a guarantee : Principal need to indemnify the
bank against all losses that the bank may incur in the performance
of its obligation to pay. The bank can obtain further comfort by
specifying the place of payment under a guarantee and the governing
law.
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General Aspects of Letter of Guarantees 3. Date of expiry of
the guarantee. 4. A bank guarantee can be amended. 5. Bank
guarantee expires when the validity period has ended or the BG is
returned for cancellation or the entire amount of BG is paid by the
bank or the bank is released from its obligations. 6. Documents
required : For grant of Bank guarantee limits Hypothecation /
Pledge agreement for collateral security formalities connected with
registration charges where necessary.