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© Islamic research and Training Institute 2016
All rights reserved. All parts of this work are subject to sole ownership of Islamic research and
Training Institute (hereinafter referred to as ‘Copyright Holder’) and remains exclusive property
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Islamic Research and Training Institute
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P.O.Box 9201 - 21413 Jeddah
Kingdom of Saudi Arabia
E-Mail:[email protected]
Disclaimer The content of these course have been developed solely for educational and training purposes. They are
meant to reflect the state of knowledge in the area they cover. The content does reflect the opinion of
the Islamic Development Bank Group (IDBG) nor the Islamic Research and Training Institute (IRTI).
Acknowledgement This textbook was developed as part of the IRTI e-Learning Program (2010), which was
established and managed by Dr. Ahmed Iskanderani and Dr. Khalifa M. Ali.
Table of Contents
Chapter 1 ....................................................................................................................................................... 5
Chapter Introduction .................................................................................................................................... 6
Learning Objectives ....................................................................................................................................... 6
Principles of an Islamic Economic System .................................................................................................... 6
Characteristics of an Efficient Financial System ............................................................................................ 9
The Roles of Financial Institutions (FIs) ........................................................................................................ 9
Two Main Tasks for FIs ................................................................................................................................ 10
Types of Financial Markets ......................................................................................................................... 11
The Role of Ethics in an Islamic Financial System ....................................................................................... 11
Differences, Conflicts, and Priorities in Islamic Finance ............................................................................. 13
Types of Contracts in Islamic Finance ......................................................................................................... 14
Types of Transactional Contracts ................................................................................................................ 15
Types of Financing Contracts ...................................................................................................................... 16
Key Terms .................................................................................................................................................... 16
Chapter 2 ..................................................................................................................................................... 18
Chapter Introduction .................................................................................................................................. 18
Learning Objectives ..................................................................................................................................... 19
The Freedom to Contract ............................................................................................................................ 19
The Freedom to Contract – Elements of a Contract ................................................................................... 20
The Concept of Al-Ribâ ............................................................................................................................... 20
Islamic framework, but excessive Gharar is prohibited. ............................................................................ 22
The Concepts of Al-Qimār and Al-Maisir .................................................................................................... 23
The Concept of Ghubn ................................................................................................................................ 25
Norms Relating to Profit ............................................................................................................................. 25
Norms Relating to Mutual Cooperation...................................................................................................... 26
Key Terms .................................................................................................................................................... 27
Chapter 3 ..................................................................................................................................................... 29
Chapter Introduction .................................................................................................................................. 30
Learning Objectives ..................................................................................................................................... 30
The Strategic Role of Financial Institutions in Society ................................................................................ 31
The Services and Benefits of Financial Institutions ..................................................................................... 32
The Working of Commercial Banks ............................................................................................................. 32
More About the Working of Commercial Banks ......................................................................................... 33
The Working of Investment Banks .............................................................................................................. 34
NBFIs and Financial Markets ....................................................................................................................... 34
Primary Characteristics of an Islamic Financial System .............................................................................. 35
Basic Operations of an Islamic Bank ........................................................................................................... 36
Organisational Model for Islamic Bank ....................................................................................................... 36
Types of Deposits in Islamic Banks.............................................................................................................. 37
An Example of Deposit Management ......................................................................................................... 38
Modes of Financing Trade, Industry, and Agriculture ................................................................................ 39
Two Approaches for Returns in Islamic Banking ......................................................................................... 40
Profit/Loss Approach in Islamic Banking ..................................................................................................... 41
Islamic Investment Banking ........................................................................................................................ 43
Key Terms .................................................................................................................................................... 44
Chapter 4 ..................................................................................................................................................... 45
Chapter Introduction .................................................................................................................................. 46
Learning Objectives ..................................................................................................................................... 46
The Concept of a Bai’ Mu’ajjal (Credit Sale) ............................................................................................... 46
Conditions of Bai’ Mu’ajjal .......................................................................................................................... 47
A Murabaha Sale ......................................................................................................................................... 48
Conditions for a Murabaha Sale ................................................................................................................. 48
Murabaha to Purchase Orderer .................................................................................................................. 49
More About MPO ........................................................................................................................................ 50
Issues in Murabaha Contracts .................................................................................................................... 52
Risks and Mitigation Measures ................................................................................................................... 53
Key Terms .................................................................................................................................................... 55
Chapter Introduction
Hello and An Overview of the Islamic Financial System.
An economic system is a collection of institutions, policies, and rules set up by society. It
deals with the allocation of resources, exchange of goods and services and trading and
distribution of wealth.
The Islamic economic system shares the key characteristics and objectives of a conventional
economic system. The additional and vital factor is the Sharī‘ah’s rules, which are designed
by Allâh (swt), operationalised through the Sunnah, and made contemporary by the Ijtihad.
The Islamic economic system adopted in various countries may vary with regard to some
policy decisions taken by legitimate national authorities. However, the core rules and
institutions must be the same. All policies, transactions, contracts and economic activities
must be Sharī‘ah-compliant.
Learning Objectives
On completing this chapter, you will be able to:
Describe the core principles of an Islamic economic system.
Identify the characteristics of an efficient financial system.
Describe the roles of financial institutions.
Explain the two main tasks for financial institutions.
Identify the different types of financial markets.
Explain the role of ethics, and how differences, areas of conflict, and priorities are
managed in an Islamic financial system.
Describe the concept of a contract and the core types of contracts including two types
of transactional contracts and four types of financing contracts that are at the core of
an Islamic financial system.
Principles of an Islamic Economic System
Modern Western concept of property:
Right to property is the right of an individual to exclude others.
Right to public property - right of an individual not to be excluded by others.
Islam differs through two basic principles derived from the need to be just towards the
individual and society.
First Principle
Allâh (swt) is the ultimate owner of all properties present in the world.
Second Principle
An individual has rights to the resources owned collectively and the products created by his
or her own creative use of those resources, without impinging on the collective rights to
those resources or products.
Use of Natural Resources
Everyone has the right and obligation to use natural resources to produce goods and
services. The individual only gains priority over the collective in using and enjoying assets
created by their own labour.
Click the underlined word to know more about it.
The Sharī‘ah describes two private property obligations that are aligned with its definition of
property rights.
1. Responsibility of sharing the income through property or sharing the use
2. Obligation to not destroy, waste, squander or misuse the property
Individuals capable of acquiring a larger amount of property and assets through greater
mental and physical capacities have greater responsibilities as well.
Key conditions with regards to contracts in Islamic economic systems are:
Every contract must be Sharī‘ah-compliant.
All Muslims are required to honour their contracts.
Contracts must be documented.
Any agreement not specifically prohibited by the Sharī‘ah is valid and binding on all
parties and can be enforced by the courts; courts treat all parties as equals.
Trust is the most important element of Islam.
It is the foundation of an individual’s relationship between Allâh (swt) and with
others.
It is an obligatory personality trait.
Keeping trust and promises are major characteristics of the faithful.
Several verses of the Qur’ān emphasize trustworthiness.
The life of the Prophet (pbuh) illustrates the importance of trustworthiness.
Justice links an individual to Allâh (swt) and to others.
The Sharī‘ah judges a person’s just nature by the actions and the intent (Niyyah)
with which the person enters into a contract.
Every public office, including that of the Khalifa is considered to be a contract
between the individual and society.
The office of the Khalifa is governed by the Mubaya’a, a contract between the ruler
and the Muslim community.
Human freedom comes from personal surrender to the will of Allâh (swt).
The Sharī‘ah holds that the rights of an individual are gained not intrinsically but as a
consequence of meeting obligations to Allâh (swt), nature, self, and to others.
Individuals have natural, guaranteed rights.
For an individual, pursuing one’s economic interests is an obligation, a duty, and
finally a right.
When the ability of an individual increases, the obligation and rights also increase.
If an individual lacks the skill to pursue one’s economic interests, the right to
economic benefits is not negated.
Work (Al-Amal), in the holy Qur’ān, is a means of seeking Allâh (swt)’s bounty. Everyone is
required to perform good or beneficial work to reap rewards.
Work is regarded as a right, a duty and an obligation.
The selection of work by an individual should be based on natural talents, skills and
technology or personal inclination.
Therefore, justice demands that the return for every individual’s work must be
commensurate with the individual’s productivity.
Islam encourages man to utilize all the resources that Allâh (swt) has created.
Non-utilisation of these resources is considered as ingratitude to Allâh (swt).
Wealth must be attained through good, productive, and beneficial work.
The Sharī‘ah specifies some non-permissible professions, trade and economic
activities and lawful practices within each permissible profession.
Wealth must be continuously circulated within the community.
The Sharī‘ah has rules and obligations regarding disposal of wealth.
The Sharī‘ah indicates that the wealth-owner is a trustee of the wealth on behalf of
Allâh (swt) and the community. He must fulfil all the duties of a trustee.
An economic system is incomplete without an incentive-motivation structure.
The concept of Barakah or divine blessings guides the incentive structure in an
Islamic economic system.
According to this, the rate of return on activities increases with righteous conduct.
This concept creates positive correlation between the system’s conduct and
prosperity.
The converse of the concept applies as well.
Risk-sharing is based on the principle of taking on liability if return is desired as well.
According to the Sharī‘ah, only profit obtained by lawful means is permitted, and that too if
the entity is willing to take the risk.
Islam guides individuals to direct their actions and participate responsibly in economic
affairs to improve the well-being of society.
Islam attempts to reconcile competition and cooperation to build an ideal society.
According to the Holy Qur’ān and the Holy Prophet (pbuh), cooperation and
competition are two sides of human nature.
These attributes can lead to both integration and disintegration of human society.
Characteristics of an Efficient Financial System
The efficiency of a financial system is measured based on how well the savings from
Savings Surplus Units (SSUs) are allocated to Savings Deficit Units (SDUs) that need the
funds.
Every investor expects more return for less risk. On basis of risk-return expectations, we
can classify the financial system efficiency into four categories:
Allocation Efficiency
Pricing Efficiency
Information Efficiency
Operational or Transactional Efficiency
Allocation efficiency involves the allotment of more funds into desirable projects with higher
profitability and lower risk and vice versa. Therefore, the financial instruments issued by
such higher value projects will involve a lower cost of funds for the issuer.
Allocation efficiency of the system improves when any change:
Reduces transaction costs.
Simplifies the transaction system.
Increases the availability and accuracy of information.
Improves information processing by participants.
Pricing efficiency impacts allocation efficiency. If an instrument or project is more valuable,
the price of an instrument linked with it increases. A high price for financial instruments
indicates low rates or low cost of funds.
Information efficiency is required to achieve pricing and allocation efficiencies. If a financial
institution has adequate information on the project, then the prices and rates will reflect the
intrinsic value of financial assets. Thus, the financial system must provide a costless flow of
relevant information.
Operational or transactional efficiency is required for pricing efficiency. This involves the
execution of transactions at minimal costs. High transaction costs prevent prices and rates
from adjusting to changes.
The Roles of Financial Institutions (FIs)
Financial institutions perform two major types of roles. They are:
Direct or Facilitator
Indirect or Intermediaries
In addition, there are many different players performing specific tasks that help achieve the
overall objectives of the financial system.
Well-developed financial systems involve direct offer of products for investment by SDUs to
SSUs.
In these systems, FIs act as facilitators in the flow of funds and help business firms
and governments in raising the funds from households.
They help SDUs design and create “securities”, price, and market them to SSUs.
Facilitating FIs are known as investment banks.
Less-developed financial systems comprise FIs that perform an indirect or intermediary role.
They raise funds from SSUs through a range of “deposit” products.
They invest the funds into SDUs through various. “financing” products.
SSUs and SDUs do not interact directly in such a system. They have no rights or
obligations with respect to each other.
Intermediary FIs are also known as commercial banks.
Two Main Tasks for FIs
A financial system performs two main tasks. They are:
Mobilising Funds from SSUs
Channelling the Funds into SDUs
FIs offer a range of financial products to SSUs that match with their needs and
expectations.
Every investor likes returns and dislikes risks.
Products with higher expected returns than others will be more attractive to
investors.
In the Islamic financial system, the SSUs always need to conform to the Sharī‘ah.
No product or service of an Islamic bank should violate the Ribâ prohibition norm.
FIs design financial products and services based on the needs and requirements of business
firms and governments.
These requirements may relate to cost of funds, maturity, level, and pattern of
expected cash inflows from the project.
However, the financial products must not violate the Ribâ-prohibition norm.
Types of Financial Markets
Financial intermediaries trade products and securities in different types of financial markets.
Primary and Secondary Market
Money and Capital Market
Spot and Futures Market
Options Market
Foreign Exchange Market
In the primary market, SDUs offer new or fresh financial securities.
In the secondary market, primary market buyers sell the products and securities they
already possess to raise cash.
This market is further divided by the maturity of the traded financial products.
The money market involves short-term debt instruments that mature in one year or
less.
The capital market involves long-term debt instruments and equity obligations.
Participants in a spot market trade stocks, commodities or foreign currencies for immediate
delivery and payment.
Spot market is also called the cash market.
Participants in the futures market trade products for future delivery at a specified price.
Participants in the option market trade stocks, commodities or currency for conditional
future delivery.
An option gives a party the right, without any obligation, to trade a product.
The foreign exchange market trades only foreign currencies. Participants trade either for
spot or future delivery.
The Role of Ethics in an Islamic Financial System
A recent study identifies seven classes of fairness relevant to a conventional financial
system:
Freedom from coercion
Freedom from misrepresentation
Right to equal information
Right to equal processing power
Freedom from impulse
Right to trade at efficient prices
Right to equal bargaining power
The holy Qur’ān and the Sunnah provide the basic principles or norms for an Islamic
financial system:
Freedom to Contract
Freedom from Al-Ribâ
Freedom from Al-Gharar
Freedom from Al-Qimār and Al-Maisir
Freedom from Price Controls or Manipulations
Freedom from Darar
Right to Transact at Fair Prices
Right to Equal, Adequate, and Accurate Information
Mutual Co-Operation and Solidarity
Islam provides the basic freedom to enter into transactions.
The holy Qur’ān itself endorses this freedom, but this basic norm does not imply
unrestricted freedom to contract. The following guidelines apply.
Exchange is permitted only for certain commodities or property (māl).
The freedom to contract in Islam may be sacrificed in favour of other norms
requiring specific injunctions.
Any contract that involves coercion is invalid.
All forms of contracts and transactions must be free from Al-Ribâ, which means excess or
interest.
The prohibition of Ribâ indicates that there is no reward for time preference alone. Reward,
returns or benefits must always be accompanied by liability or risk.
All forms of contracts and transactions must be free from excessive Gharar (or uncertainty).
Contracts are disallowed under conditions and situations that Islamic scholars have
identified as involving excessive uncertainty.
Contracting under excessive uncertainty (Gharar) and uninformed speculation are closely
related to gambling (Al-Qimār).
The holy Qur’ān and the traditions of the Prophet (pbuh) prohibit unearned income (Al-
Maisir) such as from games of chance.
Islam conceives of a free market with no hindrance in the price formation process even by
the regulators. However, historically, the Hisba intervened to ensure that the market
produced fair and just prices.
Any attempt to influence prices through creating artificial shortage of supply (Ihtikar) is not
permissible by Islam.
Any attempt to bid up the prices by creating artificial demand (Najash) is also not
permissible.
Darar
Darar is the chance that a third party will be adversely affected by a contract between two
parties.
Sometimes a contract executed between two parties with their mutual consent is
detrimental to the interests of a third party.
Prices are believed to be fair when they result from free interplay of forces of demand and
supply. However, sometimes, the pricing is based on valuation by experts and may be
manipulated. In such cases, the difference between the transaction price and the fair price
is termed as Ghubn-e-fahish or Ghubn. Ghubn makes a transaction unethical.
Islam considers equal, adequate, and accurate information as vital for the financial market.
Releasing wrong information, hiding vital information (Ghish) or misrepresenting parties in a
transaction (Jahalah) violates the norms of Islamic ethics.
Islamic ethics also refer to information on expected cash flows and asset valuation.
Islamic ethics require that all such information should be available equally to all investors.
This norm is at the core of Islamic ethics as several verses from the holy Qur’ān and
Ahadith by the Prophet (pbuh) show.
Surah Al-Maida (5:2)
Al-Bukhari and Muslim
Differences, Conflicts, and Priorities in Islamic Finance
What happens if there is potential conflict between norms of Islamic financial ethics?
In such cases, the holy Qur’ān is most important, followed by the Sunnah, and then any
other principles such as unrestricted public interest called Maslahah Mursalah.
Maslahah comprise considerations, which in line with the objectives of the Sharī‘ah, provide
benefit or prevent harm. The Maslahah Mursalah framework compares benefits and costs at
a macro-level. It involves providing maximum social benefits.
Apart from these potential conflicts, the fundamental conflict is between ethics and
efficiency in a financial system.
Ethics is primary in Islamic financial system, but efficiency is priority in conventional
finance.
Types of Contracts in Islamic Finance
The Qur’ān and the Sunnah are the sources of the:
Contracts are the basis of economic relationships. Therefore, financial instruments are also
considered as contracts. The terms and conditions of financial instruments define the risk
and return profile.
Based on function and purpose, the Islamic system classifies contracts into four different
categories.
Transactional Contracts
Financing Contracts
Intermediation Contracts
Social Welfare Contracts
This classification helps to understand how credit is created, how financing instruments are
created, how intermediation works, and the different roles each group plays in the economic
system.
In this chapter you will learn in detail about transactional and financing contracts.
Intermediation contracts are covered in detail in a later chapter.
Transactional contracts are about real economic transactions.
Exchange can be on spot or deferred basis.
Goods may be exchanged for goods, money, or simply promises to pay.
Financing contracts help to:
Create and extend credit
Fund transactional contracts
Provide channels to form capital
Transfer resources between investors and entrepreneurs
Financing contracts can be used to provide capital through equity partnership.
Intermediation contracts offer efficient and transparent execution of transactional and
financial contracts.
Economic agents perform financial intermediation and also fee-based services for economic
activities.
These contracts include Mudarabah, Musharakah Kifala, Amanah, Takaful, Wakala, and
Jo’alah.
Social welfare contracts are meant to promote the welfare of less privileged members of
society.
An FI can offer community services by institutionalizing social welfare contracts.
Types of Transactional Contracts
Islam emphasizes trade of physical assets and of rights to use the assets.
The basic transactional contracts are:
Exchange and Sale of an Asset
Sale of Rights to Utilize an Asset
The first contract involves transfer of ownership, but the second only involves the transfer
of rights to use the asset.
Let us discuss these contracts in detail.
The contract of sale can be classified using subject of sale and mode of payment.
Sale contracts can be of five types:
1. Bai’
2. Sarf
3. Sale by barter
4. Bai’ al-Dayn
5. Bai’ al-Salam and Bai’ al-Istisnah
Sale contracts can be of five types.
1. Spot cash sale
2. Instalment sale
3. Lump sum payment payable in the future
4. Bai’ al-Arabun
5. Bai’ al-Mu’ajjil
The contract of Ijarah means to give something on rent and it also means a sale of the
usufruct for a specified period.
Renting of an asset is also the contract of Ijarah.
In Ijarah, the ownership of the asset remains with the lessor and only the right to use that
asset transfers from lessor to lessee for specified period.
Types of Financing Contracts
Financing contracts offers low-risk asset-backed securities and promote risky equity
financing. Financing contracts are classified as four major contracts. They are:
Murabahah
Bai’ Bithaman Ajil
Tawarruq
Musharakah
Let us discuss about these contracts briefly.
The Murabahah (cost-plus sale) contracts help the individual to purchase a product on
credit.
For delayed payment, the financier and entrepreneur agree on a profit margin or mark-up,
which is added to the cost of the product.
For Murabahah to be valid, the contract should involve original sale, not any existing
inventory.
In some Islamic countries, the payment of a Murabahah contract is made in instalments
after delivery of goods. This kind of contract is known as Bai’ Bithaman Ajil or BBA.
The differences between Murabahah and Bai’ Bithaman Ajil are:
BBA is used for long term financing.
In BBA, the financier is not required to disclose the profit margin.
Tawarruq is also known as “reverse Mudarabah” and this contract involves two separate
transactions.
The practice is legitimate according to the Sharī‘ah.
The Musharakah (Partnership) contract is a pre-Islamic contract and was widely accepted
and promoted by the Holy Prophet (pbuh).
It is a combination of Shirkah and Mudarabah.
Key Terms
Ahādith
Al-Shufa
Bai’
Bai’ al-Dayn
Chapter 2
Chapter Introduction
Hello and Norms of Ethics in an Islamic Financial System.
Islamic ethics has certain norms that have high priority in the Islamic financial system. All
financial and business transactions must be governed by norms of Islamic ethics, as derived
by the Sharī‘ah.
Basically, an Islamic financial system may be described as a “fair” and “free” system.
However, to ensure “fairness”, it circumscribes the “freedom” of the participants in the
system. It provides the freedom to enter into transactions, while maintaining that these
norms and ethics of Islam do not imply unbridled freedom to contract.
The basic norms of the Islamic financial system include:
Freedom to contract
Freedom from Al-Ribâ
Freedom from Al-Gharar
Norms of Al-Qimār and Al-Maisir
Norms of Ghubn
This chapter will also acquaint you with the tenets of the Sharī‘ah, which lay down the
norms of profit and the norms of mutual cooperation or Ta’wun.
The idea of profit is based on one of the most important maxims of the Sharī‘ah, Al Kharaj
bi-al-Daman or Al Ghunm bil Ghurm. Al Kharaj bi-al-Daman is the standard of legality of
return on capital. It says that a person has to accept loss, if he wants to earn profit over his
investment.
The norms relating to mutual cooperation, solidarity, and brotherhood are in the nature of
advice and instances that extol and encourage good behaviour.
Learning Objectives
On completing this chapter, you will be able to:
Explain the view that Islamic jurists take on the freedom to contract.
Explain the prohibition of Al- Ribâ, in loan contracts and exchange contracts.
Describe the norm that prohibits Al-Gharar.
Explain norms prohibiting Al-Qimār, Al-Maisir and Ghubn.
Describe the norms relating to profit in financial transactions.
Describe the norms related to mutual cooperation or Ta’wun in financial activities.
Note: All terms in italics are Islamic terms and are defined in the glossary, which can be
accessed by clicking the Glossary button at the top of the screen.
The Freedom to Contract
Islam provides the necessary freedom to enter into transactions.
Through the following verses, the Holy Qur’ān asserts that trade is lawful, but Ribâ (usury)
is not.
Surah Al-Baqarah (2:275)
Surah An-Nisâ’ (4:29)
Note: All verses from the Holy Qur’ān or Hadith quoted in this chapter are cited in the
following manner:
Name of the Surah (number of the Surah: number of the verse)
All citations of verses or Ahadith are based on the following sources:
Qur’ān Complex
Hadith Al-Islam
However, this norm does not imply unrestrained freedom to contract. The terms of
acceptability are:
An exchange is acceptable only when undertaken in permissible merchandise or
property or māl.
Trade in stocks or ownership interests in companies dealing with or producing
commodities containing alcohol and pork is not acceptable.
Trade in financial options is not permitted as rights are not deemed to be māl.
A contract may also be invalid when there is a transaction with other norms requiring
specific injunctions.
The Freedom to Contract – Elements of a Contract
‘Aqd, which means conjunction or to tie, is synonymous with the word “contract” of modern
law. No ‘Aqd or contract is valid if one party has been coerced in some form or the other.
A contract involves:
The existence of two capable and sane parties together called ‘Aqidain; this is an
essential element.
The issuance of an outward act depicting internal willingness
An offer (Ijab) and acceptance (Qabul) together called Sighah; this is an essential
element.
A legal union between the two declarations, concerning the subject matter or Ma‘qud
‘alayh and the contractual obligations; this is the third essential element.
Freedom from all prohibitions
According to Sanhuri, an exponent in Islamic finance, there are seven components in a
contract:
The agreement of offer and acceptance
The agreement of the Majlis (session/meeting) of a contract
Plurality of the contracting parties
Maturity of the contracting parties
Subject matter susceptible to delivery
The object (Mahall) defined
The beneficial nature of the object, as permitted by Sharī‘ah rules
The Concept of Al-Ribâ
Al-Ribâ or Ribâ means interest. Prohibition of Ribâ is fundamental to Islamic financial ethics
and law.
The verses of the Holy Qur’ān that explicitly forbid Ribâ are:
Surah Al-e-Imran (3:130)
Surah Al-Baqarah (2: 278-279)
The Holy Qur’ān also recommends the prohibition of:
Ribâ in Loans/Debts
Ribâ in Sales/Exchange Transactions
Ribâ in Loans/Debts
Loan (Qard): Any commodity or a sum of money that is given by one party to another for a
certain estimated time.
Debt (Dain): A liability to pay, which results from any credit transaction like a trade on
credit or due rentals in Ijarah or leasing. The amount of debt has to be paid back at a
specified time and the creditor has no right to demand payment of the debt before the
mutually agreed time.
The Holy Qur’ān states that in both loans and debts, the creditor:
Has right only over the principal amount (Ra’asul-māl).
Has no right to an excess amount or interest on it.
The Holy Qur’ān explains that all income and earnings, salaries and wages, remuneration
and profits, usury and interest, rent and hire, and so on, can be categorized either as:
Permitted profit: Profit from trade and business along with its liability.
Prohibited profit: Return on cash or a converted form of cash, without bearing
liability in terms of the result of deployed cash or capital.
Permissible and prohibited transactions are distinguished based on their nature as:
Sale/Purchase: In sale (Bai ‘), the ownership of the commodity is transferred to
the buyer from the seller. This ownership transfer may take place on cash or credit;
but this involves some profit margin for the seller, which is permitted.
Loan: A loan involves a temporary transfer of ownership of goods or assets. In
Islamic finance, the loan is always free of any charge. The buyer should pay only the
principal amount as an excess amount or interest is prohibited.
Lease: In leasing or Ijarah, the ownership of the leased asset does not transfer and
only the usufruct of the asset is made available to the lessee against the payment of
rent. In Islamic finance, taking rent on leasing of assets like houses, vehicles, etc. is
permissible while charging rent on money is prohibited.
Ribâ in Sales/Exchange Transactions
Exchange: The act of changing a commodity or asset for another commodity or asset.
Exchange rules are different for different types of assets and contracts.
According to the rules of exchange of monetary units (Bai‘ al Sarf), an equal and on-the-
spot exchange is mandatory for the exchange of any asset with the same kind of asset.
Exchange rules summarized by Imam Nawawi, the commentator of Sahih Muslims are as
follows:
When the two goods being exchanged are different, excess and delay or both are
permitted. For example, exchanging gold for wheat or dollars for a car.
When the two goods being exchanged are similar, excess and delay, both are
prohibited. For example, exchanging gold for gold or wheat for wheat, dollars for
dollars, etc.
When the two goods being exchanged are different but the effective cause is the same,
then excess/deficiency is permitted, but delay in exchange is prohibited. For example,
exchanging gold for silver or US Dollars for Japanese Yen or wheat for rice.
The Concept of Al-Gharar
In Islamic finance, the second major prohibition is that of Al-Gharar or Gharar. Gharar
means legal ambiguity or uncertainty that any one of the parties to a contract can exploit at
the expense of the others. Economic risk or uncertainty are intrinsic to any economy, but
contractual risk can be mitigated by scrutinising contracts based on the Sharī‘ah. Legal
uncertainty cannot be justified under any circumstances. Unlike Ribâ, some degree of
Gharar is acceptable in the Islamic framework, but excessive Gharar is prohibited.
Gharar occurs with:
The sale of a commodity or asset, which is not present at hand.
The sale of a commodity whose quality of being good or bad is not known to the buyer.
A sale involving the hazard that one does not know whether it will come to be or not.
For example, the sale of a fish in water or a bird in the air.
Siddiq M. Al-Amen Al-Dhareer (1997) has classified the principles covering Gharar as
follows:
Gharar in the terms and essence of the contract includes:
Two sales in one
Down payment (‘Arb¯un) sale
“pebble”, “touch” and “toss” sales
Suspended (Mu‘allaq) sale
Future sale
Gharar in the object of the contract includes:
Ignorance about the genus or species
Ignorance about attributes
Ignorance about the quantity of the object
Ignorance about the specific identity of the object
Ignorance about the time of payment in deferred sales
Explicit or probable inability to deliver the object
Non-existent object
Not seeing the object
In order to avoid uncertainty, Islamic law prohibits the sale of a commodity in the following
situations:
1. Things which do not exist
2. Things which exist, but the seller does not possess or the availability is doubtful
3. Things which are exchanged under conditions of uncertain delivery and payment
Examples of transactions/ contracts involving Gharar include:
Selling goods that the seller is unable to deliver, as this involves counterparty or
settlement risk
Making a contract conditional on an unknown event
Two sales in one transaction, such as selling one article at two different prices, one
for cash and one for credit, or selling two different articles at one price, one for
immediate remittance and one for a deferred one
Making the contracts too complex to clearly define the benefits/liabilities of the
parties
Selling goods on the basis of false description
All contracts where value-relevant information is not clearly available to the parties
The Concepts of Al-Qimār and Al-Maisir
Al-Qimār and Al-Maisir are terms associated with unethical and prohibited financial
transactions.
Example: Mobilisation of funds by the Government through a lottery is considered as
gambling and therefore, is prohibited. This is because only the lottery organiser obtains
consistent returns, which are at the cost of those who buy the tickets.
Al-Qimār, which means a game of chance:
Implies that one gains at the cost of other(s).
Resembles gambling, which the Holy Qur’ān explicitly prohibits.
Means receipt of money, profit or usufruct at the cost of others by resorting to
chance.
Al-Maisir, which means wealth obtained by chance:
Implies wishing for something valuable without working for it.
Is gambling.
The Sharī‘ah prohibits the following.
Conventional transactions and bank products that involve Maisir.
Conventional insurance because it involves both Ribâ and Maisir.
The Sharī‘ah permits only the following:
Lotteries that are impartial and do not deprive anyone of possessions or
contributions already made
Drawing lots when selecting or conferring privileges or concessions among equals
Entrepreneurs offering incentives and additional products to customers to buy a
product
The Sharī‘ah prohibits the following kinds of Maisir:
When loss of funds of one investor benefits another investor
Schemes in which prize tickets or coupons are given on purchase of products, but
the customer is not guaranteed to win a prize
Bank schemes in which the bank offers a prize for depositors, which is pre-
determined additional return from the bank on the deposit.
The Concept of Ghubn
Ghubn
Ghubn = (Manipulated price) – (Fair price)
Manipulated price is the price at which a transaction is executed
Fair price is the price according to valuation by experts
The presence of Ghubn makes a transaction unethical.
The Holy Prophet (pbuh) prohibited Ghaban-e-Fahish, which means selling something at a
higher price and giving the impression to the client that he is being charged according to the
market rate.
Ghaban-e-Fahish involves excessive profiteering with deception. A person sells a commodity
stating explicitly or giving the impression that he is charging the market price, but actually
he is charging an exorbitant price by taking benefit of the ignorance of the purchaser. In
such cases the purchaser has the option to revoke the sale and get back the price paid.
Norms Relating to Profit
Islamic banking practices do not allow charging or paying interest, hence the financial
system promotes the practice of sharing both profit and loss.
Profit-sharing is based on the following:
Money by itself is not considered as capital.
Since all commercial activities involve risk, one has to bear that risk for legal
earning.
The return expected on funds invested often determines how willing and capable a
business person is to add value or bear potential loss.
Interest, lotteries and gambling, are prohibited because rewards of business should
be the result of productive activity, not luck, chance or hazard.
The following considerations apply:
Transfer of commercial risk without the transfer of the reward is not permitted
under the Sharī‘ah.
Ownership cannot be separated from the risk of potential loss.
In the case of loans, creditors cannot claim profit as they regain the full loan
amount every time.
In the case of trade, owners bear risk of loss or destruction as long as the assets
remain with them.
Risk is transferred to buyers the moment the asset is sold.
Buyers have to pay the full price at the time of settlement, even if the asset shows
signs of destruction.
Buyers may lessen their loss by way of Takaful.
In the case of Ijarah, land / asset owners may collect rent / lease only if they keep
the asset in usable condition.
In a Shirkah partnership:
The parties share both profit and loss in proportion to their individual investments.
All loss is borne by the capital owner while entrepreneurs lose the benefits of their
labour.
In the case of bank depositors, the risk comes from the failure of business and the
uncertainty regarding the profit that has to be shared.
Bank’s clients may conceal their profits and the bank might end up losing the
capital.
The Sharī‘ah treats only loss of capital as a loss, not any decrease in potential profit.
Norms Relating to Mutual Cooperation
Norms relating to mutual cooperation, solidarity, and brotherhood are central to Islamic
ethics. These norms are laid out in the form of validations of age old practices (Aqilah and
Daman Khatr al-Tariq., advice on good and ethical behaviour, and instances that encourage
good living.
The Surah Al-Maida (5:2) advocates helping one another and not provoking another into
committing sin. Ahadith by the Holy Prophet also support mutual cooperation.
Early Islamic societies displayed the following practices of mutual cooperation and support.
Gathering funds into a security called as Daman Khatr Al-Tariq to help victims of
natural disasters or hazardous journeys undertaken for trade.
Helping prisoners and the families of murder victims through an alliance known as
A'qila
Entering into contracts such as ‘Aqd Muwalat to end mutual enmity or revenge
Starting associations, by means of a Hilf, and signing agreements for mutual
assistance
The first constitution of the Islamic state of Medina contained three features relating to
insurance:
Stipulation for social insurance for the Jews, the Ansar and the Christians
The statement "the immigrants among the Quraish shall be responsible for their
word and shall pay their blood money in mutual collaboration"
Provisions for Fidya (ransom), which was paid to rescue prisoners, and the A’qila (an
alliance), which cooperated to free them
Key Terms
‘Al Kharaj bi-al-Daman
‘Aqd
‘Aqidain
Aqilah
‘Aqd Muwalat
Daman
Dain or Debt
Daman Khatr al-Tariq
Gharar
Ghubn
Ghaban-e-Fahish
Ijab
Ijarah
Maisir
Māl
Qabul
Qard
Al-Qimār
Ribâ
Risk
Ra’asul-māl
Sharī‘ah
Shirkah
Sunnah
Sighah
Takaful
Chapter Introduction
Hello and A Framework for the Islamic Financial System—Part 1.
An Islamic Financial System works on a very simple premise – Savings Surplus Units (SSU)
and Savings Deficit Units (SDU).
SSU: An SSU comprises individuals, households and government sectors.
SDU: An SDU comprises business houses and government sectors.
The availability of funds is governed by the forces of demand and supply and the risk
profiles of various stakeholders.
Financial institutions such as commercial and investment banks, micro-credit institutions
and savings and loan institutions, act as intermediaries linking SSUs and SDUs.
Financial institutions charge a rate of return from the fund users, give a part of the return to
the fund owner (saver/investor), and retain the excess of the amount deposited for
themselves.
Islamic financial institutions, SSUs, and SDUs must conform to the Sharī‘ah, especially with
regard to Ribâ, when investing and using funds.
Learning Objectives
On completing this chapter, you will be able to:
Explain the strategic role of financial institutions in society.
Describe the services and benefits of financial institutions in society.
Explain how a commercial bank essentially works.
Explain how an investment bank essentially works.
Explain the nature of non-banking financial institutions and financial markets.
Describe the primary characteristics of an Islamic financial system.
Describe the basic operations of an Islamic bank.
Identify the most suitable organisational model for Islamic banks.
Describe the two types of deposits that Islamic investment banks can provide.
Explain how a deposit may be managed by an Islamic bank.
Identify the appropriate modes of financing through which Islamic banks can invest funds in diverse sectors.
Recognise the difference between the profit/loss-sharing and exchange contract approaches used by Islamic banks to generate returns.
Describe the advantages and disadvantages of the profit/loss-sharing approach adopted by Islamic banking.
Explain the types of services that Islamic investment banks can provide.
Note: All terms in italics are Islamic terms and are defined in the glossary, which can be
accessed by clicking the Glossary button at the top of the screen.
The Strategic Role of Financial Institutions in Society
Role of Financial Institutions (FIs)
Play the role of intermediaries to facilitate efficient flow of funds.
Protect fund users from the possible disadvantages of direct transaction between lenders and borrowers.
Transform the nature of funds and their maturity terms to suit the needs of fund users. This process of transformation is known as intermediation, and such companies are known as financial intermediaries, or financial institutions.
Commercial banks are known to be the principal financial intermediaries. Other FIs include
investment banks, non-bank FIs, development FIs and the Bank of International
Settlements (BIS). The BIS coordinates and standardises the services of international banks
and financial institutions at a global level.
Commercial Banks
These FIs:
Connect the fund saving and the fund using units through intermediation.
Provide checking or current account, saving account and investment accounts facilities to savers and investors.
Non-Bank Financial Institutions or NBFIs
These FIs:
Do not provide checking or current account facilities to savers.
Facilitate the raising of funds for business and commerce directly from the saving entities or households.
Development Finance Institutions or DFIs
These FIs:
Operate in dual mode - as banking and non-banking institutions.
Provide finance to business, agriculture and other sectors that aid developmental activities.
Investment Banks
These FIs:
Are like NBFIs.
Draw profit from fee-based activities and trading in securities.
Services offered by investment banks include:
Underwriting securities
Trading in stocks and bonds
Assisting mergers and acquisitions
Organising and funding syndicated loans
Offering financial advice
The Services and Benefits of Financial Institutions
Financial institutions provide a wide range of services and enjoy benefits due to their size
and the range of services they offer.
Financial intermediaries offer four essential services:
Extensive range of fund denominations for investment in securities
Securities of different maturities
Diversification of risk
More liquidity and reduced transaction costs
Financial intermediaries benefit from certain advantages:
Economies of scale and scope leading to lower costs per transaction
Easy access to borrower’s sensitive and crucial financial information
Production of financial merchandise at lower cost
The Working of Commercial Banks
Financing Long-term mortgage
Investing depositors’ funds
Offering merchant banking
Exchanging foreign currency and money
Issuing letters of credit (L/C) and letters of guarantee (L/G)
Making and receiving payments on behalf of customers
Safeguarding valuables
Providing advisory services
Commercial banks conduct their business on the basis of the interest they levy. Most
commercial banks undertake the following functions:
Obtaining deposits
Funding short and medium-term loans
Providing advances against securities
More About the Working of Commercial Banks
In commercial banks, all deposits are considered a liability because the deposits have to be
paid back regardless of a return. Current accounts are used for managing cash flow and
therefore, carry no return while savings, term, notice deposits, certificates of investment
(COIs)/certificates of deposit (CODs) are fee-based deposits.
The main types of deposits are:
Current Accounts:
o Offer credit facilities to companies and individuals.
o May or may not offer returns.
Savings Accounts:
o Are normal, interest-bearing accounts.
o Require minimum balance.
Fixed-term Accounts:
o Lock in money for a fixed period but earn interest.
o Carry a penalty for early withdrawal of funds.
o Are issued at par or at a discounted value that grows in the given time frame.
Annuities/Perpetuities:
o Are built on savings accounts.
o Allow deposit holder to withdraw an approved amount for an indefinite period at
an approved timeframe.
o Are offered by life insurance companies, mutual funds and share markets.
Advance Profit-paying Products:
o Offer discounted profit, which is paid in advance.
o Can be compared with a term deposit receipt issued at discount.
Cash Management/Fund Management Accounts:
o Are deposits of money for an agreed period, for a fixed rate of return or a rate
linked to the capital market.
o Allow the client to instruct the bank regarding the investments of funds in non-
discretionary accounts.
Commercial banks invest depositors’ money in the form of short, medium and long-term
loans that earn interest.
The various types of loans are:
Productive loans for trade, commerce, and housing
Consumption and consumer durable loans for household items, automobiles
Clean advances given without collateral
Discounting of commercial papers
Cash credit like overdrafts but drawn from a limit set by the bank
The Working of Investment Banks
Investment banks:
Facilitate direct flow of funds from surplus to deficit units.
Help business houses and governments with financial aids.
Engage in both primary and secondary markets.
Obtain income from fees accrued.
Provide services such as:
o Underwrite securities
o Trade in stocks and bonds
o Assist mergers and acquisitions
o Organise and fund syndicated loans
o Offer financial advice
Mobilise funds from venture capitalists through private placements.
Facilitate initial public offerings (IPOs).
Serve as brokers, arbitrageurs, and corporate advisors.
Mobilise medium and long-term finance through closed and open-ended funds by issuing COIs/CODs and offer assured dividend accounts without checking facilities.
COI holders avail pre-agreed interest income and dividend at a certain rate for the period of
the deposit. In exceptional cases, account holders are offered a minimum guaranteed
return, which is below the market rate while the upside is kept open.
NBFIs and Financial Markets
NBFIs do not provide checking or current account facilities to savers. They facilitate the
raising of funds for business and commerce directly from the saving surplus entities or
households.
Financial markets facilitate the management of liquidity for investors. They help security
holders by selling their securities to third parties.
NBFIs include:
Discount houses
Leasing companies
Venture capital companies
Asset management and fund management companies
Insurance companies
These NBFIs:
Act as intermediaries between SSUs and SDUs.
Offer investors interest or a guaranteed dividend on their investments while collecting interest from the fund users.
Deal in real estate and manage property to earn fixed interest and variable returns like dividends.
Conventional financial markets comprise money and capital markets.
The money market is based on:
Receipts and payments of interest on short-term lending and borrowing
Trading in short-term debt instruments
The capital market is based on:
Medium and long-term debt
Medium and long-term equity-based transactions
Foreign exchange trade
Financial markets are further divided into:
Primary markets, where instruments are created
Secondary markets, where instruments are traded
Among the innovations in conventional finance markets are Global Depository Receipts
(GDRs). GDRs:
Are negotiable certificates held in the bank of one country
Represent a specific number of securities/shares of a stock traded on an exchange of another country.
Primary Characteristics of an Islamic Financial System
Islamic financial institutions (IFIs) perform the same functions of an intermediary between
the surplus and deficit units. The major difference between the two units is ‘interest’, which
is replaced by a number of other financial instruments.
Some of the striking characteristics that set them apart from modern commercial banks are:
IFIs share profit or loss that accrues on investments.
IFIs earn returns on trading and leasing activities.
IFIs mobilise deposits earned through profit/loss-sharing and to an extent through the Wakalah against pre-agreed service charges or agency fees.
The asset is the responsibility of the owner and the liability of a loss is borne by them in the Musharakah/Mudarabah mode of financing.
This mode also defines leasing terms, where the owner bears the risks and expenses.
Basic Operations of an Islamic Bank
An Islamic bank is a deposit- taking banking institution that performs all banking activities
except borrowing and lending on the basis of interest. This implies there is not attached fee
involved in the services they offer.
On the other hand, commercial banks with share capital, charge for all the services they
provide.
Banking activities can be categorised as activities for,
Mobilising funds
Investing funds
Let us now take a look at the general outline of Islamic banking as depicted by several
Islamic banking experts including Mabid Ali Al-Jarhi and Munawar Iqbal (2001).
On the liabilities side, an Islamic bank mobilises funds based on:
Demand deposits: Short-term interest-free loans offered to customers.
Mudarabah or Wakalah (agency) contract: Agreement upon which the loan is
provided.
An Islamic bank shares its net earnings with depositors based on size and maturity value of
each deposit.
Further in this chapter, you will learn about the basic process of the Mudarabah contract
and its application as a mode of financing.
On the assets side, deposits in investment accounts may be invested through:
Actual partnership in business where the bank makes profit-sharing investments.
Interest-free Sharī‘ah-compliant modes such as :
o Advancing funds on a profit and loss-sharing basis
o Purchasing assets on a fixed-return basis
Organisational Model for Islamic Bank
The three organisational models that banks can adopt, according to their span of activities
are:
Universal Banking Model
Bonafide Subsidiary Model
Bank Holding Company Model
The first two models may not best suit Islamic banks due to the nature of their operations.
The fully owned subsidiaries model is best suited to banks if they establish a number of
subsidiaries for various types of operations like, investment banking, commodity trade-
based banking, leasing-based banking, Istisna‘a-based banking and the normal commercial
banking. IFIs can also have special branches for industry, agriculture, commerce, real
estate, and Takaful businesses.
The modes available to banks or their subsidiaries in order of priority will be:
Musharakah
Mudarabah
Ijarah
Bai‘ Mu’ajjal
Bai‘ Salam and Istisna‘a
Types of Deposits in Islamic Banks
Islamic banks must innovate techniques to:
Mobilise deposits
Safeguard depositors from loss on profit and loss-sharing (PLS) deposits
The two types of deposits offered by Islamic banks are:
Current deposits
Savings/Investment/Term deposits
The following are the characteristics of current deposits:
They carry no return.
They are kept as Amānah; returns from investing funds are treated as loans.
They are guaranteed to the extent of the principal amount.
They can be used as source of funds for business by the bank only after prior
agreement with depositor.
The following are the characteristics of Savings/Investment/Term Deposits at Islamic banks.
All remunerative deposits are based on a PLS ratio, which is agreed between the
parties when the account is opened and must be Sharī‘ah-compliant.
Deposits of longer duration shall be compensated through assignment of higher
weightages, the range and type for which is specified by regulators.
Deposits of risk-averse clients are accepted into current accounts, special pools, or
as Murabahah and leasing funds, earning a quasi-fixed share of profits or rentals.
Risk-prone deposits are a part of the bank’s equity, the weightage for return being
on a Daily Product Basis (DPB).
Specific investment accounts can be managed on a Mudarabah or Wakalah basis or
by investing funds in mutual funds set up by banks.
An Example of Deposit Management
Most Islamic banks follow a profit-sharing system known as the Mudarabah + Musharakah
or as the Mudarabah model.
The process flow of the Mudarabah model is:
1. The bank creates an investment pool with categories based on different tenors of
deposits.
2. Each depositor, and possibly the bank as well will deposit funds in a specific category
of the investment pool, which is a Musharakah relationship with specific weightage
assigned to each depositor.
3. The pool enters into a Mudarabah contract.
4. The bank undertakes business with funds from the pool, and the profit earned is
shared between the parties in an agreed ratio.
For example, assume that the profit-sharing ratio is 50:50. The bank deploys $10,000 of
the pool for one month and earns a profit of $1,000 at the end of the month. The bank
earns $500 and the pool earns $500. The Mudarabah contract would be completed at this
stage.
The profit earned by the pool is distributed as per the weightage allocated at the beginning
of the month. The relationship within the pool is governed by the rules of Musharakah.
According to the rules of Musharakah, loss to the pool, if any, is distributed among the pool
members (Rabbul-māl) based on their investment ratio.
In practice, these pools are created only for use with restricted investment accounts. In the
case of unrestricted investment accounts, the bank is free to use the deposits for any
Sharī‘ah- compliant financing.
Modes of Financing Trade, Industry, and Agriculture
Islamic banking practice is open to utilising all rightful modes, including those based on:
Shirkah
Trade or lease
Finance trade
Industry or a budget deficit through domestic or foreign sources.
Banks should manage diversified portfolios and select proper modes to avoid risks.
Some of the modes are Musharakah/Mudarabah, Murabahah, Musawamah, Salam, Istisna‘a,
Ijarah and Istijrar.
The following modes can be used for trade and industry.
Murabaha, instalment sale, leasing and Salam
Istisna‘a
Salam or Istisna‘a
The following modes can be used for agriculture and forestry.
Murabaha, Salam
Ijarah Muntahia-bi-Tamleek, Salam, Murabahah
Diminishing Musharakah or rent-sharing
Operating Ijarah, Salam
Salam, Musāqah
The following modes can be used for consumer finance.
Murabaha, leasing, return-free loans out of the current accounts
Wakalah and Murabaha - cash financing through charge and credit cards.
Ijarah Muntahia-bi-Tamleek and Murabaha - the alternatives for auto finance
Murabaha, Diminishing Musharakah and rent-sharing
Islamic banks may sell and purchase Sharī‘ah-compliant money and capital market
instruments like stocks and Sukuk.
Highlights of Sukuk:
Earn returns on the basis of ownership rather than interest
Can be sold or purchased in the secondary market or to the central bank if
regulations permit
Can be structured on an amortising or bullet maturity basis
Direct placement or acquisition of funds on the basis of Mudarabah and Musharakah is also
possible.
The following process can be adopted by the bank:
1. Create a Mudarabah relationship with itself as Mudarib.
2. Allocate funds to pools.
3. Allocate weightages periodically.
4. Allocate profit earned according to weightages.
Profit/Loss-Sharing:
A pre-agreed Mudarib fee as a percentage of the realised profit
Additional profit from the bank’s own share of capital
Investor to bear loss unless it arises from misconduct or neglect by the Mudarib
.
Foreign exchange operations are subject to the following.
These are subject to the rules of Bai‘ al Sarf.
Spot purchase and sale of one currency against another currency is allowed.
Forward purchase and sale is not allowed.
IFIs can enter into an undertaking to purchase and sell foreign currency with
forward cover and with earnest money required from the other party to ensure
execution of transaction.
Negotiation of export documents is partially allowed.
Modes for financing public sector projects are as follows.
Government and public sector enterprises can purchase equipment or utility-
generating assets through Mudarabah or Musharakah certificates.
Ijarah Sukuk and Istisna‘a are best suited for infrastructure projects in the public
sector.
Through syndication, Islamic banks can supply highly valuable assets to
government entities or corporations on a Murabaha basis.
Two Approaches for Returns in Islamic Banking
A majority of scholars believe that profit/loss-sharing (PLS), encompassing Musharakah,
Mudarabah and their variants, is the main instrument that can replace the interest-based
system. On the other hand, there are scholars who think that contracts of exchange are
more relevant to Islamic financial institutions.
Opinions of scholars on PLS:
No risk equals no gain.
PLS is extensively used for non-trade operations.
PLS does not involve unlawful traits.
PLS are more suited to achieve the objectives of economic justice, efficiency and
stability of the Islamic economic system.
Mudarabah, Shirkah or acquisition of shares of joint stock companies is a good form
of financing.
Islamic scholars:
Consider exchange contracts both for instant and deferred prices as more relevant to
IFIs.
Deem them as equally legitimate as PLS and on par with it.
Have not forbidden debt-creating modes.
Have allowed exchange-based modes.
Islamic finance is largely based on trade or exchange-based transactions.
Profit/Loss Approach in Islamic Banking
The substitution of the interest-based system by a profit-sharing system raises a number of
fundamental theoretical, practical and policy questions.
The key questions are:
What is the theoretical framework underlying Islamic banking and finance?
Will the Islamic system be more or less stable than the traditional interest-based
system?
What will be the effect of the adoption of an interest-free Islamic system on
important macroeconomic variables like saving and investment?
Will monetary policy have a role to play in such a system?
Research findings concluded the following on the theoretical frame work of the profit-
sharing system.
The Islamic financial system replaces interest-based transactions with a type of
profit-sharing arrangement.
Islamic system is equity-based rather than debt-based as in conventional finance.
Islamic system treats deposits as shares and therefore, does not guarantee their
nominal value.
In the traditional system, such deposits are guaranteed either by the banks or by
the government, which often leads to the need for intervention in times of crises.
On the stability of the system, research findings show that:
The equity-based Islamic system may be better able to adjust to shocks that can
lead to banking crises than the interest-based banking system.
In an equity-based system, shocks due to non-performing assets (NPAs) are
immediately absorbed by changes in the nominal values of shares—deposits-held
by the public in banks.
In the conventional debt-based system, the nominal value of deposits is
guaranteed. Therefore, shocks can cause huge discrepancy between real assets and
real liabilities and prevent a quick return to equilibrium.
On the macroeconomic impact of the profit-sharing system, research findings suggest that a
full Islamic system the costs of monitoring would be minor and the equity participation
arrangement would be superior to the interest-based system.
Other research suggests that:
A profit-sharing arrangement between the lender and investor as in the Islamic
system may raise monitoring costs and could have an adverse effect on the supply
of credit and thus on investment.
To minimise this, individual contracts can be structured to account for moral
hazard.
By implementing a legal and institutional framework based on the Sharī‘ah, Islamic
nations can facilitate contracting and safeguard the terms of contracts.
Research results also indicate that specifically in the PLS based Islamic system:
Expectation-based profit-sharing ratios can serve as a means of pricing to restore
equilibrium to the loanable funds market.
Risk-free assets with positive returns will be eliminated, improving the situation of
lenders.
Profit-sharing ratios are relatively inefficient in implementing monetary policy.
Interest-free banking does not ensure that all profitable projects will receive funds
regardless of their rate of return.
Other studies, however, do not agree and conclude that:
The rate of return increases with risk, so savings may rise.
Implementing an Islamic financial system will cause structural changes that may be
favourable for the rate of return on financial assets. Therefore, savings may not be
lower than in a traditional system.
Monetary Policy
Sami Hasan Homoud (1998) presents an outline of how monetary policy based on modes of
an Islamic financial system can pump huge number of funds into an economy and lift
millions from poverty.
Let’s look at how this can happen.
Mudarabah combines funds and financial expertise for a business. Mudarabah
Sukuk can be issued to raise funds and fortify trading and industrial activities.
Shirkah-based (PLS) modes can be used for short, medium, and long-term project
financing, import financing, pre-shipment export financing, working capital
financing, and financing of all single transactions.
SPVs manage such assets as trusts/funds for their own benefit as well as for the
Sukuk holders. This generates higher rates of return for the investors relative to
most interest- based investments.
Murabahah carries less risk and has several advantages over other techniques.
Ijarah facilitates the creation of fixed assets, medium and long-term investments.
Salam has a vast potential in financing the productive activities in crucial sectors,
mainly agriculture, agro-based industries and the rural economy.
Note: In practice, the most popular forms of Islamic financing are Murabahah and Ijarah,
not Mudarabah and Musharakah.
Islamic Investment Banking
Islamic investment banks provide the same products and services as a conventional bank.
The distinguishing factor is that their products and services are Sharī‘ah-compliant while
meeting the customers’ requirements. Islamic investment banks handle portfolios for
institutions, corporate clients and high net worth individuals, and pooled investment
mediums such as unit trusts and mutual funds.
Asset management or management of funds comprises equity funds, real estate funds, and
alternative investments in Ijarah and other Sukuk. They engage in treasury operations for
managing the asset–liability mismatch generated by different tenors of investment
opportunities and different return profiles.
The opportunities for Islamic Asset management are:
Open and closed-end mutual funds
Equity benchmarks
Leasing companies involved in asset-backed financing
Venture capital financing activities must:
Avoid involvement in prohibited and unlawful activities.
Provide services to all projects, except those dealing in forbidden products and
services (alcohol, pork, entertainment, interest-based financial services and so on).
Their services relate to venture capital and corporate finance, including syndication finance,
project finance and transactions in the capital markets.
Islamic corporate finance activities are Sharī‘ah-compliant.
Their services include:
Equity issues such as IPOs, offers for sale, rights issues
Private placements
Strategic reviews
Financial restructurings
Acquisitions, divestments, mergers
Joint ventures, alliance searches and studies
The key features are,
It is a large financing facility granted to a key industrial or trading company and
lead-managed by a bank with a strong base.
Since the sum involved is huge, a number of financial institutions participate in the
financing.
This facility can be provided through Murabaha, Mudarabah, Musharakah, Ijarah or
leasing.
Key Terms
Amānah
Bai‘ al Sarf
Bai‘ Mu’ajjal
Bai‘ Salam or Salam
Ijarah Muntahia-bi-Tamleek
Istijrar
Istisna’a
Mudarabah
Mudarib
Murabahah
Musharakah
Musāqah
Musawamah
Rabbul-māl
Sukuk
Wakalah
Chapter Introduction
Hello and A Framework for the Islamic Financial System-Part 2.
Banks sell goods on credit to their customers thus creating receivables. This kind of credit
sale or Bai‘ Mu’ajjal takes on two forms:
Musawamah
Murabaha
Note: Sharī‘ah permits these two forms of exchange contracts.
Learning Objectives
On completing this chapter, you will be able to:
Explain the concept of Bai' Bithaman Ajil or Bai‘ Mu’ajjal or credit sale and conditions
for it.
Explain the concept of a Murabaha sale with Bai’ Bithaman Ajil facility.
Identify the conditions for a valid Murabaha sale.
Describe the structure of a Murabaha contract.
Explain the Murabaha to purchase orderer (MPO) contract.
Explain the steps in the MPO contract and the pre-requisites for each step.
Describe the various issues that need to be managed for Murabaha contracts.
The Concept of a Bai’ Mu’ajjal (Credit Sale)
Islamic banks offer various credit sales to their customers. The important forms of credit
sales are:
Bai’ Bithaman Ajil (BBA)/Bai’ Mu’ajjal
Murabaha
Musawamah
Bai’ Bithaman Ajil or Bai’ Mu’ajjal is a credit sale where customers make payment in a
deferred manner. BBA:
Includes the features of Murabaha.
Implies deferred payment of price.
We can describe the mechanism of BBA as follows:
Step 1: Customer requires a commodity X. He approaches the bank.
Step 2: Bank buys X from the vendor at price P.
Step 3: Bank sells X to customer at a marked-up price; say P+M, where M is the agreed
profit or mark-up taken by bank.
Step 4: Customer makes payment of P+M in a deferred manner.
Murabaha is a cost-plus sale, where customers bargain on the margin of profit over the
known cost price.
This can be described as follows:
Step 1: The customer approaches the bank, selects the commodity and collects information
of base price and mark-up. Now bank also acts as a vendor.
Step 2: The bank sells the commodity at a marked-up price to customer.
Step 3: The customer makes deferred payment.
Musawamah is a normal sale, in which the customer bargains on price.
Sellers do not disclose the original cost of the goods.
Post delivery, customers make spot or deferred payment.
Conditions of Bai’ Mu’ajjal
All Islamic financial institutions should follow the conditions and rules outlined by the
Sharī‘ah for sale transactions.
The following guidelines apply.
Only qualified people can enter into a valid sale contract.
Mutual consent is mandatory for a sale contract.
The seller should be either the owner of the object of sale (Mabi‘) or an agent of the
owner.
The sale contract must explicitly define:
Price
Date and place of delivery
Time of payment of the price
The price, once determined, cannot be changed.
The sale must be instant and absolute.
The delivery should be assured, not dependent on a future event.
A sale cannot be conditional unless the condition is a normal trade practice and is not
prohibited by the Sharī‘ah.
The Mabi‘ should be transferable. The buyer must acquire the title and assume all risks of
ownership.
The following guidelines apply.
The subject of the sale must be permitted and be of value.
The subject must exist at the time of sale.
The subject must be specifically identified to the buyer to ensure it can be
distinguished from others of the same kind.
The subject of sale must be in the physical or constructive possession of the seller at
the time of sale.
A Murabaha Sale
Murabaha means gain, profit or addition.
A Murabaha sale involves a certain cost to the seller and his profit margin. The original cost
and profit should be known to the seller and buyer.
Murabaha is also a contract of trustworthiness.
Murabaha protects innocent customers who lack skill in making purchases in the market on the basis of Musawamah.
Islamic banks conduct Murabaha in a deferred payment basis.
Upon execution of Murabaha, the bank creates a receivable, which becomes the liability of
the customer.
Conditions for a Murabaha Sale
Specific conditions regarding lawful transactions of Murabaha are related to:
The goods that are the subject matter of the Murabaha
The original price paid by the seller
Any additional cost that serves as the basis of Murabaha
The margin of profit charged on the cost
Goods to be traded should be real, but not necessarily tangible. It can be non-tangible.
Any currency and monetary units that are subject to the rules of Bai’ al-Sarf cannot be sold
through Murabaha as it requires simultaneous exchange of currencies.
Credit documents that represent the debt owed by someone cannot be the subject of
Murabaha.
The seller must disclose the original price and the additional expenses to the buyer.
Additional expenses, such can be added into the purchase price on the basis of Murabaha.
The seller must disclose all aspects related to the commodity, any defects or additional
benefits.
He should also mention the mode of payment to the original seller or supplier.
If an Islamic bank receives a discount for goods purchased even after the Murabaha sale,
the buyer is eligible to benefit from the same discount.
A mutual agreement between the buyer and seller on the margin of price is mandatory.
Any Majhul or unspecified price should not be involved in Murabaha.
If the seller provides incorrect information about the original price of goods, the buyer can
annul the sale.
The buyer in Murabaha has the right to opt out of a contract if he detects that the seller has
indulged in fraud, provided false statements, or is involved in an illegal sale of goods.
Murabaha Structures
The options for conducting Murabaha are:
Option 1: Direct trading by Bank Management
Option 2: Bank purchases through a third party/agent
Option 3: Murabaha through the client as agent
Direct trading by bank officials can be used only in cases of selected specific assets. Banks
make bulk purchases of high value asset or specific goods with trademarks. But managerial
problems and corruption can be issues in retail trading by bank officials.
After purchase from the supplier, the bank is liable if anything goes wrong before handing
the asset over to the Murabaha clients.
Banks appoint qualified suppliers as agents to purchase according to their inventory
plans.
This plan includes a MoU, sale deed, and ‘promissory note’ signed by the client.
This structure of Murabaha is the safest way for banks to avoid commodity-based risks and
related problems.
Requirement for this structure:
Goods come under the ownership and risk of the bank.
Customer should explain to the supplier about his agency status.
If the bank makes direct payment, it will be a remittance on behalf of the client. This is
essentially a loan to him, and any profit on this amount will be the interest.
Murabaha to Purchase Orderer
Modern Murabaha transactions normally take the form of Murabaha to Purchase
Orderer (MPO) (Murabaha li ‘amri bil Shira or Murabaha li Wa‘da bil Shira).
The MPO comprises three distinct contracts:
Master contract
Agency contract
Actual Murabaha contract
Murabaha transactions also involve other contracts like promise to purchase.
More About MPO
Another variant of the MPO is ‘Customer as the Bank’s Agent to Buy’ The general structure
of this variant involves six major stages:
Pre-promise Understanding
Promise Stage
Agency Stage
Acquiring Possession
Execution of Murabaha
Post-execution
Across these stages the relationship between the bank and client is that of:
Principal and agent
Promisor and promisee
Buyer and seller
Seller and buyer
Creditor and debtor
At this stage, the bank and the client sign an MoU.
Pre-requisites for the pre-promise stage are:
The contract must be authentic.
It cannot be used for providing liquidity or for business involving ready cash.
Past contracts are excluded.
The supplier has to be a third party.
The commodity should conform to Murabaha standards.
The bank should check the credibility of the commodity; the client should be tested
for cash flow and risk profile. The client will purchase the commodity as the bank’s
agent. Both the parties sign a general purpose agreement of agency.
Pre-requisites for the promise stage are:
The bank signs a master Murabaha facility agreement, or MoU.
This MoU may support sub-Murabahas.
With mutual consent, the agency agreement may be signed.
Purchase Requisition
The purchase requisition contains details of goods, name of the supplier, cost price
and the expected date of delivery.
It contains a promise from the client that he will buy the goods acquired by the
bank.
If the client already possesses the requested goods, the Sharī‘ah advisor will instruct
the bank to credit the transaction income to the Charity Account.
It is mandatory according to the AAOIFI Standard that the client purchases the goods on
behalf of the bank and the bank in turn pays the supplier. The purchase order, delivery
report, and delivery challan, should be in the name of the bank.
Pre-requisites for the agency stage are:
An agency agreement can be signed along with the MoU, but before the purchase of
goods by the client.
An agency agreement should be “specific agency”, when the purchase of the
commodity is not of a consistent nature, and “general”, when the purchase of the
commodity is of a consistent nature.
In accordance with the “agreement to sell”:
The client informs the bank about the purchase, and the possession of the asset.
The client offers to purchase it from the bank at a profit margin.
The Murabaha will be invalid if this is done after the commodity is consumed.
Pre-requisites for the purchasing stage are:
Discounts should be passed on to the client, by reducing the cost of sale.
The bank or the principal must be informed about a price rise.
The commodity must be changed only with mutual consent.
A delay allows the bank to ask the client to refund the cost of goods without any
opportunity cost.
Acquisition of Title and Possession of the Asset
In compliance with the Sharī‘ah, the bank takes ownership and possession of the
goods before executing the Murabaha.
The forms of taking possession of goods are bound by their nature and customs.
Goods must exist at the time of execution of Murabaha.
The bank appoints a person for physical inspection of the commodity.
All ownership-related expenses like Takaful, until the transaction, need to be paid by
the bank. The bank accepts the offer and concludes the sale. This transfers the
ownership and the risk of the commodity to the client.
Pre-requisites for the execution stage are:
The customer takes possession of the goods, gives a possession report, and offers to
purchase the goods acquired by him on behalf of the bank. The bank accepts the
offer and completes the transaction.
All the terms of the Murabaha should be part of the bank’s letter of acceptance.
The relationship of buyer and seller transforms into a relationship of debtor and
creditor.
The customer should confirm his satisfaction with the goods.
The customer should relieve the bank from any loss or third party liability.
The bank should assign to the customer the right to obtain compensation in case of
any defects in the goods received.
The customer will furnish security to the bank regarding timely payment of the deferred
price.
The commodity itself can be given as security.
The customer owns the risk and reward of the goods.
The bank can acquire any type of security, based on the amount of facility, type of business
and reliability of the customer.
Issues in Murabaha Contracts
The Murabaha contract is considered doubtful since it constitutes two sales in one - the
contract of promise and the sale deed. The objection by Islamic scholars is to the binding
promise that takes on the nature of a sale.
But it must be noted that it does not violate any major Sharī‘ah principles, and the promise
does not take the form of a formal contract.
Bai’ al-‘Inah, generally known as “buy-back”, is a double sale.
It is a legal device to get around the prohibition of Ribâ and thus prohibited.
Islamic banks need to ensure that the goods ordered by clients are not already owned by
them.
Khiyar is not considered to be necessary in modern Murabaha by most scholars.
Hence, from a legal point of view, a buyer:
Can avail Khiyar al-‘Aib and Khiyar al-Wasf if the goods are defective or are not
according to the stipulated specifications.
Shall be compensated by good quality goods through the same or a new Murabaha.
A Murabaha contract should be conducted only after the bank gets ownership and
possession and is responsible for loss or defects.
Agency contracts are part of Murabaha contracts.
Islamic banks should avoid this practice and treat agency contracts as being independent of
Murabaha contracts.
Some of the options to deal with delayed payments are:
Clients donate to charity.
Banks impose late fees and donate proceeds to charity.
Courts or any resolution committees appointed by the State can determine the
compensation for the actual damage but not for the loss of income.
The OIC Fiqh Academy, the Shariat Appellate Bench of the Supreme Court of Pakistan,
Sharī‘ah committees of Islamic banks in the Middle East, and Sharī‘ah scholars consider
remission for earlier payment to be similar to interest-based installment sales techniques.
However, the AAOIFI’s Sharī‘ah Standard on Murabaha allows a rebate if it is not already
predetermined in the Murabaha contract.
A “rollover” in Murabaha means booking one more Murabaha against receivables on a
previous Murabaha, and the payment for which has not been made by the client.
A mark-up is added to the receivable in default by a client. Rescheduling is allowed,
but re-pricing and rollover is not allowed.
The bank can reschedule the payment without an increase in the original receivable.
Banks can justify the mark-up they charge with Murabaha contracts on account of the risks
they share. If all risks are mitigated or transferred to the client, there can be no mark-up.
Shares represent tangible assets of joint stock companies. Their sale through Murabaha is
permitted too, but Islamic banks need to consider the following to be Sharī‘ah compliant:
Banks to pay brokers directly.
The client should not be appointed as an agent for purchasing shares.
Banks can sell shares on a Murabaha basis.
The risk of price fluctuation has to be borne by the bank.
The shares should not be of any associate firm of the client.
“Buy-back” is prohibited.
Commodity Murabaha is a short-term placement mechanism that involves purchase and
sale of commodities in the international markets like the London Metal Exchange (LME).
Internationally, Islamic banks have used this to manage their cash flow.
Risks and Mitigation Measures
In Murabaha, Islamic banks face additional risks like the asset risk, fiduciary risk, legal risk
and the Sharī‘ah compliance risk.
One way to mitigate the risk is by paying special attention to completing documentation for
various contracts under the guidance of the bank’s legal department.
The Sharī‘ah supervisory boards/advisors apply internal controls for compliance.
Let’s now see some risks and mitigation measure for them.
The customer refuses to buy goods after taking possession as agent.
Mitigation
A promise to buy the ordered goods is obtained from customers.
The bank can take Hamish Jiddiyah, from which they can cover actual loss.
Risks arise if:
The customer does not purchase new assets.
The customer has already purchased the goods and now wants finance to pay the
supplier.
The transaction involves Bai’ al-‘Inah and therefore, not compliant with the Sharī‘ah.
Mitigation:
Make direct payment to supplier through DD/PO.
Obtain invoice of goods purchased and any other evidence. For example, gate pass,
inward register, entry in stock register or truck receipt.
Inspect goods.
Risks pertaining to the condition of goods could arise if:
Goods have been used by customer prior to offer and acceptance.
Goods were non-existent when the Murabaha was executed.
Mitigation:
Make only periodic offers.
Inspect goods on a random basis.
There is often a risk of destruction of goods while in transit, prior to offer and acceptance,
without agent’s negligence.
Mitigation:
Goods are owned by the bank and all risks belong to the bank, during transit. Mitigate risk
through Takaful.
Payments may often be overdue from some customers.
Mitigation:
Obtain an undertaking from the customer to donate a certain amount to charity in case of
late payment.
With some customers, there may be high risk of default on payments.
Mitigation:
Recover loss through securities/collateral.
Non-performance of the obligation to supply the goods as specified by the buyer is a risk.
Mitigation:
The bank can ask for a guarantee from the agent that the supplier will deliver according to
promise.
Some customers may fraudulently purchase from or resell goods to their
associates/subsidiaries.
Mitigation:
Obtain the concerned party’s information through financial statements of the company or by
any other source.
Key Terms
Bai’ Bithaman Ajil or BBA
Bai’ al-‘Inah
Bai‘Mu’ajjal
Bai‘ al-Sarf
Bai‘Salam
Gharar
Hamish Jiddiyah
Hawalah
Ijarah Muntahia-bi-Tamleek
Khiyar al-‘Aib
Khiyar al-Wasf
Mabi‘
Majhul
Mudarabah