ISLAMIC BANKING AND FINANCE

Mahyuddin Khalid

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APPLICATION OF FUNDS-

FINANCING FACILITIES AND THE UNDERLYING SHARIAH CONCEPT

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CONTENT

HOME/PROPERTY FINANCING (BAI’ BITHAMAN AJIL / BBA) HOME/PROPERTY FINANCING (MUSHARAKAH)

(MUSHARAKAH MUTANAQISAH) MOTOR VEHICLE FINANCING (AL-IJARAH) (AL-IJARAH

THUMMA AL-BAI’) PERSONAL FINANCING (BAI’ AL-INAH) CREDIT CARDS (AL-WADIAH)( BAI’ AL-INAH)(QARD AL-

HASAN) PROJECT FINANCING (AL-MUDARABAH) (AL-MUSHARAKAH) WORKING CAPITAL FINANCING (AL-MURABAHAH ) LETTER OF CREDIT (WAKALAH) (MUSHARAKAH)

(MURABAHAH) ISLAMIC ACCEPTED BILLS (BAI` AL-DAYN) ISLAMIC EXPORT CREDIT REFINANCING (IECR)

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PROPERTY FINANCING BASED ON BAI’ BITHAMAN AJIL

Definition of Bai' Bithaman Ajil (BBA) A normal sale with the payment of the selling price

deferred to an agreed later date or installment payment. Practice

The item to be sold exists at the time of contract. The shariah does not require that the cost price be known

to the buyer. Objectives of BBA:

To provide financing for potential buyers who could not afford to pay cash in advance and enable them to perform daily responsibilities and obligations without any financial hardship or difficulties.

To facilitate and support the smooth flow of transaction in the business society by providing flexible modes of payment especially through credit payment.

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PROPERTY FINANCING BASED ON BAI’ BITHAMAN AJIL

Customer identify the property to acquired Bank will purchase the property chosen by customer after

determining their needs , based on their financial status. The properties will then be sold to customer (by Bank) at a pre-

agreed price , which includes Bank’s purchased price and profit margin.

Once complete , customer will allowed to pay the Selling Price(SP) in monthly installment over a specified period of time.

OWNER/VENDOR OF

ASSET

CUSTOMER

Customer identifies the assets to be acquired.

1Bank purchase the asset from the owner /vendor(ex: RM100,000)

Bank sells the assets to the customer at RM100,00 + profit margin /mark up (SP)

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4 Customer repay the Selling Price by installments.

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PROPERTY FINANCING BASED ON MUSHARAKAH

Definition of Musharakah: A form of partnership where two or more persons

combine either capital or labor or creditworthiness together to carry on a business venture on condition that they will share the profits, enjoying similar rights and liabilities.

It is basically a profit and loss sharing partnership whereby the ratio for the distribution of profits must be determined and specified in advance.

Pillars of musharakah: Shuraka’ (Shareholders ) Ra’sul Mal (Capital) Mashru’ (Project or business venture) Ribh (Pre-determined profit allocation) Sighah (Ijab (Offer) and Qabul (Acceptance ))

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PROPERTY FINANCING BASED ON MUSHARAKAH MUTANAQISAH

Definition of Musharakah Mutanaqisah: Form of partnership in which one of the partners promises

(wa’d) to buy the equity share of other partner gradually until the title of the equity is completely transferred to him.

A form of Musharakah where the financier and the client participate in a joint commercial enterprise or property. This enterprise is converted into undivided ownership of both the financier and the client. Over certain period the equity of financier, divided into equal value units, is purchased by the client. And ultimately the client becomes the sole owner of the enterprise

Application of Musharakah Mutanaqisah: Home financing Agriculture Machinery and implements financing Storage facility construction/sheds Transport vehicles, etc.

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PROPERTY FINANCING BASED ON MUSHARAKAH MUTANAQISAH

Customer

Provides most of financing e.g. 90%

Provides least offinancinge.g. 10%

Both financier + customer become partners in the

ownership of asset (Shirkah al Milk)

90%Financier’s ShareDecreasing0%

100%Customer’s share

Increasing10%

Pay monthly installment partlyas rental and partly as gradual

purchase price of part offinancier’s share in Asset

1

2

3

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VEHICLE FINANCING BASED ON AL-IJARAH

Definition of Ijarah: A contract of proposed and known usufruct with a specified and lawful

return or compensation for the effort or work which has been expended. It is used to express the sale (bai') of a known benefit in return for its known equivalent.

Under this concept, the bank makes available to the customer the use of service of assets/equipment such as plant, office automation, motor vehicle for a fixed period and price.

Practice The property to be leased belongs to the lessor. The lessor has the right to repossess the property on a default of the lessee

Pillars of Ijarah: Muajjir (A person who give something for hire – Lessor, landlord, owner etc.) Musta’jir (A person who takes on hire – Lessee, tenant, renter etc.) Ma’jur (A thing given for rent) Al-Manfaah (The benefit from a thing – usufruct, services etc.) Ujrah (Price or fee given for the payment of rent or lease) Sighah (Offer (Ijab) and Acceptance (Qabul))

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VEHICLE FINANCING BASED ON AL-IJARAH THUMMA AL-BAI’

Definition of Al-Ijarah Thumma al-Bai' (AITAB) Simple leasing for leasing period with an option for the lessee

to purchase the property at the end of the leasing period through a contract of purchase.

In AITAB, the contract of al-ijarah runs separately from the contract of al-bai'. These stages are: Stage 1: Executing the contract of true leasing (al-ijarah ‘ain) Stage 2: Executing the contract of sale (al-bai') at a nominal

value agreed upon by both parties. Condition In Al-Ijarah Thumma Al-Bai':

3 party Not a loan but a hiring arrangement Ownership does not pass to lessee until all installments paid Lessee has right to return asset. Lessee has a right to early termination or early settlement of

hiring arrangement.

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VEHICLE FINANCING BASED ON AL-IJARAH THUMMA AL-BAI’

FINANCIER CUSTOMERVEHIC

LE

1)Lease Agreement

2) Rental Payment

3) Sale Agreement

4) Sale Price

1st: Contract of al-ijarah

2nd : Contract of al-bai''’

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PERSONAL FINANCING BASED ON BAI’ AL-INAH

Definition of Bai' al-Inah: The selling of an asset with a mark up price on deferred

payment, with the intention to sell the same asset to the debtor with lower cash price, which is meant to settle his debt.

It is a bargaining (musawamah) sale and purchase contract i.e. without disclosing or referring to what the cost price is.

Bai’ al-Inah conceptually refers to a sale of an asset, which is later repurchased at a different price, whereby the deferred price is higher than the cash price.

Pillars of Bai' al-Inah: Seller and buyer Merchandise/goods Price Sighah

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PERSONAL FINANCING BASED ON BAI’ AL-INAH

BA

Asset

1) Sell Asset in deferred payment

2) Buy back Asset in cash

Price

3)Pay cash money for personal Financing

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CREDIT CARDS

A credit card is a system of payment named after the small plastic card issued to users of a system.

The difference between Islamic credit card and a conventional credit card:- In Islamic Banking, the profit rate is non-compounding

as compared to a conventional credit card It cannot be used for transactions prohibited by

Shariah such as gambling, liquor, etc. The Credit Card is formulated based on the

Shariah concepts of: Bai' al-Inah Qardhul Hassan Al-Wadiah

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CREDIT CARDS BASED ON BAI’ AL-INAH

CUSTOMER

WADIAH (Safe keeping)

1

2

3

4

Sells a price od land on deferred payment basis(profit 18%, RM10,000+RM1800=RM18,000)

Resells the land to BANK for cash at the principal price =RM10,000

Disburse RM10,000 to customer’s ICC (Islamic Credit Card) Wadiah account

(QARDHUL HASSAN)/Benevolent Loan

Allow customer to use more than available balance in ICC Wadiah account

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CREDIT CARDS BASED ON BAI’ AL-TAWARRUQ

BROKER A BROKER B

CUSTOMER

CREDIT CARD

ACCOUNT

1

2

4 5

3

The Bank purchase the commodity for a Purchase Price (Principal)

Customer sell the commodity and receives cash)

The Bank sell the commodity for a Sale Price (Principal+Profit)

Customer deposit the proceeds into the credit card account as its credit limit

Manage the facility

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MODES OF OPERATION OF ISLAMIC CREDIT CARDS

Periodic service charge The card issuer charges the card holder a monthly or annual charge (fixed

fee period) Additional charges for any forward credit balance.

Deferred payment sale The card issuer allows the customer to use his card to pay for a good or

service under murabahah type transaction. Lease purchase agreement

The card provider is the owner of the asset until the card holder makes the final payment.

The client can be charged a rental fee. Pre paid credit card

The client deposits an amount of money on their card to pay for goods and services.

Due to the nature of the card, client can not pay for goods in excess of their debit balance and credit balances do not occur.

Thus, any type of interest charges are easily avoided. The card issuer can invest the excess balances to generate a return and

must be in shariah compliant.

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PROJECT FINANCING

Definition: The financing of long-term infrastructure, industrial projects and

public services based upon a non-recourse or limited recourse financial structure where project debt and equity used to finance the project are paid back from the cash flow generated by the project..

Characteristic of Project Financing: Project cash flows Normally higher levels of debt Variety of contractual obligations and undertakings to manage and

reduce risk A variety of funding sources

Technique and instruments must comply with shariah principles: Conceptually Structurally Documentaries Modus operandi – execution and implementation.

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PROJECT FINANCING BASED ON MUDHARABAH

Financier(Rabb al Mal)

Company(Amil/

Mudarib)

Capital

Contract of Mudharabah profit sharing ratio (X:Y)

Project revenue

Invest in project

Y: to rabb al mal

Profit shared in accordance to pre-agreed proportions (X:Y)

X% to mudarib

Loss borne totally by rabb al mal

E.g.: real estate

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PROJECT FINANCING BASED ON MUSHARAKAH

Financier(Rabb al Mal)

Company(Amil/

Mudarib)

Capital

Contract of Mudharabah

Capital Contribution(X:Y)

Project revenue

Invest in project

Y%

X%

• Profit shared according to agreed ratio.• To ratio of capital contribution.• Loss shared according to ratio of capital contribution.

E.g.: real estate

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WORKING CAPITAL FINANCING BASED ON MURABAHAH

Definition of Murabahah: Sale in which the mark up is disclosed to the

purchaser as per the seller’s purchase price for a trust-sale for a certain specific asset.

Allows customer: To take delivery of the goods immediately Settle deferred payment agreement with Bank

Pillars of Murabahah Seller Buyer Merchandise/goods Price (mark-up) Sighah : Offer (Ijab) and Acceptance (qabul)

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WORKING CAPITAL FINANCING BASED ON MURABAHAH

Murabahah can be applied: Ordinary Murabahah Sale

Involve 2 parties – seller & buyer The seller is an ordinary so trader who buys a

commodity without depending on a prior promise of purchase, then he display it for Murabahah sale for a price and a profit to be agreed upon.

Murabahah based on Order & Promise Widely applicable because used as one of financing

tools by Islamic banks worldwide Murabahah to the purchase orderer for a pre-agreed

selling price, this having been specified in the customer’s promise to purchase. The payment is payable within a fixed future date in lump sum of by fixed installments.

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WORKING CAPITAL FINANCING BASED ON MURABAHAH

SUPPLIER OF GOODSCUSTOMER

ACTS AS AN AGENT FOR THE BANK

1) Purchase order

2) Supplier goods to customer

3) Settles the purchase price on cash basis

5) Settles the Bank’sselling price on maturity

4) Sells goods on deferred payment basis

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FINANCING BASED ON BAI' AL-SALAM

Definition of Bai' al-Salam: Sale contract over prescribed commodity sold as a deferred

liability on one party, in exchange for a price that is received during the contract session

The wisdom of making Bai' al-Salam permissible lies in the fact that Bai' al-Salam facilitates a types of financing for people in need of it.

By using Bai' al-Salam contract, the buyer may benefit from its permissibility as well, by acquiring the commodity at a price below the market price.

Pillars of Bai' al-Salam: Rabb as-salam/ Musallim (The Buyer) Muslam Ilaihi (The Seller) Ra’s al-Mal (The Price) Al-Musallim Fih (The Product) Sighah (Ijab (Offer) and Qabul (Acceptance))

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FINANCING BASED ON BAI' AL-SALAM

To meet the need of small farmers who need money to grow their crops and to feed their family up to the time of harvest

To meet the need of traders for import and export business

The financial institution can sell the bai' al-salam commodity through a parallel bai' al-salam contract and earn profits provided that: There must be 2 different and independent

contracts Cannot be used as a buy back facility

The financial institution can obtained a promise to purchase from a 3rd party

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FINANCING BASED ON BAI' AL-SALAM

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FINANCING BASED ON BAI' AL-ISTISNA’

Definition of bai' al-istisna’: Bai' al-istisna’ is defined as a contractual agreement with manufacturer

to produce items with specified description at a determined price, and manufactured from his own materials with his own effort.

It is an order to producer to manufacture a specific commodity for the purchaser.

Upon delivery, the IFI sells it to the customer at a prevailing market price comprising original acquisition price and a margin of profit.

The customer repays by installments within a period and in the manner agreed between the IFI and the customer.

Pillars of bai'' al-istisna’: Mustasni’ (Customer) Sani’ (Manufacturer) Ra’s al-Mal (The Price) Masnu’ (The Product) Sighah (Ijab (Offer) and Qabul (Acceptance))

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FINANCING BASED ON BAI' AL-ISTISNA’

The buyer (mustasni’) places an order to purchase an asset (e.g. building, house) to be delivered in the future.

The buyer (mustasni’) requires the seller (sani’) to construct the asset based on the specification stipulated in the contract agreed by both of parties. These specifications include the nature, type, quantity of the asset and also delivery date.

Then, both of the parties decide and agreed with the sale and purchase price and any changes cannot be making after that.

The payment can be made either spot cash or installment. It’s no required for the buyer (mustasni’) to pay the full price at the time of contract.

Lastly at the delivery date, the seller (sani’) will deliver the order to the buyer (mustasni’).

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DIFFERENCES BETWEEN ISTISNA’ AND SALAM

SALAM ITEM ISTISNA’

Can be anything that need manufacturing or not.

SUBJECT MATTER Is always a thing which needs to be manufactured.

Has to be paid in full in advance.

PRICE Does not necessarily need to be paid in full in advance.Not even necessary to pay the full price at delivery.Can be deferred to any time agreed upon by both parties.May be made in installments.

It is an essential part of the contract

TIME OF DELIVERY Does not have to be fixed

Cannot be cancelled unilaterally.

CANCELLATION OF THE CONTRACT

Can be cancelled before the manufacturer starts the work.

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DIFFERENCES BETWEEN ISTISNA’ AND IJARAH

IJARAH ITEM ISTISNA’

Provided by the customer.

MATERIAL Provided by the manufacturer.

Right of rejection of goods after inspection does not exist.

RIGHT OF REJECTION

The customer has a right to reject the goods after inspection.

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LETTER OF CREDIT

Letter of Credit is a letter from a bank guaranteeing that a buyer's payment to a seller will be received on time and for the correct amount.

In the event that the buyer is unable to make payment on the purchase, the bank will be required to cover the full or remaining amount of the purchase.

The Letter of Credit is formulated based on the Shariah concepts of : Wakalah Musharakah Murabahah

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LETTER OF CREDIT BASED ON WAKALAH

Under this concept, the Bank acts as agent on behalf of the Buyer/Applicant. Customers have to pay for fee and commissions under the concept of Ujr-wal-Umulah.

Refers to any agency relationship where a Bank acts an agent on behalf company/individual.

Procedures: The Buyer/customer informs the Bank of their LC

requirements and request the Bank to provide facility. Buyer/Applicant will place deposit to the full amount of

goods to be purchased/imported which Banks accepts under the contract of Wadiah.

Bank Islam establishes the LC and remits the payment to the Seller/Beneficiary utilizing the customers’ deposit and releases the documents to the customer.

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LETTER OF CREDIT BASED ON MUSHARAKAH

A partnership agreement between two or more individuals or bodies.

Each contributing capital. Profit or loss is shared between the partners according to the

ratios. Procedures:

Customers who interested have to admit the LC requirement and negotiates the term of Musharakah financing, following the project financing under the contract of Musharakah.

A deposit required for his share of the costs of goods to be purchased or imported.

Banks established the LC and pays the proceeds to the negotiating bank utilizing the customers deposits as well as its own share of financing and releases the documents to the customer.

Customers takes possession and dispose these off in the manner agreed in the agreement.

Bank together with customer share the profit from the venture as provided for in the agreement.

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LETTER OF CREDIT BASED ON MURABAHAH

Refers to the sale of goods at a price, which includes cost plus as agreed by both seller and the buyer. This is a contract where the commodity exchanged for is delivered immediately and the price is paid in lump sum at late date.

Procedures: The customer/buyer require the LC together with financing

over a certain period of time. The Bank will establish the LC and remit the payment to the

Seller/Beneficiary utilizing its own funds. The banks appoints the customer as its agent to purchase the

required goods on its behalf. The banks will sell the goods to the Buyer/Applicant at a sale

price comprising its cost and a profit margin (cost plus basis - al-Murabahah)

Buyer/Applicant is given a deferred payment term for the settlement the purchases.

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ISLAMIC ACCEPTED BILLS (AB-i)

Islamic Accepted Bills is an order to a bank by its customer obliging it to pay a certain amount of money to the holder of the acceptances bill.

The bank makes payment in lump sum for the goods purchased by its customer on its behalf and sells those goods to the customer on the deferred payment basis.

There are two types of financing under the AB-i facility: Imports and local purchases; and Exports and local sales.

The AB-i is formulated based on the Shariah concepts of: Bay al-Dayn Murabahah

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ISLAMIC ACCEPTED BILLS BASED ON BAI'’ AL-DAYN

Definition of bai' al-dayn: An exchange between A payable right upon the person and A

property on the basis of ownership of the price and the right Sale of debt which can be either against a debt or other

than a debt , to the debtor or other than a debtor, on a cash basis or a deferred payment basis.

Sale contract in which the creditor sells his payable right upon the debtor either to the debtor himself or to A third party at discount price or at cost price on the spot payment basis.

Pillars of bai' al-dayn: Seller and buyer Merchandise/goods Price Sighah

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ISLAMIC ACCEPTED BILLS BASED ON BAI' AL-DAYN

The Sale of Debt to a Third Party (Bai’ al-dayn li ghayr al madin) According to Hanafis, some Shafiis, Hanbalis and Zahiris –

the sale of confirmed or non confirmed debt is not allowed to be sold to the third party based on: A sale of un possessed item (bai' ma la tamlik) A sale of undeliverable item It may create a conflict between the debtor and the buyer of

the debt Some Shafiis and Hanbalis (Ibn Qayyim) – the sale of

confirmed debt to the third party is allowed based on: There is no authentic nas that prohibits such sale The debt is a right in the possession of the creditor. So he has

the full right to sell it to the debtor or the third party Based on legal maxim: All transactions are permissible until

they are proven non permissible by an authentic source

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AB-i - IMPORT

Financing facility using the Bai' Dayn contract, granted to the seller or exporter to finance their sales or export of goods on credit terms that includes raw materials, semi-finished and finished goods.

Bai' Dayn or debt trading is a short-term, financing facility whereby Bank Islam purchases the customer’s right to the debt, which is normally securitized in the form of Accepted Bills.

The previous working capital financing under al-Murabahah which gives rise to debt or al-Dayn may indeed be securitized.

The Bank drawn a Bill of Exchange to be accepted by the customer.

This bill will be drawn for full amount of the Bank’s selling price on the maturity date of the financing.

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AB-i - EXPORT

The Bank finance exports and sales on the concept of bai' al-Dayn.

Bai' al-Dayn or debt purchase is short-term financing facility whereby the bank purchases the customers rights to the debt which is normally securitizes in the form of Bill Exchange.

Under this facility, an exporter who wishes to avail himself of this facility. Prepares export documents as required under the sales contract or letter of credit.

He presents this documents to the bank to be purchased. As the exports documents have to be sent to buyer overseas, the bank request the exporter to drawn another Bill of exchange drawn on the Bank, known as AB-i Exports.

The AB-i Exports may subsequently be sold in the secondary market.

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ISLAMIC EXPORT CREDIT REFINANCING (ECR-i)

Export Credit Refinancing (ECR) provides an alternative short term pre- and post-shipment financing to direct/indirect exporters to promote export of manufactured products, agricultural products and primary commodities.

It is available to a manufacturer or trading company with ECR credit line duly established with any participating Islamic bank.

Classification: ECR-i Pre-Shipment

Pre-Shipment ECR-i is a financing facility based on Murabahah contract granted to customer as direct or indirect exporter for preparing goods prior to shipment.

ECR-i Post-Shipment Post-Shipment ECR-i is a financing facility based on Bai' Dayn contract

granted to customer as a direct exporter who exports eligible products on sight or usance terms.

For sight term, financing period shall not exceed 60 days.

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