Islamic Finance and Banking - …IRTIx+IFB1x+1T2016...Chapter Introduction Hello and An Overview of...

Islamic Finance and Banking

Power Point

Khalifa M Ali Hassanain

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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



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



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 1

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

Bai’ al-Arabun

Bai’ Bithaman Ajil or BBA

Barakah

Darar

Ghish

Ihtikar

Ijtihad

Chapter 2


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


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 3


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


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 4


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


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

Mudarib

Murabaha

Murabaha to Purchase Orderer (MPO)

Musawamah

Musharakah

Islamic Finance and Banking - …IRTIx+IFB1x+1T2016...Chapter Introduction Hello and An Overview of...

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