Islamic Modes of Financing Revised 4

8/18/2019 Islamic Modes of Financing Revised 4

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Islamic modes of Financing


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Contents of thelecture

Mode of financing;

Islamic modes;

Trade based modes of Financing;

Rental based mode of financing;

Participatory mode of financing;


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Mode of financing: – Mode of financing means way of supplying funds to those who need

funds;

– Supply of fund from a financial institution to a company is calledfinancing;

– Conventional banks supply funds under one and only mode of financingthat is LENDING of money;

– Every banking product, whether it is a car loan, industry loan,investment loan, personal loan or a governmental loan, is offered underthis mode;

Mode of financing


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Islamic mode of financing: – Islamic modes of financing mean the way of supplying funds that is

acceptable to Islam;

– As we have learned Islamic mode of financing could not be based onlending of money as lending of money is not a remunerative way of

financing; – Prohibition of interest does not allow utilization of loan/lending as mode

of earning;

– Therefore, there must be a way of funding that does not containelement of interest;

– There are three type of financing available under Islamic concept offunds supply:

Trade-based modes of financing;

Rental-based mode of financing; and

Participation-based of financing;

Islamic mode of financing


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Financial activities

Exchange of goods or services

Murabahah (cost disclosedsale)

Musawamah (simple bargainsale)

Salam (future sale)

Istisnaa' (Manufacturing Sale)

Ijarah (services rendering)

Partnership

GiftLoan

Capital provisioning

TemproryPermanent

Remunerative (partnership based financing)Non-remunerative


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Trade-based modes offinancing

Trade-based mode of Financing means a way offinancing in which Islamic banks provide financingthrough sale and purchase of commodities and assets;

Trade-based modes are secure modes because they

create debt and payables upon debtors/customers; Islamic banks buy a commodity/asset (directly or

through its agent) from the market and sells it tocustomers on deferred payment basis (instalments);

The agent may be a an employee on Islamic bank, athird party or the customer himself as well;

All conditions should be observed carefully in salefinancing.


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Trade based modes ofFinancing

There are four kinds of Trade-based modes of financingwhich are very common:

– MURABAHAHA;

Cost+profit transaction in which both are disclosed to the buyer;

– MUSAWAMAH;A simple sale transaction in which a price is quoted to customer without

any disclosure to the buyer;

– SALAM;A kind of sale in which price is paid in advance for a specific commodity to

be delivered in future;

– ISTISNAA';A sale transaction for assets that require manufacturing.


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Trade based modes offinancing

The customer expresses its wish to buy a certain thing from thebank and the bank buys it from market and sells it on instalments;

All modes follow laws and rules of Islamic Sale contract with littleor no modifications;

Each mode has separate set of additional rules which needs to be

followed strictly; Any error may lead to make the transaction a void sale;

Credit Risk is lower in this kind of financing therefore IslamicBanks prefers it;

The rate once fixed in these modes could not be changed; The concept of credit sale applies here in these modes;

Islamic banks earn money through cash purchase and credit sale;

Profit is difference between cash purchase and credit sale;


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Trade based modes offinancing

Sometimes it is argued that the time has effects oncalculation of profit in case of credit sale;

We will analyze this question in following slides;


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A common question to Islamic banks: Why the price is highin case of credit sale? This excess is as good as charging ofinterest;

But the question is too simple to reply;

The main concept is that: is there any room for time in pricing?

Meaning can a seller consider 'time' as one of the decisivefactor for pricing a commodity or asset?

The answer is yes, the is one of the main factors that play role

in determining the price; The difference of price between whole sale and retail is due

to volume which is turnover of X (quantity) in a given time;

Price difference in Creditand Cash sale


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The fast moving or perishable items are not charged high profit and return;

Slow moving and storable items are charged higher profitsand return;

The reason is 'TIME';

So the time is not something that should always be neglectedin pricing or determining the value;

The generic vale of interest is its linkage with time and not

with real assets and commodity;

If the time increases the value will follow suite.

Price difference in Credit and Cash sale

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Non-fixation of price in a Sale transaction means no precisedetermination of price which is an essential element ofIslamic Sale Contract;

So non-fixation in sale is not allowed;

While fixation in partnership is as good as consideringsomething unconfirmed as confirmed which is no doubtinjustice with one of the pertners;

So non-fixation here is the acceptable way.

Fixation of return/profit intrade-based modes


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A repeated question is that the return/profit is fixed in trade- based modes of financing while Islam prohibits fixinf of profit;

So what about famous Islamic concept of non-fixation of the profit rate?

The actual reason of prohibition is not FIXATION or NON-FIXATION;

In fact the element of GHARAR is not acceptable in financialtransaction;

Gharar sometime appears in fixation and sometime in non-fixation.

Fixinf of return/profit in trade-basedmodes


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Murabahah and Musawamah

Mura a a


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Mura a a –

definition andconcept

Murabaha is a kind of sale; It comes under trade-based modes of financing;

Murabaha means selling a commodity or asset on

“disclosure of cost and profit” basis, which means theseller discloses the cost and the added profit to buyer;

So the distinguishing feature of Murabaha from

ordinary sale is that the seller is bound to discloses the

cost and profit both to the buyer.

If he does not disclose the cost the sale will not be a

Murabaha sale;

Mura a a


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Mura a a –


The seller (bank) sells a specific commodity or asset as perthe laws and rules of Islamic sale (pertaining to Price,Subject Matter, Wordings and Contractors);

The cost and profit are disclosed to the buyer;

The buyer shows his agreement with the price for thatcommodity /asset;

Lastly the buyer takes delivery of the asset (possession,physical or constructive) and the sale is concluded;

The payment of price should be according to the rules and

laws set for Islamic sale and purchase; As per the rules set for sale and purchase either the price

or the delivery of the sold goods (not both) could bedeferred;

Mura a a


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Mura a a –


As any other sale the payment of Price in Murabahahcould be in three ways:

– Spot payment (Al-Bai' ul Muajjal - immediate delivery andpayment);

– Deferred for a specific future date (Al-Bai' ul Muwajjal - fullpayment at a future date);

– Deferred for a period of time (Al-bai' ul Muwajjal - sale oninstalment basis – payment in tranches, similar to purchase on

instalments);


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As we have discussed Islamic bank is one of the players in financial

markets;

Therefore product of Murabahah used in Islamic Banking as a modeof finance is slightly different from a simple Murabahah used in normaltrade.

Banking Murabahah is a contract wherein Islamic Bank purchases acommodity or an asset from a third party (supplier/ vendor);

This purchase happens upon request of the customer;

After purchase of the required asset Islamic bank sells the same to thecustomer usually against a deferred payment [Bai Muajjal] (sale on

instalments);

The whole process is called “Murabahah to the Purchase Orderer”;

It is a bunch of contracts completed in steps and ultimately sufficesthe financial needs of the customer.

Murabahah – definition and concept

Mura a a


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Mura a a –


Some important features of the Murabahah are: – As Banking Murabahah is a kind of sale, there must be a seller

(bank) and a buyer (customer) and something that could be

bought and sold;

– In such transactions the Bank is the seller, the customer isbuyer and a commodity/goods are exchanged between them;

– In case there is nothing that could be sold and purchasedMurrabahah is not possible;

– WC finance /Overheads financing etc. etc. are not possibleunder Murabahah since there is no sale and purchase.

– Because it is a sale from bank to customer the Bank is requiredto purchase the commodity directly or directly from the

market/seller before selling it to the customer;


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Process flow

Murabahah step by


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BANK CLIENTAGREEMENT TO MURABAHAH

Murabahah – step bystep

Step # 1: – Client and Bank sign an agreement to enter into Murabahah.


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AGENCY AGREEMENT

Murabahah – step by step

Step # 2:• Client appointed as agent to purchase goods on behalf of Bank;


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AGENCY AGREEMENT

SUPPLIERPAYMENT OF PRICE OF GOODS TO THE

SUPPLIER OR AGENT (COUSTOMER

OR THIRD PARTY)


Step # 3:• Bank gives money to directly to supplier or to the client for purchase of

goods;Client appointed as agent to purchase goods on behalf of Bank;


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BANK CLIENTPAYMENT OF PRICE IN ANAGREED PERIOD OF TIME

AND INSTALMENTS


Step # 3:• Client pays agreed price to bank according to an agreed schedule. Usually

on a deferred payment basis (Bai Muwajjal) in tranches;


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Application


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Murabahah – Application

Murabahah can be used to finance the real purchase needs ofcustomer;

It could be used for assets which are acceptable to Shari’ah and has a

tangible form.

Therefore, Murabahah can be used to finance the purchase of:

– Raw Material;

– Equipment;

– Consumer Goods;

– Personal loans;

– Credit cards.

h


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Musawamah

Musawamah is also one kind of sale; This is a simple sale we do in our daily routine life;

The difference is that the quoted price does not require

any break-up of cost and profit;

All other details are same as for Murabahah;

The process flow is also same and the payment method

may also be of same nature.


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Questions

Islamic Modes of Financing Revised 4

Documents

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