Islamic Modes of FinancingSalam

Summary of the Previous Lecture

In our previous lecture we covered one of the

important modes of financing in under Islamic

banking system, i.e. Murabaha and we covered

the following;

•Principles of Murabaha

•Procedures

•Application of Murabaha

Learning Outcomes

After this lecture you should be able to understand

the two modes of Islamic financing;

1.Salam and parallel Salam

2.Istisna and parallel Istisna

3.And the differences between the Salam and

Istisna modes of financing

Salam: Forward Purchase

• A salam transaction is the purchase of a commodity for deferred delivery in exchange for immediate payment. It is a type of sale in which the price, known as the salam capital, is paid at the time of contracting while delivery of the item to be sold, known as subject matter of salam, is deferred.

• Uses:– Purchase of commodities (financing for production

of agricultural commodities/ minerals) – Liquidity requirements of sugar mills, etc.

Salam: Shariah Legitimacy

• Allah says “O you who believe when you deal with each

other, in transactions involving future obligations in a fixed

period time, reduce them to writing” [2:282]

• Ibn Abbas reported, the Prophet (PBUH) came to Medina

and found that people were selling dates for deferred

delivery (salam) after a duration of one or two years. The

Prophet (PBUH) said: “whoever pays for dates on a

deferred delivery basis (salam) should do so on the basis

of specified scale and weight” [Bukhari and Muslim]

Wisdom of allowing Salam

• Beneficial for both seller and purchaser: seller or the

farmer can get capital to grow the crop and get better

produce of the crop, while the buyer can be sure of its

stocks and price.

• Three major problems

1. Risk of default by seller

2. Bank’s need to liquidate goods after delivery

3. Seller’s inability to produce or procure commodity

Principles of Salam

• An exception to the possession

• A contract opposite to Murabaha

• Payment of full price at spot - otherwise selling debt

for debt

• Allowed in fungible commodities

• Product of a particular origin can't be specified

• Quality and quantity decided in unambiguous terms

Principles of Salam

• The commodity should remain in the market throughout

the period of contract (different opinions).

• The time of delivery should be sufficient to allow use of

Salam capital conveniently

• A security/guarantee is preferred as safeguard to the risk

of default

• Only commodity is delivered and not the money

Parallel Salam

The disposal of commodity at the end of Bank can be through:

a. Parallel Salam: MFI may sell commodity, before the date of delivery, to some other purchaser for the date of original delivery. The period in second contract will be shorter than the original contract, but price will be higher than the original contract.

b. Unilateral Promise: Promise of purchase can be obtained from third party for delivery on the date of original contract. Price in this promise is set higher than parallel salam because the promisor has to pay nothing.

Rules of Parallel Salam and Third Party Promise

• Both the contracts i.e. Salam and parallel Salam

must be independent of each other

• Parallel Salam is allowed only with third parties

• The third party giving unilateral promise should

not pay the price in advance as this is not

allowed in Sharia.

Bank Transacts Purchase of Wheat

• Contract against payment of agreed price.

• Commodity to be delivered in six months.

• Bank apprehends trend of depressed prices in the prospect OR requires liquidity.

• Bank’s position at disadvantage as compared to other purchasers contracting lower spot price but cannot undo the contractual obligation.

• Bank can keep the original contract and enter another Salam contract with a buyer expecting trend otherwise… can lower the price risk.

Istisna

Istisna

Introduction•Istisna is a sale transaction where commodity is transacted before it comes into existence.

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

Conditions of Istisna

• the subject of Istisna is always a thing which needs

manufacturing

• Manufacturer use his own material

• Quality and Quantity should be agreed in absolute

term

• Purchase price should be fixed with mutual consent

Price of Istisna

• Price of Istisna may be spot and deferred

therefore Istisna is applicable where Salam is

not applicable.

• Price of Istisna can be paid in installments.

• The installments may be tied up with different

stages of manufacturing.

Right of Rejection

When the required goods have been

manufactured by the manufacturer, purchaser

can exercise his right to reject the goods

based on the defects in the manufactured

goods

Revoking of Istisna

• The contract of Istisna can be cancelled

unilaterally before the manufacturer starts

working.

• After starting the work, Istisna cannot be

cancelled unilaterally.

Difference between Istisna & Salam

Istisna

• The subject of Istisna is always a thing which needs manufacturing.

• The price in Istisna does not necessarily need to be paid in full in advance.

Salam

• The subject can be any thing.

• The price has to be paid in full in advance.

Difference between Salam and Istisna

Istisna

• Time of Delivery does not have to be fixed, but the stages of manufacture might be time bound

• The contract can be cancelled before the manufacturer starts working.

Salam

• Time of delivery is an essential part of the sale

• The contract cannot be cancelled unilaterally.

Security

• A security in the form of a guarantee, mortgage or hypothecation may be required for Istisna in order to ensure that the manufacturer shall deliver the commodity on the agreed date,

• In the case of default in delivery, the guarantor may be

asked to deliver the same commodity, and if there is a mortgage, the buyer can sell the mortgaged property and the sale proceed can be used either to realize the required commodity by purchasing it from the market, or to recover the price advanced by him.

Time of Delivery

• It is not necessary in Istisna that the time of delivery is fixed. However, the purchaser my fix a maximum time for delivery after the appointed time, he will not be bound to accept the goods and pay the price.

• In order to ensure that the goods will be delivered within the specified period, some modern agreement of this nature contain a penalty clause to the effect that in case the manufacturer delays the delivery after the appointed time, the price shall be reduced by a specified amount per day.

Delivery of Manufacturing goods

• Before delivery, goods will remain at the risk of seller.

• After delivery, risk will be transferred to the purchaser.

• Possession of goods can be physical or constructive.

• Transferring of risk and authority of use and

utilization/consumption are the basic ingredients of

constructive possession.

• If manufactured goods are delivered before agreed date,

purchaser can refuse to accept the goods.

Parallel Istisna and its Applications

• After the execution of Istisna agreement with one party, buyer as a seller executes another Istisna agreement with third party,

Conditions for Parallel Istisna

a. There must be two different and independent

contracts, these two contracts cannot be tied

up and performance of one should not be

subject to the other.

b. Parallel Istisna is allowed with third party only.

Istisna Sale

ParallelIstisna

1st Istisna Manufacturer

2nd Istisna Purchaser

Delivery of

Commodity

Islamic Bank Seller

Islamic Bank Purchaser

Parallel Istisna

Delivery of

Commodity

Potential of Istisna

• The client can get finance for raw material,

working capital and other overhead expenses by

the execution of Istisna agreement.

• House financing, import and export products can

be easily designed on Istisna basis.

Istisna as Mode of Financing

• House Financing

• Project Financing

• BOT Arrangement

• Export Pre Shipment

Risks in Istisna Applications and their Solutions

RISKS SOLUTIONS

Ownership of MaterialThe Islamic bank is not the owner of the materials in the possession of the manufacturer for the purpose of producing the asset.

Security is available with the bank.

Delivery RiskIslamic bank may be unable to received goods as scheduled due to late delivery of completed goods and may not be able to honor the parallel Istisna.

Bank can reduce the Istisna price according to the Istisna agreement.

Summary of the Lecture

In this lecture we discussed two modes of

Islamic financing;

1.Salam and parallel Salam

2.Istisna and parallel Istisna

3.Differences between the Salam and

Istisna modes of financing