Technical Programme 2: Financing Products

How Islamic Banks Make Money Without Charging Interest

International Islamic Banking Summit Africa-Djibouti 20162nd & 3rd November, 2016

Abubaker B. Mayanjaabm@abl.co.ug

Financing Products

• Deferred Sales Contracts: – Murabaha– Salam – Istisna’a– Ijara

• Profit and Loss Sharing(PLS) Contracts:– Mudaraba, – Musharaka

• Applications– Mortgages– Working Capital– Car Purchase– Letters of Credit– Leasing– Manufacturing

HOW DO ISLAMIC BANKS MAKE MONEY?

If Islamic Banks cannot charge Interest

Is it possible to profitably finance projects without using interest system?

Islamic Financial Institutions(IFIs) use Sharia’a compliant contracts which do not permit interest to be charged but do encourage trade and investment via alternative financing mechanisms Kettel Brian(2010)

There are mainly two categories of contracts used– Deferred Sales Contracts– Profit-and-Loss Share(PLS) contracts

1. DEFERRED SALES CONTRACTS

Sell an Object Immediately, with deferred price greater than its cash price payable in whole or instruments.Agreement on this in all the major Schools of Islamic Jurisprudence- Shafii’s, Hanafi’s, Maliki’s and Hanbali’sThe increase in the deferred price is compensation for foregoing the value today and therefore is not interest

Deferred Sales Contracts Murabaha. Sale with a known profit. The object of sale is

delivered at the contract time but the price becomes due as debt in the future

Salam Sale. The price is paid at the time of contract but the object of Sale becomes due as debt in kind

Istisna’a. The price is paid at the time of contract and the object of sale becomes due as debt-in-kind

Ijara. Sale of the use of the rights of assets where assets are delivered to the user, who in turn pays periodical rentals later

PROFIT-AND-LOSS SHARE(PLS) CONTRACTS

A PLS contract implies that the outcome of business or project is sharing based and not pre determined.Share holders or Partners are only repaid if profits are made and if no profits are made then no pay outs take place.

PLS ContractsMudaraba- contract between two parties: An Islamic

Bank as an Investor who provides the entrepreneur[mudarib]. Profits are shared between the parties in a proportion agreed in advance. Losses are the liability of the Islamic Bank, Mudarib sacrifices efforts.

Musharaka- Equity[part ownership] participation contract. The bank is not the sole provider of capital to finance a project. Two or more partners contribute to joint capital for the investment. Losses are shared in proportion to the contribution to capital.

Islamic Financing Modes

Deferred Sales Contracts[Debt Based Contracts]

SalamIjara

MurabahaIstisna’a

PLS contracts[Shareholders]

MudarabaMusharaka

MURABAHA MODE OF ISLAMIC FINANCE

Sale of Goods with a pre-agreed profit mark-up on the cost, in the two cases applicable, on the one hand the bank already has an intention to buy from the customer and in other cases in does not

Murabaha-Transactions

• Murabaha is a term of Fiqh [Islamic Jurisprudence

• A seller agrees to sell a commodity with a certain profit added to the cost

• The basic ingredient is that the seller discloses the actual cost he incurred in acquiring the commodity

Elements of a Murabaha Contract

1. An order by a prospective buyer to a seller to buy a specific commodity promising to buy it for a profit

2. The seller has to own the commodity3. The seller then makes an offer to the buyer after

the commodity has been bought and owned by the seller

4. The prospective buyer has the option to buy the commodity or not to buy it, If he agrees to buy then a Murabaha Contract is formed

Murabaha sharia’a Compliance

• The bank finances the purchase of a good or asset by buying the item on behalf of a client and adding a mark up before selling the item to the client, on a cost plus basis contract.

• It may appear like interest but it is not, in contrast the interest system would only apply a mark up on the money and there is no requirement on the conventional bank to be involved in the actual buying of the good or asset.

• The operation is thus not a mere exchange of money.

Murabaha Sharia Compliance-cont.• The bank takes responsibility for the goods before they

are delivered to the client, its at liberty to sell at a profit whether cash or on credit.

• Money and commodities[that have intrinsic value are thus treated differently– Money has no intrinsic utility– Commodities can have different qualities other than value– Commodities transactions are specific– Islam treats money and commodities differently– Charging for the time value of money is deemed riba and

therefore money lent out without an underlying transaction should not attract higher payments

Rules for contract of sale

• Kettel(2010) citing Usmani (1999)– The subject of Sale must exist at the time of sale– The subject of Sale must be owned by the seller at

the time of sale– The subject of sale must be in the physical or

constructive possession of the seller when he sells it to another person

• The Sharia’a rules are relaxed with respect to salam and Istisna’a sale

PRACTICAL APPLICATIONS OF MURABAHA

We then discuss the applications of Murabaha to further illustrate its applications in practice for; Mortgages, Working Capital, syndicated credits, letters of credit, car purchase

Mortgages

• It involves Purchase of a residence at a specified price by a bank

• The bank sells its client including a profit to be paid in installments over time

• This mode of financing is now actively growing the home ownership industry in many countries

Working Capital

• Raw materials, machinery and equipment can be bought and resold by a bank to a company or entrepreneur on a revolving basis

• Although Murabaha is used mainly for trade financing, it has been used to provide Independent power projects with finance on a deferred basis to finance equipment for the project with the repayment kicking in from cashflows generated from power sales.

Letters of credit(L/C) 1. Customer requests the bank to open an L/C to import goods from

abroad through an application enclosing a pro-forma invoice 2. after verification, the bank opens an L/C in favour of the client to the

correspondent bank and exporter3. The customer endorses a promise to buy the goods. 4. The exporter sends the goods and documentation to the

correspondent bank5. After confirmation of the bank’s ownership of the goods through the

acquisition of related documents, it signs an agreement of sale with the client

• See Kettel(2010)

Car and house Purchase• Individual submits an application to the bank requesting the

purchase of a car• He promises to buy it at a later stage• The bank issues an order to a seller of cars, the bank pays

the seller on delivery and registering the car in the name of the bank

• The bank sells the car to the purchaser, on a deferred basis, with the car often serving as the mortgaged property to guarantee

• This method is also applied to the purchase of Land and buildings

Comparison of Murabaha with Interest based Finance

Interest based Finance

•Place funds in bank•Bank pays agreed rate of interest

Depositors

•Bank lends to borrowers•Borrower pays agreed rate of interest and keeps any profits made

Borrower

•Borrowers invest money to generate a profit•100 percent of profits received by the borrower

Business Venture

Murabaha Finance-Islamic Bank

•Share risk and return of business venture•Mark up not interest is paid to the depositor

Depositor

•Purchases items at customer request•Bank sells the item at cost plus mark up

Islamic Bank

•Obtains specific goods and assets from bank on deferred payment•Pays back on future date the agreed price including the bank’s mark up

Business Venture

MUDARABA

A business contract where one party contributes Capital and other personal effort, know how and time. The share of profits between the capital provider and the user of funds is determined prior to commencement of the business or project

Mudaraba

• Partnership in profit between capital and work.– Conducted between investment account holders

and the bank, the investment account holders entrust the bank with funds, with the bank shring profits it makes using the funds with the depositors

– It may also be the bank providing the funds to an entrepreneur to undertake a project

Mudaraba Terminology

• The basics are that the bank provides all the capital while the entrepreneur provides the management

• Profit sharing contract, However unlike murabaha there is no loss sharing. In the event of loss the bank loses money the entreprenuer loses time

• This partly explains its limited use in practice due to asymetric information and moral hazard that can be perverse

• It can be restricted or unrestricted in the type of business the mudarib undertakes

Terminology

Rab-Ul-Mal- Financier

Mudarib- Entrepreneur

Its important to note that the bank can be both, a Mudarib to Investment account depositors as well as a Rab-ul- Mal to entrepreneurs

Thus fulfilling the traditional intermediation of fundsIn this case the returns to depositors will mirror the quality and quantity of the investment decisions of the Islamic BankThus the need to exercise extensive due diligence and management safeguards in this type of Product.

It is Equity related as opposed to Trade Related

Sharia’a rules on Mudaraba

• Capital must be specific and the amount known

• Capital must be normal currency in circulation, or merchandise with a known monetary value

• Mudarib is a trustee, not a debtor• Mudarib can hire assistant• Restrictions can be imposed• Profit rate must be specific

Mudaraba practical applications

• Banks relationship with depositors-unrestricted mudaraba to raise funds

• Financing professionals: Dentists, Doctors, Engineers

• Financing Traders

Comparison of Mudaraba with Interest based Finance

Interest based Finance

•Place funds in bank•Bank pays agreed rate of interest

Depositors

•Bank lends to borrowers•Borrower pays agreed rate of interest and keeps any profits made

Borrower

•Borrowers invest money to generate a profit•Loan is usually secured and whether losses are made payment must be made•100 percent of profits received by the borrower

Business

Venture

Murabaha Finance-Islamic Bank

•Share risk and return of business venture•Receives share of profits

Depositor

•Bank contributes Capital•Bank receives a share of the profit instead of interest from the venture. •Bank takes all financial losses•Yield is not guaranteed

Islamic Bank

•Contributes effort, management and know how•Shares profits with the bank.

Entrepreneur

MUSHARAKA

Partnership between the bank and its clients, both parties contribute capital in different proportions with similar expectations in the profits of the business. Losses are shared in proportion to the contributed Capital.

Constant or Diminishing Musharaka[gradual reduction in the ownership proportion of the bank. Musharaka means sharing, joint business ventures sharing profits and losses.

Musharaka-Practical Examples• Working Capital facility, in cases where the company has

a record of profitability. Periodically collected and netted out at the end of the financial year

• Diminishing Musharaka-joint ownership of property or equipment that produces revenues that are shared. Similar to shared Equity model in financing housing for poor families in developed countries, rent payments are paid for the portion of the house you don’t yet own. If you have paid half to the financing institution then you pay half or the rent.

• House purchase- payments of rent on portion not owned and paying periodically to purchase units divided into say 10 percent of the whole value of the house.

Musharaka-Practical examples cont.

• Service Sector- Taxi business• SME financing – small business ventures can

co own with a financial institution that shares in the profits, the bank can gradually reduce its shareholding by receiving payments from the SME owner

• Commercial and Real estate development.

IJARA-LEASING

Transfer use of productive assets in exchange for rental payments, commonly known as asset finance.

Finance Lease- eventually own at the end of period, Operating Lease- at the end of the period the asset is returned to the financier.

IDB defines leasing as “ Medium-term mode of financing, which involves purchasing, and subsequently transferring, the right of use of equipment and machinery to the beneficiary for a specific period of time, during which time the IDB retains the ownership of the asset”

Practicalities of Implementing Ijara• Acceptable items: Equipment,

machinery, consumer goods, computers, motor vehicles,

• The asset financed must not be forbidden-suce as leasing of machines for alcoholic beverages and casinos[‘sin industry’

• Factors-used equipment market, second hand value, capital allowances

• Repossession is made if lessee defaults on payments or terms of the lease with repossession costs borne by the lessee

• Guarantees[Al kafalah]• Security[Al-Rahn], in this

case the asset could be the security

• Asset must have valuable use

• Period of lease must be determined in clear terms

• Purpose of use specified• Rental must be determined

Ijara Financing OperationCustomer Identifies the Asset to be acquired

Bank Purchases the asset from the vendor at say USD 10,000

Bank leases the Asset to the customer at USD 10,000 + Profit

Customer Repays USD 10,000 + Profit by monthly lease rental

ISTISNA’A

Sale Contract-purchaser asks the seller to manufacture a specifically defined product, using the seller’s raw materials at a given priceSimilar to Salam, the product in question is not available at the time of sale

Istisna’a • An agreement whereby a customer requiring an item,

equipment, building, or project, which needs to be constructed, manufactured, fabricated, or assembled, approaches the bank for financing.

• The bank offers to have the item produced, and after adding its profit margin it sells to the customer.

• Frequent use in construction finance, user pays at different stages. The bank acts as an intermediary

• Parallel istisna’a –bank and customer agreement with specifications, bank and contractors or manufacturers

• Some disagreements among scholars-supported by Hanafi

Istisna’a

$ $10

Purchase contract Title

FinancierIslamic Financial Institution

Manufacturer ContractorFabricator

CustomerDeveloper

$11Sale Contract Title

SALAM

Seller Undertakes to supply some specific goods to the buyer at a future date, in exchange for an advanced price fully paid at spot, opposite of Murabaha. Contract farming, applicable to small farmers,

Rules Governing Salam

• Price paid in full at the time of the contract

• Goods must have specific quality and quantity, and defined in terms of attributes

• Exact date of delivery and place must be specified

• Not tied to a specific field or farm

• Seller may be asked for security

• Parallel salam permissible but independent of the first contract

Thank You!

“An Islamic Bank does not charge interest but rather participates in the yield resulting from the use of funds”Brian Kettel(2010) ‘Islamic Finance in a Nutshell:A guide

to Non Specialists’