Islamic Finance and Banking:

Modes of Finance

Power point and Assessments

Khalifa M Ali Hassanain

Copy Rights Notice

Islamic research and Training Institute 2016 All rights reserved. All parts of this work are subject to sole ownership of Islamic research and Training Institute (hereinafter referred to as Copyright Holder) and remains exclusive property of the Copyright Holder. No part of this work may be copied, reproduced, adapted, distributed, modified or used in any other manner or media without prior written authorization of the Copyright Holder. Any unauthorized use of this work shall amount to copyright infringement and may give rise to civil and criminal liability. Enquiries and communications concerning authorization of usage may be made to the following:

Islamic Research and Training Institute Member of the Islamic Development Bank Group P.O.Box 9201 - 21413 Jeddah Kingdom of Saudi Arabia E-Mail:irti@isdb.org Disclaimer

The content of these course have been developed solely for educational and training purposes. They are meant to reflect the state of knowledge in the area they cover. The content does reflect the opinion of the Islamic Development Bank Group (IDBG) nor the Islamic Research and Training Institute (IRTI).

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 5 ....................................................................................................................................................... 6

Chapter Introduction .................................................................................................................................... 7

Learning Objectives ....................................................................................................................................... 7

Leasing or Ijarah Contracts ........................................................................................................................... 8

Ijarah vs Bai Contracts ................................................................................................................................. 8

Ijarah Structures: Operating Lease ............................................................................................................... 9

Ijarah Structures: Financial Lease ............................................................................................................... 10

Two More Types of Ijarah Structures ......................................................................................................... 12

Issues in Ijarah Contracts ............................................................................................................................ 13

Modern Mode of Leasing ............................................................................................................................ 15

Conventional vs Islamic Leasing .................................................................................................................. 17

Sale After Ijarah .......................................................................................................................................... 17

Ijarah Muntahia-bi-Tamleek ....................................................................................................................... 18

Issues in Modern Ijarah Contracts .............................................................................................................. 19

The Concept of Ijarah Sukuk ....................................................................................................................... 21

Deferred Delivery or Salam Contracts ........................................................................................................ 21

Essential Elements of a Salam Contract...................................................................................................... 21

Application of Salam Contracts ................................................................................................................... 23

The Istisnaa Contract ................................................................................................................................. 24

The Istijrar Contract .................................................................................................................................... 25

Chapter Summary ....................................................................................................................................... 25

Key Terms .................................................................................................................................................... 26

Chapter 6 ..................................................................................................................................................... 29

Chapter Introduction .................................................................................................................................. 30

Learning Objectives ..................................................................................................................................... 30

Shirkah and its Two Categories ................................................................................................................... 30

The Concept of Mudarabah ........................................................................................................................ 31

Raising Capital for Mudarabah ................................................................................................................... 31

Types and Conditions of a Mudarabah Contract ........................................................................................ 31

Profit and Loss Under Mudarabah .............................................................................................................. 32

The Concept of Musharakah ....................................................................................................................... 33

Capital Under Musharakah ......................................................................................................................... 34

Profit and Loss Under Musharakah ............................................................................................................ 35

Comparison of Musharakah and Mudarabah ............................................................................................ 36

Mudarabah and Musharakah ..................................................................................................................... 37

The Wadiah Wad Dhamanah Deposit ........................................................................................................ 38

The Qard-ul-Hasan Deposit ........................................................................................................................ 39

The Concept of Wakalah (Agency) ............................................................................................................. 39

The Concept of a Tawarruq Contract .......................................................................................................... 41

The Concept of a Jualah Contract .............................................................................................................. 42

Chapter Summary ....................................................................................................................................... 43

Key Terms .................................................................................................................................................... 43

Chapter 7 ..................................................................................................................................................... 45

Chapter Introduction .................................................................................................................................. 46

Functions of Financial Intermediaries ......................................................................................................... 47

Intermediation Contracts Permitted by the Sharah ................................................................................. 47

Historical vs. Modern Mudarabah .............................................................................................................. 49

Trust-based Intermediation Contracts ........................................................................................................ 50

Security-Based Intermediation Contracts ................................................................................................... 51

Business Models for Islamic Financial Institutions (IFIs) ............................................................................. 52

The Two-windows Business Model In the two-windows business model, liabilities and assets of the bank

balance sheet are divided into two windows. ............................................................................................ 52

Risks and Mitigation .................................................................................................................................... 53

Conceptual Balance Sheet of an IFI ............................................................................................................. 53

The Types of Investment Accounts at an IFI ............................................................................................... 53

Investment Choices for an IFI ..................................................................................................................... 54

Categories of IFIs ......................................................................................................................................... 55

Chapter Summary ....................................................................................................................................... 56

Key Terms .................................................................................................................................................... 57

Chapter 8 ..................................................................................................................................................... 59

Chapter Introduction .................................................................................................................................. 60

A Credit Card Based on Bai al-Einah .......................................................................................................... 61

Controversial Aspects of Bai al-Dayn ......................................................................................................... 63

Tawarruq ..................................................................................................................................................... 63

Issues in Managing Tawarruq Products ...................................................................................................... 64

Letter of Credit Under Wakalah ................................................................................................................. 64

Letter of Guarantee Under Kafala .............................................................................................................. 65

Other Fee-based Services ........................................................................................................................... 66

Key Terms .................................................................................................................................................... 67

Chapter 5

Chapter Introduction

Hello and A Framework for the Islamic Financial System-Part 3.

You learnt about the exchange and sale contracts such as Murabaha and Musharakah in the

chapter A Framework for the Islamic Financial System-Part 2.

In this chapter, you will learn about more types of contracts that the Sharah permits.

These contracts are used for sale of the rights to an asset under various conditions. The

contracts include Ijarah or leasing, Ijarah Muntahia-bi-Tamleek, Ijarah Sukuk, Salam,

Istisnaa and Istijrar.

Learning Objectives

On completing this lesson, you will be able to:

Explain the concept of an Ijarah contract.

Distinguish between Ijarah and Bai Muajjal contracts.

Describe the various structures of an Ijarah contract.

Explain the various issues that need to be managed for Ijarah contracts.

Describe the types of modern Ijarah contracts.

Distinguish between conventional and Islamic leasing contracts.

Explain why the sale of an asset after the expiry of the Ijarah contract is compliant

with the Sharah.

Describe the process of the Ijarah Muntahia-bi-Tamleek arrangement.

Explain the issues that need to be managed when executing modern Ijarah

contracts.

Describe the concept of Ijarah Sukuk.

Recognise the potential of Ijarah contracts in financing medium and long term

economic investments.

Describe the structure of a Salam contract.

Identify the essential elements of a Salam contract.

Identify the conditions for and a special application of valid Salam contracts.

Describe the structure, application, and risks of an Istisnaa contract.

Describe the structure of an Istijrar contract.

Leasing or Ijarah Contracts

Ijarah means leasing or hiring of a physical asset. It has two parties:

The Ajir or Mujir (lessor), usually a bank, which leases out its asset to its clients.

The Mustajir (lessee), the banks client who is in need of the assets.

By paying a predetermined rent (Ujrah) for a specified time, the lessee receives known

usufruct, that is, the benefits associated with the ownership of the assets. This is the

essence of an Ijarah contract.

The subject matter of Ijarah can be divided into two types:

Property or assets whose usufruct is transferred to another person in exchange for

rent. Example: Houses, vehicles, and residences.

Labour involving employment of a person for a wage. Example: Work of an engineer,

doctor, tailor, and carpenter.

According to the Majallah code, a third type is leasing animals.

The lessor, as owner of the asset, must bear the expenses and risks that are related to

ownership.

The consideration of lease is Ujrah (rent or hire of things) or Ajr (wages in hiring of people).

Rent or wage agreed in the contract is called Ajr al-Musammah. When decided by a judge or

arbitrator, it is called Ajr al-Mithl.

Ijarah vs Bai Contracts

Both Ijarah and Bai or sale contracts involve the transfer of something to another party for

a valuable consideration. However, there are a few differences between Ijarah and Bai.

Lets see how these differ in two vital characteristics.

Bai

After executing the sale, the purchaser:

Becomes the owner of the property

Assumes the risk and rewards of ownership.

Ijarah

The lessor remains the owner of the property; only the usufruct or right to use the property

is transferred to the lessee. The Ijarah ceases to be in force if the lessee inherits or is gifted

the property.

Bai

The transfer of ownership is definite and immediately after the sale is executed.

Ijarah

Ijarah is time bound, that is, the lease has to terminate at some time.

Ijarah Structures: Operating Lease

Among the seven financing structures of Ijarah, in the first three structures, the ownership

of the asset remains with the bank. This concept is known as an operating lease.

In this structure, the bank owns the asset and leases it out to its client against

predetermined rentals for an agreed period. This structure:

Adheres entirely to the features of the classical Ijarah.

Is the least popular structure.

Steps:

1. The client approaches bank, which is also the vendor, identifies the asset, and collects

relevant information, including rent.

2. The bank leases out the asset to client, permitting the client to possess and use the

asset.

3. The client pays pre-determined rentals over a fixed period.

4. At the end of the period, the asset is returned to the bank.

This structure, which consists of two phases, involves a vendor.

Phase One: The bank purchases the asset needed by its client from the vendor.

Phase Two: The bank leases out the asset to its client against a predetermined rent

for a specified period.

Steps:

1. The client approaches a vendor or supplier of the asset and collects all relevant

information.

2. The client approaches the bank for Ijarah of the asset and assures the bank of leasing

the asset from it once purchased.

3. The bank pays the vendor.

4. The vendor transfers ownership of asset to the bank.

5. The bank leases the asset and transfers possession and right of specified use to the

client.

6. The client pays pre-determined rentals over a fixed period of time.

7. At the end of the period, the asset is returned to the bank.

In this structure, the bank does not deal directly with the vendor. It appoints the client as

its agent. This structure has two stages and correspondingly two relationships between the

bank and the client.

First Stage:

The client is an agent of the bank and buys the asset on behalf of the bank.

The client will only carry out the functions of an agent.

Second Stage:

This begins when the client takes delivery from the supplier.

The bank is the lessor and the client is the lessee.

From the date of delivery of the asset, the client is liable to discharge his obligations

as a lessee.

Steps:

1. A mutual agreement is signed between the bank and client, in which the bank promises

to lease and the client promises to take the asset on lease against predetermined rent

for a specific period.

2. The bank appoints the client as its agent.

3. The client identifies the vendor, selects the asset on behalf of the bank and informs the

bank of its particulars in writing. These include the vendor's name and its purchase price

to the bank.

4. The vendor makes physical delivery of asset to the agent (client) of bank; trained staff

from bank supervises this process.

5. The bank arranges payment to the vendor.

6. The agency contract comes to an end. The bank leases the asset and transfers

possession and right of specified use to the client.

7. The client pays pre-determined rentals over a fixed period of time.

8. The asset is returned to the bank.

Ijarah Structures: Financial Lease

What happens if the asset has been built to specification?

Its extremely difficult for the bank to find a second client willing to take such an asset on

lease or even buy it.

Financial leases help a bank avoid such scenarios.

A bank can do two things to avoid the scenario mentioned earlier.

1. If the Ijarah period is the same as or close to the economic life of the asset, there would

be very little residual value in the asset. The bank may therefore gift the asset to the

client without any mutual consideration or even abandon the asset. The gift contract is

independent of the Ijarah contract.

2. When there is a significant residual value at end of the Ijarah period, the bank may sell

the asset to the client at a predetermined price. This arrangement is called lease-sale or

Al-Ijarah-Thummal-Bai (AITAB). The sale contract is independent of the Ijarah contract.

The bank may even gift the asset to its client.

Under both structures, the asset would continue to remain with the client. These are called

financial lease structures.

This structure involves an independent promise by the bank to gift or sell the asset at the

end of the lease period to the client at a predetermined price.

This deal works out for the client as the asset meets a specialised need of the client or

because the price is below market price.

Steps:

1. An agreement is signed between the bank and the client where the bank promises to

lease the asset and the client promises to take the asset on lease against predetermined

rent for a specific period.

2. The bank appoints the client as its agent.

3. The client identifies the vendor, selects the asset on behalf of the bank and informs the

bank of its particulars in writing. These include the vendor's name and its purchase

price.

4. The vendor makes physical delivery of asset to the agent (client) of bank; trained staff

from bank supervises this process.

5. The bank arranges payment to the vendor.

6. The agency contract ends. The bank leases the asset and transfers possession and right

of specified use to the client.

7. The client pays pre-determined rentals over a fixed period. 8. The bank transfers ownership of asset to client at the end of Ijarah period either through

a gift or through sale.

Click the Resources button at the top of the screen to see a case study of how a leading

UAE bank has financed property through such an Ijarah structure.

Another method of Ijarah that ends in transfer of ownership to the client is Ijarah with

partnership (based on Musharakah or Mudarabah). It is quite common in equipment and

housing finance.

Steps:

1. The bank forms a partnership with the client based on Musharakah; the bank is the

agent-manager of the partnership and undertakes subsequent activities in this capacity.

2. The bank purchases the property on behalf of the Musharakah.

3. The property is taken on lease by the client and generates rental income for the bank

over a period.

4. The bank allocates the rentals between both parties; one portion goes back to the bank

as its share in rental income. Another portion, which is the share of the client in rental

income, is used to redeem part of the banks stake in partnership. The bank transfers

ownership of asset to the client when its stake is reduced to zero.

Two More Types of Ijarah Structures

There are two more types of Ijarah financing structures.

Lets look at each of them.

Consider a situation in which a client needs to invest in a large plant and machinery. The

finances required may be too huge for one bank to handle. Therefore, the bank may enter

into a co-Ijarah or a leveraged transaction with itself as Manager or Lead-Lessor. Ijarah can

be leveraged by using debt in the total financing. The bank forms a Special Purpose Vehicle

(SPV) or a master Ijarah agreement. Debt may be provided through Murabaha and Ijarah

for specific components of the pool of assets under the master Ijarah agreement. Sub-

Ijarah or Ijarah of a leased asset is allowed if it is provided in the Ijarah or if permission is

obtained from the lessor.

The rent of the two Ijarahs can be different. Additionally, a lessor can sell some or all of the

leased assets to a third person whereby the new party takes on the role of the lessor.

The total inflow of cash to the SPV is distributed among the co-lessors or investors

according to the proportion of their shares in the leased assets. The bank or the lead-lessor

may charge the other co-lessors or investors a management fee, which is deducted before

the rentals are distributed.

Steps:

1. The SPV or a master Ijarah agreement invites other financial institutions to contribute

equity to the pool of capital required to finance the assets. This is done through modes

that are permitted by Islam like Musharakah or Mudarabah.

2. The SPV buys the asset.

3. The SPV leases the asset and transfers possession and right of specified use to the

client; the client pays known rentals over a fixed period of time.

4. The bank charges a management fee and a pro-rata share in rental.

5. The bank shares the balance with all parties as per agreement.

6. The bank retains pro-rata share in residual value.

7. The bank shares the balance with all parties as per agreement.

In the structure of a sale-and-lease-back, the client continues to use the asset in lieu of

periodic Ijarah rentals paid to the bank, which now owns the asset.

Steps:

1. The client sells an asset it owns to bank on cash basis; while the ownership papers are

transferred to the bank, possession of the asset remains with the client.

2. The client enters into an Ijarah contract with bank for the same asset.

3. The client pays fixed rent over fixed period of time.

4. The bank transfers ownership of asset to client at the end of Ijarah period either through

gift or sale.

Issues in Ijarah Contracts

There are seven issues that need to be managed for Ijarah contracts.

These relate to:

Execution of Contract

Determination of Rent

Sublease by Lessee

Security and Liabilities

Gharar

Default Risk

Termination

Based on the nature of the asset, an Ijarah contract can be:

Executed before or after the lessor possesses the asset.

Enforced or commenced instantly or in the future.

Future enforcement is permissible, if:

The asset to be leased exists.

The lessor continues to own the asset and takes on the risk of damage to the asset.

The nature or quality of the asset is specified and destruction or damage to a

particular unit of the asset does not terminate the contract.

If a particular asset is specified for Ijarah, a lease contract cannot be executed before:

The asset comes into existence.

Owning the asset or its usufruct in the case of sub-lease.

The following guidelines apply.

If both parties agree and other conditions are met, the Sharah permits them to

decide the rental based on aggregate cost of the purchase, construction, or

installation of the asset.

The price, leasing rate, or rental must be determined at the time of contracting for

the whole period of Ijarah.

The Ijarah period can be split into smaller intervals with floating but predetermined

rates.

Criteria to modify the periodic rate:

A well-defined and variable benchmark such as LIBOR

A macroeconomic rate such as a Consumer Price Index (CPI)

A specified percentage

The increase or decrease in tax

The rate of inflation

Click the Resources button at the top of the screen to see a case study of an equipment

finance product developed by Leading US-based NBFI.

The following guidelines apply.

The Sharah permits sub-lease by the lessee only if the lessor permits and it is

provided in the lease agreement.

The Sharah does not object if the rent from the sub-lessee is equal to or less than

the rent payable to the owner/original lessor.

There are different perspectives among Islamic jurists if the rent charged from the

sub-lessee is higher than the rent payable to the owner.

Sub-leasing is not allowed under these situations, the last two effectively being Rib-based

transactions:

There are a number of sub-lessees.

The sub-lessor invites others to share the rentals without transferring partial

ownership.

The sub-lessor charges a fee to partners for sharing the rentals.

The following guidelines apply because a leased asset is considered to be in Amanah.

The lessee is a trustee and has a fiduciary responsibility to protect the asset.

The lessor can ask the lessee to guarantee against damage to the asset and demand

some form of security.

The following principles apply because lease rent is a form of debt.

If there is damage or if the lessee defaults on rent, the lessor can recover the costs

from the security, excluding the opportunity cost.

If any amount exceeding such costs is also collected, the lessor is indulging in Rib.

Gharar in Ijarah occurs in the following situations:

A sale contract is added to the original Ijarah contract.

Options are stipulated in the Ijarah contract make the contract complex.

A forward sale contract such as the AITAB mechanism, which involves a mutual

promise by the bank to sell and by its client to buy in future.

Gharar in Ijarah does not occur if the sale, gift, or option (promise) is executed

through a distinct agreement not linked to the Ijarah agreement.

The following guidelines apply for managing risk of default by the lessee.

Any charge by the bank for default by the lessee is a form of Rib.

To deter exploitation by lessees, jurists allow the lessor to include a clause in the

Ijarah agreement asking for a formula-based donation to a charity operated by the

lessor in case of default.

Where the lessee defaults deliberately, the lessor can recover its dues by taking

possession of the leased asset or enforcing the collateral.

The following guidelines apply for termination of an Ijarah contract.

The Ijarah cannot be terminated without mutual consent, except if the lessee breaks

any term of an Ijarah agreement.

Under the framework of al-Khiyar, Ijarah allows either or both the parties to confirm

or rescind the contract within a specified period.

Unlike in conventional leases, the lessee only needs to pay the rent due when the

contract is terminated.

If the lessor terminates the lease due to misuse or negligence by the lessee, the

lessor can ask for compensation.

Contracts may be terminated for any of the following reasons:

If the asset is damaged such that its no longer useful

If the objective of the lease cannot be achieved

If the asset is sold to the lessee

If heirs to the lessee can no longer pay the rent after the demise of the lessee

Modern Mode of Leasing

Islamic Financial Institutions (IFIs) see a lot of opportunity in leasing because of its benefits

and the asset-based nature of investments in Islamic finance. For IFIs, Ijarah operations

can be conducted only by rules prescribed in Fiqh text.

The three types of leasing contracts in modern Islamic finance are financial lease, security

lease and operational lease.

Financial lease is also called hire-purchase. In conventional financial lease:

The lease period is such that the lessor can recover the cost of the asset and earn a

market-based return on its capital.

The banks or NBFIs pay the supplier, either directly or through the lessee.

The monthly rent is the total purchase cost plus interest divided by the lease period.

Rents begin on the day on which the price is paid by the lessor.

The lessee bears all the risks of ownership.

Termination:

Lease cannot be terminated before the expiry of the lease period without mutual

consent.

The lessee is allowed to purchase the asset before the lease is terminated.

The lessor charges an extra amount for prior termination because the sale

discontinues their regular income.

If the lessee defaults, the lessor can take possession of the asset without a court

order.

The lessor can also sell the asset to a third party to raise cash in an emergency,

provided the rental payments accrue to the new buyer.

Conventional financial leases exploit the need of the lessee, who can end up paying far

more than outright purchase on instalments.

Security lease is also known as financing lease. Effectively, it is:

A financing transaction.

A security for the amount advanced.

A mode of transferring all risks and rewards associated with ownership to the lessee.

In an operational lease, the owner:

Transfers only possession of the asset to the lessee in return for rental.

Retains ownership and takes back the asset when the lease ends.

The Sharah permits this transaction subject to other conditions being met.

Operational lease is best for acquiring the use of assets that take a very long time to

manufacture and require large amounts of money for purchase.

More NBFIs than banks use this mode. They can:

Lease a number of assets to meet the needs of different customers.

Re-lease the assets once a lease expires.

However, they have to bear the risk of obsolescence, recession or diminishing demand

Conventional vs Islamic Leasing

There are four key differences between conventional and Islamic leasing. Lets look at each

of them.

In conventional leasing, once the leasing contract expires, the lessee becomes the owner of

the leased good. This is done without additional charge or at a nominal price.

In Ijarah hirepurchase, both parties must agree from the beginning that:

The Ijarah contract also includes sale of the asset.

The amounts the lessee must pay periodically include rent and the cost of the asset.

In Ijarah finance lease, the amount the lessee must pay periodically is the rental.

However, the parties may not agree at the beginning of the contract that the lessee will

become the owner when the contract terminates normally.

In conventional leasing, the lessor:

Charges rental from the date funds are transferred to the supplier of the asset.

Leases an asset before buying it and gaining possession.

The Sharah forbids such risk-less reward. It allows the lessor to charge rent only after it

has taken delivery of the asset, thereby assuming risk of ownership.

Conventional and Islamic leases differ primarily the way expenses are allocated.

In conventional leasing, the lessor transfers all the risks to the lessee, especially when the

lease contract also specifies the residual value of the asset.

The Sharah stipulates that:

The lessor must incur all expenses to rectify the defects that prevent the lessee from

using the equipment.

The lessee must incur daily maintenance and operational expenses.

In conventional operating leases, the lessee bears all the risks and expenses.

In Islamic operating leases:

The lessor must maintain the asset and bear all the risks and costs of ownership.

The lease period is different from the useful life of the leased asset and must be

mutually renewed.

Sale After Ijarah

In both cash and credit sale, the buyer becomes the owner of the asset immediately after

the sale. In Ijarah, the lessor continues to be the owner. The parties in an Ijarah cannot

execute a sale contract effective from a future date to transfer ownership.

However, the lessor can separately and unilaterally promise to sell the asset when the lease

terminates normally. The lessee is not obliged to purchase even if the lessor promises to

sell. A bilateral promise to sell and buy the asset is forbidden because such a promise is

essentially a contract, making the Ijarah a two-in-one contract.

Similarly, instead of sale, the lessor can separately and unilaterally promise to gift the asset

to the lessee at the end of the lease period. Since the periodic amount paid by the lessee

usually covers the rent and a profit for the lessor, the lessee has the right to own the asset

at the end of the lease. Islamic scholars recommend gifting the asset as the best way to

transfer ownership since the cost has already been paid for. This arrangement is called

Ijarah Muntahia-bi-Tamleek.

Note that Ijarah Muntahia-bi-Tamleek does not violate Sharah rules due to the following

reasons.

The lessor fixes the periodic payment such that the cost and rent are received during

the lease period.

It comprises an Ijarah contract, which is immediately effective, and a unilateral

promise to sell or gift the asset, not a contract to sell and buy at the end of the lease

period.

This arrangement does no injustice to either party. It does not involve Rib or any

disputable element. For the lessee, it is only justified that they own the asset since they

have already paid the cost in addition to the rental.

Ijarah Muntahia-bi-Tamleek

In Ijarah Muntahia-bi-Tamleek, the leasing contract is the real and major contract. It is

subject to all the Sharah rules of an ordinary Ijarah contract. Standard Sharah principles

such as defining the asset to be leased, its terms and essential prerequisites of contracts

have to be adhered to. The five-step process that Islamic banks usually adopt is described

on this screen.

The client conveys the requirement to the bank and enters into a MoU. The bank asks for a

promise of purchase from the lessee along with an amount called Hamish Jiddiyah to ensure

that the client fulfils the promise.

Acting as a trustee for the amount, the bank can:

Invest it on the basis of Mudarabah.

Invest it as a PLS deposit in the name of the client.

Consider it as an advance payment of rental.

If the bank uses the money in its business, it becomes the banks liability.

The bank can purchase the asset directly or through an agent, who can be the banks client

itself. The client raises a letter of credit from the bank and places the order with the

supplier. The bank reimburses all duties and taxes plus transportation and other charges

levied by port authorities.

If the client also specifies the supplier of the asset, the bank can get a bond from the client

to the effect that the client will accept the asset when supplied. The bank, however, will

take the risk and expenses of ownership.

Unlike a Murabaha sale, the bank need not first take possession of the asset and then

deliver it to the lessee. Unlike an MPO, the lease can start from the date the client receives

the asset as an agent of the bank.

The bank and client can create a Shirkatulmilk partnership (joint ownership) to purchase the

asset. The bank can then lease its share to the client on the principle of Diminishing

Musharakah. The rental should be in proportion to the banks share in the ownership. If the

client periodically purchases any part of the banks share, the rental decrease

proportionally.

When the bank buys the asset and takes possession or the client-agent takes possession,

the formal lease agreement is executed. Rent accrues to the bank from this point provided

the asset is completely installed and ready for use. Rent accrues even if there is any delay

in using the asset by the lessee due to a problem at their end.

If the client defaults on rents, the bank can ask it to speed up payment for the rest of the

period, provided the agreement allows such a demand. Effectively, this means the bank is

terminating the lease ahead of the lease period. The bank can then take back the asset or

the lessee can be made to purchase the asset, but only the due rent can be deducted from

sale value.

In addition, the lessor cannot earn income from penalties on rent defaults, therefore any

penalty has to be donated to charity.

Issues in Modern Ijarah Contracts

Islamic With respect to modern leasing operations, Islamic banks face four sets of issues.

These issues relate to:

1. Ownership Risk

2. Timing the Ijarah Contract

3. Cancellation of Lease

4. Return for the Bank

To address these issues, IFIs must consider the following points when designing Ijarah

contracts.

1. Risk cannot be separated from ownership.

2. Lease and sale are contracts of different natures.

According to the Sharah principles for an Ijarah:

The lessor must spend for large scale repair of damaged assets since any repairs

benefit the lessor as the owner.

The lessee is responsible only for normal operating maintenance.

When the lessee is an agent of the lessor, the lessor is responsible for any damage

to the asset when it is supplied, unless the agents fault can be proved. If not, then

the lessor must adjust the rent or expand the lease period to compensate the lessee

for the period the asset cannot be used.

Any clause in the contract seeking to transfer the ownership-related costs to the lessee is

forbidden.

In case of delayed delivery of the asset to the lessee, the lessor cannot charge any rent for

the period between the execution of the Ijarah agreement and the date of delivery of the

asset. To avoid such loss of rent,, the bank should only sign a promise to lease when the

funds are disbursed to the supplier. The actual Ijarah agreement can be signed only when

the asset is delivered. Rent can be calculated to cover the date difference between disbursal

of funds and asset delivery.

Sometimes the usufruct, which may be inherently risky, is less than expected due to any

events beyond the control of the lessee. In such a case, the Sharah allows termination of

the lease. For example, if a crop grown on leased land fails due to natural calamity, then the

Ijarah on the leased land becomes invalid, and the lessee must receive a normal wage as an

employee.

During purchase of assets, because the bank is the owner, it is:

Required to pay all expenses incurred in the process of purchase.

Entitled to any discounts provided by the supplier of the asset.

The bank may calculate rent to cover for such expenses. However, the return on the asset is

not really fixed. For example, the cost of repair may be higher than any claim settled by the

Takaful insurance company.

You will learn more about the Takaful insurance framework from a conceptual perspective in

Chapter 9 of this course, The Islamic Takaful System-Part 1, and from a product

perspective also in Chapter 10, The Islamic Takaful System-Part 2.

The Concept of Ijarah Sukuk

According to the Sharahs guidelines for an Ijarah contract:

The lessor can sell the asset to a third party together with its rights and obligations.

If the lessor doesnt transfer the ownership and only assigns rental to the third party,

the lessor cannot charge money for this right.

The new party to whom the lessor sells the asset gains the same rights as the old

lessor but also carries all the old lessors liabilities.

But what if the lessor sells the asset to multiple investors in different ratios?

Then, the lessor must grant leasing certificates to each investor called Ijarah Sukuk that

show the proportional purchase of the asset. Each investor owns the asset to that extent

and takes on the risk of ownership and maintenance to that extent.

Ijarah Sukuk issues can be used to finance large corporate and government infrastructure

projects. Ijarah Sukuk also helps IFIs in managing liquidity better.

The Sukuk process is briefly illustrated on screen. You will learn in detail about Sukuks in

Chapter 12 of this course, Islamic Investment Funds.

Deferred Delivery or Salam Contracts

BaiSalam or deferred delivery is a forward contract wherein the price is paid in advance at the time of signing the contract, but the goods are delivered later.

Unlike Murabaha and Ijarah, Salam or Salaf was originally intended to finance small farmers

and traders.

Under a Salam agreement:

1. A client in need of short-term funds sells merchandise to the bank on a deferred delivery

basis. The date of delivery is agreed at this time. It receives full price for the

merchandise on the spot.

2. At the pre-agreed date, the client delivers the merchandise to the bank.

The bank sells the merchandise in the market at the prevailing price. It can expect to make

a profit because the spot price that it pays can be pegged lower than expected market price.

Essential Elements of a Salam Contract

The six elements required for a valid Salam contract are:

Subject Matter

Means of Payment

Period and Place of Delivery

Khiyar or Options

Conditions for Amending/Revoking the Salam Contract

Penalty for Non-Performance

The following comprise the subject matter of Salam:

All goods that are quantifiable and can be qualitatively described

Well-defined goods without specific units but with specifications that influence prices

Fungible (Mithli) and similar goods

Non-identical goods

Standardised and available goods

Gold, silver and metallic money like Fulus of copper or other metals

The following types are not permitted:

Goods that may not yield any produce

Goods that are prone to subjective evaluation

Paper currency

The following are permitted as means of payment.

Legal tender

Goods in barter, if Rib is avoided

Usufruct of assets

The following are not permitted as means of payment.

Outstanding loans on the seller or on a third party

Payment delayed beyond three days as specified in the agreement and definitely not

after delivery

Partial payment

In barter, advance payment in the form of the same species of goods in exchange of

deferred delivery of similar goods

Payment can be credited to a sellers account.

The following principles apply for delivery of goods.

It is important to fix the time and place of delivery of goods.

The nature of the goods decides the due date and delivery mode.

If a place of delivery is not specified in the agreement, then the place where the

contract was finalised will be regarded as the place of delivery.

Goods are a responsibility of the seller before the delivery and of the buyer after the

delivery.

The Islamic law of option (Khiyar al-Shart) is not permitted in Bai Salam as it upsets or

delays a sellers ownership over the price of the goods. A buyer:

Does not have the option of seeing (Khiyar al-Royat).

Has the option of defect (Khiyar al-Aib) and the option of specified quality, This

means that a buyer can withdraw the sale if goods are found to be defective or fails

to match the quality as agreed at the time of contract.

Can only recover the price already paid for the goods, nothing more.

A seller must deliver the goods as specified in the agreement. The following principles apply

regarding amendment or revocation of the contract.

A buyer cannot independently change any conditions of the contract once the seller

has been paid.

Both parties have the right to withdraw the contract with mutual consent with the

buyer entitled to recover only the amount already paid.

If the market price of the goods seems higher at the time of delivery than what a

buyer has paid, a seller may want to withdraw the contract.

A bank may want to withdraw from purchase if the price of the item decreases at the

time of delivery.

To avoid such scenarios, it is advisable to make the contract binding on both the parties,

except if the goods are absent from the market or are inaccessible to the seller at the time

of delivery.

Guidelines regarding the sellers inability to deliver include the following.

A seller may voluntarily agree in the contract to donate to the Charity Account, held

by the bank, in case of a delay in delivery.

If a seller fails due to bankruptcy, banks cannot penalise but may grant additional

time, according to Clause 5/7 of the AAOIFIs Salam Standard.

Application of Salam Contracts

Application of Salam in Pre-Shipment Export Finance

The bank receives an export letter of credit (LoC) in favour of its client for certain

goods. This allows the bank to act as a seller towards the foreign buyer.

The bank agrees to buy the goods from its client under a Salam contract and makes

advance payment to the client. The delivery date should be reasonably after the

shipping date, and the port of delivery should be the same mentioned in the LoC.

Once the client submits the in-order shipping documents such as bill of lading or

certificate of origin, delivery is deemed to be satisfactory.

The banks profit is the difference between the agreed payment (pre-shipment

finance) made by the bank to its client and the amount of the export LoC.

The Istisnaa Contract

Under Istisnaa, the seller undertakes to develop or manufacture a commodity for an agreed

price and deliver after an agreed period. In Istisnaa, nothing is exchanged at the time of

contracting.

The seller and the manufacturer can be different, which opens an opportunity for Islamic

banks to take on the role of a seller and get the goods manufactured from another party. It

signs two Istisnaa agreements, one with the buyer and the other with the manufacturer.

Under an Istisnaa agreement:

1. The client asks the bank to develop an asset with clear specification.

2. The bank asks the manufacturer to develop the asset.

3. The manufacturer develops the asset and receives periodic payments from the bank at

different stages of manufacturing.

4. At a pre-agreed date, the manufacturer delivers the asset to the bank.

5. The bank delivers the asset to the client.

6. The client pays in full or in parts over the agreed period of time.

A big risk under Istisnaa includes construction-related risks and risk of nonconformity to

specifications.

To mitigate this, the bank can include a penalty clause in the agreement and designate its

client as an agent or a surveyor to oversee satisfactory completion of the job.

Another type of risk under Istisnaa is default and delinquencies risk. To protect itself

against such outcomes, the bank can take a legal charge on the land, giving it the right to

repossess the land. However, this is not a mortgage, which is the risk mitigation product for

banks in conventional finance. It can also ask for a third party guarantee.

The Istijrar Contract

Under Istijrar, the purchaser buys different quantities of a commodity from a single seller

over a period. As Istijrar involves repeat purchases from a single seller, the Sharah permits

flexible pricing and payment although the price may be determined in advance. This is

subject to the absence of Gharar. The price may be paid at a future date and may be based

on a normal price or the average market price.

A master agreement in Istisjrar is signed for financing on an ongoing basis under

appropriate normal modes. However, any formal or informal Murabaha or Salam contracts

are operative, their conditions and the Sharah essentials have to be fulfilled.

An example of an Istisjrar contract is one between any wholesale merchant and a retailer.

Chapter Summary

You have completed the chapter, A Framework for the Islamic Financial System Part 3. The key points of this chapter are as follows:

Ijarah is a contract means leasing or hiring of a physical asset. The bank and the

client are its two parties.

In a Bai, the ownership of the property is transferred to the purchaser, whereas, in

Ijarah, the property remains in the ownership of the lessor, and only its usufruct, i.e.

the right to use it, is transferred to the lessee against an agreed consideration.

Ijarah has seven financing structures.

Execution of contract, determination of rent, sublease by lessee, security and

liabilities, Gharar in Ijarah, default risk and termination of Ijarah are the seven

issues that need to be managed for Ijarah contracts.

Leasing operations by banks and financial institutions are governed by rules

prescribed in Fiqh for Ijarah transactions. Financial lease, security lease and

operational lease are the three types of leasing contracts.

Transfer of ownership, rental, responsibility of expense and operating lease are the

four key differences between conventional and Islamic leasing.

In Ijarah, ownership remains with the lessor. Transfer of the ownership in the leased

property cannot be made by executing a sale contract that will become effective on a

future date. In addition to the rental, the lessee pays a sum, which goes toward

buying the leased property. Upon making full payment along with rental, the

ownership will transfer to him.

In Ijarah Muntahia-bi-Tamleek, leasing is the real and major contract. Receiving

Hamish Jiddiyah, purchasing the asset, creating partnership of ownership, formal

lease agreement and managing defaults in payment are the five steps taken to

conduct Ijarah Muntahia-bi-Tamleek.

Burden of assets, lack of knowledge on Ijarah, damage to the asset, cancellation of

lease, default in payment, no fixed return to bank, are the six issues Islamic banks

face in the leasing business.

Ijarah Sukuk is a means of raising funds by selling an asset proportionally to several

investors. Each of these receives a leasing certificate showing their proportion of the

asset.

Ijarah is the most important mode for financing operations of Islamic banks for

meeting the needs of the retail, corporate and public sectors. It is used directly for

plant and machinery, automobiles, housing and consumer durables and indirectly for

Sukuk issues by the corporate and government sectors.

Bai Salam or deferred delivery is a forward contract wherein the price was paid in

advance at the time of making the contract for the prescribed goods to be delivered

later.

The six conditions required for a valid Salam contract are subject matter of Salam,

payment of price, period and place of delivery, Khiyar in Salam, amending or

revoking the Salam contract and penalty for non-performance.

For the Salam to function smoothly, it is important that the commodity is freely

available and tradable in the market. Its scope includes industrial and agricultural

products and services.

Under Istisnaa, the seller undertakes to develop or manufacture a commodity for an

agreed price and deliver after an agreed period. The unique feature of Istisnaa is

that nothing is exchanged at the time of contracting.

Under Istijrar, the buyer purchases different quantities of a commodity from a single

seller over a period, with flexibility in fixation and payment of price.

Key Terms

Ajir

Ajr al-Musammah or Ajr al-Mithl

Amanah

Al-Ijarah-Thummal-Bai (AITAB)

Bai Bithaman Ajil or BBA

Bai al-Inah

BaiMuajjal

Bai al-Sarf

BaiSalam

Fiqh

Fulus

Gharar

Hamish Jiddiyah

Hawalah

Ijarah

Ijarah Muntahia-bi-Tamleek

Ijarah Sukuk

Istisnaa

Istijrar

Khiyar

Khiyar al-Aib

Khiyar al-Royat

Khiyar al-Shart

Khiyar al-Wasf

Mabi

Majallah

Majhul

Mithli

Mudarabah

Mudarib

Murabaha

Murabaha to Purchase Orderer (MPO)

Musawamah

Musharakah

Mustajir

Rib

Tawarruq

Ujrah

Chapter 6

Chapter Introduction

Hello and A Framework for the Islamic Financial System - Part 4.

As you have learned in other chapters, in Islamic finance, willingness to share the risk to

share profits is most important. Shirkah-based businesses are therefore a common mode.

The basic principle underlying Shirkah is that a person who shares in profits must also bear

the risks. Shirkah-based contracts include Mudarabah, Musharakah and Diminishing

Mudarabah.

Learning Objectives

At the end of this chapter, you will be able to:

Explain the concept of Shirkah and its two main categories.

Explain the concept of a Mudarabah contract.

Identify the restrictions on capital invested in a Mudarabah contract.

Identify the types of Mudarabah and the conditions of a Mudarabah contract.

Identify the rules relating to distribution of profit or loss under a Mudarabah contract.

Explain the concept of a Musharakah contract.

Explain the rules for capital being invested in a Musharakah contract.

Identify the rules relating to distribution of profit or loss under a Musharakah contract.

Distinguish between a Musharakah and a Mudarabah contract.

Explain the working of a Mudarabah and Musharakah or Mudarabah with Musharakah contract.

Explain the concept of a Wadiah wad Dhamanah deposit.

Explain the concept of a Qard-ul-Hasan deposit.

Explain the concept of Wakalah or agency.

Explain the concept of a Tawarruq contract.

Explain the concept of a Jualah contract.

Shirkah and its Two Categories

Shirkah is proportionate ownership between two or more people who combine their wealth to establish a business firm and decide to share their profits and losses.

Shirkah categories:

Shirkatulmilk

Shirkatulaqd

This category refers to fusing of ownership through freewill or compulsion.

Freewill or Optional ownership: A and B jointly receive a gift or bequest, or they jointly

purchase an article.

Compulsive ownership: A and B inherit a property or their capital becomes indivisible

without their action.

In this type of ownership,

A and B are indebted to each other.

A cannot avail benefits from Bs property without permission.

This partnership is bound by a contract. It can be categorised into:

Shirkatulamwal: Each partner contributes capital.

Shirkatulamal: Each partner contributes services.

Shirkatulwujooh: Each partner trades commodities independently in the market.

The Concept of Mudarabah

Mudarabah is a type of Shirkah in which:

One partner or group of partners provides capital to an agent or manager called

Mudarib for investment in a business venture.

The profit and loss from the venture is shared among the partners in an agreed ratio.

If there is a profit, the Mudarib is paid for the effort invested in running the venture.

If there is a loss, the Mudarib loses the remuneration.

Click the Resources button at the top of the screen to view the finance flow in a Mudarabah

contract in which the banks client is a Mudarib.

Raising Capital for Mudarabah

Five restrictions imposed by Islamic law on Mudarabah capital are listed below.

Mudarabah capital should be in the form of only legal tender money, not commodities.

Mudarabah capital should be free from debt and liabilities.

For profit-sharing with the Mudarib, an investor cannot:

o Give two different amounts of capital to the Mudarib on unequal terms of profit-

sharing.

o Cite different periods.

o Use different transactions.

Types and Conditions of a Mudarabah Contract

Mudarabah business can be restricted or unrestricted but must be according to the

customary practice of Mudarabah contracts.

Restricted Mudarabah

The Mudarib undertakes a business based on the terms and conditions set by the provider

of capital.

Unrestricted Mudarabah

The Mudarib can invest funds by own choice.

Mudarabah contracts are therefore conditional or unconditional. Conditions include nature of

work, place of work and period of work. Special conditions may also be placed regarding

who to do business with and goods in which to do business.

Lets look at the rights of the Rabbul-ml and the restrictions that the Rabbul-ml can

impose on the Mudarib.

Rights of the investor of capital are as follows:

They can appoint banks as investment agents.

The Rabbul-ml may specify:

o The time limit for the contract.

o The goods permissible or not permissible for trade.

o The place to do business in or places to be avoided.

o The entities to avoid relationships with.

The Rabbul-ml may also:

Stop the agent from entering into another Mudarabah with another party.

Require the Mudarib to fulfil their fiduciary responsibilities.

Order the Mudarib to sell goods if the profit at the time is likely to be

substantial.

The investor can enforce unbiased conditions on a Mudarib only in the interest of the business. The Mudarib cannot:

Violate the investors conditions and restrictions.

Buy goods at more than market price or sell goods at lesser than market price.

Donate funds or waive receivables without the investors permission.

Profit and Loss Under Mudarabah

The rules governing the distribution of profit or loss under a Mudarabah contract are as

follows.

Profit-Sharing Ratio

All parties can mutually decide on the profit-sharing ratio in different scenarios. The ratio

can be equal or in different proportions. However, a lump sum amount as profit is not

permitted.

The ratio can be changed at any time but is effective for the period agreed upon. If the

parties cannot agree on the ratio, the profit is to be distributed according to traditional

practice.

Profit-Sharing Period

If a Mudarabah contract accrues profits, it can be shared among partners after a period

treated as closing of accounts. Provisional withdrawal of profit is permitted and must be

adjusted during final settlement.

The Mudarib can claim a share of profit when the business operations of the Mudarabah

have realised profit, but this is subject to the interim profits being retained to protect

the capital. The Mudaribs profit accrues only after the Mudarabah is liquidated and

investors recover their capital and profit.

Loss-Sharing

Loss can be compensated by the profit of the future business operation or the contingency

reserves created in the past.

The Concept of Musharakah

Shirkatulamwal

All the partners investing in a business own it in the ratio of their capital.

Shirkah al-Inan

Two entities may invest different amounts of capital or merely act as partners. They are then agents of each other, not as guarantors.

Musharakah

A general partnership that combines the above two concepts is called a Musharakah partnership. The profits are shared according to an agreed ratio but losses are shared in the ratio of their ownership. A bank and its customer may often enter into a Musharakah agreement. Both parties contribute capital and entrepreneurial expertise.

Lets see a basic Musharakah financing structure between a bank and its client.

Step 1:

Based on a business plan, the bank and the client decide to jointly contribute to the capital of a joint venture.

Step 2:

Once the business venture is set up, the bank and its client manage its operations together, sharing the responsibilities as per pre-signed terms and conditions.

Step 3:

Profits are shared as per pre-signed terms and conditions.

Step 4:

Losses are shared in proportion to the capital contributed. This effectively reduces the asset value but retains their respective shares.

As in any contract in Islamic finance, a Shirkah-based contract must be free of coercion, misrepresentation, deception and so on. A Musharakah contract is valid if conditions related to the following are fulfilled.

1. Conditions with Respect to Partners

2. Rules Relating to Musharakah Capital

3. Mutual Relationship Among Partners and Musharakah Management Rules

4. Treatment of Profit and Loss

5. Guarantees in Shirkah Contracts

6. Maturity/Termination of Musharakah

Capital Under Musharakah

Opinion of Maliki, Hanbali and Shafie Jurists:

In Musharakah, a partner can invest money or prevalent currency or even goods as capital

of a venture. Its value should be clear.

Opinion of Hanafi Jurists:

How much a partner has invested need not be known at the time of the contract; it must be

known before the business starts. Of course, it cannot be a debt or a nonexistent

commodity.

The forms of capital can change according to the Urf of the place.

Opinion of Contemporary Jurists:

They agree that the value of goods should be assessed in monetary terms. Debt cannot

become a part of partnership capital until it is received by the investors.

Shirkah rules require that the partners must merge and commingle their capital.

Commingling means the following.

Individual ownership turns into collective ownership of the joint venture.

In addition, if the value of Musharakah assets appreciates, the new value represents

the rights of all the partners in the ratio of capital investment made by each.

Commingling does not mean capital should be cash, identical goods or transfer of either

cash or goods into the partnership capital when the contract is signed.

The merger of capital can be:

Actual

Constructive, using valuation standards such as market value or money value if the

capital is in the form of goods

Profit and Loss Under Musharakah

If the share of partners in capital in a Musharakah business is unequal, the share in profits

and losses must also be unequal. However, the share of profit for all partners should be

determined clearly.

Imam Ahmad and Imam Abu Hanifa hold that if the ratio of profit is not agreed when the

contract is being executed, the contract becomes invalid under the Sharah.

Lets see some basic rules to share the profit and loss under Musharakah.

Most Islamic jurists believe that:

The ratio of profit and loss may be different from the ratio of the capital invested by

each partner.

The difference can be on the basis of the labour invested by each partner.

Heres what important Islamic jurists think:

Imams Malik, Shafie and Zufar: Each partner will get profit exactly in the

proportion of his investment.

Imam Ahmad and most Hanafi jurists: The ratio of profit may be different the

ratio of capital investment, provided all partners freely agree on the ratio.

Imam Abu Hanifa: Profit ratio may differ from investment ratio. However, if a

partner is only a dormant partner and will not work for the Musharakah, that

partners share of the profit cannot be more than the share of invested capital.

Hanbali jurists: Even a sleeping partner may get a bigger share in profit than the

share in capital.

All jurists: The profit-share of a partner may be less than the share in capital.

All contemporary jurists believe that:

Profit may be shared differently from the ratio of capital

Loss must be shared exactly according to the ratio of capital invested by the

partners.

According to this rule, contracts can:

Specify that profit-shares must relate to the actual profit accrued to the business,

not to the amount of capital invested by any partner.

Not define profit as a percentage of the capital or as a fixed sum.

Specify the percentage of profit that each partner will receive.

This rule specifies the profit/loss relationship with labour invested in the following manner.

The partner investing less capital but more labour can get equal or more share in

than other partners.

The partner investing equal capital but more labour must get a bigger share of the

profit.

Loss must be shared exactly according to the share of the capital, regardless of who

works more.

This rule indicates the following treatment for premature use of profit:

Lump sum withdrawal of profit is allowed before closure of accounts.

Drawn amount will be adjusted from the partners share of profit during final

settlement.

In case of shortfall in actual profit, extra profit withdrawn will be recovered from

their share of capital.

This rule about changes in contracts indicates that at any time the partners can change:

The terms of the partnership contract.

The ratio of profit-sharing, provided profit is not already realised.

This rule pertains to the terms of profit/loss-sharing for a Shirkatulwajooh partnership, in

which individuals pool their creditworthiness for the benefit of the business.

The rule indicates that:

Loss-sharing ratio can differ from the profit-sharing ratio.

Loss-sharing ratio can be based on the ratio of the assets purchased on credit by

each partner.

No lump sum profit for a partner can be specified in the contract.

Comparison of Musharakah and Mudarabah

Musharakah and Mudarabah are different from each other. Lets see some aspects in which

they differ.

Musharakah

All the partners:

Invest in the business.

Can participate in the management of the business.

Can work for the business.

Mudarabah

All partners, except the Mudarib, invest in the business.

The investors have:

No right to participate in management, except on pre-agreed terms.

The right to ensure that the Mudarib is executing fiduciary responsibilities defined in

the agreement.

Musharakah

All the partners share the loss in the proportion of their investment.

Mudarabah

Loss is shared by investors only, except when it can be proved that the loss has been

caused due to the Mudaribs negligence or dishonesty. In such a case, the Mudarib is liable

for the loss.

Musharakah

The liability of the partners is unlimited, except when all partners have agreed that none of

them will incur any debt during business. If a partner violates this agreement, then he is

responsible for all liabilities exceeding the assets.

Mudarabah

The liability of the investor is limited to the extent of their investment, unless they have

permitted the Mudarib to incur debts on their behalf.

Musharakah

Profit can be distributed annually, quarterly, or monthly based on the valuation of assets.

Mudarabah

Profits can be finally distributed place only after the Mudarabah business is officially

liquidated. However, interim payment of profit is possible subject to adjustment against

final settlement.

Musharakah

All partners jointly own all assets based on their share of investment. Each one of them can

benefit from appreciated value of the assets, even if business sales havent generated

profits.

Musharakah does not require any valuation of assets during dissolution.

Mudarabah

The investor solely owns all the goods/assets purchased by the Mudarib. The Mudarib can

earn a share in the profit only if the assets are sold profitably.

If the Mudarabah business is dissolved, its assets and profit can be distributed only after

evaluating its monetary value.

With regard to perpetual Mudarabah, constructive liquidation of assets by determining the

market value of non-liquid assets is permitted.

Mudarabah and Musharakah

In Mudarabah, all the investments come from the partner and the Mudarib is responsible for

only management. In some situations, the Mudarib can also invest some amount in the

Mudarabah after permission by the Rabbul- ml. This arrangement combines a Musharakah

and a Mudarabah. In this contract, the Mudarib becomes both a partner in the business and

a worker. As long as the Mudarib stays invested, rights and liabilities are governed by the

rules of Musharakah business.

Lets see how this works in the case of a bank acting as the Mudarib for a group of

investors.

Group of investors: $100,000

Banks own money: $50,000

Banks agreed profit as Mudarib: 50 % of total profit

Suppose the business earns $ 3,000 as profit.

Banks proportion of profit as an investor: $1,000 ($3,000/3)

Profit-share for investors: $1,000 ($2,000/2)

Banks profit as Mudarib: $1,000 ($2,000/2)

Banks total profit: $2,000

The Wadiah Wad Dhamanah Deposit

A current deposit account essentially provides for safekeeping of ones deposits, free of

cost, while a savings deposit account serves the purpose of safekeeping ones surplus funds

and providing modest returns.

Withdrawals are guaranteed and honoured by the bank.

To enable easy withdrawal, additional features include:

Checking facility

ATM and charge cards

Travellers cheques

Remittances

Phone banking and branch service

Standing instructions

Statement request facility

Balance enquiry facility

Some Islamic banks base these deposits on the principle of Wadiah-wad-dhamanah or

guaranteed deposits.

The features of this mechanism are:

Deposits are held as Amanah or in trust and used by the bank at its own risk.

Depositor does not share the risk or return. Profit or loss from the investment of these

funds belongs entirely to the bank.

Deposits and withdrawals are unconditional.

Banks in South East Asia primarily use the Wadiah mechanism.

The bank guarantees the principal amount and any-time withdrawal of funds from this

account.

Banks offer gifts to a depositor as return for the Wadiah savings account but cannot promise

the gift in the contract.

While this product may be safe and convenient, Islamic banks must:

Seek permission from depositors to use their funds and claim ownership over profits

earned from such use.

Reward customers by returning a portion of the profits at its discretion.

Guarantee partial or full withdrawal.

Provide depositors with all withdrawal facilities.

The Mudarabah-based model:

Requires depositors to appoint the bank as Mudarib for investing funds.

Offers safe custody and modest return.

Allows depositors to withdraw funds at will.

Uses the minimum balance maintained for a fixed period to calculate profits.

Uses different profit-sharing ratios over time.

A good example of this model is a savings account offered by a leading Islamic bank in

Malaysia.

The Qard-ul-Hasan Deposit

Current deposits are also treated as Qard or benevolent loan by the depositor. The bank

operates a "Qard-ul-Hasan current account" and is free to use these funds at its own risk.

The depositor, as the lender, cannot insist on a return as this leads to Rib. Any benefit that

the depositor receives as a part of the agreement amounts to Rib.

Marketing challenges may force banks to promise additional benefits on a Qard-ul-Hasan

deposit to attract more customers. However, these benefits go against the spirit of this

mechanism and are not approved by Islamic scholars.

The Qard-ul-Hasan model can be applied to a savings account as well. Its used primarily by

Iranian banks. Although the depositors are not entitled to dividends, banks provide a variety

of benefits, including non-contractual gifts.

The Concept of Wakalah (Agency)

Wakalah means looking after, taking custody, applying skill or remedying on behalf of

others. Wakalah is also a responsibility. It is therefore, essential for a Wakil to fulfil his duty

in the way a trustee fulfils his responsibility in the case of Amanah.

Wakalah-based services will be dealt with in detail in Chapter 8 of this course, Controversial Financing & Fee-based Products.

The types of Wakalah are:

Wakil-bil-Kusoomahfor disputes

Wakil-bil-Taqazi al Daynfor debt receipt

Wakil-bil-Qabaza al Daynfor debt collection

Wakil-bil-Bai for trading

Wakil-bil-Shirafor purchasing

The subject matter of agency should be defined.

Agency is not permitted for acts that:

Are prohibited in the Sharah.

Cannot be delegated.

An agent must:

Act according to the instructions of the principal.

Show due care and skill.

Not delegate the job to another person without the consent of the principal.

Avoid conflicts of interest.

A Wakalah contract ends by:

Mutual agreement.

Unilateral termination.

Discharging of obligation.

Destruction of the subject matter.

Death or loss of legal capacity.

An agency contract may be specific or general. The nature of the job to be done has to be

defined in both types to avoid disputes.

General Agency Contract: In which an entity simply appoints an agent to purchase goods,

as and when desired by it

Specific Agency Contract: In which an entity asks an agent to sell a particular asset at a

given price or as per its instruction

IFIs use a Wakalah contract along with:

Murabaha

Salam

Istisnaa

Ijarah

Diminishing Musharakah

A Wakalah is useful for activities such as:

Letter of Credit (LoC)

Payment and collection of bills

Fund management

Securitisation

A Wakalah contract is both commutative and non-commutative.

Islamic banks generally:

Do not pay a fee to clients who perform duties on their behalf.

Charge fees for agency services rendered by them on behalf of their clients.

Islamic banks may manage funds on behalf of clients through a service called Wakalatul

Istismar.

From this, banks can get a fixed fee regardless of the profit or loss on the relevant portfolio.

The fee can be a lump sum, a percentage of investment amount, or of the NAV provided the

method is disclosed in the prospectus of the fund.

The Concept of a Tawarruq Contract

Tawarruq means to buy on credit and sell at spot value with the objective of getting cash.

This implies that the buyer is not interested in the commodity but the liquidity it provides.

Tawarruq-based services are covered in detail in Chapter 8 of this course, Controversial Financing & Fee-based Products.

Transactions Permitted:

Sale to a third party in the market

If a Mutawarriq, the entity seeking cash, appoints the bank as an agent to sell goods to

the Mutawarriq, but the agency only occurs after unconditional sale

Tawarruq of shares of joint stock companies, Ijarah Sukuk (assets and services) and

bundles of assets, comprising real assets as well as cash and receivables

Transactions Not Permitted:

Sale to the entity from whom the goods are purchased on credit (Inah)

If a bank employs the Mutawarriq, the entity seeking cash, as its agent to purchase the

commodity on its behalf with the intent to sell the same back to the entity

If a Mutawarriq, the entity seeking cash, appoints the bank as an agent to sell goods to

the Mutawarriq and the agency is specified in the sale contract

If Tawarruq is executed through a national or international commodity exchange, where

brokers only provide agency services and goods remain where they are without transfer

of ownership from the seller to the buyer

Some Islamic banks use Tawarruq to place and obtain funds, thereby earning fixed returns.

This practice is widely used in the Middle East as Commodity Murabaha or Shares

Murabaha.

Acceptable Tawarruq arrangements are executed as follows:

1. A bank needing funds and another bank seeking to place funds selects any

commodity/stocks that are highly liquid.

2. The second bank acquires the commodity from the market by paying cash.

3. The first bank purchases it from the second bank on credit (Murabaha).

4. After taking delivery, the first bank sells it in the market at spot price.

Tawarruq transactions should be:

Implemented as more than a mere exchange of papers between two brokers and one

or two banks.

Used only in extreme cases where no interest-free option is available.

Strictly monitored by Sharah boards of IFIs.

The Concept of a Jualah Contract

Jualah is a contract in which one party, called the Jail, promises a specific reward, called

the Jual to anyone who may be able to realise a specific or uncertain result. Promising a

reward for finding a stolen car is an example of this contract.

Jualah is permitted by the Holy Qurn and the Sunnah but was originally restricted to a

reward for the return of a runaway slave.

Jualah can be used by IFIs if:

The required end result of the transaction is alone specified.

A desired result cannot be achieved using Ijarah.

Overdue debts need to be recovered.

Other services where the subject cannot be specified in detail have to be provided.

Financial services based on Jualah include:

Collection of Debts

Securing Permissible Financing Facility

Brokerage

For collecting debts, the reward is:

Related to realisation of all or part of the debt.

Calculated as a percentage of the amount collected on the basis of Jualah.

May be paid in advance fully or partially or before the work is completed, but is paid

on account only.

When used to secure permissible financing, Jualah contracts may involve services such as

preparation of feasibility reports.

When used in brokerage activities, Jualah contracts grant the award to the entity executing

the contract only when the brokers customer signs a purchase contract intermediated by

the broker.

Chapter Summary

You have completed the chapter, A Framework for the Islamic Financial System-Part 4. The key points of this chapter are as follows:

Shirkah is proportionate ownership between two or more people who combine their

wealth to establish a business concern and decide to share their profits and losses.

Shirkah is categorised as Shirkatulmilk and Shirkatulaqd.

Mudarabah is a type of Shirkah in which one partner or group of partners provides

capital to an agent or manager for investment in a business venture. In Mudarabah,

the profit from the venture is shared among the partners on an agreed ratio. The

Mudarib is paid for the effort invested in running the venture or may receive a share

of the profit if the Mudarib is also part owner.

There are several restrictions on capital invested in Mudarabah and sharing of profit/loss. Restrictions may apply also to the type of business, place of business, parties involved, or the manner in which the Mudarib uses or manages the funds.

In a Musharakah partnership, the profits are shared according to an agreed ratio but losses are shared in the ratio of their ownership.

Several conditions and restrictions may apply to partners in a Musharakah, management of the business, treatment of profit and loss, share of each partner in

profit/loss guarantees of capital and termination of the contract. Musharakah and Mudarabah contracts are different in terms of partnership,

profit/loss treatment, rights and liabilities of partners. However, they can be

combined effectively as well.

IFIs can provide financial services based on Wakalah (agency contracts) & Jualah

and deposit products based on Wadiah or Qard Hasan concept. Both current and

savings deposit products can be created. A Wakalah contract can be used together

with Murabaha, Mushrakah, Salam etc.

Tawarruq means to buy on credit and sell at spot value with the objective of getting

cash. Tawarruq products are popular in South East Asia and are generally permitted

by Islamic jurists with some restrictions.

Jualah is a contract in which one party, called the Jail, promises a specific reward

for any entity that can realise a specific or uncertain result.

Key Terms

Amanah

BaiSalam

Ijarah

Istijrar

Inah

Istisnaa

Jualah

Kafala

Mudarabah

Mudarib

Murabaha

Musharakah

Mutawarriq

Qard al-Hasan

Rabbul-ml

Rib

Shirkah

Shirkah al-Inan

Shirkatulamwal

Shirkatulaqd

Shirkatulmilk

Sunnah

Tawarruq

Urf

Wadiah

Wadiah-wad-dhamanah

Wakalah

Chapter 7

Chapter Introduction

Islamic Banking System and its Financial Products.

In a modern economy, financial systems play a vital role in:

Allocating financial resources.

Enabling financial intermediation through financial markets and institutions, and

Managing financial issues, risk management tools and operations related to financial

intermediation.

In a financial system, the role of intermediaries is different from economic agents because

they help to:

Transfer resources from SSUs to the corporate sector and other sectors seeking funds.

Allow households and firms to share risks through smoothing of household expenses.

Learning Objectives

On completing this chapter, you will be able to:

Explain the three main functions of financial intermediaries.

Distinguish among the three types of intermediation contracts permitted by the Sharah.

Recall the historical use of Mudarabah and Musharakah modes of financing.

Distinguish between the historical form and the modern form of a Mudarabah contract

Explain the four dist