THE DIFFERENT MODES OF ISLAMIC

FINANCEBy: Camille Silla PaldiCEO of FAAIF

This presentation is based on the textbook by Dr. Muhammad Hanif, Islamic Banking: Theory and Practice.

MODES OF ISLAMIC FINANCE Murabahah Salam Istisna’a Ijarah Musharakah Mudharabah

MURABAHAH Murabahah is a cost-plus profit sale contract whereby disclosure of cost to the buyer is necessary.

Two Parties: Customer and Bank. Bank Buys and Owns Asset and Sells to Customer on Cost-Plus Mark-Up over a Deferred Payment Plan.

Bank charges a certain profit usually linked to the Inter Bank Offered Rate.

MURABAHAH Amount of installment or price of the asset cannot be increased or decreased in case of default or early payment.

The amount of penalty for defaults cannot be included in the income of the IFI and must be donated to charity.

STEPS IN MURABAHAH Step One: Customer requests to an IFI to purchase an asset. The IFI gets the written promise from the customer to purchase the asset once it is acquired by the IFI.

Step Two: IFI purchases asset as per the specifications of the customer. In certain cases, the IFI can appoint another person as a purchasing agent including the customer him or herself. However, at this stage, the customer is only the agent of the IFI and the underlying asset belongs to the IFI. All risks of ownership are borne by the IFI. Invoice by supplier must be in the name of the bank and the price must be paid to the supplier by the IFI.

STEPS IN MURABAHAH Step Three: After completion of sale and purchase agreement of the asset plus transfer of the asset to the Customer, Customer bears all risk and returns of ownership.

MURABAHAH Currency, gold, and silver cannot be the subject-matter of the murabahah.

It is permissible to demand a security deposit (Hamish Jiddiya) from the customer in the case of a binding promise, which can be forfeited equal to the amount of actual loss suffered by the bank (excluding time value of money) if customer breaches his promise.

Urbun or down-payment is allowed after the execution of the murabahah contract, however, it is preferable to forfeit the amount equal to actual loss suffered.

SALAM Mode of finance used in agriculture. IFI pays upfront cash on spot for future delivery. IFI usually locks in a lower price while the farmer gets a cash advance to finance the crop production.

A method for farmers to finance crop production without taking a loan with interest.

Crop must be available in the market as in case the crop fails, the farmer has to purchase the crop in the marketplace and deliver to the IFI.

SALAM As a matter of practice, the IFI enters into a parallel salam contract with another party after entering the first salam contract, selling the proceeds of the first salam contract to the third party buyer.

Execution of the second contract is not conditional upon the fulfilment of the first contract, therefore, the IFI bears the risk of supplying the contracted good to the third party even if the first salam contract fails or is delayed.

SALAM Step One: Customer makes a request to an IFI for salam financing, requesting payment upfront for deferred delivery.

Step Two: The IFI enters into a contract of parallel salam with a third party, receives the payment from the third party, and promises to deliver the goods at a future date.

Step Three: IFI receives delivery from first salam contract. Step Four: IFI delivers product from first salam contract to third party buyer in the second salam contract.

SALAM The contract should clearly stipulate the specifications and quantity of goods to be delivered.

In salam contracts, the commodities are fungible goods and standardized products of companies.

It is not permitted to stipulate the products of a specific piece of land or i.e. an unborn calf.

The subject-matter of the salam contract must be different from the mode of payment of the price. (i.e. if the capital provided is currency or gold, then the commodity in the salam contract must not be currency or gold).

SALAM The commodity should be clearly known at the time of contract without ambiguity and uncertainty as to the object, quality, and quantity of the commodity.

Date and Place of Delivery should be clearly defined in the salam contract.

Security in the salam contract can be obtained through guarantee, pledge, etc.

Replacement of commodities with other commodities, except with cash, is permissible.

SALAM It is permitted to settle the salam contract at discount if the seller provides inferior goods.

It is permissible to settle the salam contract earlier than the due date if the commodities can be supplied by the supplier at an earlier date.

It is permissible to settle the salam contract with superior commodities.

However, it is not permissible to stipulate a penalty clause for delay in delivery.

ISTISNA’A Istisna’a is manufacture to order and is used in project financing. Bank enters into first istisna’a contract with contractor to build a project.

Bank then enters into parallel istisna’a contract as contractor to supply project to third party buyer.

Thus, bank provides finance to contractor in first istisn’a contract to build the contract and then contracts with third party buyer to supply the project to the third party.

Can pay on the spot or in deferred payment option.

STEPS IN ISTISNA’A Step One: Customer requests istisna’a financing from the bank and agrees to sell the project with deferred delivery and either spot or deferred payment usually at a lower price at the time of contract then would be the price at the end of the construction period. Step Two: The bank then enters into a parallel istisna’a with a third party buyer, receives payment either on spot or in deferred payment option, and contracts to deliver the project at a future date. Step Three: The contractor in the first istisna’a contract delivers the project to the bank. Step Four: The bank then delivers the project to the third party buyer in the second istisna’a contract.

ISTISNA’A The contract of istisna’a is binding upon the parties to the contract provided certain conditions fulfilled including specifications of underlying subject-matter (project), price, and delivery date.

The contract of istisna’a cannot be executed with a customer who is the purchaser of the project from the IFI and at the same time acts as the contractor of the project.

Istisna’a is allowed only where the project originates from raw materials that are transformed from their original shape to the final form through a construction/manufacturing process.

ISTISNA’A Istisna’a contract cannot be executed for a project, which is already manufactured or constructed.

Contractor can outsource the work to sub-contractors. The price in istisna’a can be paid at spot, deferred payment, subject to completion, at stages of completion, and in cash or in kind as the parties agree. However, determination of price on murabahah basis or cost plus mark-up is not allowed in istisna’a.

Urbun or down-payment can be demanded and forfeited if the contract is rescinded. However, it is preferred to forfeit the amount equal to the actual damages suffered. Guarantee allowed/security allowed.

ISTISNA’A It is permitted to change the price of the contract due to events of force majeure.

It is permitted to appoint the purchaser in the istisna’a contract as the agent for the IFI.

It is permitted to charge a penalty for delay in completion of project, however, penalty for default in payment is not allowed.

The contractor can also be appointed as agent of the IFI to dispose of the project.

ISTISN’A It is not permissible to sell the subject-matter of an istisna’a contract before taking possession of it.

The IFI can enter into a parallel istisna’a contract, however, the parallel istisna’a contract cannot be conditional upon completion of the first istisna’a contract.

IJARAH Ijarah is Islamic Leasing. It is a rental contract whereby the IFI leases an asset for a specific rent over a specific period of time.

Ownership risks of the asset are borne by the IFI except in the case of negligence of the lessee.

The ljarah contract begins when lessee takes possession of asset rather than when the contract is signed (conventional lease).

Ending Ijarah in sale of the asset to the lessee is allowed through a separate contract (Ijarah Muntahia Bittamleek).

IJARAH Consumables cannot be leased out. Rentals of joint property are shared according to equity. Inter Bank Rate can be used as a benchmark amount for the rental price.

At the completion of the Ijarah contract, the rented asset is either returned to the lessor or purchased by the lessee through a separate contract.

STEPS IN IJARAH Step One: Customer approaches IFI for Ijarah financing for asset. Step Two: IFI either purchases the asset itself or appoints the customer as agent to purchase the asset on behalf of the IFI. Once the asset is purchased, the IFI makes payment to the vendor.

Step Three: After the IFI obtains possession and ownership of the asset, the IFI and customer sign the Ijarah contract.

Step Four: Customer takes the benefit of the usufruct and makes the periodic rent payments as according to the Ijarah contract. At the end of the contract, either asset is returned to the Bank or the Bank sells the asset to the Lessee through a separate contract.

IJARAH Under ijarah, the contract terminates if the asset becomes unusable for any reason.

Lessor can charge a penalty for late payment, however, this amount must be given to charity.

IJARAH Urbun or down-payment is permitted. If the Ijarah contract is not executed by the lessee, the lessor can take the urbun or down-payment.

The subject-matter of the lease must be capable of being used. The benefits from the Ijarah contract must be Shari’ah compliant and use of the asset must be for halal purposes.

Lease rentals may be in cash or kind (goods) or benefits (services) and must be specified as lump sum or installments.

IJARAH Lease rentals begin from date the lessee begins to use the asset. If rentals are variable, the price should be fixed for the first period and then tied to a bench mark. The bench mark must be based on a clear formula subject to a floor and ceiling.

Future rental prices can be changed with mutual agreement, however, it is not permissible to change past rental prices.

Securities/Guarantees are allowed. Lessor can charge a penalty for late payment, however, this must be forwarded to charity.

MUSHARAKAH Shirkah means partnership. Musharakah occurs when two partners come together to form a joint-venture.

Partners share in profit in a pre-agreed ratio and share loss according to capital contribution.

There must be a written agreement specifying the terms and conditions of the musharakah including management, capital contributions, and profit and loss sharing.

MUSHARAKAH Capital can be contributed in cash or in kind. Sleeping partner cannot share in profit more than his/her proportionate share in equity.

The partners cannot guarantee the capital or profit share to the other partners.

Profit must be a percentage of actual profits and not a lump sum determined at time of contract.

Each partner is entitled to participate in management, however, if management is vested in one or a few partners by agreement, then the other partners are bound not to interfere in management.

MUSHARAKAH The managing partner is entitled to higher share in profit, however, in pre-agreed ratio/percentage and not lump sum.

Any third party can provide guarantee of capital subject to: - (a) financial liability of guarantor is independent of partnership contract; (b) guarantee is provided for zero consideration.

Final distribution of profits is subject to valuation of assets (actual or constructive).

Accounts receivables should be valued at cash value less allowances for doubtful accounts.

MUSHARAKAH It is not permitted to account for present value of accounts receivables.

It is allowed to allocate some profit to partners provisionally subject to final settlement after calculation of actual profit.

It is permitted to create a reserve and charity out of profit subject to agreement.

It is permitted for a partner to sacrifice his or her share of profit in total or in part at the time of profit distribution to another partner.

It is also allowed for partners to bear total loss at the time of loss.

MUSHARAKAH Musharakah can be dissolved by one partner after serving a notice to the other partner(s) subject to:

(a) If a partnership is formed for a specific period, then it must be terminated mutually;

(b) if a partnership is formed to complete a project, then it cannot be terminated unilaterally prior to completion of the project.

A partner can enter into a binding promise with others to buy the assets of a partnership as per agreed price and date of buying, however, entering into a promise to buy at face value is not allowed.

MUSHARAKAH At time of dissolution, assets should be distributed accordingly: -

(a) Payment of liquidation expenses; (b) Payment of liabilities; © Distribution to the partners in accordance with their contributions. If the remaining amount is less than the contribution amount, then the distribution should be made on a pro-rata basis.

DIMINISHING MUSHARAKAH Diminishing musharakah is a form of declining partnership between the IFI and the client generally used to finance the purchase of real estate by the client.

A customer requests a diminishing musharakah from the Bank. The Bank then contributes a certain percentage of finance and a certain percentage must be contributed by the customer.

The Bank’s share of the asset is divided into units of smaller amounts, which are purchased by the client in installments until the client owns the entire share of the Bank’s equity in the real estate.

Title is transferred to the client.

DIMINISHING MUSHARAKAH The Diminishing Musharakah must be in the form of a written agreement.

The capital of the partnership can be in cash or in kind. If in kind, the monetary values of the assets must be expressed in currency to determine the share contributed by each partner.

Net assets of a company entering into partnership are allowed to be used as capital in the partnership.

It is not allowed that debts (Receivables) alone be used as contribution in capita of partnership.

DIMINISHING MUSHARAKAH Third party can provide guarantee of capital subject to:- (a) financial liability of guarantor is independent of the partnership contract;

(b) guarantee is provided for zero consideration. One partner cannot guarantee the capital of the other partner(s).

DIMINISHING MUSHARAKAH Same rules for profit and loss sharing and termination of partnership as in musharakah.

In diminishing musharakah, the contract of buying and selling equity shares must be separate from the partnership contract. It is not permitted that one contract be entered into as a condition for concluding the other.

The contract of diminishing musharakah must not include a clause whereby any of the partners is allowed to withdraw his share in capital.

DIMINISHING MUSHARAKAH Maintenance and insurance is the liability of all of the owners. The profit/income/benefit sharing ratio must be clearly determined. It is permitted to agree on a ratio of profit sharing, which is disproportionate to equity stake.

It is also permitted to agree on a fixed profit sharing ratio or variable (according to changing equity stake), however, loss must be shared according to equity stake.

It is not permitted to stipulate that a partner will receive a lump sum of profit or a percentage of capital.

DIMINISHING MUSHARAKAH It is permissible to issue a binding promise of sale and purchase of equity, gradually, at an agreed price at the time of transaction, however, it is not permissible to sell or purchase equity shares at their original or face value as this constitutes guarantee of capital to the selling partner.

Renting or leasing the equity shares of the other partner is allowed for a specified time and for whatever duration of time.

MUDHARABAH Mudharabah is a partnership where one partner (rabb-ul-mal) provides the capital and one partner acts as the manager (mudarib).

The partners share profit in a pre-agreed profit ratio, however, all loss is borne by the rabb-ul-mal.

MUDHARABAH The written mudarabah contract must stipulate the terms and conditions relating to profit sharing and guarantees.

Under the restricted mudarabah contract, the mudarib is obliged to act within the scope of the agreement, while under the unrestricted mudarabah agreement, the mudarib is free to invest according to his/her expertise and the market conditions in order to fulfill the objective of the mudarabah partnership (profit generation).

MUDHARABAH The rab-ul-mal can obtain a guarantee/security from the mudarib, which is enforceable in the case of negligence, misconduct, or breach of contract.

The capital of the mudharabah can be contributed in the form of cash or in kind, however, if in kind, the fair value of the asset should be determined.

The amount of capital in the mudharabah must be known to both parties to the contract.

MUDHARABAH Debt receivables from the mudarib or a third party cannot be treated as a contribution to the capital of the mudharabah.

Profit-share must be in a pre-agreed ratio of profit share and not a lump sum or percentage of capital.

It is permitted to stipulate a lump sum for a partner if profit exceeds a certain limit.

The final profit distribution must be made on the basis of valuation of the business (actual or constructive), however, it is not allowed to allocate the profit on account to be settled later on.

MUDHARABAH Cost of living and travelling expenses for the mudarab is allowed as per agreement or custom.

A gift, loan, or charity out of the mudharabah fund and waiver of receivables by the mudarib are allowed subject to the approval of the rabb-ul-mal.

MUDHARABAH Both parties can agree to liquidate the mudharabah. The mudharabah can be liquidated upon maturity of the mudharabah agreement.

If the remaining funds in the mudharabah are insufficient to run the business after suffering losses, the mudharabah can be liquidated.

If the mudarib dies or there is a liquidation of the institution acting as mudarib, the mudharabah can be liquidated.

If the mudharabah business has completed, the mudharabah can be liquidated.

CAMILLE@FAAIF.COM

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