introduction to basic contracts in islamic banking

8/12/2019 Introduction to Basic Contracts in Islamic Banking

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It is important to understand the basic contracts inIslamic banking in terms of the characteristics based on

the terms and conditions.

In the profit and loss sharing agreements, there are two

main types of contracts which are Musharakah (jointventure profit sharing) and Mudharabah (trustee profit

sharing).

For the contract of sales, exchange goods for money such

as bay‟ al muajjal (example bai‟ al murabahah, bai‟ bithaman ajil, bai‟ al istina, bai‟ al salam,bai‟ as-sarf),

and exchange of services for money such as qard-hassan

(al-ijarah and al-ju‟alah).



Shariah aspects of Islamic banking contracts meet the

Shariah requirements that referring to avoidance of

prohibitions, and ensuring that the contracts have all

their essential elements with their necessary

conditions.



The word riba has been used in the Holy Qur’an on several

occasions.

Riba has been extracted from Raba. (increase).

In the Shari’ah, “riba” technically refers to the premium that must

be paid by the borrower to the lender along with the principal

amount as a condition for the loan or for an extension in its

maturity.

In this sense riba has the same meaning as interest in accordance

with the consensus of all jurists without any exception.

So the Holy Qur’an and the Hadith do not make any such difference

between usury and interest.



Riba al-nasi‟ah,

Riba al-fadl.



Islam, however, wishes to eliminate not merely the exploitation

that is intrinsic in the institution of interest, but also that which is

inherent in all forms of unjust exchange in business transactions.

Riba al-fadl is the excess over and above the loan paid in kind. It

lies in the payment of an addition by the debtor to the creditor in

exchange of commodities of the same kind. The following tradition

of the Prophet Muhammad (saw) is cited as evidence. It is related

that Abu Said al-Khurdi said: “the Prophet Muhammad (saw) has

said that gold in return for gold, silver for silver, wheat for wheat,

barley for barley, dates for dates and salt for salt, can be traded if

and only if they are in the same quantity and that is should be hand

to hand. If someone gives more or takes, then he is engaged in riba

and accordingly has committed a sin.”



Riba is prohibited in Islam as it appears explicitly in the Holy Qur’an.There is complete unanimity among all Islamic schools of thoughtregarding the prohibition of riba. Since the Qur’an is the undisputedsource of guidance in Islam for all Muslims, there is unanimousagreement on the fact that Islam has forbidden the practice of riba.The debate on whether interest is riba or not has been settled. The

ulama have made crystal clear that interest is riba. The modernbanking system is organized on the basis of a fixed payment calledinterest. That is why the practices of the modern banking system arein conflict with the principles of Islam which strictly prohibit riba.Islam is opposed to exploitation in every form and stands for fair and

equitable dealings among all men. To charge interest from someonewho is constrained to borrow to meet his essential consumptionrequirement is considered an exploitative practice in Islam. Chargingof interest on loans taken for productive purposes is also prohibitedbecause it is not an equitable form of transaction. Now let’s have a

look on the prohibition of interest in the light of the Qur’an and theSunnah (tradition of Prophet Muhammad (saw).



“ That which ye lay out for increase through the property of

(other) people, will have no increase with Allah: But that which

ye lay out for charity, seeking the countenance of Allah (will

increase): it is these who will get a recompense multiplied” .(30:39)

“That they took riba (usury), through they were forbidden and

that they devoured men’s substance wrongfully – We have

prepared for those among men who reject faith a grievous

punishment. ” (4:161)

“O ye who believe! Devour not usury doubled and multiplied;

but fear Allah, that ye may (really) prosper. ” 3:140)



Jabir reported: The Prophet (saw) cursed the

receiver and the payer of interest, the one who

records it (the contract) and the two witnesses

to the transaction and said, “They are all alike (inguilt). ”

Jabir ibn Abdullah, giving a report on the

Prophet’s farewell pilgrimage, said: The Prophet

(saw), addressed the people and said, “All the

riba al-jahiliyyah is annulled, the first riba that I

annulled is our riba, accruing to al-Abbas ibn

Abdul Mutalib (the Prophet’s uncle). ”



Despite the fact that interest occupies a central position in modern

economic system and that it became the very life blood of the existing

financial institutions, Islam considers that the principle of charging interest

is quite opposite of that of business in the spirit of sharing and cooperation

and that lending on interest is not as a business in the real sense.

In legalizing trade and condemning interest, Islam considers that there are

fundamental differences between the nature of profit resulting from

interest charges and that earned by trade. In interest-based transactions,

there may be no equitable division of profit between the buyer who makes a

profit on the sale of good purchased, and the seller who derives a profit inconsideration of the labour and time spent in procuring the goods.

Moreover, there could be no end for an interest-based transaction, since

there could always be interests of unpaid interests as long as the principle

amount loaned is not fully returned. This could, in extreme cases, create

un-repayable debt for generations.



a) Profit-and-loss sharing contracts (mudarabah) The Islamic bank pools investors' money and

assumes a share of the profits and losses

agreed upon with the depositors

filter parses company balance sheets

determine whether any sources of income to thecorporation are prohibited



i. Declining-Balance Shared Equity: Commonly used to finance a home purchase

the investor to purchase the home jointly

ii. Lease-to-Own similar to the declining balance one described above

except that the financial institution puts up most

iii. Installment (Cost-Plus) Sale (murabaha):• This is an action where an intermediary buys the home

with free and clear title to it

• This credit sale is an acceptable form of finance and is

not to be confused with an interest-bearing loan.

b) Partnership and joint stock ownership

(musharakah)



c) Leasing ('ijarah/'ijar )

The sale of the right to use an object (usufruct) for aspecific time period

the lessor must own the leased object for the

duration of the lease

'ijarah wa 'iqtina provides for a lease to be written



These are rare forms of financing, used for

certain types of business

exception to gharar

The price for the item is prepaid

the item is delivered at a definite point in the

future



• is a partnership contract betweenrabbul mal and mudarib in which therabbul mal provides capital to themudarib for investing it in a businessenterprise by applying his skill and

labour.• The financer is known as “rabbul mal”or “shahibul mal”, while theentrepreneur is known as “mudarib”.

Mudarabah

• is a contract between the partners tocontribute capital to an enterprise or aventure, whether existing or new, or toowner of a real estate or moveable asset,either on a temporary or permanent basis.

Musharakah



The proportionate share in profit is determinedby mutual agreement.

Profit is shared between the rabbul mal andmudarib according to a pre-determined profit

sharing ratio.

In principal, any financial loss undermudharabah financing must be borne byIslamic banking institution.

However, if the loss is caused by negligence,management or breach of contracted terms bythe customer, then the customer is liable forloss.



• It is an agreement between thebank and the depositors, whoagree to put their money intothe bank‟s investment account

and to share profits with it.

First tier

• It is an agreement between thebank and the entrepreneurswho seek finance from thebank on the condition that

profits accruing from theirbusiness will be sharedbetween them and the bank ina previously mutually agreedproportion, but that loss shallbe borne by the financier only.

Secondtier



a. Contracting parties

Mudarabah gives the right to the contracting parties toshare the profit, while liability for losses is borne bythe participants.

b. Offer and Acceptance Mudarabah has two pillars of offer and acceptance.

Mudarabah is concluded when the parties use wordsthat clearly indicate the contract of mudarabah in theiroffer and acceptance.

c. Capital

The capital in this partnership must be in absolutecurrency, it should be ready cash and not form in thedebt.



d. Profit

Any profit made will be share between the

rabb-ul-maal and the mudarib according to

an agreed ratio while losses are borne solelyby the rabb-ul-maal.

e. Work/Labour

The rabb-ul-maal has no right to participatein the management which is carried out by

the mudarib only.



Restricted Mudarabah (al-mudarabah al muqayyadah)

• The rabbul mal may specify aparticular type of business or toa particular location or specifiedperiod for the mudarib, in which

case he shall invest the moneyin that particular business only.

• Restricted mudarabah dividedinto 3 parts:

• i. Restriction in respect ofspecified time or period.

• ii. Restriction in respect of

specified place or location.• iii. Restriction with respect of

specific business.

Unrestricted Mudarabah ( al-mudarabah al-mutlaqah)

• It is a contract in which therabbul mal permits the mudaribto admister the mudarabah fundwithout any restriction.

• In this case, the mudarib has awide range of business optionson the basis of trust and thebusiness expertise he hasacquired.

• Mudarabah interbankinvestments (MII) refers to a

mechanism whereby a deficitIslamic banking institution„investee bank‟ can obtaininvestment from a surplusIslamic banking institution„investor bank‟ based onmudarabah.



The literal meaning of Musharakah is sharing.

The root of the word “Musharakah” in Arabic isShirkah, which means engagement of two or more

parties who have a common interest to form apartnership.

It is a contract of partnership between two or more

parties in which all the partners contribute capital,participate in the management, share the profit inproportion to their capital or as per pre-agreedratio and bear the losses (if any) in proportion totheir capital ratio.



a. Capital

The contract of musharakah can be basedonly on money and not on commodities. Theshare capital of a joint venture must be in

monetary form. No part of it can becontributed in kind.

b. Contracting Parties

Parties involved in a partnership

arrangement contribute funds to and havethe right to exercise executive powers inthat project in accordance with an agreedformula.



c. Work

The partners must belong to the same trade andthey should work in one place. Besides, all thepartners should participate in actual work and

should get profit according to their work.d. Risk

The musharakah financing entails lower risks,since it involves risk sharing through partnership.The number of individuals who are in a positionto provide musharakah financing is limited ,although modern musharakah funding throughequity market participation may have muchsmaller risks because of the ease of divestment.



Musharakah

Shirkah al-milk (non-contractual partnership)

Shirkah al-uqood(contractualpartnership)



Shirkah al-milk (non-contractual) implies co-ownership and comes into existence whentwo or more persons happen to get joint-ownership of some asset without having

entered into a formal partnership agreement for example, two persons receiving an

inheritance or a gift of land or propertywhich may or may not be divisible.

The partners have to share the gift, orinherited property or its income, inaccordance with their share in it until theydecide to divide it.



Shirkah al-uqood (contractual partnership)however can be considered a proper partnershipbecause the parties concerned have willinglyentered into a contractual agreement for joint

investment and the sharing of profits and risks.

Shirkah al-uqood has been divided in the fiqhbooks into four kinds:

i. al-mufawadah (full authority and obligation)ii. al-inan (restricted authority and obligation)

iii. al-abdan (labour, skill and management)

iv. al-wujuh (goodwill, credit-worthiness and

contracts)



-An legal exchange of a useful and desirable thing for

a similar thing by mutual consent for the alienation of

property.



A form of an exchange value or

consideration, return, wages, or rent of

services of an asset

Contract between two parties, the lessor and

lessee, where the lessee enjoys or reaps a

specific service or benefit against a specified

consideration or rent from the asset ownedby the lessor.



BANK

(Lessor)

PROPERTY

(1) Bank buys property

(3) Customer pays rental

(2) Bank leases property

Ijarah (cont…)

PEOPLE

(Lessee)



A party undertakes to pay another party a

specified amount of money as a fee for

rendering a specific service in accordance

to the terms of the contract stipulated

between the two parties.

-For example, Ahmad (Ja’il) declares that if

anyone(Amil) recovers his lost property, hewill give him RM10.



Contract between a buyer and a seller which

the seller sells specific goods allowed under

Shariah principles to the buyer at a cost plus

agreed profits payable in cash on any fixed

future date in a lump sum or by instalments.



Bai’ al-Murabahah (cont..)

Bank

Customer

Supplier ofcommodity

1.Customer identifiescommodity

2.Customer

approaches bank,

promises to buy

commodity from

bank

3.Bank buys

commodity on

cash basis

4. Customer buys

commodity via

murabahah on

deferred payment

terms



Contract of a sale and purchase transaction forthe financing of an asset on a deferred paymentbasis with a pre-agreed payment period.

Buyer and Seller are not restricted from dealing inbusiness transactions. In addition, they are notbankrupt and safih (an extraordinarily extravagantperson/spendthrift) and are not being forced toenter into contract. The seller must be the realowner of the merchandise and able to deliver themerchandise to buyer and the asset is free fromany circumstance.

The asset has the following characteristic, suchas in the form of Mal (valuable asset) halal/lawful, valuable (has trade value). Besides that,the asset should not be an unusable materialaccording to shariah.



A contract in which advance payment is

made and the goods will be delivered later

on. The seller supply specific goods to the

buyer at a future date while an advance

price is fully paid at the time of contract.



Salam (cont…)



Contract for the acquisition of goods byspecification or order.

The sale of goods by way of ordering wherethe price is paid in advance orprogressively but the assets are

manufactured and delivered at a laterspecified/defined date.



Customer identifiescommodity and the

design

Customer approaches bank, promises to

buy commodity from bank throughIstisna‟a contract

The bank then enters

into a back-to-backIstisna'a contract with

a third party to have

the subject commodity

manufactured, built or

assembled.

Bank sell the commodity by

cost+profit to customer oncebank own the commodity



A sale in order to get cash, not property or a salein which a commodity is sold for a deferredpayment (thaman mu’ ajjal) and then resold tothe seller on cash basis (which is cheaper than

deferred payment price).

Such an organised same-item sale-repurchasebetween the same parties is not allowed in many

jurisdictions.



Islamic contract and transaction need toconfirm to the principle of Shariah withoutinvolving any prohibited elements such as ribaand gharar.

Islamic bank’s contract performance providessignal to the bank’s management whether toimprove its deposit services or financingservices or both in order to improve bank’s earnings.

Every contract exposed to various types ofrisks so it requires proper, adequate and soundrisk management infrastructure and internalcontrols to manage the risks.

introduction to basic contracts in islamic banking

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