islamic finance and banking - … finance and banking: modes of finance khalifa m ali hassanain. ......

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Islamic Finance and Banking:

Modes of Finance

Khalifa M Ali Hassanain

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The content of these course have been developed solely for educational and training

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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.

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Table of Contents

Chapter 5 - A Framework for the Islamic Financial System-Part 3 ........... 6

Introduction .................................................................................................................. 6 Leasing or Ijarah Contracts .......................................................................................... 6 Ijarah vs Bai’ Contracts ................................................................................................ 7

Ijarah Structures ........................................................................................................... 8 Issues in Ijarah Contracts ........................................................................................... 12 Modern Mode of Leasing ........................................................................................... 15 Conventional vs Islamic Leasing ................................................................................ 17 Sale After Ijarah ......................................................................................................... 18

Ijarah Muntahia-bi-Tamleek ...................................................................................... 19 Issues in Modern Ijarah Contracts ............................................................................. 20 The Concept of Ijarah Sukuk ...................................................................................... 22

Deferred Delivery or Salam Contracts ....................................................................... 22 Essential Elements of a Salam Contract ..................................................................... 22 Application of Salam Contracts .................................................................................. 25 The Istisna‘a Contract ................................................................................................ 25

The Istijrar Contract ................................................................................................... 26 Chapter 6 - A Framework for the Islamic Financial System-Part 4 ......... 26

Introduction ................................................................................................................ 26 Shirkah and its Two Categories .................................................................................. 27 The Concept of Mudarabah ....................................................................................... 28

Raising Capital for Mudarabah .................................................................................. 28

Types and Conditions of a Mudarabah Contract ....................................................... 28 The Rules of Profit and Loss in Mudarabah .............................................................. 29 The Concept of Musharakah ...................................................................................... 30

Capital under Musharakah ......................................................................................... 31 Profit and Loss Under Musharakah ........................................................................... 32 Comparison of Musharakah and Mudarabah ............................................................ 34

Mudarabah and Musharakah ..................................................................................... 36 The Wadiah Wad Dhamanah Deposit ........................................................................ 36

The Qard-ul-Hasan Deposit ....................................................................................... 38 The Concept of Wakalah (Agency) ............................................................................. 38 Types of Wakalah ....................................................................................................... 38

The Concept of a Tawarruq Contract ......................................................................... 39 The Concept of a Ju’alah Contract ............................................................................ 41

Chapter 7 - Islamic Banking System and its Financial Products ............. 42

Introduction ................................................................................................................ 42 Financial Intermediaries: Their Three Main Functions .............................................. 43 Intermediation Contracts Permitted by the Sharī‘ah .................................................. 44 Historical vs. Modern Mudarabah ............................................................................. 45 Distinct Features of a Mudarabah Contract ............................................................... 46

Trust-based Intermediation Contracts ........................................................................ 47 Security-Based Intermediation Contracts ................................................................... 48 Business Models for Islamic Financial Institutions (IFIs) ......................................... 49

The Two-tier Mudarabah Model ................................................................................ 50 The Two-windows Business Model ........................................................................... 50

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Risks and Mitigation ................................................................................................... 51 Theoretical Perspective of an IFI’s Balance Sheet ..................................................... 51 The Types of Investment Accounts at an IFI ............................................................. 52 Investment Choices for an IFI .................................................................................... 52 Categories of IFIs ....................................................................................................... 53

Chapter 8 - Controversial Financing and Fee-based Products. ............... 56

Introduction ................................................................................................................ 56 Bai’ al-Einah (Repurchase) ........................................................................................ 57 Controversial Aspects of Bai’ al-Einah ..................................................................... 57 A Credit Card Based on Bai’ al-Einah ....................................................................... 58

Bai’ al-Dayn (Bill Discounting) ................................................................................. 59 Controversial Aspects of Bai’ al-Dayn ...................................................................... 59 Tawarruq .................................................................................................................... 60

A Credit Card Based on Tawarruq ............................................................................. 61 Issues in Managing Tawarruq Products ..................................................................... 61 The Use of Wakalah to Provide a Letter of Credit ..................................................... 62 The Use of Kafalah to Provide a Letter of Guarantee ................................................ 63 Other Fee-based Services ........................................................................................... 64

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Chapter 5 - A Framework for the Islamic Financial

System-Part 3

Introduction

A Framework for the Islamic Financial System-Part 3.

In this chapter, you will learn about more types of contracts that the Sharī‘ah 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, Istisna‘a and Istijrar.

On completing this lesson, you will be able to:

Explain the concept of an Ijarah contract,

Distinguish between Ijarah and Bai‘ Mu’ajjal 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 Sharī‘ah,

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 Istisna‘a contract and

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 first party is

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

Mustajir, which is the second party. The Mustajir or lessee is in need of the assets.

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By paying a predetermined rent (Ujrah), the lessee receives the benefits linked with

the ownership of the assets. Ijarah is for a known time period called Ijarah period.

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, a code of Islamic commercial law that is based on the Hanafi

Fiqh, 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 or Ajr. 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

In Ijarah and Bai’ contract, something is transferred to another person for a valuable

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

Let’s see how these differ in two vital characteristics.

Ownership

In a Bai’, the purchaser becomes the owner of the property after executing the sale and

assumes the risk and rewards of ownership.

In 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.

Duration

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A big difference between Ijarah and Bai’ contracts is that Ijarah is always time bound,

that is, the lease has to terminate at some time, while Bai’ implies the transfer of

ownership is definite and immediately after the sale is executed.

Ijarah Structures

There are seven financing structures of Ijarah. In the first three structures, the

ownership of the asset remains with the bank. This is known as operating lease. The

bank may lease it or even sell it to another client.

Structure 1

In this structure, the bank is the owner of the asset and leases it out to its client against

predetermined rentals for an agreed period.

While it adheres entirely to the features of the classical Ijarah, it’s also the least

common and the least popular structure.

The steps are as follows:

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.

Structure 2

This structure has two distinct phases in the arrangement and involves a vendor. In

phase one, the bank purchases the asset needed by its client from the vendor. In phase

two, the bank leases out the asset to its client against a predetermined rent for a

specified period.

The steps involved in this structure are:

1. The client first identifies and approaches a vendor or supplier of the asset to

collect all the 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 the asset to the bank.

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

the client.

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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.

Structure 3

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

as its agent. This structure has two relationships between the bank and the client.

In the first stage, the client is an agent of the bank and buys the asset on behalf of the

bank. At this stage, the client will only perform the functions of an agent.

In the second stage, which 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, the client is

liable to discharge his obligations as a lessee.


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 ends. The bank leases the asset and transfers possession

and right of specified use to the client.


8. The asset is returned to the bank.

The first three structures may not be good alternatives if the concerned asset is built

to specification. The bank will find it extremely difficult to locate a second client willing

to lease the asset or even buy it. The structures you will learn about now help the bank

avoid such scenarios.

Let’s look at these structures.

Structure 4

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

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1. If the Ijarah period is identical to or approximately the same as the economic

life of the asset, the asset would have little residual value. Therefore the bank

may gift the asset to the client without any mutual consideration or may even

abandon the asset. The gift contract is not connected to 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 price that has been predetermined. This

arrangement is called lease-sale or Al-Ijarah-Thummal-Bai’ or AITAB. The sale

contract is not connected to the Ijarah contract. The bank may even gift the

asset to its client.

The asset would continue to remain with the client under both these structures. These

are called “financial lease” structures. This structure involves an independent promise

by the bank to gift the asset or sell the asset to the client at a predetermined price

when the lease period ends.

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.


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.


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

through a gift or through sale.

Structure 5

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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.


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 bank’s stake in partnership.

The bank transfers ownership of asset to the client when its stake is reduced to

zero.

Structure 6

Let us 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 upfront before the rentals are distributed.


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.

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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.

Structure 7

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.


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 when the Ijarah period ends,

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 and

Termination

Execution of Contract

Based on the nature of the asset, an Ijarah contract can be executed before or after

the lessor possesses the asset and enforced or commenced instantly or in the future.

If the asset to be leased is existing, for example, a liveable house, a lease contract can

be executed either for instant or future enforcement. This is because both parties know

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the usufruct of the house clearly and can agree on the rental, keeping in mind the

benefit.

Future enforcement is also permissible if the the lessor retains ownership. The lesser is

responsible for the risk of damage to the asset. Future enforcement is also possible in

Ijarah Mosufah bil Zimmah. In this type, the quality of the asset is specified and

destruction of or damage to a particular unit of the asset does not terminate the

contract.

However, if a specific asset is identified in the Ijarah, a lease contract cannot be

executed before the asset comes into being or before owning the asset or its usufruct

in the case of sub-lease.

Determination of Rent

If both parties agree, deciding the rental based on aggregate cost of the purchase,

construction, or installation of the asset by the lessor is permissible under the rules of

the Sharī‘ah. This is subject to all other conditions of valid lease being met.

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

whole period of Ijarah. However, the Ijarah period can be split into smaller intervals

with floating but predetermined rates. The rates for each interval are agreed between

the parties at the time of effecting an Ijarah. A floating rate Ijarah is advantageous in

changing conditions of market and economy, especially if the Ijarah period is quite long.

Parties can agree to use any of the following criteria to modify the periodic rate:

A well-defined and variable benchmark such as LIBOR,

A macroeconomic rate such as a Consumer Price Index,

A specified percentage (say two percent),

The increase or decrease in tax and

The rate of inflation.

Sublease by Lessee

In principle, sub-lease by the lessee is permissible only if the lessor permits and can be

provided in the lease agreement. There is no objection under the Sharī‘ah if the rent

from the sub-lessee is equal to or less than the rent payable to the owner or original

lessor. However, if this rent is higher than the rent payable to the owner, there are

different perspectives among Islamic jurists. Shafi‘is allow the sub-lessor to enjoy the

surplus received from the sub-lessee. However, Imam Abu Hanifa says that the sub-

lessor must donate such a surplus to charity. The only exception is if the sub-lessor has

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added value to the property or has sub-leased it in a different currency different from

the one in which the owner or original lessor is paid.

Sub-leasing is not allowed under these situations:

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

In the last two situations, the sub-lessor merely grants the right to collect rent to the

sub-lessees and thus indulges in Ribâ.

Security and Liabilities

A leased asset is considered to be in Amanah. The lessee takes on the role of a trustee

and has a fiduciary responsibility to protect the asset. Because Amanah does not allow

compensation in case the asset is destroyed or damaged, the lessor can ask the lessee

to guarantee against damage to the asset and demand some form of security.

In addition, rental on a lease is a form of debt.

If there is such 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 Ribâ.

Gharar

Fiqh texts do not permit two-in-one contracts because they consider these to possess

excessive Gharar. Adding a sale contract to the original Ijarah contract or stipulating

options in the Ijarah contract make the contract complex. However, if the sale, gift, or

option (promise) is executed through a distinct agreement not linked to the Ijarah

agreement, it does not constitute Gharar.

But a sale contract appended to the original Ijarah as in the AITAB mechanism is highly

controversial. A sale agreement that involves a mutual promise by the bank to sell, and

by its client to buy in future is a forward agreement, which may be considered an

example of Gharar.

Default Risk

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Once due, Ijarah rental is a debt for the lessee and is subject to all rules applying to

debt default. Any charge by the bank for default is a form of Ribâ. To deter lessees from

exploiting this restriction on the lessor, jurists allow the lessor to include a

clause in the Ijarah agreement asking for a donation to a charity operated by the lessor

in case of default. The amount can vary depending on the period of default and can be

calculated as an annual percentage.

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

possession of the leased asset or enforcing the collateral.

Termination

If the lessee breaks any term of an Ijarah agreement, the lessor can terminate the

contract unilaterally. Otherwise, the Ijarah cannot be terminated without mutual

consent.

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

rescind the contract within a specified period. However, unlike conventional leases, only

the rent due at the time of termination needs to be paid by the lessee. 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 it’s no longer useful,

If the objective of the lease cannot be achieved,

If the asset is sold to the lessee and

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

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

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lessee. The bank calculates the monthly rent as the total cost incurred for purchase of

the assets plus interest divided by the total months of the lease period. Lease rents

begin on the day on which the price is paid by the lessor, regardless of

whether the lessee has paid the supplier or taken delivery of the asset. The lessee bears

all the risks of ownership.

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 normally charges an extra amount as a fine or liquidation damage 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. Through this mode, the

lessee can end up paying far more for the asset through compound interest on rental

delays than through purchase on credit instalments.

Security Lease

Security lease, also known as financing lease, is essentially a financing transaction. It

is a security agreement in disguise for the amount financed to the lessee. All risks and

rewards associated with ownership are effectively transferred to the lessee through this

mode.

Operational Lease

In an operational lease, the owner transfers only possession of the asset to the lessee

in return for rental. It retains ownership and takes back the asset when the lease ends.

This method is permissible under the Sharī‘ah provided other conditions are met.

Operational lease is the most appropriate method for acquiring the use of assets that

take a very long time to manufacture and require large amounts of money for purchase.

Most aircraft and ships are leased through this mode.

More NBFIs than banks use this mode, especially to lease specialised machinery. They

lease a number of assets to meet the needs of different customers. Because the assets

remain the property of the NBFI, they can re-lease them once a lease expires. However,

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

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Conventional vs Islamic Leasing

There are four key differences between conventional and Islamic leasing. Let’s look at

each of them.

Transfer of Ownership

In conventional leasing, once the leasing contract expires, the ownership of leased

goods is transferred to the lessee. This is done without additional charge or at a nominal

price.

In Ijarah hire–purchase, both parties must agree from the start that the Ijarah contract

also includes sale of the asset. They must also agree that 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 in the normal manner.

Rental

In conventional leasing, the lessor charges rental from the date funds are transferred

to the supplier of the asset. Thus the lessor leases an asset before buying it and gaining

possession.

Getting such reward without bearing risks of ownership is forbidden by the Sharī‘ah.

By the Sharī‘ah’s principles, rent can be charged only from the date when the lessee

can start benefiting from the leased assets. This is only possible after taking delivery of

the asset, not from the day the lessor releases funds to the lessee or pays the supplier.

Responsibility of Expense

Conventional and Islamic leases differ primarily in fixing responsibility for expenses.

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.

According to the Sharī‘ah’s principles, the lessor must incur all expenses to rectify the

defects that prevent the lessee from using the equipment. The lessee is responsible for

daily maintenance and operational expenses.

Operating Lease

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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.

In addition, the operating lease does not extend to the entire useful life of the leased

asset. It is only for a specific period and ends at the end of the period unless the lessor

and lessee mutually renew the lease.

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 the asset

to to the lessee as a gift when the lease period ends. 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 Sharī‘ah 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 Ribâ 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.

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Ijarah Muntahia-bi-Tamleek

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

subject to all the Sharī‘ah rules of an ordinary Ijarah contract. Standard Sharī‘ah

principles such as defining the asset that is to be leased, its terms and the prerequisites

of contracts have to be adhered to. The five-step process that Islamic banks usually

adopt is described.

The sequence of steps is as follows.

1. Receiving Hamish Jiddiyah

2. Purchasing the Asset

3. Creating Partnership of Ownership

4. Executing Formal Lease Agreement

5. Managing Defaults in Payment

Receiving Hamish Jiddiyah

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

for an undertaking from the lessee along with money called Hamish Jiddiyah, to ensure

that the client is serious in their request and will take the asset on lease when purchased

by the bank.

The bank acts as a trustee for this money. With the consent of the client, the bank can:

Invest it on the basis of Mudarabah,

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

Consider it as an advance payment of rental.

If the bank uses the money, it is transformed into a debt and therefore becomes the

bank’s liability.

Purchasing the Asset

The bank can purchase the asset directly or through an agent. If the asset needs to be

imported, the bank can appoint the customer as its importing agent although the

AAOIFI standard says a third party is preferable. 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 performance

bond from the client to the effect that they will accept the asset supplied. The bank,

however, will take the risk and expenses of ownership.

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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.

Creating Partnership of Ownership

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 bank’s share in the

ownership. If the client periodically purchases any part of the bank’s share, the rental

decrease proportionally.

Executing Formal Lease Agreement

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.

Managing Defaults in Payment

If the client defaults on rents, the bank can ask for payment for the rest of the period

to be speeded up, provided the agreement allows such a demand. Such a demand is

effectively an early termination of the lease. The bank can then take back the asset or

the lessee can be made to purchase the asset. If such an early termination occurs, only

the due rent can be deducted.

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

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 and

4. Return for the Bank

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

contracts.

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1. Risk cannot be separated from ownership.

2. Lease and sale are contracts of different natures.

Provided these aspects are addressed, an IFI can adopt any procedure to lease the

assets, mitigate the risks and transfer ownership to the lessee.

Ownership Risk

According to the Sharī‘ah principles for an Ijarah, the lessor must conduct 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 serves as an agent of the lessor, any damage to the asset when the

asset is supplied is the responsibility of the lessor unless the agent’s fault can be proved.

If not, then the rent must be adjusted or the lease period expanded to compensate the

lessee for the period it cannot be used.

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

is forbidden.

Timing the Ijarah Contract

As we learned before in this chapter, whenever there is a delay in 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

a situation, when the funds are disbursed to the supplier, the bank should only sign a

promise to lease. The actual Ijarah agreement can be signed only when the asset is

delivered. Rent can be calculated to cover for the entire period including the difference

between disbursal of funds and asset delivery.

Cancellation of Lease

The usufruct or benefit from the asset is a future event and may be risky and unstable.

If the usufruct is less than expected due to any events beyond the control of the lessee,

then the Sharī‘ah 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 is invalid and the

lessee must receive a normal wage as an employee.

Return for the Bank

During purchase of assets, a bank has to pay all expenses, including importing

expenses and duties incurred in the process of purchase as it is the owner of the

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asset. The bank is of course 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 bank must pay

heavy Takaful insurance premium and other expenses to insure the asset. But in case

of damage, the cost of repair may be higher than the claim settled by the insurance

company.

The Concept of Ijarah Sukuk

The Sharī‘ah permits the lessor to sell the asset to a third party together with its rights

and obligations. However, if the lessor doesn’t 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 is also

responsible for every liability arising from the lease contract.

But what happens 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.

Deferred Delivery or Salam Contracts

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. Unlike Murabaha and Ijarah, Salam or Salaf was originally intended to serve as a

financing mechanism for small farmers and traders. Under a Salam agreement, a client

needing short-term funds sells merchandise to the bank on the basis of deferred

delivery. The bank receives the full price of the merchandise on the spot that serves its

current financing needs. At a future date that has been pre-agreed, the client delivers

the merchandise to the bank. The bank sells the merchandise at the prevailing price in

the market. The bank should earn a profit with this transaction since the bank pays a

lower spot price than the expected future price.

Essential Elements of a Salam Contract

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

means of payment, period and place of delivery, Khiyar or options, conditions for

amending or revoking the Salam contract and penalty for non-performance.

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Subject Matter of Salam

The following comprise the subject matter of Salam:

All goods for which the quality and quantity of the goods can be accurately

established,

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

prices,

Fungible (Mithli) things that do not differ significantly,

Non-identical goods,

Goods that can be measured in standard units and are available in the market

at least at the time of delivery and

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

functions other besides as modes of payment and can be traded as metals.

The following types are not permitted:

Goods that may not yield any produce for example, any general field,

Goods that are prone to subjective evaluation, for example, landscapes or

precious stones and

Paper currency, which is only a means of payment

Means of Payment

The following are permitted as means of payment because these are considered as

immediate receipt of the capital.

Legal tender

Goods in barter, if Ribâ is avoided

Usufruct of assets

The following are not permitted as means of payment.

Outstanding loans on the seller or on a third party because that is debt for debt, which

is prohibited to avoid Gharar.

Payment delayed beyond three days as specified in the agreement and definitely

not after delivery,

Partial payment and

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

exchange of deferred delivery of similar goods

Payment need not always be made through hard cash; it can be credited to a seller’s

account.

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Period and Place of Delivery

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.

Khiyar or Options

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

or delays a seller’s ownership over the price of the goods. A buyer does not have the

“option of seeing”, or Khiyar al-Ro’yat.

A buyer has the “option of defect”, or Khiyar al-‘Aib, and the option of specified quality,

after the delivery of goods. 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. In

such cases, a buyer can only recover the price already paid and nothing more than that.

Conditions for Amending or Revoking the Salam Contract

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 the conditions of the contract regarding

the quality, quantity, or the period of delivery once payment is made to the

seller.

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

such cases, a buyer may recover the amount already paid, but nothing more

than that.

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,

with one exception – if the goods are absent from the market or is inaccessible to the

seller at the time of delivery.

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Penalty for Non-Performance

A seller may agree in the contract that he shall donate to the Charity Account, held by

the bank, in case of a delay in delivery. This is a self-imposed penalty. Banks do not

have rights to penalise. But if a seller fails due to bankruptcy, he may be granted

additional time.

Clause 5 of 7 of the AAOIFI’s Salam Standard says: “It is not permitted to stipulate a

penalty clause in respect of delay in the delivery of the Muslam Fihi (Salam

commodity).”

Application of Salam Contracts

Let’s now look at an application of Salam in pre-shipment export finance. It involves

the following process:

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

goods; the client gives the LoC under the bank's lien. 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 bank’s profit is the difference between the agreed payment or pre-shipment

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

The Istisna‘a Contract

Under Istisna‘a, the seller agrees to develop or manufacture a commodity for an agreed

price and to deliver it after an agreed period. In Istisna‘a, 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 Istisna‘a agreements, one with the buyer and the other with the

manufacturer.

Under an Istisna‘a agreement:

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

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

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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.

A big risk under Istisna‘a 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 Istisna‘a 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 the buyer repeatedly purchases from a single seller in Istijrar ,

the Sharī‘ah 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 Sharī‘ah essentials have to be fulfilled.

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

retailer.

Chapter 6 - A Framework for the Islamic Financial

System-Part 4

Introduction

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

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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.

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 and

Explain the concept of a Ju’alah 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. The

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

bear the risks.

Shirkah is categorised as Shirkatulmilk and Shirkatul‘aqd.

Shirkatulmilk or Joint Ownership

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

Optional ownership is when A and B jointly receive a gift or bequest, or they jointly

purchase an article. Compulsive ownership is when A and B inherit a property or their

capital becomes indivisible without their action.

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This type of ownership ensures that A and B are indebted to each other. The terms

prohibit A to avail benefits from B’s property without permission

Shirkatul‘aqd

This is a partnership between two or more people that is bound by a contract. It can

be categorised into Shirkatulamwal, Shirkatula‘mal and Shirkatulwujooh.

In Shirkatulamwal, each partner contributes by way of capital towards a common

business venture undertaken by them.

In Shirkatula‘mal, each partner contributes by way of services offered to

customers.

In Shirkatulwujooh, all partners purchase commodities independently from the

market on credit and sell them to share the profit proportionately.

The Concept of Mudarabah

Mudarabah is a type of Shirkah in which an agent or manager is provided capital by

one partner or a group of partners, 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.

Loss is borne by the partners who invested in the venture. The Mudarib loses the

remuneration for the time and effort invested.

Mudarabah helps the society and concerned parties by encouraging the hiring of

capital and trade skills on judicious terms of sharing risk.

Raising Capital for Mudarabah

Islamic laws specify restrictions on capital invested in a Mudarabah contract.

These are as follows:

Mudarabah capital should be in the form of legal tender money and not

commodities.

Mudarabah capital should be free from debt that is debt owed by Mudarib or third

party to the financier and liabilities.

For profit-sharing with the Mudarib, an investor cannot give two different amounts

of capital to the Mudarib on unequal terms, cite different periods and 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. In a restricted Mudarabah, the Mudarib

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

capital. In an 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.

Let’s look at the rights of the Rabbul-māl and the restrictions that the Rabbul-māl can

impose on the Mudarib.

Rights of the Rabbul-māl

The investor need not directly contract with the Mudarib. Banks can

therefore act as investment agents for their clients.

The Rabbul-māl may fix a time limit for the operation of the contract.

They may specify the goods permissible or not permissible for trade, the

place to do business in or places to be avoided and entities to avoid

relationships with.

They can stop the agent from entering into another Mudarabah with

another party.

They can require the agent to fulfil their fiduciary responsibilities and may

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

substantial.

Restrictions on the Mudarib

The investor can enforce unbiased conditions on a Mudarib only in the interest of the

business. The Mudarib is obliged to follow the investor’s conditions.

Violation of restrictions amounts to usurping the business.

The Mudarib cannot buy goods at more than market price or sell goods at lesser

than market price.

The Mudarib cannot donate funds or waive receivables without the investor’s

permission.

The Rules of Profit and Loss in Mudarabah

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

as follows.

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.

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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.

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 Mudarib’s profit accrues only after the

Mudarabah is liquidated and investors recover their capital and profit.

If a Mudarabah contract incurs a loss, it can be compensated by the profit of the

future business operation or the contingency reserves created in the past.

The Concept of Musharakah

According to the concept of Shirkatulamwal, all the partners investing in a business

own it in the ratio of their capital. In 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.

A general partnership that combines these two concepts is called a Musharakah

partnership. In this partnership, the sharing of profits is in an agreed ratio but the

sharing of losses is in the ownership ratio the partners. A bank and its customer may

often enter into a Musharakah agreement. Both parties contribute capital and

entrepreneurial expertise. Let’s see a basic Musharakah financing structure between

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:

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Losses are shared in the ratio of 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. Apart from these conditions, 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 or Termination of Musharakah

Capital under Musharakah

According to Maliki, Hanbali and Shafi‘e jurists, in Musharakah, a partner must invest

money or prevalent currency or even goods as capital of a venture. Its value should

be clear.

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.

However, contemporary jurists 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, or

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Constructive, for which the valuation methods may use 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 Sharī‘ah.

Let’s see some basic rules to share the profit and loss under Musharakah.

Rule 1

Most Islamic jurists believe that the ratio of profit and loss distribution may be

different from the ratio of the shares in capital invested by each partner. The

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

is also important for the success of the Musharakah.

Imams Malik, Shafi‘e and Zufar believe each partner will get profit exactly in the

proportion of his investment.

Imam Ahmad and most Hanafi jurists think that he ratio of profit may be different the

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

According to 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 partner’s share of the profit cannot be more than the share of invested capital.

Hanbali jurists have allowed even a sleeping partner a bigger share in profit than the

share in capital.

All jurists consider that the profit share of a partner may be less than the share in

capital.

Rule 2

All contemporary jurists believe that while profit may be shared different from the

ratio of capital, a loss must be shared exactly according to the ratio of capital invested

by the partners. This principle was first put forward by the pious fourth Caliph of

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Islam, Ali. This principle recognises the legitimacy of profit earned by engaging in an

economic activity and thereby contributing to the socio-economic welfare of society.

Rule 3

This rule pertains to what contracts can specify regarding profit. The profit ratio must

relate to the actual profit accrued to the business, not to the amount of capital

invested by any partner. This implies the contract should not contain any condition

defining profit as a percentage of the capital or as a fixed sum. The contract can

however specify the percentage of profit that each partner will receive.

Rule 4

This rule specifies the profit/loss distribution in relation to the amount of labour

invested by each partner. If a partner contributes less capital but works more for the

Shirkah than the other partner, he can get an equal share in profits or even more

than the share of the other partner.

Likewise, if both partners have equal shares in capital, but one partner works more

for the Shirkah, the working partner must get a bigger share of the profit.

However, loss must be shared based exactly on the share of capital regardless of who

works more.

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Rule 5

This rule pertains to treatment of profit withdrawn prematurely by partners. Any

partner can withdraw any lump sum amount of profit before the business closes

accounts. However, that amount will be adjusted from his share of profit during final

settlement.

If the business only breaks even or if the actual profit is less than the expected profit,

the lump sum amount drawn by a partner will be deducted from their share of capital.

Rule 6

This rule pertains to what partners can change about the contract. At any time,

partners can change the terms of the partnership contract. They can change the ratio

of profit-sharing, while keeping in mind that losses are to be shared according to the

share of capital of each partner.

However, once the profit is realised, it has to be shared according to the agreed ratio.

Rule 7

This rule pertains to the terms of profit or loss-sharing for a Shirkatulwajooh

partnership. In a Shirkatulwajooh partnership, the partners have pooled their

individual creditworthiness for the benefit of the business. In such a case, it’s

important that they agree on the terms of both profit-sharing and loss-sharing.

The loss may be shared in a different ratio from the profit-sharing ratio. Loss may be

borne in a ratio-based on the proportion 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. Let’s compare them with

respect to the following aspects.

Investor Rights

Loss-Sharing

Profit-Sharing

Liability

Valuation and Settlement

Investor Rights

In Musharakah, all the partners invest in the business. All partners can take part in

the management of the business and can also work for it.

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In Mudarabah, all partners, except the Mudarib, invest in the business. The investors

have no default right to participate in management. However, with pre-agreed terms,

the investor can work for the venture. They have the right to ensure that the Mudarib

is executing fiduciary responsibilities defined in the agreement.

Loss-Sharing

All the partners in a Musharakah share the loss in a ratio proportional to their

investment.

In a Mudarabah, loss is shared by investors only, except when it can be proved that

the loss has been caused due to the Mudarib’s negligence or dishonesty. In such a

case, the Mudarib is liable for the loss.

Liability

The liabilities of the partners in a Musharakah are not limited, except in a situation

where all partners have agreed that none of them will incur any debt during business.

If a partner violates this agreement, then all liabilities exceeding the assets are the

responsibility of that partner.

The liability of the investor in a Mudarabah is limited to the extent of their investment,

unless the Mudarib is permitted to incur debts on their behalf.

Profit-Sharing

In Musharakah, profit can be distributed annually, quarterly, or monthly based on the

valuation of assets.

In the case of Mudarabah, profits can be finally distributed only after the Mudarabah

business is officially liquidated. However, interim payment of profit is possible subject

to adjustment against final settlement.

Valuation and Settlement

In 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 haven’t generated profits.

Musharakah does not require any valuation of assets during dissolution.

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In a Mudarabah, the investor solely owns all the goods or assets purchased by the

Mudarib. The Mudarib can claim a share of 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, modern Islamic jurists have approved

constructive liquidation of assets by determining the market value of non-liquid

assets.

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 Mudarabah after permission by the Rabbul-māl. This arrangement

combines a Musharakah and a Mudarabah. If a Mudarib contributes some capital to

the Mudarabah, 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.

Let’s see how this works in the case of a bank acting as the Mudarib for a group of

investors. Consider, the bank has invested $50,000 of its own money in addition to

$100,000 given to it by a group of investors. Assume that the group agrees to give

the bank 50% of profit as the Mudarib.

If the business earns $3,000 as profit, then the bank will first get $1,000 as profit in

proportion to the one-third capital investment it made. The remaining profit of $2,000

will then be distributed equally between the group and the bank. The bank’s total

profit is $2,000.

The Wadiah Wad Dhamanah Deposit

A current deposit account essentially enables the safekeeping of one’s deposits, free

of cost, while a savings deposit account serves the purpose of safekeeping one’s

surplus funds and providing modest returns.

Current Account

Withdrawals, including checks drawn for and against the deposit, are guaranteed and

honoured by the bank.

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Additional features to enable easy access to withdrawal include checking facility, ATM

and charge cards, traveller’s cheques, remittances, phone banking and branch

service, standing instructions, statement request facility, balance enquiry facility,

remittances and so on.

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. The

risk or return is not shared by the depositor. Profit or loss from the investment of

these funds belongs entirely to the bank.

Deposits and withdrawals are unconditional.

Savings Account

Banks in South East Asia primarily use the Wadiah mechanism to offer a popular

savings product. The bank guarantees the principal amount and any-time withdrawal

of funds from this account. This account is different from the Wadiah current account

in the sense that the bank provides a gift as return to the depositor. This gift is not

part of the contract.

This product is meant for clients looking for safety and convenience. When offering

this product, Islamic banks must:

Seek permission from depositors to use their funds as long as they stay with the

bank and to claim ownership over profits earned from the use of such funds.

Reward customers by returning a portion of the profits, at its discretion; most

banks do this if the customer invests the minimum deposit amount,

Guarantee partial or full withdrawal or refund of balances when customers desire

and

Provide depositors with withdrawal facilities such as, savings pass books, ATM

cards and related facilities.

Another model, which is based on Mudarabah, requires depositors to appoint the bank

as Mudarib for investing funds. The objective is safe custody and modest return.

Depositors have the right to withdraw their funds. Profits are calculated based on the

minimum balance maintained for a fixed period. This balance is the investment for

that period and is required to qualify for a share in profits. The sharing ratio varies

with time but may not correctly reflect how the profit is calculated over time.

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A good example of this model is the 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 Ribâ.

Any benefit that the depositor receives as a part of the agreement amounts to Ribâ.

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. It’s 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 fulfill

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

Types of Wakalah

The types of Wakalah are:

Wakil-bil-Kusoomah – used as an agency to take up various disputes or cases on

behalf of the principal

Wakil-bil-Taqazi al Dayn - used as an agency for receiving debt

Wakil-bil-Qabaza al Dayn - used as an agency for possession of debt

Wakil-bil-Bai‘ - used as an agency for trading

Wakil-bil-shira – used as an agency for purchase

Subject Matter

The subject matter of agency should be defined. For example, if the agency is for

purchasing something, the genus, kind, quality and other necessary characteristics

of the commodity should be specified.

Agency is not permitted for acts prohibited in the Sharī‘ah or acts such as robbery,

usurpation of property or Ribâ-based business.

The appointment of an agent for an act such as prayer, fasting, giving evidence or

for taking an oath is not allowed because these acts cannot be delegated.

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An agent must act according to the instructions of the principal, show due care

and skill and must not delegate the job to another person without the consent of

the principal. An unauthorised person is termed Fuduli in Islamic law. The agent

must also 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.

Nature of Agency

An agency contract may be specific or general. A general agency contract is one in

which an entity simply appoints an agent to purchase goods, as and when desired by

it. A specific agency contract is one in which an entity asks an agent to sell a

particular asset at a given price or as per its instruction. Even in a general contract,

the nature of the job to be done has to be defined to avoid disputes.

Application

IFIs use a Wakalah contract in almost all modes of business such as Murabaha,

Salam, Istisna‘a, Ijarah, Diminishing Musharakah and in activities such as LoC,

payment and collection of bills, fund management and securitisation. A Wakalah

contract is both commutative and non-commutative.

Islamic banks generally do not pay a fee to their clients who purchase or sell goods on

their behalf or perform other duties. However, banks usually charge fees for agency

services rendered by them on their clients’ behalf.

A specific application of Wakalah is Wakalatul Istismar, which means agency services

for the management of the funds. Banks can get a fixed fee, for their services,

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. The method needs to be 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.

Valid and Invalid Tawarruq

Sale to a third party is acceptable. Sale to the person from whom the goods are

purchased on credit is not Sharī‘ah-compatible.

Tawarruq is allowed by the Hanbali and Shafi‘e jurists.

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Some Hanafi jurists are of the opinion that Tawarruq is ‘Inah and hence offensive.

But ‘Inah applies to a situation in which the buyer sells the commodity back to the

person from whom he purchased it; if it is sold in the market, the transaction is

valid and permitted.

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, the transaction will not be valid.

Suppose a Mutawarriq appoints a bank as the agent to sell goods that the

Mutawarriq itself would purchase from the bank for Tawarruq in the market. If this

agency is specified in the contract of sale as a provision, the transaction is not

valid. If the agency is not a condition in the sale contract but occurs after

unconditional sale, the transaction is valid, but not advisable.

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

where brokers only provide agency services and goods remain where they are

without transferring ownership from the seller to the buyer, the Tawarruq is

susceptible to breach of Sharī‘ah rules.

Some Islamic banks conduct Tawarruq of shares of joint stock companies, Ijarah

Sukuk or assets and services and even “bundles of assets”, comprising real assets

as well as cash and receivables. While this is legal, such extensive use is to be

avoided unless the need for cash is extremely urgent.

Liquidity Management

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 in the Middle East.

Acceptable Tawarruq arrangements are executed as follows:

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

commodity or 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 through Murabaha.

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

Precautions

Tawarruq transactions should not turn into a mere exchange of papers between two

brokers and one or two banks. Tawarruq arrangements should be used in extreme

cases where no interest-free option is available. Sharī‘ah boards need to strictly

monitor all Tawarruq-based transactions to prevent extensive misuse and long term

harm to the Islamic banking industry.

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The Concept of a Ju’alah Contract

Ju’alah is a contract in which one party, called the Ja‘il, promises a specific reward,

called the Jua‘l 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.

Permissible and Non-Permissible

Ju’alah is permitted by the Holy Qur’ān and the Sunnah. The Surah Yousuf refers to

this.

According to the Sunnah, the Holy Prophet (peace be upon him) approved a deal by

some Companions who stipulated that if the Chief of the tribe was cured, they would

be compensated for that.

Ju’alah was originally restricted to a reward for the return of a runaway slave, but a

majority of jurists now permit it for a number of activities.

If the required end result of the transaction is alone specified, the transaction is

permissible.

Ju’alah is a relevant and functional transaction for activities that cannot be achieved

using Ijarah. For example, regaining lost property from an uncertain location can be

achieved through Ju’alah because an Ijarah contract asks for more specifications.

Islamic banks can use Ju’alah to recover overdue debts and provide other services

where the subject cannot be specified in detail.

Financial Services

Financial products based on Ju’alah include:

Collection of Debts

Securing Permissible Financing Facility

Brokerage

Ju’alah contracts are used to collect debts. The claim for the reward is related to

realisation of all or part of the debt. For example, Bank A may enter into a Ju’alah

contract with Company B for recovery of debt. The reward is a percentage of the

amount collected on the basis of Ju’alah. It may be paid in advance fully or partially

or before the work is completed. A worker shall not be absolutely entitled to reward

until the required result is achieved, so the payment is made “on account” to him.

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Ju’alah contracts are used to secure permissible financing. This may involve services

such as preparing of feasibility reports.

Ju’alah contracts are used in brokerage activities. In these, the entity executing the

contract is entitled to a reward only when the broker’s customer signs a purchase

contract intermediated by the broker.

Chapter 7 - Islamic Banking System and its Financial

Products

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.

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

Sharī‘ah.

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 distinct features of a Mudarabah contract.

Distinguish among the four types of trust-based intermediation contracts in an

Islamic financial system.

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Distinguish among the three types of security-based intermediation contracts in an

Islamic financial system.

Identify a general structure and three theoretical models for an Islamic Financial

Institution (IFI).

Explain the two-tier Mudarabah, two-windows and Wakalah-based models of

business for an IFI.

Identify the risks and mitigation strategies for the two business models for an IFI.

Identify the nature of assets and liabilities in the general structure of an IFI.

Describe two types of investment accounts that an IFI can offer to customers.

Describe the choices for investments that are available to an IFI.

Distinguish between the categories of IFIs based on the services they provide.

Financial Intermediaries: Their Three Main Functions

The functions of financial intermediaries are asset transformation, payment system,

and brokerage.

Through asset transformation, financial intermediaries help to:

Meet the demand and supply of financial assets and liabilities and

Transform maturity value of assets and liabilities.

Financial intermediaries offer an orderly payment system through services such as

cheque transfer, electronic funds transfer, settlement, etc.

Financial intermediaries also offer brokerage or match-making between the borrower

and the lender. This helps to meet the need and fulfilment of insubstantial and reliable

assets and liabilities. These services include collaterals, guarantees, financial advice,

and custodial services.

The concept of financial intermediation has been altered significantly in the modern

economic era due to:

Macroeconomic policies

Liberalisation of capital accounts

De-regulation

Advances in financial theory, and

Technological advancements.

To compete successfully, FIs in advanced economies especially have evolved a new

approach to intermediation that offers market-based transactions and fee-based

services.

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But what about financial intermediation in Islamic societies?

Financiers existed in early Islamic societies as well and were called Sarrafs. These

persons:

Executed cross-border payments safely between borrowers and lenders,

Operated through an organised network and

Helped to overcome liquidity shortages.

Intermediation Contracts Permitted by the Sharī‘ah

Intermediation contracts permitted by Sharī‘ah stabilise and handle risks in the

financial system by:

Forming a partnership of capital and entrepreneurial skills

Depositing assets with intermediaries based on trust and

Guaranteeing financial performance.

Therefore, intermediation contracts facilitate transparent transactions through

partnership, trust and security.

Partnership

Intermediation contracts that are based on the principles of partnership are

Mudarabah and Musharakah.

Mudarabah is a trustee finance contract that allows a profitable partnership between a

capital owner and an agent with skills.

Musharakah is an equity partnership that merges the principles of investment and

management. A Musharakah is essentially a hybrid of Mudarabah and Shirkah.

Trust

Intermediation contracts based on the principles of trust are Wadiah, Amanah,

Wakalah, and Ju’alah. These contracts are established on custodial relationship

between the borrower and lender.

A Wadiah deposit is one in which one’s property is entrusted to another for

safekeeping and use without the trustee availing a return.

An Amanah contract is a trust deposit in which one’s property is entrusted to

another only for safekeeping and not use as in the case of Wadiah.

A Wakalah contract is used when an agent is assigned the role of performing tasks

based only on instructions provided.

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Ju’alah or service fee contract is used when a service is offered for a pre-

determined fee or commission.

Security

Intermediation contracts based on the principles of security are Kafala, Rahn and

Hawala.

Kafala or suretyship requires a third party to offer surety in case a financial

liability is not met by the borrower.

Rahn or pledge is a contract in which the borrower pledges an asset to as an

assurance of repayment of liabilities.

Hawala or transfer of debt is a contract that releases a principal debtor from

financial obligations by shifting them to another entity.

Historical vs. Modern Mudarabah

History records the use of Mudarabah and Musharakah since medieval Islamic era.

Even in the seventh century AD, tax revenues were being transferred from the region

now known as Iraq to the region now known as the Kingdom of Saudi Arabia.

Musharakah was used in trade between the regions now known as Egypt and Syria.

These partnerships brought together the three vital factors of production, such as

capital, labour and entrepreneurship. The concept was adopted by Europeans between

the eleventh and twelfth century. The Europeans made huge profits by directing funds

from small investors into large business operations, eventually leading to the concept

of the joint stock corporation.

Let’s now look at the historical and modern concept of Mudarabah in detail.

Historical Mudarabah

In historical Mudarabah, the owner of funds entrusted them to a Mudarib or agent to

trade and return the principal together with a profit.

The contract of Mudarabah allowed the agent to receive a share of the profit, but the

loss was borne only by the investor.

The practice of Mudarabah dates back to the holy Prophet himself (peace be upon

him) who was his wife’s agent during his extensive trade expeditions.

Modern Mudarabah

In modern Mudarabah, the agent determines the manner of investing and share

profits according to a pre-defined ratio.

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The loss is still the investor’s risk.

This arrangement forms the basis of modern day Islamic banking, where a recognised

bank, acting as a Mudarib, uses the investor’s money on profitable projects to fetch

good capital returns for the investor.

Distinct Features of a Mudarabah Contract

The four distinct features of a Mudarabah contract are:

Control,

Profit and Loss Sharing,

Multiple Tiers and

Negligence Risk.

Let’s look at each feature in detail.

Control

In a regular Mudarabah contract, the agent is free to choose from a range of available

investing options, whereas in a restricted Mudarabah, the agent’s decisions are

limited by the investor’s conditions and preferences.

Compare this with a Wakalah contract in which the agent only performs assigned

tasks.

Profit and Loss Sharing

The terms permitted for sharing of profit and loss in a Mudarabah contract are:

All profit needs to be shared between the agent and the investor.

Losses, if any must be borne by the investor, unless caused by the agent’s

negligence or misconduct.

In a Mudarabah contract, the determination and distribution of profit is based on:

Ratios and proportions rather than absolute numbers,

Specific profit-sharing formula cited in the agreement,

Difference between the ratio of profit distribution and ratio of the capital invested

and

Balance available after the investor has retrieved his capital.

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In some cases, the two parties share interim returns that will be adjusted during

contract closure against expected future profit.

Multiple Tiers

Islamic banks work on a network created by the agent. With the freedom granted to

an agent, he forms a network of active and passive investors who entrust him with

their capital. The Mudarib can also identify more businesses into which the capital can

be invested.

Negligence Risk

Investors can minimise the risk of negligence by investigating the agent’s past

performance, whereas agents can screen projects on the basis of risk and potential

returns. In addition, banks when acting as Mudaribs, may ask for collateral from the

businesses in which they invest.

There are no reserve requirements for investment balances since these would violate

Basel II & Basel III requirements.

Trust-based Intermediation Contracts

The four types of trust-based intermediation contracts are:

Wadiah,

Amanah,

Wakalah and

Ju’alah.

Let’s look at each type of contract in detail.

Wadiah

In a Wadiah contract, an entity’s property is entrusted to another entity for

safekeeping and use without the trustee availing a return.

Liabilities are shared based on the specific terms of a contract. A trustee will not be

liable for damage to the property if the trustee does not charge a fee for safe-

keeping,unless it is proven that the damage was caused by the trustee’s negligence.

If the trustee charges a fee, it is required to compensate the property owner for all

damages.

With prior consent of the owner, the trustee can use the property in a manner

thought fit, including leasing, lend it for use, use it for their own purpose, or even

pledge the property as collateral.

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Amanah

In an Amanah contract, an individual’s property is entrusted to another only for

safekeeping; the trustee cannot use it as in the case of Wadiah. This essentially

means the client will be charged a fee for Amanah deposits and does not have a free

current account. The trustee is held liable for losses due to negligence. Amanah

contracts form the basis for demand deposit products of an Islamic bank.

Wakalah

In a Wakalah contract, the agent is assigned to perform tasks only according to the

instructions provided by the investor. This type of contract differs from Mudarabah

which offers agents almost total control and freedom to use funds.

Ju’alah

A Ju’alah contract is used when a service is offered for a pre-determined fee or

commission. Services covered by this contract include asset management, consulting,

advisory and custodial services.

Parties can use a Ju’alah contract for services related to an object that may not exist

or be under the control of a party.

Security-Based Intermediation Contracts

The three types of security-based intermediation contracts are:

Kafala or suretyship,

Rahn or pledge and

Hawala or transfer of debt.

Kafala

Kafala or suretyship requires a third party to offer surety in case a financial liability is

not met by the debtor. On behalf of the debtor, the guarantor vows timely repayment

of all financial claims.

Important features:

It does not relieve the primary debtor from liability; it is only an additional

guarantee.

More than one Kafala can be provided for the same liability.

Joint surety is allowed.

Any extension of repayment deadline for the main liability implies an extension

for the Kafala also.

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Fulfilment of Kafala does not imply fulfilment of the primary liability.

The Kafala contract can help IFIs develop modern instruments for underwriting

financial claims and guaranteeing financial performance.

Rahn

Rahn or pledge is a contract where the borrower pledges an asset to assure the

lender of repayment of liabilities. The lender can recover the pledged asset if the loan

is not repaid.

Important features:

Only assets that have potential sale value are accepted as collateral.

Different creditors may secure a joint pledge from a single debtor.

If the pledge is accepted by the lender, it does not imply cancellation of the

liability.

If at the repayment date, the debtor refuses to pay, the creditor can ask a

court to force the debtor to sell the asset or to sell it themselves.

Hawala

Hawala or transfer of debt releases a principal debtor from financial obligations by

shifting it on another entity, whereas Kafala does not permit this release.

Business Models for Islamic Financial Institutions (IFIs)

Intermediation, transaction and financial contracts help Islamic Financial Institutions

to:

Cater to a diverse audience

Mobilise resources

Execute intermediation

Design business models for IFIs and

Offer a wide range of commercial and investment banking products and

services.

The flowchart displays how Islamic banks mobilise funds from depositors and generate

revenue. It also shows the types of investments available on the asset and liabilities’

side.

The three business models derived from financial intermediation are:

Two-tier Mudarabah model,

Two-windows model and

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Wakalah-based model.

The Two-tier Mudarabah Model

In the two-tier Mudarabah model, funds mobilisation and funds utilisation among the

depositor, bank and entrepreneur is based on the profit-sharing concept.

This provides stability during economic crises by minimising the need for active asset

and liability management.

Let’s look at each tier in detail.

First Tier

In the first tier of Mudarabah, the contract is signed between the depositor and the

bank. The depositor provides funds to the bank who acts as the agent. The bank

accepts funds through investment accounts, deposit accounts and current deposits.

These profit-sharing investment deposits are non-voting, limited equity. They are not

liabilities that the bank is obliged to repay.

The bank also accepts current deposits that are liabilities and must be repaid on

demand to the investors. But there is no reserve requirement for this purpose. A part

of these deposits must be granted as very short term interest-free loans called Qard-

ul-Hasan loans.

Second Tier

In the second tier of Mudarabah, the contract is signed between the bank and the

entrepreneur. The bank provides funds to the entrepreneur for business. The

entrepreneur shares the profit gained from business according to a pre-defined

percentage. The bank in return shares this profit with the depositors according to the

contract terms.

Assets and liabilities are integrated, thereby minimising the need for actively

managing the balance sheet. There are no specific reserve requirements for deposits.

The Two-windows Business Model

In the two-windows business model, liabilities and assets of the bank balance sheet

are divided into two windows to handle reserve requirement with ease.

The first window represents demand deposits or transaction balances in the form

of Amanah that requires a 100 percent reserve at all times as the funds

entrusted cannot be used by the bank for money creation.

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The second window represents investment balances that require fractional

reserves as the bank uses the money for risk-bearing projects.

There is no reserve requirement for the second window.

The depositor is charged a fee for using the bank’s safekeeping services.

Interest-free loans are disbursed based on available funds in the depositor’s

account.

The depositor has the option to select a suitable window.

This model is similar to the financial instruments used in the mid-eighth century by

Muslim scholars and merchant bankers who offered currency exchange transactions in

the form of cheques, debt transfer, and bills of exchange.

Abiding by Islamic banking principles, the two-windows business model restricts the

bank from using the deposited money, unlike the West where banks are free to use

available reserves.

Risks and Mitigation

The two-tier Mudarabah model and the two-windows business model consider losses

from investment activities as an outcome of the depreciation value of the depositor’s

wealth. The two models minimise the probability of such losses through meticulous

selection, monitoring, control, and diversification of bank’s investment portfolios.

The risk in the first model is more when compared to second model as it is applicable

only to investment deposits.

The risk can be mitigated using the bank’s direct and indirect control on the agent or

entrepreneur’s behaviour through explicit terms cited in the contract or implicit

reward-punishment system.

Theoretical Perspective of an IFI’s Balance Sheet

A theoretical perspective of the balance sheet of an IFI provides an overview of the

structure, operations and capabilities of intermediation outlined by Islamic banks. The

balance sheet uses diversification and portfolio management technique to design a

portfolio of trade-related and asset-backed securities. The technique offers short-term

deposits with minimal financial risks and facilitates system-wide payment supported

by real assets. Note that this is similar to the typical deposit-accepting function of

conventional commercial banks.

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The Types of Investment Accounts at an IFI

The four types of accounts offered to depositors are grouped as current, savings,

investment and special investment accounts. Current accounts are funds entrusted

with the bank for safekeeping.

Investment accounts are equity investments that fetch banks more returns when

compared to current accounts.

Let’s look at the types of investment accounts in detail.

Investment Account

An investment account offers:

Services in different forms,

Stipulated maturity period,

Profit-return distribution between depositors and the bank and

Pre-determined ratio of 80:20 for depositors and bank.

Special Investment Account

Special investment accounts are specialised funds to finance different classes of

assets. They offer:

Customised accounts for corporate and high net-worth individuals,

Special investment opportunities, such as specific size and maturity value of the

investment,

Negotiable maturity and distribution value of profits and

Banking services, such as funds transfer, letters of credit, foreign exchange

transactions, and investment management.

Investment Choices for an IFI

The assets side of the bank focuses on a diversified profile of asset classes. Therefore,

unlike the liabilities side, it provides more scope for mobilising funds.

The investment options available on the assets side are classified by the maturity

period as short-term maturity, medium-term maturity and longer-term maturity

investments.

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Short Term Maturity

Short-term maturity investments enable clients to meet business needs. This type of

investment is highly preferred over other investment options as it offers:

Asset-backed securities derived from trade-related activities, such as Mudarabah,

Bai’ al-Mu’ajjal or Bai’ Salam and

Short-term maturity and limited risk investments.

Medium Term

Medium-term maturity investments in the form of Ijarah and Istisna’a offer:

Asset-backed securities with a fixed or floating rate feature facilitating portfolio

management and

Additional investment opportunities, such as investing in conventional leases that

can be modified.

This type of investment option is less preferred due to the following issues.

Operating a lease involves purchase cost, safekeeping cost and disposal cost,

Disposing assets involves close watch on market trends and

Banks are required to engage in activities beyond intermediation.

Longer Term

Longer-term maturity investments in the form of Mudarabah and Musharakah allow

the IFIs to customise Mudarabahs for assets classes to match the Mudarabahs on the

liabilities side. It also gives them an option to participate in private equity activities in

the form of Musharakah.

Categories of IFIs

Islamic intermediation has changed with time across IFIs. The Islamic public and

private sectors ensure strict adherence to Sharī‘ah-compliant products.

Apart from commercial banks, IFIs are broadly categorised as:

Islamic Windows

Islamic Investment Banks and Funds

Islamic Mortgage Companies

Takaful Companies (Islamic Insurance Institutions) and

Mudarabah Companies.

Let’s look at each category in detail.

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Islamic Windows

The decline in quality investment opportunities available in the 1980s paved the way

for the entry of Western banks in the Islamic world as intermediaries.

Gradually, Western banks offered Islamic products to attract customers. In lieu, non-

Western conventional banks offered Sharī‘ah-compliant products to retain depositors.

Islamic Windows evolved as exclusive set-ups available within the conventional

banking framework to target affluent individuals.

Note: Most IFIs frequently seek advice from Sharī‘ah scholars and advisors.

Islamic Investment Banks and Funds

The 1990s witnessed Islamic banks leading financial markets through voluminous

transactions and attractive investment banking services, unlike conventional Islamic

banks.

The services offered by Islamic investment banks include:

Innovative large-scale transactions for projects, such as the Hub Power Project in

Pakistan and EQUATE- the petrochemical project in Kuwait

Mobilising and redirecting funds to Muslim countries

Increasing direct investments from foreign countries and

Developing national and regional capital markets through public listing of

companies.

Islamic Mortgage Companies

Islamic mortgage companies use four mortgage models to target the Muslim

communities in the Western world as transactions there are transparent and

streamlined.

The four models are based on lease, equity partnership, contract, and equity

membership.

The first model is similar to traditional mortgage contract.

The second model calls for equity in ownership between the lender and the borrower

which shifts when the property is mortgaged.

The third model, which is mostly practised in the UK, differs on stamp duty from

Ijarah-or Musharakah-based mortgage.

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The fourth model, frequently used in cooperative societies, helps members to use

funds from the common resource pool to buy a property.

Takaful Companies

Takaful refers to a mutual or joint guarantee based on solidarity Mudarabah. Takaful,

unlike contemporary Islamic instruments entitle participants to avail a plum share of

the profit generated. Takaful companies own reserves from conventional mutual and

insurance companies to supplement contributions if claims exceed premiums.

Mudarabah Companies

A Mudarabah company is an autonomous legal entity run by a fund management

company. It is funded by the sponsor’s subscribed capital and by Mudarabah

investment certificates obtained through public offering. Profit from investments is

distributed among subscribers and the manager based on contribution and services

respectively. Mudarabah is classified based on its investment purpose as multi-

purpose and specific-purpose. The concept of Mudarabah is sustained with respect to

the use and abuse of profits. A Mudarabah company is thus considered the nucleus of

financial sectors.

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Chapter 8 - Controversial Financing and Fee-based

Products.

Introduction

Controversial Financing and Fee-based Products.

While attempting to maximise profit, many Islamic commercial banks have devised

controversial debt-based mechanisms. Mainstream Islamic scholars consider these

mechanisms to be in violation of the Sharī‘ah’s rules. These debt-based concepts are:

Repurchase (Bai’ al-Einah)

Bill discounting (Bai’ al-Dayn)

Tripartite resale (Tawarruq)

Normally, a bank acts as an intermediary in certain types of transactions in order to

create an environment of security and confidence among both sellers and buyers. In

these situations, the bank either extends a short-term loan based on interest to its

customer or acts as a guarantor of its customer’s liability. The first service is provided

through a Letter of Credit (LoC).

For Islamic banks, since interest is forbidden, the mechanism of Wakalah or acting as

an agency can be used and a fee charged. The second service requires a Letter of

Guarantee (LoG). For Islamic banks, the mechanism of Kafala is the appropriate way

to provide this service.

On completing this chapter, you will be able to:

Describe the process of Bai’ al-Einah.

Identify the controversial aspects of Bai’ al-Einah

Explain the specification of a credit card based on Bai’ al-Einah.

Explain the process of Bai’ al-Dayn.

Identify the controversial aspects of Bai’ al-Dayn.

Explain the concept of Tawarruq.

Describe the working of a credit card based on Tawarruq.

Identify the issues likely when managing Tawarruq-based products.

Describe the Sharī‘ah-compliant process for Islamic banks of providing a Letter of

Credit.

Explain the Sharī‘ah-compliant process for Islamic banks and uses of a Letter of

Guarantee, and

Identify other fee based services provided by Islamic banks.

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Bai’ al-Einah (Repurchase)

Repurchase or Bai’ al-Einah is popular among Islamic commercial banks in South East

Asia. In this, the bank purchases a commodity from its client on a spot basis and

resells it to the client at cost-plus price on a deferred basis. This mechanism is used

to raise short-term working capital or personal finance.

Suppose that a client needs an amount C. Let’s look at how banks use Bai’ al-Einah to

provide the client with these funds.

Note: A Murabaha contract can be converted into a Bai’ al-Einah if the vendor is the

same as the client.

Step 1

The client sells a commodity X to the bank at price C.

Step 2

The bank gives the amount C to the client on spot basis.

Step 3

The client buys back the same commodity X from the bank at an inflated price, C + I,

on a deferred basis.

Controversial Aspects of Bai’ al-Einah

Let’s now see why the Bai’ al-Einah mechanism is so controversial.

Repurchase

Although the value of a commodity is used as a basis for the amount of funds, the

commodity itself is not sold or repurchased. Only funds flow between the client and

the bank.

In addition, the amount effectively borrowed or the deferred repurchase price need

not be related to the market price of the commodity. The client doesn’t even need to

own the commodity.

Interest-based Loan

Let’s compare with the structure of an interest-based loan. In an interest-based loan,

a client borrows an amount C from bank and pays C + I on maturity to the bank.

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There is no discernible difference between the rate of profit in Bai’ al-Einah and Ribâ

on a conventional loan. When renewed unlimited number of times, a Bai’ al-Einah

based loan works like a regular, compound interest loan. This is, of course, prohibited

by the Sharī‘ah!

A Credit Card Based on Bai’ al-Einah

Using Bai’ al-Einah, the bank can aim for a certain profit while still being able to

finance any amount for any maturity. This allows the design of even a credit card that

has none of the risk associated with a normal credit card for the bank. This concept

uses two types of contracts - Wadiah and a Qard ul-Hasan or overdraft facility.

Let’s see how Bai’ al-Einah works.

Step 1

This consists of two simultaneous steps.

The bank agrees to sell land to the customer at price P. Simultaneously, it signs

another agreement to repurchase the land at a lower price. The bank’s maximum,

pre-determined profit is the difference in price.

Step 2

The bank disburses proceeds of the second agreement into the customer’s Wadiah

account which is created and maintained by the bank.

Step 3

The customer uses their card for making retail purchases and withdrawing cash just

like a conventional credit card, but the cash held in his Wadiah account now backs

each transaction. The customer can use the Qard ul-Hasan facility also.

Step 4

At the end of every month, the sum of all transactions made by the customer is

calculated. Any overdraft must be repaid, but the bank cannot charge interest or fees.

The bank’s profit is calculated monthly based on monthly outstanding or total monthly

transactions. The customer renews the Wadiah account every month.

Note that the lack of fees doesn’t affect the bank’s revenue. In conventional finance

as well, most credit card revenue comes from the fees retailers have to pay networks

such as Visa, Discover, JCB or Mastercard for offering the payments facilities and

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guaranteeing the payment. Fees paid by the credit card holder, if charged, are only a

minor source of revenue.

Bai’ al-Dayn (Bill Discounting)

As you may be aware, bill discounting is quite commonplace in conventional banking.

In Islamic finance, this is referred to as Bai’ al-Dayn. This mechanism is used as a

means of raising working capital and financing foreign trade.

Let’s recall the steps involved.

Step 1

A seller draws up a bill of exchange asking the buyer to pay a certain amount, M,

after a certain period, t, called maturity.

Step 2

There are two options available for the seller.

The seller can wait till maturity and get the full maturity value, or M.

Alternatively, the seller can sell the bill to a bank at a discounted value, N. The

discount is determined by the rate of interest and the date difference between

purchase by the bank and the maturity.

Step 3

If the seller discounts the bill, the bank presents the bill to the buyer at maturity and

receives the maturity value, M. The bank’s profit is M minus N.

Controversial Aspects of Bai’ al-Dayn

Let’s now see how some Islamic banks may be violating the Sharī‘ah’s rules when

they use bill discounting or Bai’ al-Dayn.

Bill Discounting

Mainstream Islamic scholars insist that the sale or transfer of debt must be at par. No

discount is allowed between the price at purchase by the bank and the maturity value.

If the bank buys the bill of exchange at a discount, it is effectively engaging in Ribâ

based transactions.

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Factoring

Here’s why factoring as practiced by an Islamic bank would be controversial:

A company may assign its accounts receivables to an Islamic bank.

The bank now has the right to collect the receivables and provides funds against the

receivables.

In return, the bank can charge a fee under the Sharī‘ah’s rules. However, charging

interest on the loan it gives to the company is a Ribâ transaction.

Tawarruq

Tawarruq is an example of Hiyal, or a legal device, that has been permitted by Islamic

scholars under certain conditions. Tawarruq as a source of funds achieves Sharī‘ah-

compliance by combining two separate sale and purchase transactions.

An individual who requires funds purchases goods on a deferred payment basis. The

individual then sells the goods in the market immediately in order to obtain cash. This

is regarded as Hiyal, since the individual doesn’t intend to buy or sell the commodity.

He executes these purchase and sale transactions only to obtain cash.

This mechanism is used to raise short-term working capital or personal finance.

Step 1

A customer approaches a bank for short term funds, say, an amount P.

Step 2

The bank purchases a commodity from a vendor at a value equivalent to P.

Step 3

The bank sells the goods to the customer at P + I but defers payment by the

customer.

Step 4

The bank resells the goods to the vendor at P* and provides the money to its

customer. P* may be different from P.

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A Credit Card Based on Tawarruq

Let’s now see how Tawarruq can provide the basis for a credit card.

Step 1

The bank loans a certain amount of funds to the customer under Tawarruq.

Step 2

The bank then creates a guaranteed deposit account under the Wadiah principle for

the customer.

Step 3

The customer uses their card for making retail purchases and withdrawing cash just

like a conventional credit card, but the cash in his Wadiah account now backs each

transaction.

At the end of every month, the sum of all transactions made by the customer is

calculated. A fresh Tawarruq for this value is created to replenish the deposit account.

Issues in Managing Tawarruq Products

Let us now look at some issues that arise while managing Tawarruq-based products.

Risk Exposure

Tawarruq fulfils a genuine need for funds. Scholars have permitted it providing it does

not involve Ribâ, is Sharī‘ah-compliant and fulfils certain requirements.

The requirements are:

1. The client must sell the goods to a third party, else this will be regarded as Bai’ al-

Einah.

2. A gap in time between the purchase by the bank and its sale to client is necessary

as in case of all acceptable Murabaha.

3. A time gap must exist between the sale by the bank to client and sale by the client

in the market.

A time gap creates price risk for the parties. This ensures that the profit from the

transaction is a compensation for risk borne and therefore is free from Ribâ.

Prior Tripartite Arrangement

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The three parties in a Tawarruq transaction are the bank, the client and the vendor.

There are three amounts involved:

P (amount requested by the client)

P* (amount paid by the vendor to the bank on resale of commodity X)

P+I (amount to be repaid by the client to the bank on deferred basis)

The three parties may enter into a prior agreement under which none of the values

are related to the market price - cash or deferred, of product X. The deferred sale to

the client may be for a price that comprises the amount of loan plus interest. The

cash purchase from the vendor and cash sale to the vendor may be for the amount to

be borrowed by the bank’s client.

Tawarruq is permitted only if there is no such pre-arrangement between the three

parties. Clients need to be cautious while accepting a Tawarruq contract as Sharī‘ah-

compatible. To achieve marketing objectives, the bank may declare that the terms of

the Tawarruq-based product are similar to terms of other conventional financing

products. The pertinent question here is how financial products that are prone to

market risk can offer the same conditions as other products that are not prone to risk.

The Use of Wakalah to Provide a Letter of Credit

A Letter of Credit is a document issued by a bank for use in trade finance. It works as

an assurance that the buyer will pay the amount agreed to the seller. Conventional

banks provide a short-term loan to buyers as part of this service and charge interest

on it. However, due to the Sharī‘ah’s rules, Islamic banks can provide the Letter of

Credit, but not the interest-earning loan.

Therefore, Islamic banks can use the mechanism of Wakalah, that is, acting as an

agency or Wakil for its customer. The bank may then charge a fee or commission for

the services provided. There is no interest involved.

Let’s see how this mechanism works.

Step 1

A customer of a bank wants to purchase goods worth X from a vendor V on credit of

90 days. The vendor agrees to supply these goods only if a Letter of Credit for 90

days for the full amount is given.

Step 2

The customer requests the bank to provide the Letter of Credit facility.

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Step 3

The customer appoints the bank as its agent or Wakil for executing the transaction.

Step 4

The bank asks the customer to place a deposit for the amount X, which it accepts

under the principle of al-Wadiah.

Step 5

The bank establishes the Letter of Credit and pays the bank that is acting as the

vendor’s Wakil. This payment is made by using the customer’s deposit.

Step 6

Subsequently, the bank releases pertinent documents to its customer.

Step 7

The bank charges fees and commissions to customer for its services under the

principle of agency fee or Ujr.

The Use of Kafalah to Provide a Letter of Guarantee

In international trade, a guarantee of payment is often required when the sellers and

the buyers do not know each other. Banks provide such a document to the seller on

behalf of the buyer. It eliminates the risk, for the seller, of not receiving the payment

for the goods sold.

Islamic banks have extended such a facility in areas such as trade finance,

construction, project related finance, shipping and other activities. Under a strict

interpretation of the Sharī‘ah, a guarantor cannot charge a fee for a voluntary service,

unless the service is a necessity.

Since the guarantee is a necessity in modern trade, Islamic banks can follow the

Sharī‘ah-compliant process called Kafala and charge a fee for this service on grounds

of Darura.

Let’s see how this works.

Step 1

A customer of an Islamic bank wants to buy a product on credit from a company C

that it has not traded with previously. Company C needs a guarantee of payment.

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Step 2

On basis of its customer’s request, the bank provides a Letter of Guarantee to

company C on behalf of its customer.

Step 3

The bank asks its customer to place a certain amount of deposit for this facility, which

the bank accepts under the principle of Wadiah wad Dhamanah.

Step 4

The bank charges a fee to its customer for the services it provides.

Other Fee-based Services

Islamic banks provide the following fee-based services, also called Ujr-based services.

Custody of negotiable tools, including shares and bonds and collection of

payments, which is based on Wakalah where the bank is the client’s Wakil,

Internal, or domestic, and external transfer operations, which is based on Wakalah

where the bank is the client’s Wakil,

Hiring strong boxes, or coffers, which is based on Amanah or Ijarah and

Administration of assets, estates, wills, etc, which is based on Wakalah where the

bank is the client’s Wakil.

Islamic banks also offer fee-based services in real estate, property management and

project management to customers regardless of whether they avail financing or not.

These services are natural extensions of their financing activities. Let’s look in some

detail at one such example from a leading bank in the UAE.

Property management services include:

1. Marketing assets through advertising to create and maximise demand,

2. Ensuring full occupancy to maximise returns to the owner,

3. Collecting rent to assist owner,

4. Conducting general and preventive maintenance to optimise client

satisfaction and maintain the value of assets,

5. Assisting clients in purchase, sale, or rent of assets, through services like,

feasibility, valuation, assessment, survey and valuation for financing against

property and

6. Providing location and construction advice and plot appraisal.

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Project Management

Project management services may include activities in pre-development phase of

construction, such as project planning, cost planning and contract procurement.

This phase is crucial as many aspects are organised, such as dealing with regulations

and purchasing materials for construction. Coordinating the multiple elements such as

construction management and monitoring, project scheduling and property

development are also included in this phase.

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