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Islamic
Financing
AN
ALTERNATE
FINANCING
TECHNIQUE
SAHEEBA
SABAKKA
ISLAMIC FINANCING
AN ALTERNATE FINANCING TECHNIQUE
A PROJECT REPORT
Under the guidance Of
Mrs. Neena P. G
Submitted By
SAHEEBA SABAKKA
Roll No. 510915516
Of
MBA
in
FINANCE
DEC 2010
2
ACKNOWLEDGEMENT
I would also like to thank Ms. Gopika and all other staff at
Mercy Institute of Technology who have extended their help and support
throughout the project.
3
BONAFIDE CERTIFICATE
SIGNATURE SIGNATURE
Vinod C. T Neena P. G
MBA MBA
Mercy Institute of Technology Mercy Institute of Technology
Punnathoor Rd. Punnathoor Rd.
Puthanpally (P. O) Puthanpally (P. O)
Guruvayur – Thrissur Guruvayur - Thrissur
4
EXECUTIVE SUMMARY
Uncontrolled capitalism has caused the global economy into a plunge into
an unprecedented crisis. Adding to the distress, economists worldwide are
expecting the global economy to experience a double dip in the near
future. This calls in for a need for eradicating huge bubbles of fiat money
and assets brought in by capitalism and build up a real and stable
economy.
5
TABLE OF CONTENTS
1. INTRODUCTION
2. ISLAMIC FINANCE
2.1 Basic Tenets of Islamic Banking and Finance
2.1.1 Riba
2.1.2 Gharar
2.1.3 Zakaat
2.1.4 Haram
6
2.2.4 Making money from money is not acceptable
7
2.4.4 Muzara’at and Musaqat (Agricultural Partnership)
2.4.9 Istisna
8
2.4.9.1 Ways of effecting Istisna Sale Contract
9
2.7.1 Hurdles on the way of introducing Islamic Banking in
India
2.7.2 Risks inherent in Islamic Banking
3. CONCLUSION
10
LIST OF TABLES
11
LIST OF FIGURES
12
LIST OF ABBREVIATIONS AND NOMENCLATURE
SYMBOLS
1. Rs. Rupees
2. & And
3. % Percent
4. @ at the rate
5. $ Dollar
6. i.e that is
7. viz namely/ that is to say
ABBREVIATIONS
13
19. USA United States of America
20. BRA Banking Regulation Act
21. RBI Reserve Bank of India
22. IPO Initial Public Offering
NOMENCLATURE
14
21. Shirkat-ul-Inan restricted authority and obligation
partnership
22. Shirkat-ul-Wujuh goodwill/ credit worthiness partnership
23. Shirkat-ul-Abdan labor, skill and management partnership
24. Mazara'at and musaqat Agricultural partnership
25. Baligh Major/ Mature
26. Ijara Islamic lease
27. Ijara Thumma Al- Baai Hire Purchase
28. Ijara Wa Iqtina A form of Islamic lease
29. Qard Hassan Benevolent Loan
30. Aqil person with sound mind
31. Rashid person capable of sound judgment
32. Ijab offer
33. Qabul acceptance
34. Sanduq Box
35. Amana/Wadia Pure Deposit
36. Salam Forward Contract
37. Bai’ Salam Forward Contract
38. Takaful Islamic Insurace
39. Ra’s ul Mal Islamic Insurance Contributions
40. Retakaful Reinsurance
41. Wakala Islamic Agency Insurance
42. Tabarru’ Contract in writing in Takaful
43. Istisna Manufacture Financing
44. Suku k Islamic Bonds
15
AN INTRODUCTION TO FINANCIAL SYSTEM
16
Sound financial system can be considered as the back bone of a
prospering economy. A defective one could reduce effectiveness of
monetary policy and deepen or prolong economic downturn. It creates a
capital flight ( or large fiscal costs related to rescuing troubled institution)
on a large scale. To add to it, in the modern liberal world scenario,
weakness of one country can rapidly spill over across national borders
and result in a global economic slump as we’ve seen in the recent past.
That is to say, a sound financial system is essential for the domestic as
well as the countries those that have trade or financial linkages with the
country concerned.
Thinkers of the recent and ancient past have devised several forms of
financial system to keep large economies on its heels. The most popular
of them are capitalistic and communist system of finance, both of which
in the present scenario have proven to fail on account the unprecedented
economic crisis that the planet plunged into.
This situation calls out for a need for alternative financial system for a
healthy and sustainable global economy. Islamic finance is an answer to
that quest.
17
ISLAMIC FINANCIAL SYSTEM
18
The history of non-interest banking in its present day incarnation is of
recent origin. In the second half of the 20th century, efforts were made to
adopt Islamic finance in Egypt. It slowly spread to Middle East and then
to other parts of the world. Today approximately 700 registered Islamic
finance institutions are said to exist covering 51 countries. The annual
growth rate of Shariah compliant assets is more than 15% on year-to-year
basis. At this rate, it is the world’s fastest growing financial sector and is
becoming an increasingly important component of the international
financial system.
19
The basic tenets of Islamic banking and finance can be put down as
under;
Riba
Perhaps the most far reaching of these is the prohibition of interest (riba).
The payment and acceptance of riba, which are the fundamentals of
conventional banking system is explicitly prohibited in Islamic banking
and thus investors must be compensated by other means. Technically,
riba refers to the addition in the amount of the principal of a loan
according to the time for which it is loaned and the amount of the loan.
While earlier there was a debate as to whether riba relates to interest or
usury, there now appears to be consensus of opinion among Islamic
scholars that the term extends to all forms of interest.
In banning riba, Islam seeks to establish a society based upon fairness and
justice. A loan provides the lender with a fixed return irrespective of the
outcome of the borrower's venture. It is much fairer to share the profits
and losses. Fairness in this context has two dimensions: the supplier of
capital possesses a right to reward, but this reward should be
20
commensurate with the risk and effort involved and thus be governed by
the return on the individual project for which funds are supplied.
Gharar
Another feature condemned by Islamic banking is economic transactions
involving elements of speculation, gharar. Buying goods or shares at low
price and selling them for higher price in the future is considered to be
illicit. Similarly an immediate sale in order to avoid a loss in the future is
condemned. The reason is that speculators generate their private gains at
the expense of society at large.
Under this prohibition any transaction entered into should be free from
uncertainty, risk and speculation. Contracting parties should have perfect
knowledge of the counter values intended to be exchanged as a result of
their transactions. Also, parties cannot predetermine a guaranteed profit.
This is based on the principle of 'uncertain gains' which, on a strict
interpretation, does not even allow an undertaking from the customer to
repay the borrowed principal plus an amount to take into account
inflation. The rationale behind the prohibition is the wish to protect the
weak from exploitation. Therefore, options and futures are considered as
un-Islamic and so are forward foreign exchange transactions because
rates are determined by interest differentials.
21
manufacture (lstisna); and hire contract (jIara). However, there are legal
requirements for the conclusion of these contracts to be organized in a
way, which minimizes risk.
Zakat
A mechanism for the redistribution of income and wealth is inherent is
Islam, so that every Muslim is guaranteed a fair standard of living, nisab.
An Islamic tax, Zakat (a term derived from the Arabic zaka, meaning
"pure") is the most important instrument for the redistribution of wealth.
This tax is a compulsory levy, one of the five basic tenets of Islam and
the generally accepted amount of the zakat is one fortieth (2.5 per cent) of
Muslim's annual income in cash or kind from all forms of assessed wealth
exceeding nisab.
Every Islamic bank has to establish a zakat fund for collecting the tax and
distributing it exclusively to the poor directly or through other religious
institutions. This tax is imposed on the initial capital of the bank, on the
reserves, and on the profits as described in the Handbook of Islamic
Banking.
Haram
A strict code of 'ethical investment' is prescribed and hence it is forbidden
for Islamic banks to finance activities or items forbidden in Islam, haram,
such as trade of alcoholic beverage and pork meat. Investments should
only support practices or products that are not forbidden or even
discouraged by Islam.
22
while the production and marketing of luxury activities, israf wa traf is
considered as unacceptable from a religious viewpoint.
In order to ensure that the practices and activities of Islamic banks do not
contradict the Islamic ethical standards, Islamic banks are expected to
establish a Sharia Supervisory Board, consisting of Muslim
jurisprudence, who act as advisers to the banks.
23
Islamic banking has its own unique principles that clearly distinguish it
from the rest of the financial system. Principles of Islamic banking and
finance are largely value based and as per the guidelines prescribed by
the sharia law. These principles form the basis for the tools and
techniques of Islamic financing.
24
Thus the interest is replaced by profit and loss sharing arrangements,
where the rate of return on financial assets held in banks is not known
and not fixed prior to the undertaking of the transaction. The actual rate
of return can be determined only ex-post, on the basis of actual profits
accrued from real sector activities that are made possible through
productive use of financial assets.
As such, Islamic banks deal with asset management for the purpose of
income generation. They will have to prudently handle the unique risks
involved in management of assets by adherence to best practices of
corporate governance. Once the banks have stable stream of Halal
income, depositors will also receive stable and Halal income.
Though the apparent similarity between trade profit in credit sale and
Riba in loaning is not denied in literature, trade has been permitted and
Riba is prohibited. Profit has been recognised as 'reward' for (use of)
25
capital and Islam permits gainful deployment of surplus resources for
enhancement of their value. However, alongwith the entitlement of profit,
the liability of risk of loss on capital rests with the capital itself; no other
factor can be made to bear the burden of the risk of loss. Financial
transactions, in order to be permissible, should be associated with goods,
services or benefits.
Besides trading, Islam allows leasing of assets and getting rentals against
the usufruct taken by the lessee. All such things/assets corpus of which is
not consumed with their use can be leased out against fixed rentals. The
ownership in leased assets remains with the lessor who assumes risks and
gets rewards of his ownership.
26
unacceptable. In Islam, money represents purchasing power which is
considered to be the only proper use of money. This purchasing power
(money) cannot be used to make more purchasing power (money)
without undergoing the intermediate step of conversion into kind; i.e. by
acquisition of goods and services.
27
While the Islamic financial institutions started almost fifty years back, the
growth was slow in the early stages and it is a system, which is still
young, evolving and expanding in terms of innovation and geographical
location. It is estimated that as of now there are more than three hundred
Islamic financial institutions spread across both the Islamic and non-
Islamic countries. Some of the major forms of Islamic financial
institutions are;
a) Islamic Banking
Islamic banking is the most popular form of financial institution and it is
estimated to be into several hundred billion dollars. There are different
models of Islamic banking;
wherein the Islamic banking is a private institution with a traditional
conventional economy
a nationalized Islamic banking and third is the existence of both the
Islamic and conventional banking system running parallel
28
system. The islamic banking is currently undertake through two channels;
• Islamic banks and ;
• Islamic windows.
Islamic banks are purely based on Islamic principle and all their
operations are in conformity with sharia. Islamic windows are services
provided by the traditional commercial banks to Muslim customers who
engage in Islamic banking through exclusive window.
29
create venture capital funds wherein they provide seed capital for the
start-up business growth stages of the business.
Though this type of fund resembles a traditional mutual fund but the
funds have to be invested in a company only if it fulfills certain
conditions prescribed in the sharia laws.
One of these conditions for the company is that its principal business
30
must be halal that is, it should not be dealing in business like pork selling,
liquor, gambling.
Secondly, the company should not be using debt, in other words having
no borrowed money on which it is paying interest and it should not be
keeping its money in a bank, which pays interest on these deposits.
If all the assets are in money then the shares will have to be purchased at
par. There has been a huge growth in Islamic equity funds and there are
islamic indexes, one of the popular ones is the Dow Jones islamic index.
Even though a fund may be tracking an Islamic index, this by itself does
not make the profits fully sharia compliant.
31
TOOLS AND TECHNIQES OF ISLAMIC FINANCING
In order to cater to the needs of the modern world, Islamic financing puts
forwards a wider range of tools and techniques of financing. These while
ensuring to meet the needs of the financial world, also takes care to
adhere to rules of sharia, which is primarily staying off interest system.
As per the rules of sharia, any addition to the principal amount which
adds up without creation of real wealth amounts to riba. That is to say,
the amount earned without sharing of risks or losses would in effect
amount to riba.
A wide range of tools and techniques of Islamic financing has been listed
in the upcoming chapters.
32
MURABAHA
Steps in Murabaha
33
valid sale contract, with payment due on the agreed date in the
future.
Subject of Murabaha
The assets (mal), which are the subject of the sale, must fulfill the
following requirements:
• The subject of sale must exist and be in the ownership (physical or
constructive) of the bank at the time of sale. In other words, the
second contract must "follow" the first contract. This risk- bearing
by the bank - even if for a short or fleeting time period - legitimizes
banks' profits under Shari'ah as distinct from prohibited riba.
• They must be something of value that is classified as property in
fiqh (Islamic jurisprudence) and must not be forbidden
commodities, such as alcohol, pork etc.
34
Specification of price
The sale price and payment terms must be known. The price is fixed at
the time of contracting, as is the mode of payment, e.g. frequency and
quantum of installment payments. This is to avoid any gharar or
uncertainty. Where the sale price includes a known profit or mark-up, the
profit rate can be determined or expressed in relation to the market
interest rate such as LIBOR. The price may not always be specified in the
main murabaha documentation but can often be the subject of side
letters/agreements between the parties.
35
MUDARABA
Participatory Financing
The central idea in the concept of mudaraba is that two parties, one with
capital and the other with know- how, get together to carry out a project.
The financier provides the capital and plays no further part in the project;
specifically, he does not interfere in its execution, which is the exclusive
province of the entrepreneur.
36
Mudaraba is usually translated as profit-and-loss-sharing but, as far as the
financier is concerned, it is in fact profit-sharing-and-loss-absorbing.
The banker may also grant it upon conditions what has to be made with it
which would then constitute what is called Restricted Mudaraba
(Mudaraba al Muqayyadah), e.g. all investment funds.
37
The first tier Mudaraba between depositors and the Islamic has those
depositors acting as Rabb ul Mal and the bank acting as the Mudarib. The
depositors place their funds with the bank with no guarantee of principal
and a return based on the profitability of the investments made by the
bank on their behalf. As with other Mudaraba, the depositors bear any
losses and share profits with the Islamic bank according to a pre-agreed
ratio.
The second tier Mudaraba between the Islamic bank and those receiving
financing has the bank acting as Rabb ul Mal and the customers acting as
Mudarib. The bank bears all losses except in cases of fraud by the
Mudarib and share profits with the customer according to a pre-agreed
ratio.
Table No. 1
38
Table No. 2
Termination of Mudaraba
39
MUSHARAKA
(Joint Venture)
40
1. Shirkat-ul-Mufawadah (full authority and obligation) – This is a
limited partnership with equal capital contributions, responsibility,
full authority on behalf of others, along with responsibility for
liabilities incurred through the normal course of business.
2. Shirkat-ul-Inan (restricted authority and obligation) – This too is
a limited form of partnership, but with unequal capital
contributions. They do not share equal responsibility, and this
reflects their share of profits.
3. Shirkat-ul-Wujuh (goodwill/ credit worthiness) – This is a kind of
partnership entered into with companies based on reputations of
one of both parties, typically small scale business.
4. Shirkat-ul-Abdan (labour, skill and management) – Partnership
with a company based on the contribution of human efforts with no
capital contributions. These are again typically small scale
business.
5. Shirkat-ul-Mudaraba – This is a partnership for a Mudaraba
contract.
Diminishing Musharakah
This is a derived form of Musharakah and was developed in the near past.
According to this concept, the financier-and the client participate either in
the joint ownership of a property or an equipment, or in a joint
commercial enterprise, on a diminishing share basis. The share of the
financier would be divided into a number of units and the contract is on a
condition that the client purchases the units of the share of the banker one
by one periodically, thus increasing his own share till all the units of the
financier are purchased by him so as to make him the sole owner of the
property, or the commercial enterprise, as the case may be. At the same
41
time, the share of ownership of the financier in the property keeps
diminishing and hence the name ‘Diminishing Musharaka’.
Table No. 3
An example of Payment Schedule under Musharaka
Extra Total Fixed Bank’s
Month Rent (Rs.) Payment Payments ownership
(Rs.) (Rs.) (Rs)
opening 120000
1 800 347 1147 119653
2 789 349 1147 119304
…. ….. ….. 1147 …
176 37 1110 1147 4439
177 30 1117 1147 3322
178 22 1125 1147 2197
179 15 1132 1147 1065
180 7 1065 1072 0
Every partner has a right to take part in the management and to work for
it. However, the partners may agree upon a condition that the
management shall be carried out by one of the and not by other partners.
In that case, the sleeping partner should be entitled to the profit only to
the extent of his investment, and the ratio of the profit allocated to him
should not exceed the ratio of his investment.
42
Termination of Musharaka
43
MAZARA'AT AND MUSAQAT
(Agricultural Partnership)
Mazara'at and musaqat are two types of partnership. They are similar to
mudarabah, in that they are both types of partnerships between capital
and labour. The difference is that mudarabah is relevant to trading
whereas muzara'at is for farming.
If a person leaves his trees with someone for a specified period of time,
so that he cares, tends and waters them, and in return, that person will
take an agreed quantity of fruits, this transaction is called Musaqat.
Contracting Musaqat
While concluding a transaction of Musaqat, the prescribed formula can be
recited in any language, or without reciting the formula, if the owner of
trees hands over them, with the intention of Musaqat, to the person who
44
has agreed to take care of them, and he also receives them with the same
intention, the transaction will be in order. (Of course, the necessary talks
about the duration and the conditions, etc. should have taken place
earlier).
1. The owner of the trees and the person who undertakes to tend and
care for them, should be Baligh and sane.
2. No one should have compelled them to do so.
3. They should not have been banned from having discretion over
45
their own property.
4. The period of Musaqat should be specified, and if the beginning of
it is specified, and its end is fixed to be the time when fruits for that
year become available, the contract is in order.
5. It is necessary that the share of each one of them be fixed as 1/2 or
1/3 etc. of the crop.
6. It is necessary that the contract of Musaqat be concluded before the
appearance of the crop. And if the contract is made after the
appearance of the fruits and before they are ripe, the contract will
be in order, provided that some work like, watering and spraying
which are required for increasing the crop and protecting the trees,
still remain to be done. And if the work required to be done, is
merely plucking the fruits and looking after them, the contract is in
order but it is not Musaqat.
Termination of Musaqat
The parties involved can cancel the transaction of Musaqat with mutual
consent, and also if, when concluding the contract, they had agreed that
one or both of them would have the right to cancel it, then, he can do so
according to the agreement. And if in the contract of Musaqat, they had
laid a condition and that condition is not fulfilled, and if the person who
benefits from the condition is not able to compel the other party to fulfill
it, then, he can cancel the transaction.
The Musaqat transaction will not terminate with the death of the owner of
the orchard, and his heirs will act on his behalf. However, if the person
who has undertaken to look after the trees, dies and if they had agreed
46
that he himself would do the job, the contract will become cancelled, but
if they have not laid such a condition, his heirs will take his place.
47
IJARA
(ISLAMIC LEASE)
48
shall be borne by the lesser.
8. A property under joint ownership can be leased out and the lease
amount distributed between the owners In proportion to their
shares in the property.
9. The leased asset should be fully identified by all the parties.
10. If variable rentals are fixed different phases, the particulars should
be agreed upon at the time of the lease; else the agreement would
not be valid.
11. The lease period commences on the delivery of the asset.
12. If the leased asset loses the function for it was leased, provided it
can’t be repaired and it didn’t occur due to negligence on part of
the lessee, the lease is terminated.
Types of Ijara
49
Ijara- Wal- Iqtina
A contract under which an Islamic bank provides equipment, building or
other assets to the client against an agreed rental together with a unilateral
undertaking by the bank or the client that at the end of the lease period,
the ownership in the asset would be transferred to the lessee. The
undertaking or the promise does not become an integral part of the lease
contract to make it conditional. The rentals as well as the purchase price
are fixed in such manner that the bank gets back its principal sum along
with profit over the period of lease.
50
QARD HASSAN
(Benevolent Loan)
Islam allows loan as a form of social service among the rich to help the
poor and those who are in need of financial assistance. Loan in Islam may
be obtained in two ways: (i) Loan with condition of repayment, and (ii)
gratuitous loan without any compensation or gift. However, Islam does
not recognize any loan with interest for the benefit of the debtor. It only
recognizes gratuitous loan or better known as al-qard al-hasan.
M. Umer Chapra has given the definition of qard al hasan as: "Qard al-
hasan is a loan which is returned at the end of the agreed period without
any interest or share in the profit or loss of the business." Therefore, qard
al- hasan is a kind of gratuitous loan given to the needy people for a fixed
period without requiring the payment of interest or profit. The receiver of
qard al-hasan is only required to repay the original amount of the loan.
51
7. It can remove social and economical discrimination from the
society.
8. To eradicate unemployment problem from the society.
Ijab and qabul should be clearly indicated in the contract, otherwise, the
loan contract may create dispute in future. In the loan agreement, there
should have clear expression, collation and conjunction of the ijab and
qabul between the parties.
52
4. The loan contract should be written down
If any bank or other institutions give al-qard al-hasan, they may require
service charge or administrative fee. However, there is no scope for an
53
individual lender to demand this charge unless any amount incurred due
to procedural requirements of the loan agreement, such as lawyer's fee,
stamp duty etc.
7. Extra Payment
It is very clear that in the loan agreement, there will be no condition for
extra payment, otherwise, it will be riba . It is however, permissible for
the debtor to give some sort of gift to the creditor as a sign of
appreciation of his voluntary deed.
9. Guarantors:
In the case of the al-qard al-hasan, there can be guarantors. The
guarantors of the borrower may be any person or the property of the
borrower that is collateral security, such as, mortgage, charge etc. In case
of the borrower's failure to pay back the loan after the expiration of the
54
time specified, his guarantor has to pay or the collateral security is to be
valued for the repayment of the loan. But, Muslims should remember that
a true believer should not delay to pay back his obligations.
The application for interest free loans is relevant especially among larger
families, which may put in place a private “box” called Sanduq among
them where needy family members could draw out an interest free credit.
Wealthy member may draw out a finance facility against profit/loss
sharing explained later on.
55
loan himself. The administration of such a model could be subject to fees
which are not bound by time and size of the credit.
Another positive factor to be seen is the effect of a stress test for the
borrower – having savings over a period time is a good way to know the
own repayment capacity. Further a credit history is no longer an absolute
must. It is a called in the conventional sector a rotating savings and credit
association (ROSCA ), and reported to be practiced in the informal sector
even in UK and Australia but not on a professional basis.
56
(Forward Contracts)
Condition of Salam
• The buyer should pay the price in full to the seller at the time of
effecting the sale. Else, it will be tantamount to a sale of debt
against debt, which is expressly prohibited. Moreover, the basic
wisdom behind the permissibility of Salam is to fulfill the instant
needs of the seller. If the price is not paid to him in full, the basic
purpose of the transaction will be defeated.
57
• Salam cannot be effected on a particular commodity or on a
product of a particular field or farm. Because it is possible that
field is destroyed before the delivery, and in the presence of this
possibility the delivery remains uncertain.
58
• It is not permissible for the buyer of a Salam commodity to sell it
before receiving it because that is similar to the prohibited sale of
debts before holding.
59
TAKAFUL
(Islamic Insurance)
Principles of Takaful
60
Modules under Takaful
61
and returns thereof distributed on Mudarabah principle between the
participants and the Takaful operators. The profit attributable to the
participants is credited into the two accounts separately.
62
4. The surplus generated belongs to the contributor (i.e.
policyholders) solely under wakala model and to both i.e.
policyholder and Takaful Company under mudarba model. This is
a unique feature of Takaful insurance
5. Since the surplus goes back to the participants in proportion to
their contribution, there is an inbuilt check on over-pricing.
6. Funds are invested in Shariah compliant instruments / avenues.
7. Incidentally, Reliance Life has come out with a plan called RSIP
where the investment is made in non-banking sector excluding
liquor, cigarette, tobacco, entertainment, gambling, etc.
63
ISTISNA
64
purchaser. If the manufacturer undertakes to manufacture the goods
for him, the transaction of Istisna comes into existence. But it is
necessary for the validity of Istisna that the price is fixed with the consent
of the parties and that necessary specification of the commodity (intended
to be manufactured) is fully settled between them.
Termination of Istisna
The contract of Istisna creates a moral obligation on the manufacturer to
manufacture the goods, but before he starts the work, any one of the
parties may cancel the contract after giving notice to the other. But after
the manufacturer has started the work, the contract cannot be cancelled
unilaterally.
However, the party placing the order has the right to retract, if the
commodity does not conform to the specifications demanded..
Application of Istisna
Istisna contracts are applied in high technology intensive industries such
as the aircraft industry, locomotive and ship building industries. In
addition, this type of business transaction is also used in the production of
large machinery and equipment manufactured in factories and workshops.
Finally, the istisna contract is also applied in the construction industry
65
such as apartment buildings, hospitals, schools, and universities to
whatever that makes the network for modern life. The Istisna contract is
best used in those transactions in which the product being purchased can
easily be measured in terms of the specified criteria of the contract.
66
SUKUK
(Islamic Bonds)
67
the proceeds of the realization of the sukuk assets.
• A distinguishing feature of a sukuk is that in instances where the
certificate represents a debt to the holder, the certificate will not be
tradable on the secondary market and instead is held until maturity
or sold at par.
Features of Sukuk
The most common uses of sukuk can be named as project specific, asset-
specific, and balance sheet specific.
1. Project-specific Sukuk
Under this category money is raised through sukuk for specific project.
2. Assets-specific Sukuk
Under this arrangement, the resources are mobilized by selling the
beneficiary right of the assets to the investors.
68
3. Balance Sheet-specific Sukuk
This is an arrangement wherein the Islamic bank mobilizes funds by
issuing sukuk and these funds are used to finance various projects of the
member countries.
Types of Sukuk:
Sukuk takes several innovative Shariah compliant forms that combine
various particles of Islamic forms of finance together.
1. Ijarah Sukuk
Ijarah Sukuk are related to leased properties and assets, they carry equal
values, and are issued by the owner of the leased property or his agent.
The aim of the transaction at the end is to sell the leased property through
issuing Sukuk, accordingly, the holders of the certificates or Ijarah Sukuk
own the asset and its charges during the rental period, each in proportion
to the certificates of Sukuk held in the leased asset.
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3. Usufructs of Future Assets:
The usufruct could also be futuristic for a specified period of time for a
specified asset which would not be ready at the time of issuing the Sukuk
certificates but, it could be under construction or contracted for
construction and delivery at a future time. This is analogous to the Salam
contract.
4. Contractor's Sukuk:
A contractor's or a supplier's Sukuk can be issued by a contactor or a
supplier of a good or a service. The Sukuk could be for existing
commodities or those, which would be offered during a contracted time
in future. These sukuk carries equal values issued by a covenanter to
provide or sell services described in the security, such services are to be
sold in a form of sukuk, so that the holders of the same shall to be the
owners of such services and shall gain the proceeds from selling the same
in the markets.
6. Salam Sukuk
Sukuk or certificates of Salam carry equal values for mobilizing the
capital necessary to produce some specified commodities contracted for
deliverance at specified periods of time in future while their value prices
are fully paid in advance. A separate parallel Salam contract could be
signed by the Salam item buyer with a third party, without linking it to
the first contract. Ethically, the contractors should be committed towards
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their contract parties, and should not transfer their own responsibilities in
a contract to their parties in another one.
7. Istisna Sukuk
Sukuk or certificates of Istisna carry equal values for mobilizing capital
necessary to produce some specified commodities. Such commodities
could be sold with partial advance payments according to Istisna
contracts in order to be delivered at a specified period of time in future.
Istisna is applicable on building and establishing ships, airplanes, bridges,
roads, power generation stations, water supply stations and the alike
according to a specific specifications stipulated in the contract and
according to a pre-stated delivery date and value. It is possible to
synthesize another formula with the same to respond to the requisites of
the process and finance. This type is amongst the most active instruments
in world of Sukuk.
8. Murabaha Sukuk
These Sukuk carry equal values and are issued by the merchant or his
agent in order to finance the purchasing a commodity then to sell the
same at a known Murabaha as for equipments required within an Istisna’a
contract weher the equipments shall be purchased on a known Murabaha
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and the holders of Sukuk will be the owners of such equipments and of
the sales income from the same.
9. Musharakah Sukuk
These Sukuk carry equal values and are issued by the supplier
(entrepreneur or a covenanter )or his agent, to finance a project or
projects where the holders of Sukuk will be the owners of such projects,
this is far similar to partnership companies although they might differ if
the Sukuk issuer is authorized to select the projects which are transferred
and constructed.
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subject of the contract, in order to finance the processes of irrigation and
cultivation, where the holders of Sukuk become partners in the produced
crops as per the terms stipulated in the Musaqat contract.
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shares of Sukuk holders diminishes, while the shares of the working
partners increases ending to stage where the ownership of the assets and
its associated services, the asset alone or the services alone in favor of the
partners. This formula combines the limited period lease Sukuk for assets
and services.
Different sukuk structures have been emerging over the years but most of
the sukuk issuance to date have been ijara sukuk, since they are based on
the undivided pro-rata ownership of the underlying leased asset, it is
freely tradable at par, premium or discount. Tradability of the sukuk in
the secondary market makes them more attractive. Although less
common than Ijara sukuk, other types of sukuk are also playing
significant role in emerging markets to help issuers and investors alike to
participate in major projects, including airports, bridges, power plants etc.
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It can be seen that in any banking business, there exist two aspects - at the
one end is the deposit aspect and at the other end is the lending or
investment aspect. At the deposit end of the scale, Islamic banks normally
operate three broad categories of accounts, namely, current, savings, and
investment accounts.
1. Current accounts
Current accounts are based on the principle of al-wadiah, whereby the
depositors are guaranteed repayment of their funds. At the same time, the
depositor does not receive remuneration for depositing funds in a current
account, because the guaranteed funds will not be used for PLS ventures.
Rather, the funds accumulating in these accounts. can only be used to
balance the liquidity needs of the bank and for short term transactions on
the bank's responsibility.
2. Savings accounts
Savings accounts also operate under the al-wadiah principle. Savings
accounts differ from current deposits in that they earn the depositors
income: depending upon financial results, the Islamic bank may decide to
pay a premium, riba, at its discretion, to the holders of savings accounts.
3. Investment accounts
An investment account operates under the mudaraba-al-mutlaqa
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principle, in which the mudarib (active partner) must have absolute
freedom in the management of the investment of the subscribed capital.
The conditions of this account differ from those of the savings accounts
by virtue of: a) a higher fixed minimum amount, b) a longer duration of
deposits, and c) the depositor may lose some of or all his funds in the
event of the bank making losses; ie, the principal or the rate of return on
the deposits is not guaranteed. The only contractual agreement between
investment depositors and banks is the proportion according to which
profits or losses are to be distributed between the parties of the deposit
contract.
a. Equity Fund
• In an equity fund the amounts are invested in the shares of joint
stock companies. The profits are mainly derived through the capital
gains and dividends earned on the equity shares.
• Dealing in shares or acquisition of shares of companies can be
acceptable under Shariah, subject to the following conditions:
• The main business of the company is not violative of Shari'ah.
• If the main business of the companies is ha/al, like automobiles,
textile, etc. but they deposit their surplus amounts in an interest
bearing account or borrow money on interest, the shareholder must
express his disapproval against such dealings, preferably by raising
his voice against such activities in the annual general meeting of
the company.
• If some income from interest-bearing accounts is included in the
income of the company, the proportion of such income in the
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dividend paid to the shareholder must be given in charity, and must
not be retained by him.
• The shares of a company are negotiable only if the company owns
some illiquid assets.
The management of the fund may be carried out in two alternative ways.
The managers of the Fund may act as mudaribs for the subscribers. In this
case a certain percentage of the annual profit accrued to the fund may be
determined as the reward of the management. The second option for the
management is to act as an agent for the subscribers. In this case, the
management may be given a pre-agreed fee for its services. This fee may
be fixed in a lump sum or as a monthly or annual remuneration.
According to the contemporary Shari'ah scholars, the fee can also be
based on a percentage of the net asset value of the fund.
b. Ijarah Fund
In this fund the subscription amounts are used to purchase assets like real
estate, motor vehicles or other equipments for the purpose of leasing
them out to their ultimate users. The ownership of these assets remains
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with the Fund and the rentals are charged from the users. These rentals
are the source of income for the fund which is distributed pro rata to the
subscribers. Each subscriber is given a certificate to evidence his
proportionate ownership in the leased assets and to ensure his entitlement
to the pro rata share in income. These certificates may preferably be
called 'sukuk' -a term recognized in the traditional Islamic jurisprudence.
Since these sukuk represent the pro rata ownership of their holders in the
tangible assets of the fund, and not the liquid amounts or debts, they are
fully negotiable and can be sold and purchased in the secondary market.
Anyone who purchases these sukuk replaces the sellers in the pro rata
ownership of the relevant assets and all the rights and obligations of the
original subscriber are passed on to him. The price of these sukuk will be
determined on the basis of market forces, and are normally based on their
profitability.
c. Commodity Fund
Another possible type of Islamic Funds may be a commodity fund. In the
fund of this type the subscription amounts are used in purchasing
different commodities for the purpose of their resale.
d. Murabaha Fund
If a fund is created to undertake Murabaha, it should be a closed-end fund
and its units cannot be negotiable in a secondary market. The reason is
that in the case of murabaha, as undertaken by the present financial
institutions, the commodities are sold tothe clients immediately after their
purchase from the original supplier, while the price being on deferred
payment basis becomes a debt payment payable by the client. Therefore,
the portfolio of murabaha does not own any tangible assets. It comprises
either cash or the receivable debts, therefore, the units of the fund
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represent either the money or the received debts are not negotiable. If
they are exchanged for money, it must be at par value.
e. Mixed Fund
Another type of Islamic Fund may be of a nature where the
subscription amounts are employed in different types of investments, like
equities, leasing, commodities, etc. This may be called a Mixed Islamic
Fund. In this case if the tangible assets of the Fund are more than 51%
while the liquidity and debts are less than 50%, the, units of the fund may
be negotiable. However, if the proportion of liquid assets and debts
exceeds 50%, its units cannot be traded according to the majority of the
contemporary scholars. In this case the Fund must be a closed-end fund.
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Since the early 1980s, Islamic banking has developed into a multi-billion
dollar business. The Western world is realizing that, even in its own
cities, it is no longer a ‘fringe’ business.
Commercial Islamic banking took off in the 1970s when a number of new
institutions were established in the Gulf, including the Dubai Islamic
Bank (1975), the Kuwait Finance House (1977) and the Bahrain Islamic
Bank (1979). However, the most significant developments took place in
Saudi Arabia, aided by its huge economic infrastructure. One of the prime
movers of such developments was Prince Mohammad Al-Faisal, whose
ambition was to create a network of Islamic banks across the Muslim
world - a process which saw the founding of the Faisal Islamic Bank in
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Egypt in 1977 and the Faisal Islamic Bank in Sudan in 1978. But it was
Prince Al Faisal's Geneva-based Dar Al Mal Al Islami, founded in 1981
that brought Islamic banking to the attention of those Western bankers
who, previously, had little or no knowledge of Islam or Middle Eastern
countries. The Geneva office of Dar Al Mal is now the centre of a
network of 43 branches in 20 countries with assets under management in
excess of $3bn.
The assets of Islamic banks incorporated in the Middle East rose from
$4.4bn in 1985 to $15.7bn in 1994, although total assets controlled by
Islamic financial institutions, including assets under management and the
activities of banks based outside the Middle East, are estimated to be in
the order of $80-$100bn. Compared with conventional banking this is a
relatively small sum, but the overall demand for Islamic banking products
is probably much greater than banks have so far been able to tap.
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economy nor the distributive goals for the poor and marginal enterprises
could be attained.
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15 per cent of Indians have any bank account. In other words the
overwhelming majority of Indians, say 85 per cent, are outside the net of
banking activities – they are not bankable. This is a precarious situation
for any country because normally when a person becomes bankable he
also brings his savings in the main stream of economy. As Islamic
Banking is genuinely expected to attract savings of Muslims living in
non-Muslim countries it will increase the bankability in a country and
will have direct positive effect on the economy of the countries.
4. Invites Petrodollar
It is said that introduction of Islamic Banking in any country will serve as
the drain through which petrodollar will flow through. As the economy of
the members of Gulf Cooperation Council (GCC) countries in particular
and other members of Organisation of Petrol Exporting Countries
(OPEC) in general is rentier based the fund saved in these countries are
mostly invested outside their own respective countries. Till 9/11 a major
portion of those savings were being invested in the USA and other
Western countries. But now the situation has changed and the Arab
investors have started looking around for other possible opportunities. If
Islamic banks are opened in non-Muslim countries, including India, such
funds will be attracted and this will ultimately give a boost to economy
and a fillip to the overall welfare of the states.
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Like how the emerging Islamic finance world has shown us, it is clear
that banking without interest can take care of any kind of financing which
the conventional banks are indulged in. This may also save thousands of
needy people to come forward to borrow from the banks and can free the
banks from the clutch of Non-Performing Assets to a large extend;
ultimately resulting in complacency amongst the customers of the bank as
well as for the banks themselves.
In Kerala alone, it is reported that this money could be above Rs. 40,000
crore. Research reveals that a handsome bulk of money in. India owned
by the believers is lying idle, which if invested in profit sharing basis -
and utilized properly, can have a major impact on the Indian economy.
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Southern
Region
Western Region
Northern Region
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Central Banker the context of Islamic Banking. Though the basic
functions of a modern Central Bank may be relevant also for an Islamic
monetary system, the mechanisms may have to be different.
In this regard the Scholars in the field of Islamic Banking' has suggested
that adjustments in profit-sharing ratios can be substituted for bank rate
manipulations by the Central Bank.
3. Issue of Credit
According to Scholars, credit can be tightened by reducing the share
accruing to the businessmen and eased by increasing it. It is also
proposed that the Central Bank should acquire an equity stake in
commercial banking by holding, say, 25 per cent of the capital stock of
the commercial banks which would give-the Central Bank access to a
permanent source of income so that it effectively act as lender of last
resort could.
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The problems of liquidity shortage or surplus would have to be handled
differently in Islamic banking, since the ban on interest rules out resort to
the money market and the Central Bank.
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RISKS INHERENT IN ISLAMIC BANKING
There are some unique risks in Islamic banking in additional to the risks
faced by conventional banks:
1. Credit risk
While the profit — loss sharing modes of financing may shift the direct
credit risk of these banks to their investment depositors, they-may also
increase the overall risk on the asset side of the balance sheet. This
significantly increases the potential for moral hazard and creates an
incentive for risk taking and operating financial institution without
adequate capital. This risk arises when the bank is under pressure to pay a
rate that exceeds the return that has been earned on assets financed by
their investment depositors. The breach of the investment contract for
management of investor's funds may also lead to fiduciary risk.
2. Market risk
Owing to the Sharia's prohibition against interest-based instruments,
interest rate risk affects Islamic banks only indirectly through the mark-
up price of deferred sale and lease-based transactions. This risk arises
from exposures to the price volatility of the underlying "real" assets
inherent in some financing modes, which are in the form of trading and
real investment. Similarly, the bank has to share any increase in earnings
with investment depositors, but cannot, at the same time, re-price its
receivables on the asset side at higher rates. The bank, is therefore,
exposed to mark-up price risk due to this pricing mismatch.
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These banks are directly exposed to commodity price risk because, unlike
conventional banks, they typically carry, inventory items on their books.
They are exposed to a greater extent than conventional banks to equity
price risk as the very nature of Islamic banking is equity financing
through the PLS modes.
3. Operational risk
The unique activities that these banks perform like administration of
profit loss sharing modes of financing — which includes determination of
profit and loss sharing ratios in investment projects in various sectors of
the economy, as well as on-going auditing of financed projects to ensure
proper governance and appropriate valuation, is more complex and these
activities that are not normally performed by conventional banks. This is
compounded by the non-standard nature of some Islamic financial
products and lack of an efficient and reliable Sharia litigation system to
enforce financial contracts.
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CONCLUSION
Over a period of 300 hundred years the emergence of fiat currencies (i.e.
currency without an intrinsic value), the role of compound interest and
the development of limited liability company structures have shaped
western finance.
Such developments have also been the sole reason why the West has
come to be characterized with regular financial crises. This is because the
financial sector moved away from raising finance to fund business start-
ups and projects to speculating on company share prices and the
movement of currencies. In this way trading in the financial sector ceased
to be about purchasing currency or buying shares in the hope of receiving
a dividend to purchasing financial commodities in the hope they could be
sold for a higher price.
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The problems that the world economy faced caused hues and cries about
an alternative financial system for smoother and healthier economy. The
answer to this human quest was Islamic Banking and Finance.
Its basis laid down centuries ago, and practiced for once at the time it was
opened to the world, it was soon forgotten for the greed of money and
sheer selfish ends. Now that on the verge of crisis, some entities
practically reminded the world of this wonderful system of finance, lets
hope that the world will receive it a warm welcome, like it apparently
does now.
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REFERENCES/ BIBLIOGRAPHY
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