Islamic Mode of Financing

Muhammad Kaleem Khan

Islamic Finance System - An introduction

Based on QURAN and SUNNAH Demands socio economic justice Prohibits all kinds of RIBA Prohibits all forms of exploitation Provides equal opportunities to all Condemns accumulation of wealth in few hands Encourages acts of benevolence

Principles of Islamic Finance

Prohibition of RIBA Alkharajo bil dhaman (entitlement to profit is associated with corresponding risk) Prohibition of sale of goods before acquiring ownership Prohibition of sale of food stuff before possession Prohibition of debt for debt Avoidance of Gharar (uncertainty)

Prohibition of Riba (in Quran)

ALLAH has permitted BAI(sale)and prohibited RIBA(Al Baqarah: 275) O you believers, fear ALLAH and give up whatever is left in lieu of RIBA if you are indeed believer, Watch out!If you do notobey this order (and give up all outstanding RIBA), then there is a declaration of waragainst you from ALLAH and HIS PROPHET. However, if you repent you have entitlement only to your principals.Neither you inflict zulmon others, nor the others should do zulmon you. (Al Baqarah: 278

Prohibition of Riba (in Hadith)

Obadah ibn Samit directly reports from the Prophet as saying: Buy and sell gold for gold, silver for silver, dates for dates, wheat for wheat, salt for salt, and barley for barley on the like for like basis. Whosoever gave more or took more, verily he made a RIBA deal. However, trade gold for silver as you wish subject to the condition that the exchange be hand to hand(spot). Trade wheat for dates or barley for dates also likewise.

Islamic Contracts
Musharaka (Profit and Loss sharing) Modaraba (Profit sharing) Musawamah (Bargaining sale) Ijarah (Leasing) Salam (Advance payment sale) Istisna (Contract of manufacturing) Murabaha (Cost plus margin sale)

Musharakah
Hadees-e-Qudsi Allah Subhan o Tallah has declared that he will become a prtnert in a business between two Mushariks untill they indulge in cheating or breach of trust. (Khayanah)

Definition of Musharakah
Under Islamic jurisprudence, Musharakah means A joint enterprise formed for conducting some business in which all partners share the profit according to a specific ratio while the loss is shared according to the ratio of contribution. It is an ideal alternative for the interest based financing with far reaching effects on both production and distribution.

Rules and Regulations of Shirkat-ul-Aqd

Common conditions Existence of Mutaaqideen (Partners) Capability of partners: Must be sane & mature Contract must be take place with free consent, without any fraud Presence of commodity

Rules and Regulations of Shirkat-ul-Aqd

Special Conditions Commodity should be capable of an agency Rate of profit sharing should be determined Profit and loss sharing

Management of Musharakah
Every partner has right to take part in management Partner may agree upon condition that mgt shall be carried out by one of them. Sleeping partner shall be entitled to the profit allocated to the extent of his investment. If partners agree to work for the joint venture, each one of them shall be treated as agent of the other in all matters of business.

Difference b/s Interest based financing and musharikah

Interest Based Financing A fixed rate of return on a loan advanced by the financier is predetermined irrespective of the profit earned or loss suffered by the deb The financier cannot suffer loss. Musharikah Musharikah does not envisage a fixed rate of return. The return is based on the actual profit earned by the joint venture. The financier suffer loss if joint venture fails to produce fruits.

Difference b/s Interest based financing and musharikah

Interest Based Financing
Results are injustice either to the creditor or to the debtor. If debtor suffers a loss, it is injust on the part of the creditor to claim a fixed rate of profit. If debtor earns a very high rate of profit, it is injustice to the creditor to give him only small proportion of profit leaving the rest for the debtor.

Musharikah
The returns of the creditor are tied up with actual profits occurred through the enterprise. The greater the profits of the enterprise, the higher the rate of return to the creditor. If the enterprise earns enormous profits, all of it cannot be secured by the debtor exclusively but will be shared by common people e.g Depositors in the bank.

Applications of Musharakah
Investment accounts depositors are sleeping partners, bank also invests its own funds Stock companies Mutual funds Project financing Import/export financing

Mudarabah

Mudarabah
This is a kind of partnership where one partner gives money to another for investing in a commercial enterprise. Investment comes from first partner who is called Rabul-Maal while the management and work is an exclusive responsibility of the other, who is called Mudarib and the profit generated are shared in a predetermined ratio.

Types of Mudarabah
Al Mudarabah Al Muqayyadah (restricted Mudarabah): Rab ul maal may specify a particular business or a particular place for the mudarib. Al Mudarabah Al Mutlaqah (unrestricted Mudarabah): If Rab-ul-maal gives full freedom to mudarib to undertake whatever business he deems fit. However Mudarib cannot with consent of Rab-ul-Maal lend money to anyone. Mudarib is authorized to do anything, however if they want to do extraordinary work, which is beyond the normal routine of traders, he cannot do so without permission of Rab-ul-Maal.

Difference b/w Musharakah and Mudarabah

Musharakah All partners invest. All partners participate in mgt. All partners share the loss to the extent of the ratio of their investment. The liabilities of partners is normally unlimited. All assets are jointly owned by all partners according to prop. of their respective investment. Mudarabah Only Rab-ul-maal invest. Management is carries out only by Mudarib. Only Rab-ul-Maal suffers loss. The liability of Rab-ulMaal is limited to his investment. Assets are solely owned by Rab-ul-Maal.

Combination of Musharakah & Mudarabah

A contract of mudarabah normally presumes that the mudarib has not invested anything to the mudarabah. He is responsible for the management only, while all the investment comes from rabb-ul-mal. But there may be situations where mudarib also wants to invest some of his money into the business of mudarabah. In such cases, musharakah and mudarabah are combined together.

DIMINISHING MUSHARIKAH

Diminishing Musharikah
A financier and his client participate either in joint ownership of a property or an equipment, or in joint commercial enterprise. The share of the financier is further divided into a number of units and it is understood that the client will purchase the units of the share of financier one by one periodically , thus increasing his own share until 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.

Examples of DM
House Financing DM for carrying business of services (e.g taxi transportation) DM in Trade Uses All purchases of fixed assets House Finance Plant and factory finance Car/Transport Financing Project financing of fixed assets

MURABAHA

Murabaha
Murabaha is a particular kind of sale where the seller expressly mentions the cost of the sold commodity he has incurred and sells it to another person by adding some profit. Thus murabaha is not a loan given on interest; it is a sale of commodity for cash/deferred price. The Bai Murabaha involves purchase of a commodity by a bank on behalf of client and its resale to the latter on cost-plus profit basis. Under this arrangement the bank discloses its cost and profit margin to the client. In other words, rather than advancing money to a borrower, the bank will buy the goods from a third party and sell those goods on to the customer for a pre agreed price.

 A simple sale in Arabic is called Musawamah a bargaining sale without disclosing or referring to what cost price is . However when the cost price is disclosed to the client, it is called Murabahah. A simple Murabaha is one where there is cash payment and Murabah Muajjal is one on deferred payment basis.

Step by Step Murabaha Financing

Overall agreement b/w client and institution, whereby institution promises to sell and client promises to buy commodity. An agency agreement is signed. Institution appoints the client as his agent for purchasing the commodity on its behalf. Client purchases commodity on behalf of institution and takes possession as agent of institution. Client informs the instituion that it has purchased the commodity and simultaneously makes an offer to purchase it from institition. Instituion accepts the offer. Ownership as well as risk is transferred to the client.

Uses of Murabaha
Short/medium/ long term finance for: Raw material Inventory Equipment Asser financing Import financing Export financing (pre-shipment) Consumer goods financing House financing Vehicle financing Land financing Shop financing

SALAM

 This mode of financing is especially for agriculture sector by modern banks. In Salam, the seller undertakes to supply specific goods to buyer at a future date in exchange of an advanced price fully paid at spot. Financing through purchase, deferred delivery of goods, payment spot. To meet the needs of small farmers who need money to grow their crops and to feed their family up to the time of harvst. When Allah declared Riba haram, the farmers couldnt get usurious loans. Therefore Holy Prophet (SAW) allowed them to sell their agricultural products in advance. To meet the needs of traders for import and export business. Salam is beneficial for seller because they receive the price in advance , beneficial for byuer because normally the price in Salam is lower than the price in spot sales.

ISTISNA

 Istisna is a sale transaction where a commodity is transacted before it comes into existence. It is an order to manufacturer to manufacture a specific commodity for purchase. The manufacturer uses his own material to manufacture the required goods. In Istisna, price must be fixed with consent of all parties involved. All other necessary specifications of the commodity must also be fully settled.

Difference b/w Istisna and Salam

Istisna The subject on which transaction of Istisna is based, is always a thing which needs to be manufactured The price in istisna does not necessarily need to be paid in full in advance. It is not even necessary to pay the full price at delivery. Salam The subject can be any thing that need manufacturing or not. The price has to be paid in full in advance.

Difference b/w Istisna and Salam

Istisna The time of delivery does not have to be fixed in Istisna. The contract can be cancelled before the manufacturer starts the work. Salam The time of delivery is an essential part of sale. The contract cannot be cancelled unilaterally.

IJARAH

 'to give something on rent'. In the Islamic jurisprudence, the term 'Ijarah' is used for two different situations. In the first place, it means 'to employ the services of a person on wages given to him as a consideration for his hired services." The second type of Ijarah relates to the usufructs of assets and properties, and not to the services of human beings. The lessor i,e, the financial institution purchases the asset through the lessee himself. The lessee purchases the asset on behalf of lessor who pays price to the supplier, either directly or through the lessee.

Difference b/w Istisna and Ijarah

Istisna The manufacturer either uses his own material and if it is not available with him, obtains it to make the ordered goods. The purchaser has a right to reject the goods after inspection. Ijarah The material is provided by the customer and the manufacturer uses only his labor and skill. Right of rejection of goods after inspection does not exist.

Ijarah wa iqtina
Lessor signs a separate promise to gift the leased asset to the lessee at the end of lease period, subject to his payment of all amount of rent.