ISF 1101 Foundation of Islamic Finance

TOPIC 3. SPECIFIC CHARACTERISTICS

OF ISLAMIC FINANCE

1)Salient Features of Islamic Finance2)Debt Versus Equity

TOPIC CONTENT

1.Philosophy and Features of

Islamic Finance

• Avoiding interests• Avoiding gharar• Avoiding gambling

1. BASIC PROHIBITIONS

• IB transaction is not just merely advancing money.

It involves certain trade arrangement • Major forms or business contracts of Islamic

finance1. Contract of Profit-Sharing: Mudharabah; Musharakah

2. Contract of Sale: Murabahah; Ijarah; Bay as-Salam; Istisna’a; Qard ul hasanah; BBA; Bay as-sarf; Ju’alah

3. Contract of Deposits: Al-wadiah

4. Contract of Agency: Wakalah

5. Contract of Hibah

6. Contract of Security: Al-Rahn; Kafalah; Hiwalah

2. ALTERNATIVE FINANCING PRINCIPLES

1. Basics of Mudarabah

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• Definition: An arrangement whereby owner of property (rabbal mal) provides a specified amount of capital to another person who is to act as entrepreneur to trade with the capital (mudarib)

• Profit sharing is justified: one on basis of capital, another on basis of labor

• A form of trustee partnership; a contract of fidelity

• An investor/group provides capital to agent/manager to trade with it. Example:– Bank (rabbal-mal) = owner of capital– Entrepreneur/Customer (mudarib) = responsible for management of business;

provide expertise to initiate and operate business

• 2 types of mudarabah:– Restricted: financier may specify particular business to be invested in– Unrestricted: financier does not specify; mudarib invests in business he deems fit

1. Basics of Mudarabah

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• Profits– Shared between the two parties according to a mutually pre-agreed ratio– Profit sharing must be a percentage of actual profit– Cannot be a fixed amount or a fixed percentage of capital contribution

- Both parties at liberty to agree on the ratio- Must be decided at the conclusion of contract- Different proportions can be agreed for diff situation (eg: deal in wheat vs

cloth)– Loss means erosion in capital, loss can be compensated by future profit– Financier can award/donate bonus

• Losses– Investor/financier: bears financial loss; Entirely absorbed by capital provider; A

shortfall in capital

– Agent/mudarib: bears loss of time and efforts; Will not be compensated except if mudarib negligent or dishonest, he has to bear financial losses

2. Basics of Musharakah

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DefinitionAn arrangement whereby two/more persons contribute capital for purpose of trading with the joint capital, profit of which, shall be shared among the partners

Forms of musharakah: depending on economic activity: - muzara’a (agriculture)- musaqat (gardening)- musharakah (trading)

Salient features of musharakah– Profit to be shared according to mutually agreed ratio– Losses to be borne strictly according to ratio of capital contribution– All partners have right to participate in business– Difference of opinion amongst fiqh schools on what constitutes acceptable

capital: money vs physical commodities

2. Basics of Musharakah

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Basic principles– Cannot entail mere advancing of money: Must involve equity or

participation in business

– Financier must share any losses incurred by business, according to proportion of capital investment

– Profits can be distributed in any mutually agreed ratio

Musharakah-Mudarabah Compared

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Characteristics Musharakah Mudarabah

1. Investment/Capital

Comes from all partners Comes from rabbul mal, not mudarib

2. Right to participate

All partners Rabbul mal has no right to participate

3. Loss sharing All partners, according to capital contribution

Absorbed fully by rabbul mal

4. Liability Normally unlimited Liability of rabbul mal limited to his investment

5. Distribution of profit

Can be distributed on any interval by valuation of the assets (annual, quarterly, monthly)

Final distribution takes place only after liquidation of mudarabah business

6. Ownership of assets

All assets become jointly owned by all partners according to the proportion of their investment

All asset owned by rabbul mal

3. Murabahah Contract

Definition: a contract of sale between buyer and seller where seller discloses the actual cost of commodity and profit margin added to buyer

Purpose: to protect innocent consumers lacking in trade expertise from tricks of cunning traders

Different from musawwamah: commodity is sold for a lump sum price without any reference to cost (based on bargaining from both sides)

Payments for murabahah -Can be cash basis or deferred payment terms-Commonly deferred payment (murabahah-muajjal)

Shari’ah Basic Rules of Sale

Since murabahah is a sale contract, its validity is based on the conditions pertaining to sale as prescribed by the shari’ah

1. On matters pertaining to object of sale:1. Must be existing at time of sale2. Must be owned by seller at time of sale3. Must be in physical/constructive possession of seller at time of sale4. Must be of value5. Must be specifically known and identified6. Cannot be for haram use

2. On matters pertaining to the sale transaction:1. Sale must be instant and absolute2. Sale must be unconditional

-Certainty of delivery-Certainty of price

Murabahah as a Mode of Financing

Concept of murabahah is highly used by IBs Debt-based, no sharing of risks A means of circumventing prohibition of riba Caution: a murabahah transaction does not become valid simply by

replacing the term “interest” with “profit” or “mark-up”-All conditions stipulated by Shari’ah in relation to a murabahah transaction must be observed to ensure Shari’ah validity

Mechanisms of Murabahah Financing

Bank

CustomerSupplier of commodity

1. Customer identifies commodity

2. Customer approaches bank, promises to buy commodity from bank

3. Bank buys commodity on cash

basis

4. Customer buys commodity via murabahah on deferred payment

terms

4. Ijarah Definition

‘ajr; ujrah: consideration, return, wages, rent A form of exchange value/consideration/rent of service of an asset contract between 2 parties: Lessor (mu’jir) leases property to lessee (musta’jir) in

exchange for lease or rental payment (‘ujrah)

Basis for ijarah Al-Quran: “If you had wished, surely you could have exacted some recompense for it” (Surah al-

Kahf, verse 77) Sunnah: “Whoever hired a worker must inform him of his wages and give a worker his wages

before his sweat dries”

Sale of usufruct (bay’ al manfa’ah) Usufruct : Right to use and enjoy profits/advantages/benefits of property belonging

to others as long as it is not damaged or altered in any way

Basics of Ijarah

Types of usufruct Property - capital assets (manfa’ah al-’ayn) Labour - employment and service (manfa’ah al-’amal)

In ijarah-based financing, ijarah ‘ayn is applied

Major difference between ijarah and al-bay’ (sale) contracts Ownership of property is NOT transferred Risks and responsibilities remained with the owner (lessor)

Comparable (but not identical) to conventional leasing contract

BANK(Lessor)

PROPERTY

CUSTOMER(Lessee)

(2) Bank leases property

(1) Bank buys property

AL- IJARAH

(3) Customer pays rental

Salient Features1. Asset must have valuable use

2. Asset must not be consumable• Must be returned to lessor in its original form at end of leasing period• Normal wear and tear accepted/expected

3. Ownership of asset • Remains with lessor• Only usufruct is transferred to lessee

4. Liabilities and risks • Incidental to ownership: reside with lessor• Associated with usage: reside with lessee

5. Lease contract is a bilateral contract• Termination must be mutually agreed

6. Upon loss or non-existence of usufruct, ijarah contract is terminated

Terms and Conditions

1. Period of ijarah arrangement must be clearly specified

2. Purpose and mode of usage should be agreed upfront

3. Leased asset is a trust in hands of lessee• Lessee liable for damage only due to negligence• Lessee does not guarantee safeguarding of leased asset nor indemnifies lessor of

damages

4. Rental payment must commence after delivery of leased asset either actually or constructively (e.g. give keys to house)

5. Salam Contract

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1. Definition Sale whereby seller undertakes to supply specific goods to buyer at a future date

in exchange for advanced payment made at spot Price paid in advance (at conclusion of the contract) for goods to be delivered

later Sale by advance payment

2. Permissibility of salam• Being practiced during time of the Prophet

• People used to pay in advance for dates to be delivered in 1, 2 or 3 months• Application of salam subject to the strict observance of certain conditions:

quality, measure, weight, price and quantity to be specified• Prophet ordered: “Whoever who wishes to enter into a contract of salam, he must

effect the salam according to the specified measure and the specified weight and the specified date of delivery”

Features of Salam

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1. Subject matter• Consensus: Any commodity that can precisely be determined in quality and

quantity• Not particularized (with specified origin: e.g. product of a particular farm or

field) – might not be able to produce• Cannot be for exchange of identical items and subjective assessments, like

antiquities, diamond

2. Payment• Majority view: buyer should give full price/payment at the time of making

contract• Shafi’e: on the spot, before separation of the parties• Maliki: allows voluntarily concession of 2 or 3 days

• Contemporary jurists: 3 days, provided before delivery of goods• Normally in legal tender

Features of Salam

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3. Period & place of delivery• Necessary to fix period/time & place to deliver goods (part of the

condition)• Hadith: 1-3 years for delivery, later jurists: shorten the period, some to

1 day for transporting goods

4. Penalty for non-performance• AAOIFI Standard: not permitted to impose penalty for late delivery• As deterrent, penalty can be agreed in contract and be channeled to

charity account – not part of bank profit

Benefits of Salam

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Seller• Price received in advance – able to cover cash/liquidity needs for

personal/productive/trading activities• Better way of taking financing rather than loan with interest

• No risk/hardship in marketing produce• Ready demand, no oversupply

Buyer• Gain cheap price - salam price is typically lower than cash/market/spot price• Get commodity at the time he needed• No risk of product non-availability

• No excess demand• Secured against price fluctuations - effective price stabilizer

Salam as Mode of Financing

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Suitability of salam Agricultural financing

Source of bank profit Difference between salam price and market/cash/spot price

Problems/Issues• Banks would receive commodities, not money• Banks are accustomed to dealing with only money, not equipped with

competency to trade in commodities• To earn halal profit, banks have to deal with commodities in one way or the

other• Paradigm shift required

1. Parallel Salam with Third Party

BankCommodity Producer

Commodity Buyer

Deliver goods in 6 months (July 2005)

Pay $10,000 immediately (Jan 2005)

Deliver goods in 3 months (July 2005)

Pay $11,000 immediately

(Apr’05)

First salam (Jan’05)

Second salam (Apr’05)

Parallel Salam with Third Party

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Source of bank profit• Price differences between first and second salam• Period of second salam is shorter, thus price of second salam is typically

higher than price of first salam

Bank engages in two salam contracts As buyer and seller These contracts must be independent of each other

-In second salam, bank bear risk and liability as the owner of commodity-If commodity producer does not deliver goods as per first salam contract,

bank must still deliver goods to commodity buyer as per second salam contract

6. Basics of Istisna’ Contract

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Definition Contract whereby purchaser orders a manufacturer to manufacture a

specific commodity• Price and necessary specifications of commodity are determined and agreed

upfront

Cancellation• Before work starts, any party may cancel contract (although there is moral

obligation on manufacturer to manufacture the commodity)• After work has started, contract cannot be cancelled unilaterally

Payment• Mode is flexible as long as mutually agreed• Can be in advance, progressive with stages of work completed, upon delivery or

deferred for periods after delivery

Basics of Istisna’ Contract

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Required materials Sourced by manufacturer (otherwise becomes contract of ijarah) Purchaser can specify quality of materials Manufacturer arranges both raw materials and labour

Not necessary for seller himself to manufacture unless specified in the contract

Time of delivery need not be fixed• However, purchaser may fix maximum time for delivery, beyond which

• Purchaser not bound to accept goods and pay the price• Financial penalty imposed for late delivery

Istisna’ as Mode of Financing

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Istisna’ can be used for financing of assets that require construction• Applied in financing purchase of real estate from property developers on concept of

“sell and build”• Unfortunately, much of Islamic home financing have inappropriately used contracts

like BBA and murabahah when istisna’ should have been used

A parallel istisna’ arrangement is used given that the bank has no competencies to build houses

• Bank engages a third party (contractor)• The two istisna’ contracts are independent of each other• In the event that the contractor fails to deliver or delivers but with defects, bank

must be liable to customer• Bank has contracted to deliver the house to the customer as per stipulated and

agreed specifications and must do so regardless of whether the contractor delivers

Parallel Istisna’ with Third Party

BankBank Customer

Developer/

Contractor

Deferred payment schedule

To deliver house as per specifications

To deliver house as per specifications

First istisna’

Second istisna’

Progressive payment

Comparison of Salam and Istisna’

Features Salam Istisna’

1. Delivery of goods In the future In the future

2. Payment of price Spot Flexible(spot, progressive, on delivery, in installments after delivery, or some combination)

3. Type of goods Homogenous commodities with a ready market

Assets requiring construction or tailor-made manufacturing

4. Suitable sector Agriculture Construction, small batch manufacturing

7. Wadi’ah (Safe-keeping)Literal definition: Leave, i.e. things left with a person (not the owner) for purpose of

safe-keeping

Legal definition-Authorization of a person to keep the property of another in his safe custody by explicit

or implicit terms-Basis: “and if one of you deposits a thing on trust with another, let the trustee

(faithfully) discharge his trust, and let him fear his Lord” [Al-Baqarah: 238]

Types1. Wadi’ah yad amanah (like current account)

Gives no return on deposits, allow depositors to withdraw funds anytime2. Wadi’ah yad dhamanah (like saving account)

Bank may at its own discretion pay depositors positive return in form of hibah (gift), depending on banks profitability

No pre-determined/priori guarantee of benefits

Wadi’ah Contracts (2)Wadi’ah yad amanah Wadi’ah yad dhamanah

Pure safe custody Guaranteed safe custody

Original contract of wadi’ah Modification of original contract: combines wadi’ah with contract of guarantee (kafalah or dhaman)

No liability on custodian in case of loss or damage (except if negligent)

Custodian liable for any loss or damage

Custodian not allowed to use or benefit from deposited item

Deposited property can be used for trade

Not entitled to any profit gained Profit gained from use of deposited property exclusively right of custodian

Deposited property must be kept separately, no pooling of funds

Deposit properties need not be segregated

Owner of asset (depositor) can take back deposited asset at any time

Custodian is allowed to charge a fee for custodianship but traditionally wadi’ah has been a charitable act

Wadi’ah yad Dhamanah

In contemporary Islamic banking, wadi’ah yad dhamanah contract is used to emulate conventional savings account

Salient features of its use Bank guarantees deposited monies Depositor can withdraw monies at any time Bank can use deposited monies to generate profit Depositor is not entitled to profits generated by bank

Bank typically gives a return to depositor in form of discretionary and voluntary hibah (gift or token of appreciation)

In Malaysia, hibah rates used to calculate profit allocated for wadiah saving accounts is determined by bank at end of each month

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8. Al-Rahnu

1. Parties in contract: Pledger (rahin), pawn broker (murtahin), pledged asset (rahn)

2. Three contracts in operation Al-rahn – pledged property taken as collateral for debt Qard hasan – benevolent loan = interest free loan Wadi'ah yad amanah – custodianship of property

3. Source of profit for bank: Storage cost: custodial fee levied as part of wadi’ah amanah contract

4. If pledger does not repay qard hasan loan within agreed period, pawn broker can auction off pledged asset

Murtahin takes loan amount plus storage fee due to him and returns any surplus to rahin

Mechanisms of Al-Rahnu

Islamic pawn broker

Customer

2. Qard hasan loan

Repay qard hasan loan

1. Pledge asset

3. Custodial fee under wadi'ah amanah

Return pledged asset

9. Bay’ Bithaman Ajil (BBA) Meaning:

-Bay (sale), thaman (price), ajil (deferment)-A sale where payment of price is deferred

A payment facility to complement a murabahah sale

Thus, BBA facility refers to a murabahah sale where payment of goods sold is deferred over a period of time

Terms BBA, bay’ muajjal and murabahah are used interchangeably

Most common instrument for Islamic home financing in Malaysia

Property Sale Agreement (PSA)

BBA Home Financing (Malaysian Practice)

Customer Seeking Financing

Bank

Property Developer / Original Home Owner

Sales & Purchase Agreement (S&P)

4. Deeds of Assignment / Charge

1. Beneficial ownership

1. 10% down payment

5. Balance 90%

3. BBA price (deferred payment)

Property Purchase Agreement (PPA)

2. House

2. Cash price (90% balance)

3. House sell back

Bay’ al-’inah

BankCustomer

1. Sell Asset A

2. Sell back Asset

A

1. Pay cash $X

2. Deferred Payment $X + y (bank profit

margin)

Musharakah Mutanaqisah

Based on concept of diminishing partnership in ownership

Mechanisms1. Home buyer and bank jointly acquire and own property2. Bank leases its share of property to home buyer on basis of ijarah3. Home buyer, as owner-tenant, promises to acquire, periodically, bank’s

share of property4. Home buyer pays rental to bank under ijarah, which partially

contributes towards increasing home buyer’s share in property5. Risks and costs of ownership to be shared equally between home buyer

and bank6. At end of ijarah/lease term and upon payment of all ijarah/lease

rentals, customer would have acquired all of bank’s shares and partnership will ceased

7. Customer becomes sole owner of house

Mechanisms of Musharakah Mutanaqisah

Bank CustomerJointly

Purchased Property

10%90%

Bank leases its 90% share of property to

customer

Customer pays rent for usage of Bank’s 90% share of

propertyCustomer gradually buys

share of property from Bank

Customer’s monthly

installment payments

Musharakah Mutanaqisah

DateAcquisitionPayment (£) Rent (£)

Total Monthly Payment

(£)

July 333.33 615.85 949.18

August 335.26 613.92 949.18

September 337.69 611.99 949.18

October 339.12 610.06 949.18

November 341.05 608.13 949.18

December 342.98 606.20 949.18

Islamic Bank of Britain (IBB): An Example of Monthly Installments under Home Purchase Plan

Calculations are based on property purchase price of £150,000; the customer contribute 30,000 (20%) towards the property purchase price; the financing period is 30 years; and the rent rate is 6.95% (and assuming rent rate is fixed).

Comparison between BBA Home Financing and Diminishing Partnership (MMP)

Issues

BBA Home Financing Diminishing

Musharakah (MMP)

1. Contract

Buyer and Seller (Debt) Partnership (Equity)

2. Ownership risk

Customer Jointly customer and

financier

3. Pricing

Fixed profit rate Variable rental rates

(review)

4. Contracted amount

Fixed based on Selling Price

Flexible market rental rates

5. Monthly installment

Repayment of Profit/Principal

Repayment of rental and share redemption portion

6. Treatment on profit

Profit is capitalized in installment sum

Profit is shared between customer and financier based on ratios

7. Early settlement

Banks decides on profit rebate

Customer redeem more shares

8. Changes in economic cycle

Fixed rates cannot be varied thus mismatch of funds

Variable rental rates can address mismatch of funds

8. Other Arrangements

Tawarruq: buy on credit, then sell at spot to third party for cash: murabahah financing with tawarruq

Wakalah: a contract of agency – contract between two parties in which one party appoint another to act on his behalf. Delegating duty to another party for specific purposes and under specific conditions

Hibah: gift; discretionary

Original Form of Tawarruq

Person A

Person C

Person B (needs

financing)

B buys asset

RM120 Deferred

B sells asset

RM100Cash

1

2

2.DEBT VERSUS EQUITY

Debt versus Equity

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Basic differences between debt and equity financingDebt financing: where investor is just capital provider, fixed return no matter

what the outcome of business ventureEquity financing: reflecting share of ownership; sharing of profit & loss, return

depending on outcome of business venture

In Islam, equity financing is most desirableAsset-based, entail real economic activityUndertaking responsibility and liability: Risk and liability sharingDirect participation/contribution of parties involvedShirkah-based participatory mode of business

Shirkatul milk: partnership by ownership-profit motive may not necessarily exist

Shirkatul aqd: partnership by contract – partnership to do joint business with objective to earn profit

Role of Equity in Islamic Economics

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Earliest financing instrument being proposed in IB literature – Principle alternative for replacing interest-bearing transactions– Murabahah, ijarah and BBA are derivatives and complements

-should be limited to cases where mudarabah and musharakah are not applicable Mudarabah is an ideal instrument to achieve objectives of IE

– To alleviate concentration of wealth– Reduce income disparities via equitable allocation of capital-promotes

distributive justice– Productive uses of resources: labor and capital– Islamic concept of development includes moral, spiritual and material aspects

-Money and property are social tools to achieve social goals; promote brotherhood

-Bank’s objective should be maximization of social benefit, not solely profit maximization

1. Ayub (2007)

References