Mode
of Financing by Islamic Banks
The selection of mode in Islamic financing depends upon the
nature, purpose and size of the transactions involved, essentially these are:
a) Selling on profit: This mode implies the purchase of goods by
banks and their sale to clients at appropriate mark-up in price on deferred
payment basis, without levy of mark-up on mark-up; it encompasses the purchase
of a property by banks from their clients with a buy-back agreement.
b) Shared-risk financing and sharing of profit and loss: This mode
implies the sharing profit and the risk of loss among the investors, i.e. the
bank on the one hand and the client on the other hand.
c) Renting of assets (leasing)
d) Benevolent Loans
The modes which are closest to the spirit of Islamic finance are Musharakah
(shared risk partnership or joint venture) with Mudarabah (profit-and-loss-sharing,
also a form of partnership). However, some practical difficulties which had
sometimes hindered their application and adoption led Shari’ah scholars
to allow the use of other modes such as ijarah (leasing), and murabaha
(cost plus mark-up). These latter modes are comparatively easy to
understand and apply, however the mark-up in murabaha and lease rental
in ijara suffer from having a resemblance to some of the conventional
banking interest-bearing products. Shari’ah advisors have expressed a
desire to encourage the use of products based on the concepts of musharakah and
mudarabah as early as possible.
Debt Type Instruments include:
o Murabaha
(cost-plus profit mark-up)
In its simplest form, murabaha, is a trading mode and
refers to a purchase and resale transaction involving an asset whereby the cost
of the purchase and profit margin (mark-up) on the resale is known and the
mark-up agreed by the parties involved. Another general and regular kind of
sale is musawamah, in which the price of goods to be traded is
negotiated between seller and buyer. Musawamah is usually used where the
seller is not in a position to ascertain precisely the costs of commodities offered
for sale or does not want to disclose the cost price; all other conditions
relevant to murabaha are valid for musawamah as well.
Under murabaha, the Islamic bank purchases, in its own
name, goods from a third party (the supplier/seller) that are required by their
clients, and then re-sells the goods to their clients, on spot or deferred
payment, with an pre-determined mark-up.
The difference between the bank’s purchase cost and its sale price
forms the profit available to the Islamic bank on this transaction. The
ownership of the goods being sold to a client at a mark-up price on deferred
payment terms remains with the bank.
o Salam
(advance payment for goods)
Salam is a trading mode allows a buyer to make payment in
advance for goods to be delivered on a specified future date at an agreed
price. Salam is also defined as a forward purchase of specified goods
for assets or a full forward payment (i.e. a forward contract). In normal
circumstances, a sale cannot be affected unless the goods / assets are in existence
at the time of the bargain. However, this type of sale is an exception,
provided the goods / assets are defined and the date of delivery is fixed. The
objects of the sale must be tangible goods/ assets that can be defined as to
quantity, quality and workmanship
o Istisna’a
(contract to manufacture)
Istisna’a is a trading mode where specific goods or an asset is
made against a purchase order for delivery at a specified future date. An order
to manufacture goods or assets requires various expenses including expenditures
on raw materials, utilities, labour, and direct and indirect over-heads; these
types of expenses may not be suited to murabaha financing which is
primarily focused on the trade in commodities.
As a mode of finance, Islamic banks frequently use istisna'a to
finance construction projects that may also involve the manufacturing of
industrial equipment and various capital goods. Under this mode, the client
will request and the bank will agree to construct and to sell the project to be
constructed at the bank’s selling price (cost plus profit margin) on deferred
payment terms and thereafter the bank will request another party (a contractor)
to construct the project and the bank will purchase the project to be
constructed at the bank’s purchase price (cost price/facility amount).
o
Tawarruq
(Reverse Murabaha) Bai Al Ajel
Tawarruq as an Islamic banking product is a recent
introduction. It may be considered as a reverse form of commodity murabahah.
Tawarruq is a debt instrument that many Shari’ah scholars have
approved allowing Islamic banks another way financing individuals and
businesses in need of cash or liquidity without contravening the rules of the Shari’ah.
Under a tawarruq contract, Islamic banks sell any saleable goods or
assets a client on deferred payment at cost plus profit, and the customer then
sells the goods or the asset on a spot basis to a third party for cash.
There is a view that tawarruq is prohibited because the
structuring resembles bai` `inah, a mode used in Malaysia, whereby an
Islamic bank and a client (in need of cash) enter into a transaction
between themselves involving a buy-back arrangement. It involves the
bank buying goods or an asset from a client for immediate cash and then
selling it back immediately same client for a higher amount on deferred
payment.
o Qard
Hasan (Benevolent Loan)
Qard Hasan is a non-interest bearing loan or benevolent loan that
may not collateralised. It refers to a loan given by a person (the lender) to
another (the borrower) without any expectation of any return for the use of the
funds. The borrower is obliged to only repay the original amount to the lender
within the agreed stipulated period of time. The borrower can pay more than the
amount borrowed so long as it is not required by the contract. Qard Hasan is
granted on compassionate grounds free of interest and/or service charge. It is
repayable as and when the borrower is able to repay. Under this mode of
financing many Islamic banks are providing Qard Hasan to clients who are
in need, for example for education and medical treatment. Other Islamic banks
give interest-free loans only to the holders of investment accounts with them;
some extend Qard Hasan to all the bank’s clients; some banks restrict
the loans other economically weaker sections of society; and some provide
interest-free loans to small producers, farmers and entrepreneurs who are
unable to obtain finance from other sources. Qard Hasan is also in
Islamic microfinance.
Quasi
- Debt Type Instruments include:
o Ijarah
(leasing)
Ijarah is one of the simplest asset-based financial
instruments. Under Islam, leasing began as a trading activity and then much
later became a mode of finance. As a mode of finance, under an ijarah contract,
the Islamic bank purchases an asset or equipment at the request of a client and
leases / rents it to the client a price that includes a fair return for the
bank. The lease contract specifies the leasing period, the amount and timing of
lease payments and the responsibilities of both parties during the life of the
lease. Lease can be simple rental or more elaborate contractual arrangements
committing the parties to future action. The bank can, by agreement with the
client, re-negotiate the quantum of the lease payment at agreed intervals.
The risk in Ijarah principally revolves around the fact
that the Islamic bank is the owner of the asset / equipment being financed.
This ownership is helpful from the point of view that there is comfort for the
bank who may rely more on the high quality of an asset than the credit risk of
the client, which allows a client of relatively weak credit rating to obtain
Ijarah financing.
Under the standard ijarah contract, the client does not
normally have the option to purchase the leased asset in instalments but may
purchase the asset at the end of the lease period. Subject to fulfillment of
certain condition, this object may be achieved by means similar to a hire
purchase agreement, known as an ijara wa iqtina (equivalent to a
leasing and instalment loan), whereby each lease rental payment includes a
portion of the agreed asset price and can be made for a term covering the
asset's expected life. The optional purchase price declines over the period of
the lease agreement, but as the client is not obliged to purchase, the
Profit-And-Loss-Sharing
Instruments include:
o Musharakah | Diminishing Mushrakah (partnership or joint venture)
Musharakah implies an arrangement of business or its financing
based on the concept of profit-and-loss sharing in which all parties contribute
capital or labour skills or a combination of all three in a venture. The profit
of the venture can be shared in any agreed proportion but any loss is shared in
strict proportion to the capital contributed by each party. As a participatory
mode with profit-and-loss sharing musharakah is considered to be the
most desired mode of Islamic financing.
It a form on equity participation and also widely regarded as the
purest form of an Islamic financial contract, conforming to the underlying
partnership principles of sharing in, and benefiting from, risk. All key Shari’ah
essentials are promoted in a musharakah contract, such as
(a) Absence of profit
(b) Sharing in the risk
(c) Sharing in the profit-and-loss (profits can be divided up in
any agreed ratio, while losses must be shared in strict proportion the
investment)
(d) Direct link between capital investment and underlying
asset-backed transactions
As a form of financing, an Islamic bank enters into a partnership
with a client in which both invest in the equity capital required to finance a
transaction or project, perhaps even participate in the management ; both share
in the profits according to a pre-determined basis or in losses according to
their investment. As such, musharakah is an equity participation
arrangement which works like a partnership, normally for a limited duration. It
can be conveniently adopted by Islamic banks for single transactions. Musharakah
may also be adopted to finance new projects, or to provide additional
funding for existing ones.
A variant of the musharakah
is Diminishing Musharakah (DM).
The
DM arrangements, as in the case of musharakah, allow equity participation and
sharing of profits on a pro-rata basis, but also provide a method through which
the bank keeps on reducing its equity in an asset against periodical payments,
ultimately transferring ownership of the asset to the client. Over and above
the payment against the bank’s share in the equity held by the bank, the client
also makes rental payments based on the level of equity held by the bank, with
each payment, the bank’s equity reduces followed by a reduction in the rental
calculated on the reducing equity. Thus, by the capital repayments the client
purchases the bank’s equity, progressively increasing the client’s equity and
reducing (diminishing) the bank’s equity until the bank has no equity and thus
ceases to be a partner and the client has acquired complete ownership.
Likewise, the rental payments to the bank reduce with the bank’s diminishing
equity in the asset until no further rental payment has to be made. The real
estate, housing and construction sectors increasingly use DM.
o Mudarabah (profit-and-loss
sharing partnership)
Mudarabah, also a participatory mode and a form of investment
partnership, ranks alongside musharakah as one of Islamic finance’s
preferred financing modes, musharakah being the most desired form of
financing. Mudarabah also embodies the spirit of profit-and-loss sharing
partnerships and the encouragement of trade, as well as an active management of
capital linked to assets. Unlike musharakah, in mudarabah one
party provides the capital while another other party, as the managing partner,
provides the labour and skills to manage the venture. Profits are shared
between the parties according to a pre-agreed ratio; however losses are borne
by the capital provider only.
As a financing mode adopted by Islamic banks, it is a contract in
which all the capital is provided by the Islamic bank and the business, or a
project, is undertaken by the client. The profit is shared in pre-agreed
ratios, and loss, if any, is borne by the bank only, except in the case of
misconduct, negligence, or violation of the conditions agreed with the bank.
While many banks are providing mudarabah financing for various business
activities, they may also make mudarabah investments in the small
budding entrepreneurs in the form of venture capital finance transactions.
Hybrid or Combination Modes
Frequently there are projects which call for the use of a variety
of, or a combination of, modes within an Islamic financing transaction. In such
a situation, the prudent Islamic banker basically describes the transaction and
breaks the transaction into its constituent parts, using some modes as building
blocks where it appears to be most appropriate, but they must all be
independent of one another. Islamic banks may use these modes with accessory
contracts, such as:
• Jua′alah (Wages, pay, stipend, or reward in exchange for
a service provided by the bank)
• Wakalah (Whereby the bank acts on behalf of a client for
a fee)
• Amanah (Trust)
• Hawalah (Assignment of debts)
• Kafalah (Whereby the bank acts as guarantor)
Combinations modes are allowed by Shari’ah scholars based
on the general principle of necessity provided they “make something forbidden
as permissible or something permissible as forbidden”. Some scholars have
raised objections to certain types of modes being combined as in such cases all
rights and obligations will be seen as inseparable and dependent on each other.
“What is at dispute is not the validity of combination contracts in principle.
The concern is with the nature and form of such combinations” (A Guide to
Islamic Finance, by Munawar Iqbal, 2007).
