Islamic Finance and Banking: Modes of Finance

Power point and Assessments

Khalifa M Ali Hassanain Copy Rights Notice ©

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Acknowledgement

This textbook was developed as part of the IRTI e-Learning Program (2010), which was established and managed by Dr. Ahmed Iskanderani and Dr. Khalifa M. Ali. Table of Contents Chapter 5 ...... 6 Chapter Introduction ...... 7 Learning Objectives ...... 7 Leasing or Contracts ...... 8 Ijarah vs Bai’ Contracts ...... 8 Ijarah Structures: Operating Lease ...... 9 Ijarah Structures: Financial Lease ...... 10 Two More Types of Ijarah Structures ...... 12 Issues in Ijarah Contracts ...... 13 Modern Mode of Leasing ...... 15 Conventional vs Islamic Leasing ...... 17 Sale After Ijarah ...... 17 Ijarah Muntahia-bi-Tamleek ...... 18 Issues in Modern Ijarah Contracts ...... 19 The Concept of Ijarah ...... 21 Deferred Delivery or Salam Contracts ...... 21 Essential Elements of a Salam Contract...... 21 Application of Salam Contracts ...... 23 The Istisna‘a Contract ...... 24 The Istijrar Contract ...... 25 Chapter Summary ...... 25 Key Terms ...... 26 Chapter 6 ...... 29 Chapter Introduction ...... 30 Learning Objectives ...... 30 Shirkah and its Two Categories ...... 30 The Concept of Mudarabah ...... 31 Raising Capital for Mudarabah ...... 31 Types and Conditions of a Mudarabah Contract ...... 31 Profit and Loss Under Mudarabah ...... 32 The Concept of Musharakah ...... 33 Capital Under Musharakah ...... 34 Profit and Loss Under Musharakah ...... 35 Comparison of Musharakah and Mudarabah ...... 36 Mudarabah and Musharakah ...... 37 The Wadiah Wad Dhamanah Deposit ...... 38 The Qard-ul-Hasan Deposit ...... 39 The Concept of Wakalah (Agency) ...... 39 The Concept of a Tawarruq Contract ...... 41 The Concept of a Ju’alah Contract ...... 42 Chapter Summary ...... 43 Key Terms ...... 43 Chapter 7 ...... 45 Chapter Introduction ...... 46 Functions of Financial Intermediaries ...... 47 Intermediation Contracts Permitted by the Sharī‘ah ...... 47 Historical vs. Modern Mudarabah ...... 49 Trust-based Intermediation Contracts ...... 50 Security-Based Intermediation Contracts ...... 51 Business Models for Islamic Financial Institutions (IFIs) ...... 52 The Two-windows Business Model In the two-windows business model, liabilities and assets of the bank balance sheet are divided into two windows...... 52 Risks and Mitigation ...... 53 Conceptual Balance Sheet of an IFI ...... 53 The Types of Investment Accounts at an IFI ...... 53 Investment Choices for an IFI ...... 54 Categories of IFIs ...... 55 Chapter Summary ...... 56 Key Terms ...... 57 Chapter 8 ...... 59 Chapter Introduction ...... 60 A Based on Bai’ al-Einah ...... 61 Controversial Aspects of Bai’ al-Dayn ...... 63 Tawarruq ...... 63 Issues in Managing Tawarruq Products ...... 64 Letter of Credit Under Wakalah ...... 64 Letter of Guarantee Under Kafala ...... 65 Other Fee-based Services ...... 66 Key Terms ...... 67

Chapter 5

Chapter Introduction

Hello and A Framework for the Islamic Financial System-Part 3.

You learnt about the exchange and sale contracts such as and Musharakah in the chapter A Framework for the Islamic Financial System-Part 2.

In this chapter, you will learn about more types of contracts that the Sharī‘ah permits. These contracts are used for sale of the rights to an asset under various conditions. The contracts include Ijarah or leasing, Ijarah Muntahia-bi-Tamleek, Ijarah Sukuk, Salam, Istisna‘a and Istijrar.

Learning Objectives

On completing this lesson, you will be able to:

 Explain the concept of an Ijarah contract.

 Distinguish between Ijarah and Bai‘ Mu’ajjal contracts.

 Describe the various structures of an Ijarah contract.

 Explain the various issues that need to be managed for Ijarah contracts.

 Describe the types of modern Ijarah contracts.

 Distinguish between conventional and Islamic leasing contracts.

 Explain why the sale of an asset after the expiry of the Ijarah contract is compliant with the Sharī‘ah.

 Describe the process of the Ijarah Muntahia-bi-Tamleek arrangement.

 Explain the issues that need to be managed when executing modern Ijarah contracts.

 Describe the concept of Ijarah Sukuk.

 Recognise the potential of Ijarah contracts in financing medium and long term economic investments.

 Describe the structure of a Salam contract.

 Identify the essential elements of a Salam contract.

 Identify the conditions for and a special application of valid Salam contracts.

 Describe the structure, application, and risks of an Istisna‘a contract.

 Describe the structure of an Istijrar contract. Leasing or Ijarah Contracts

Ijarah means leasing or hiring of a physical asset. It has two parties:

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

 The Mustajir (lessee), the bank’s client who is in need of the assets.

By paying a predetermined rent (Ujrah) for a specified time, the lessee receives known usufruct, that is, the benefits associated with the ownership of the assets. This is the essence of an Ijarah contract.

The subject matter of Ijarah can be divided into two types:

 Property or assets whose usufruct is transferred to another person in exchange for rent. Example: Houses, vehicles, and residences.

 Labour involving employment of a person for a wage. Example: Work of an engineer, doctor, tailor, and carpenter.

According to the Majallah code, a third type is leasing animals.

The lessor, as owner of the asset, must bear the expenses and risks that are related to ownership.

The consideration of lease is Ujrah (rent or hire of things) or Ajr (wages in hiring of people). Rent or wage agreed in the contract is called Ajr al-Musammah. When decided by a judge or arbitrator, it is called Ajr al-Mithl.

Ijarah vs Bai’ Contracts

Both Ijarah and Bai’ or sale contracts involve the transfer of something to another party for a valuable consideration. However, there are a few differences between Ijarah and Bai’.

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

Bai’

After executing the sale, the purchaser:

 Becomes the owner of the property

 Assumes the risk and rewards of ownership.

Ijarah

The lessor remains the owner of the property; only the usufruct or right to use the property is transferred to the lessee. The Ijarah ceases to be in force if the lessee inherits or is gifted the property. Bai’

The transfer of ownership is definite and immediately after the sale is executed.

Ijarah

Ijarah is time bound, that is, the lease has to terminate at some time.

Ijarah Structures: Operating Lease

Among the seven financing structures of Ijarah, in the first three structures, the ownership of the asset remains with the bank. This concept is known as an operating lease.

In this structure, the bank owns the asset and leases it out to its client against predetermined rentals for an agreed period. This structure:  Adheres entirely to the features of the classical Ijarah.  Is the least popular structure.

Steps: 1. The client approaches bank, which is also the vendor, identifies the asset, and collects relevant information, including rent. 2. The bank leases out the asset to client, permitting the client to possess and use the asset. 3. The client pays pre-determined rentals over a fixed period. 4. At the end of the period, the asset is returned to the bank. This structure, which consists of two phases, involves a vendor.  Phase One: The bank purchases the asset needed by its client from the vendor.

 Phase Two: The bank leases out the asset to its client against a predetermined rent for a specified period.

Steps: 1. The client approaches a vendor or supplier of the asset and collects all relevant information. 2. The client approaches the bank for Ijarah of the asset and assures the bank of leasing the asset from it once purchased. 3. The bank pays the vendor. 4. The vendor transfers ownership of asset to the bank. 5. The bank leases the asset and transfers possession and right of specified use to the client. 6. The client pays pre-determined rentals over a fixed period of time. 7. At the end of the period, the asset is returned to the bank. In this structure, the bank does not deal directly with the vendor. It appoints the client as its agent. This structure has two stages and correspondingly two relationships between the bank and the client. First Stage:

 The client is an agent of the bank and buys the asset on behalf of the bank.

 The client will only carry out the functions of an agent.

Second Stage:

 This begins when the client takes delivery from the supplier.  The bank is the lessor and the client is the lessee.  From the date of delivery of the asset, the client is liable to discharge his obligations as a lessee. Steps: 1. A mutual agreement is signed between the bank and client, in which the bank promises to lease and the client promises to take the asset on lease against predetermined rent for a specific period. 2. The bank appoints the client as its agent. 3. The client identifies the vendor, selects the asset on behalf of the bank and informs the bank of its particulars in writing. These include the vendor's name and its purchase price to the bank. 4. The vendor makes physical delivery of asset to the agent (client) of bank; trained staff from bank supervises this process. 5. The bank arranges payment to the vendor. 6. The agency contract comes to an end. The bank leases the asset and transfers possession and right of specified use to the client. 7. The client pays pre-determined rentals over a fixed period of time. 8. The asset is returned to the bank.

Ijarah Structures: Financial Lease

What happens if the asset has been built to specification?

It’s extremely difficult for the bank to find a second client willing to take such an asset on lease or even buy it.

Financial leases help a bank avoid such scenarios.

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

1. If the Ijarah period is the same as or close to the economic life of the asset, there would be very little residual value in the asset. The bank may therefore gift the asset to the client without any mutual consideration or even abandon the asset. The gift contract is independent of the Ijarah contract. 2. When there is a significant residual value at end of the Ijarah period, the bank may sell the asset to the client at a predetermined price. This arrangement is called lease-sale or Al-Ijarah-Thummal-Bai’ (AITAB). The sale contract is independent of the Ijarah contract. The bank may even gift the asset to its client.

Under both structures, the asset would continue to remain with the client. These are called “financial lease” structures.

This structure involves an independent promise by the bank to gift or sell the asset at the end of the lease period to the client at a predetermined price.

This deal works out for the client as the asset meets a specialised need of the client or because the price is below market price.

Steps:

1. An agreement is signed between the bank and the client where the bank promises to lease the asset and the client promises to take the asset on lease against predetermined rent for a specific period. 2. The bank appoints the client as its agent. 3. The client identifies the vendor, selects the asset on behalf of the bank and informs the bank of its particulars in writing. These include the vendor's name and its purchase price. 4. The vendor makes physical delivery of asset to the agent (client) of bank; trained staff from bank supervises this process. 5. The bank arranges payment to the vendor. 6. The agency contract ends. The bank leases the asset and transfers possession and right of specified use to the client. 7. The client pays pre-determined rentals over a fixed period. 8. The bank transfers ownership of asset to client at the end of Ijarah period either through a gift or through sale.

Click the Resources button at the top of the screen to see a case study of how a leading UAE bank has financed property through such an Ijarah structure. Another method of Ijarah that ends in transfer of ownership to the client is Ijarah with partnership (based on Musharakah or Mudarabah). It is quite common in equipment and housing finance. Steps:

1. The bank forms a partnership with the client based on Musharakah; the bank is the agent-manager of the partnership and undertakes subsequent activities in this capacity. 2. The bank purchases the property on behalf of the Musharakah. 3. The property is taken on lease by the client and generates rental income for the bank over a period. 4. The bank allocates the rentals between both parties; one portion goes back to the bank as its share in rental income. Another portion, which is the share of the client in rental income, is used to redeem part of the bank’s stake in partnership. The bank transfers ownership of asset to the client when its stake is reduced to zero. Two More Types of Ijarah Structures

There are two more types of Ijarah financing structures.

Let’s look at each of them.

Consider a situation in which a client needs to invest in a large plant and machinery. The finances required may be too huge for one bank to handle. Therefore, the bank may enter into a co-Ijarah or a leveraged transaction with itself as Manager or Lead-Lessor. Ijarah can be leveraged by using in the total financing. The bank forms a Special Purpose Vehicle (SPV) or a master Ijarah agreement. Debt may be provided through Murabaha and Ijarah for specific components of the “pool of assets” under the master Ijarah agreement. Sub- Ijarah or Ijarah of a leased asset is allowed if it is provided in the Ijarah or if permission is obtained from the lessor. The rent of the two Ijarahs can be different. Additionally, a lessor can sell some or all of the leased assets to a third person whereby the new party takes on the role of the lessor. The total inflow of cash to the SPV is distributed among the co-lessors or investors according to the proportion of their shares in the leased assets. The bank or the lead-lessor may charge the other co-lessors or investors a management fee, which is deducted before the rentals are distributed. Steps: 1. The SPV or a master Ijarah agreement invites other financial institutions to contribute equity to the pool of capital required to finance the assets. This is done through modes that are permitted by like Musharakah or Mudarabah. 2. The SPV buys the asset. 3. The SPV leases the asset and transfers possession and right of specified use to the client; the client pays known rentals over a fixed period of time. 4. The bank charges a management fee and a pro-rata share in rental. 5. The bank shares the balance with all parties as per agreement. 6. The bank retains pro-rata share in residual value. 7. The bank shares the balance with all parties as per agreement. In the structure of a sale-and-lease-back, the client continues to use the asset in lieu of periodic Ijarah rentals paid to the bank, which now owns the asset.

Steps:

1. The client sells an asset it owns to bank on cash basis; while the ownership papers are transferred to the bank, possession of the asset remains with the client. 2. The client enters into an Ijarah contract with bank for the same asset. 3. The client pays fixed rent over fixed period of time. 4. The bank transfers ownership of asset to client at the end of Ijarah period either through gift or sale.

Issues in Ijarah Contracts

There are seven issues that need to be managed for Ijarah contracts.

These relate to:

 Execution of Contract

 Determination of Rent

 Sublease by Lessee

 Security and Liabilities

 Default Risk

 Termination

Based on the nature of the asset, an Ijarah contract can be:

 Executed before or after the lessor possesses the asset.  Enforced or commenced instantly or in the future.

Future enforcement is permissible, if:

 The asset to be leased exists.

 The lessor continues to own the asset and takes on the risk of damage to the asset.

 The nature or quality of the asset is specified and destruction or damage to a particular unit of the asset does not terminate the contract.

If a particular asset is specified for Ijarah, a lease contract cannot be executed before:

 The asset comes into existence.

 Owning the asset or its usufruct in the case of sub-lease.

The following guidelines apply.  If both parties agree and other conditions are met, the Sharī‘ah permits them to decide the rental based on aggregate cost of the purchase, construction, or installation of the asset.

 The price, leasing rate, or rental must be determined at the time of contracting for the whole period of Ijarah.

 The Ijarah period can be split into smaller intervals with floating but predetermined rates.

Criteria to modify the periodic rate:

 A well-defined and variable benchmark such as LIBOR  A macroeconomic rate such as a Consumer Price Index (CPI)

 A specified percentage

 The increase or decrease in tax

 The rate of inflation

Click the Resources button at the top of the screen to see a case study of an equipment finance product developed by Leading US-based NBFI.

The following guidelines apply.

 The Sharī‘ah permits sub-lease by the lessee only if the lessor permits and it is provided in the lease agreement.

 The Sharī‘ah does not object if the rent from the sub-lessee is equal to or less than the rent payable to the owner/original lessor.

 There are different perspectives among Islamic jurists if the rent charged from the sub-lessee is higher than the rent payable to the owner.

Sub-leasing is not allowed under these situations, the last two effectively being Ribâ-based transactions:

 There are a number of sub-lessees.

 The sub-lessor invites others to share the rentals without transferring partial ownership.

 The sub-lessor charges a fee to partners for sharing the rentals.

The following guidelines apply because a leased asset is considered to be in Amanah.  The lessee is a trustee and has a fiduciary responsibility to protect the asset.

 The lessor can ask the lessee to guarantee against damage to the asset and demand some form of security.

The following principles apply because lease rent is a form of debt.

 If there is damage or if the lessee defaults on rent, the lessor can recover the costs from the security, excluding the opportunity cost.

If any amount exceeding such costs is also collected, the lessor is indulging in Ribâ.

Gharar in Ijarah occurs in the following situations:  A sale contract is added to the original Ijarah contract.  Options are stipulated in the Ijarah contract make the contract complex.

 A forward sale contract such as the AITAB mechanism, which involves a mutual promise by the bank to sell and by its client to buy in future.

 Gharar in Ijarah does not occur if the sale, gift, or option (promise) is executed through a distinct agreement not linked to the Ijarah agreement.

The following guidelines apply for managing risk of default by the lessee.  Any charge by the bank for default by the lessee is a form of Ribâ.  To deter exploitation by lessees, jurists allow the lessor to include a clause in the Ijarah agreement asking for a formula-based donation to a charity operated by the lessor in case of default.  Where the lessee defaults deliberately, the lessor can recover its dues by taking possession of the leased asset or enforcing the collateral. The following guidelines apply for termination of an Ijarah contract.  The Ijarah cannot be terminated without mutual consent, except if the lessee breaks any term of an Ijarah agreement.  Under the framework of al-Khiyar, Ijarah allows either or both the parties to confirm or rescind the contract within a specified period.  Unlike in conventional leases, the lessee only needs to pay the rent due when the contract is terminated.  If the lessor terminates the lease due to misuse or negligence by the lessee, the lessor can ask for compensation. Contracts may be terminated for any of the following reasons:  If the asset is damaged such that it’s no longer useful  If the objective of the lease cannot be achieved  If the asset is sold to the lessee

 If heirs to the lessee can no longer pay the rent after the demise of the lessee

Modern Mode of Leasing

Islamic Financial Institutions (IFIs) see a lot of opportunity in leasing because of its benefits and the asset-based nature of investments in Islamic finance. For IFIs, Ijarah operations can be conducted only by rules prescribed in text.

The three types of leasing contracts in modern Islamic finance are financial lease, security lease and operational lease.

Financial lease is also called hire-purchase. In conventional financial lease:

 The lease period is such that the lessor can recover the cost of the asset and earn a market-based return on its capital.

 The or NBFIs pay the supplier, either directly or through the lessee.  The monthly rent is the total purchase cost plus interest divided by the lease period.

 Rents begin on the day on which the price is paid by the lessor.

 The lessee bears all the risks of ownership.

Termination:

 Lease cannot be terminated before the expiry of the lease period without mutual consent.

 The lessee is allowed to purchase the asset before the lease is terminated.

 The lessor charges an extra amount for prior termination because the sale discontinues their regular income.

 If the lessee defaults, the lessor can take possession of the asset without a court order.

 The lessor can also sell the asset to a third party to raise cash in an emergency, provided the rental payments accrue to the new buyer.

Conventional financial leases exploit the need of the lessee, who can end up paying far more than outright purchase on instalments.

Security lease is also known as financing lease. Effectively, it is:  A financing transaction.

 A security for the amount advanced.

 A mode of transferring all risks and rewards associated with ownership to the lessee.

In an operational lease, the owner:  Transfers only possession of the asset to the lessee in return for rental.

 Retains ownership and takes back the asset when the lease ends.

The Sharī‘ah permits this transaction subject to other conditions being met. Operational lease is best for acquiring the use of assets that take a very long time to manufacture and require large amounts of money for purchase. More NBFIs than banks use this mode. They can:  Lease a number of assets to meet the needs of different customers.

 Re-lease the assets once a lease expires.

However, they have to bear the risk of obsolescence, recession or diminishing demand Conventional vs Islamic Leasing

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

In conventional leasing, once the leasing contract expires, the lessee becomes the owner of the leased good. This is done without additional charge or at a nominal price. In Ijarah hire–purchase, both parties must agree from the beginning that:  The Ijarah contract also includes sale of the asset.  The amounts the lessee must pay periodically include rent and the cost of the asset. In Ijarah finance lease, the amount the lessee must pay periodically is the rental.

However, the parties may not agree at the beginning of the contract that the lessee will become the owner when the contract terminates normally.

In conventional leasing, the lessor:

 Charges rental from the date funds are transferred to the supplier of the asset.  Leases an asset before buying it and gaining possession.

The Sharī‘ah forbids such risk-less reward. It allows the lessor to charge rent only after it has taken delivery of the asset, thereby assuming risk of ownership.

Conventional and Islamic leases differ primarily the way expenses are allocated.

In conventional leasing, the lessor transfers all the risks to the lessee, especially when the lease contract also specifies the residual value of the asset.

The Sharī‘ah stipulates that:

 The lessor must incur all expenses to rectify the defects that prevent the lessee from using the equipment.  The lessee must incur daily maintenance and operational expenses.

In conventional operating leases, the lessee bears all the risks and expenses. In Islamic operating leases:

 The lessor must maintain the asset and bear all the risks and costs of ownership.  The lease period is different from the useful life of the leased asset and must be mutually renewed.

Sale After Ijarah

In both cash and credit sale, the buyer becomes the owner of the asset immediately after the sale. In Ijarah, the lessor continues to be the owner. The parties in an Ijarah cannot execute a sale contract effective from a future date to transfer ownership. However, the lessor can separately and unilaterally promise to sell the asset when the lease terminates normally. The lessee is not obliged to purchase even if the lessor promises to sell. A bilateral promise to sell and buy the asset is forbidden because such a promise is essentially a contract, making the Ijarah a two-in-one contract.

Similarly, instead of sale, the lessor can separately and unilaterally promise to gift the asset to the lessee at the end of the lease period. Since the periodic amount paid by the lessee usually covers the rent and a profit for the lessor, the lessee has the right to own the asset at the end of the lease. Islamic scholars recommend gifting the asset as the best way to transfer ownership since the cost has already been paid for. This arrangement is called Ijarah Muntahia-bi-Tamleek.

Note that Ijarah Muntahia-bi-Tamleek does not violate Sharī‘ah rules due to the following reasons.

 The lessor fixes the periodic payment such that the cost and rent are received during the lease period.

 It comprises an Ijarah contract, which is immediately effective, and a unilateral promise to sell or gift the asset, not a contract to sell and buy at the end of the lease period.

This arrangement does no injustice to either party. It does not involve Ribâ or any disputable element. For the lessee, it is only justified that they own the asset since they have already paid the cost in addition to the rental.

Ijarah Muntahia-bi-Tamleek

In Ijarah Muntahia-bi-Tamleek, the leasing contract is the real and major contract. It is subject to all the Sharī‘ah rules of an ordinary Ijarah contract. Standard Sharī‘ah principles such as defining the asset to be leased, its terms and essential prerequisites of contracts have to be adhered to. The five-step process that Islamic banks usually adopt is described on this screen.

The client conveys the requirement to the bank and enters into a MoU. The bank asks for a promise of purchase from the lessee along with an amount called Hamish Jiddiyah to ensure that the client fulfils the promise.

Acting as a trustee for the amount, the bank can:

 Invest it on the basis of Mudarabah.

 Invest it as a PLS deposit in the name of the client.

 Consider it as an advance payment of rental.

If the bank uses the money in its business, it becomes the bank’s liability. The bank can purchase the asset directly or through an agent, who can be the bank’s client itself. The client raises a letter of credit from the bank and places the order with the supplier. The bank reimburses all duties and taxes plus transportation and other charges levied by port authorities.

If the client also specifies the supplier of the asset, the bank can get a bond from the client to the effect that the client will accept the asset when supplied. The bank, however, will take the risk and expenses of ownership.

Unlike a Murabaha sale, the bank need not first take possession of the asset and then deliver it to the lessee. Unlike an MPO, the lease can start from the date the client receives the asset as an agent of the bank.

The bank and client can create a Shirkatulmilk partnership (joint ownership) to purchase the asset. The bank can then lease its share to the client on the principle of Diminishing Musharakah. The rental should be in proportion to the bank’s share in the ownership. If the client periodically purchases any part of the bank’s share, the rental decrease proportionally.

When the bank buys the asset and takes possession or the client-agent takes possession, the formal lease agreement is executed. Rent accrues to the bank from this point provided the asset is completely installed and ready for use. Rent accrues even if there is any delay in using the asset by the lessee due to a problem at their end.

If the client defaults on rents, the bank can ask it to speed up payment for the rest of the period, provided the agreement allows such a demand. Effectively, this means the bank is terminating the lease ahead of the lease period. The bank can then take back the asset or the lessee can be made to purchase the asset, but only the due rent can be deducted from sale value.

In addition, the lessor cannot earn income from penalties on rent defaults, therefore any penalty has to be donated to charity.

Issues in Modern Ijarah Contracts

Islamic With respect to modern leasing operations, Islamic banks face four sets of issues.

These issues relate to:

1. Ownership Risk 2. Timing the Ijarah Contract 3. Cancellation of Lease 4. Return for the Bank

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

1. Risk cannot be separated from ownership. 2. Lease and sale are contracts of different natures.

According to the Sharī‘ah principles for an Ijarah:  The lessor must spend for large scale repair of damaged assets since any repairs benefit the lessor as the owner.

 The lessee is responsible only for normal operating maintenance.

 When the lessee is an agent of the lessor, the lessor is responsible for any damage to the asset when it is supplied, unless the agent’s fault can be proved. If not, then the lessor must adjust the rent or expand the lease period to compensate the lessee for the period the asset cannot be used.

Any clause in the contract seeking to transfer the ownership-related costs to the lessee is forbidden. In case of delayed delivery of the asset to the lessee, the lessor cannot charge any rent for the period between the execution of the Ijarah agreement and the date of delivery of the asset. To avoid such loss of rent,, the bank should only sign a promise to lease when the funds are disbursed to the supplier. The actual Ijarah agreement can be signed only when the asset is delivered. Rent can be calculated to cover the date difference between disbursal of funds and asset delivery.

Sometimes the usufruct, which may be inherently risky, is less than expected due to any events beyond the control of the lessee. In such a case, the Sharī‘ah allows termination of the lease. For example, if a crop grown on leased land fails due to natural calamity, then the Ijarah on the leased land becomes invalid, and the lessee must receive a normal wage as an employee.

During purchase of assets, because the bank is the owner, it is:

 Required to pay all expenses incurred in the process of purchase.  Entitled to any discounts provided by the supplier of the asset.

The bank may calculate rent to cover for such expenses. However, the return on the asset is not really fixed. For example, the cost of repair may be higher than any claim settled by the insurance company.

You will learn more about the Takaful insurance framework from a conceptual perspective in Chapter 9 of this course, The Islamic Takaful System-Part 1, and from a product perspective also in Chapter 10, The Islamic Takaful System-Part 2.

The Concept of Ijarah Sukuk

According to the Sharī‘ah’s guidelines for an Ijarah contract:

 The lessor can sell the asset to a third party together with its rights and obligations.  If the lessor doesn’t transfer the ownership and only assigns rental to the third party, the lessor cannot charge money for this right.  The new party to whom the lessor sells the asset gains the same rights as the old lessor but also carries all the old lessor’s liabilities.

But what if the lessor sells the asset to multiple investors in different ratios?

Then, the lessor must grant leasing certificates to each investor called Ijarah Sukuk that show the proportional purchase of the asset. Each investor owns the asset to that extent and takes on the risk of ownership and maintenance to that extent.

Ijarah Sukuk issues can be used to finance large corporate and government infrastructure projects. Ijarah Sukuk also helps IFIs in managing liquidity better.

The Sukuk process is briefly illustrated on screen. You will learn in detail about in Chapter 12 of this course, Islamic Investment Funds.

Deferred Delivery or Salam Contracts

Bai‘Salam or deferred delivery is a forward contract wherein the price is paid in advance at the time of signing the contract, but the goods are delivered later.

Unlike Murabaha and Ijarah, Salam or Salaf was originally intended to finance small farmers and traders.

Under a Salam agreement:

1. A client in need of short-term funds sells merchandise to the bank on a deferred delivery basis. The date of delivery is agreed at this time. It receives full price for the merchandise on the spot.

2. At the pre-agreed date, the client delivers the merchandise to the bank.

The bank sells the merchandise in the market at the prevailing price. It can expect to make a profit because the spot price that it pays can be pegged lower than expected market price.

Essential Elements of a Salam Contract

The six elements required for a valid Salam contract are:

 Subject Matter

 Means of Payment  Period and Place of Delivery

 Khiyar or Options

 Conditions for Amending/Revoking the Salam Contract

 Penalty for Non-Performance

The following comprise the subject matter of Salam:

 All goods that are quantifiable and can be qualitatively described

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

 Fungible (Mithli) and similar goods

 Non-identical goods

 Standardised and available goods

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

The following types are not permitted:

 Goods that may not yield any produce  Goods that are prone to subjective evaluation  Paper currency The following are permitted as means of payment.  Legal tender

 Goods in barter, if Ribâ is avoided

 Usufruct of assets

The following are not permitted as means of payment.

 Outstanding on the seller or on a third party

 Payment delayed beyond three days as specified in the agreement and definitely not after delivery

 Partial payment

 In barter, advance payment in the form of the same species of goods in exchange of deferred delivery of similar goods

Payment can be credited to a seller’s account.

The following principles apply for delivery of goods.  It is important to fix the time and place of delivery of goods.

 The nature of the goods decides the due date and delivery mode.  If a place of delivery is not specified in the agreement, then the place where the contract was finalised will be regarded as the place of delivery.

 Goods are a responsibility of the seller before the delivery and of the buyer after the delivery.

The Islamic law of option (Khiyar al-Shart) is not permitted in Bai‘ Salam as it upsets or delays a seller’s ownership over the price of the goods. A buyer:  Does not have the “option of seeing” (Khiyar al-Ro’yat).

 Has the “option of defect” (Khiyar al-‘Aib) and the option of specified quality, This means that a buyer can withdraw the sale if goods are found to be defective or fails to match the quality as agreed at the time of contract.

 Can only recover the price already paid for the goods, nothing more.

A seller must deliver the goods as specified in the agreement. The following principles apply regarding amendment or revocation of the contract.  A buyer cannot independently change any conditions of the contract once the seller has been paid.

 Both parties have the right to withdraw the contract with mutual consent with the buyer entitled to recover only the amount already paid.

 If the market price of the goods seems higher at the time of delivery than what a buyer has paid, a seller may want to withdraw the contract.

 A bank may want to withdraw from purchase if the price of the item decreases at the time of delivery.

To avoid such scenarios, it is advisable to make the contract binding on both the parties, except if the goods are absent from the market or are inaccessible to the seller at the time of delivery. Guidelines regarding the seller’s inability to deliver include the following.  A seller may voluntarily agree in the contract to donate to the Charity Account, held by the bank, in case of a delay in delivery.

 If a seller fails due to bankruptcy, banks cannot penalise but may grant additional time, according to Clause 5/7 of the AAOIFI’s Salam Standard.

Application of Salam Contracts

Application of Salam in Pre-Shipment Export Finance

 The bank receives an export letter of credit (LoC) in favour of its client for certain goods. This allows the bank to act as a seller towards the foreign buyer.  The bank agrees to buy the goods from its client under a Salam contract and makes advance payment to the client. The delivery date should be reasonably after the shipping date, and the port of delivery should be the same mentioned in the LoC.

 Once the client submits the in-order shipping documents such as bill of lading or certificate of origin, delivery is deemed to be satisfactory.

 The bank’s profit is the difference between the agreed payment (pre-shipment finance) made by the bank to its client and the amount of the export LoC.

The Istisna‘a Contract

Under Istisna‘a, the seller undertakes to develop or manufacture a commodity for an agreed price and deliver after an agreed period. In Istisna‘a, nothing is exchanged at the time of contracting.

The seller and the manufacturer can be different, which opens an opportunity for Islamic banks to take on the role of a seller and get the goods manufactured from another party. It signs two Istisna‘a agreements, one with the buyer and the other with the manufacturer.

Under an Istisna‘a agreement:

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

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

3. The manufacturer develops the asset and receives periodic payments from the bank at different stages of manufacturing.

4. At a pre-agreed date, the manufacturer delivers the asset to the bank.

5. The bank delivers the asset to the client.

6. The client pays in full or in parts over the agreed period of time.

A big risk under Istisna‘a includes construction-related risks and risk of nonconformity to specifications.

To mitigate this, the bank can include a penalty clause in the agreement and designate its client as an agent or a surveyor to oversee satisfactory completion of the job.

Another type of risk under Istisna‘a is default and delinquencies risk. To protect itself against such outcomes, the bank can take a legal charge on the land, giving it the right to repossess the land. However, this is not a mortgage, which is the risk mitigation product for banks in conventional finance. It can also ask for a third party guarantee. The Istijrar Contract

Under Istijrar, the purchaser buys different quantities of a commodity from a single seller over a period. As Istijrar involves repeat purchases from a single seller, the Sharī‘ah permits flexible pricing and payment although the price may be determined in advance. This is subject to the absence of Gharar. The price may be paid at a future date and may be based on a normal price or the average market price.

A master agreement in Istisjrar is signed for financing on an ongoing basis under appropriate normal modes. However, any formal or informal Murabaha or Salam contracts are operative, their conditions and the Sharī‘ah essentials have to be fulfilled.

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

Chapter Summary

You have completed the chapter, A Framework for the Islamic Financial System – Part 3. The key points of this chapter are as follows:

 Ijarah is a contract means leasing or hiring of a physical asset. The bank and the client are its two parties.

 In a Bai’, the ownership of the property is transferred to the purchaser, whereas, in Ijarah, the property remains in the ownership of the lessor, and only its usufruct, i.e. the right to use it, is transferred to the lessee against an agreed consideration.

 Ijarah has seven financing structures.

 Execution of contract, determination of rent, sublease by lessee, security and liabilities, Gharar in Ijarah, default risk and termination of Ijarah are the seven issues that need to be managed for Ijarah contracts.

 Leasing operations by banks and financial institutions are governed by rules prescribed in Fiqh for Ijarah transactions. Financial lease, security lease and operational lease are the three types of leasing contracts.

 Transfer of ownership, rental, responsibility of expense and operating lease are the four key differences between conventional and Islamic leasing.

 In Ijarah, ownership remains with the lessor. Transfer of the ownership in the leased property cannot be made by executing a sale contract that will become effective on a future date. In addition to the rental, the lessee pays a sum, which goes toward buying the leased property. Upon making full payment along with rental, the ownership will transfer to him.

 In Ijarah Muntahia-bi-Tamleek, leasing is the real and major contract. Receiving Hamish Jiddiyah, purchasing the asset, creating partnership of ownership, formal lease agreement and managing defaults in payment are the five steps taken to conduct Ijarah Muntahia-bi-Tamleek.

 Burden of assets, lack of knowledge on Ijarah, damage to the asset, cancellation of lease, default in payment, no fixed return to bank, are the six issues Islamic banks face in the leasing business.

 Ijarah Sukuk is a means of raising funds by selling an asset proportionally to several investors. Each of these receives a leasing certificate showing their proportion of the asset.

 Ijarah is the most important mode for financing operations of Islamic banks for meeting the needs of the retail, corporate and public sectors. It is used directly for plant and machinery, automobiles, housing and consumer durables and indirectly for Sukuk issues by the corporate and government sectors.

 Bai‘ Salam or deferred delivery is a forward contract wherein the price was paid in advance at the time of making the contract for the prescribed goods to be delivered later.

 The six conditions required for a valid Salam contract are subject matter of Salam, payment of price, period and place of delivery, Khiyar in Salam, amending or revoking the Salam contract and penalty for non-performance.

 For the Salam to function smoothly, it is important that the commodity is freely available and tradable in the market. Its scope includes industrial and agricultural products and services.

 Under Istisna‘a, the seller undertakes to develop or manufacture a commodity for an agreed price and deliver after an agreed period. The unique feature of Istisna‘a is that nothing is exchanged at the time of contracting.

 Under Istijrar, the buyer purchases different quantities of a commodity from a single seller over a period, with flexibility in fixation and payment of price.

Key Terms

Ajir

Ajr al-Musammah or Ajr al-Mithl

Amanah

Al-Ijarah-Thummal-Bai’ (AITAB)

Bai’ Bithaman Ajil or BBA

Bai’ al-‘Inah

Bai‘Mu’ajjal Bai‘ al-Sarf

Bai‘Salam

Fiqh

Fulus

Gharar

Hamish Jiddiyah

Hawalah

Ijarah

Ijarah Muntahia-bi-Tamleek

Ijarah Sukuk

Istisna’a

Istijrar

Khiyar

Khiyar al-‘Aib

Khiyar al-Ro’yat

Khiyar al-Shart

Khiyar al-Wasf

Mabi‘

Majallah

Majhul

Mithli

Mudarabah

Mudarib

Murabaha

Murabaha to Purchase Orderer (MPO)

Musawamah Musharakah

Mustajir

Ribâ

Tawarruq

Ujrah

Chapter 6

Chapter Introduction

Hello and A Framework for the Islamic Financial System - Part 4.

As you have learned in other chapters, in Islamic finance, willingness to share the risk to share profits is most important. Shirkah-based businesses are therefore a common mode. The basic principle underlying Shirkah is that a person who shares in profits must also bear the risks. Shirkah-based contracts include Mudarabah, Musharakah and Diminishing Mudarabah.

Learning Objectives

At the end of this chapter, you will be able to:

 Explain the concept of Shirkah and its two main categories.  Explain the concept of a Mudarabah contract.  Identify the restrictions on capital invested in a Mudarabah contract.  Identify the types of Mudarabah and the conditions of a Mudarabah contract.  Identify the rules relating to distribution of profit or loss under a Mudarabah contract.  Explain the concept of a Musharakah contract.  Explain the rules for capital being invested in a Musharakah contract.  Identify the rules relating to distribution of profit or loss under a Musharakah contract.  Distinguish between a Musharakah and a Mudarabah contract.  Explain the working of a Mudarabah and Musharakah or Mudarabah with Musharakah contract.  Explain the concept of a Wadiah wad Dhamanah deposit.  Explain the concept of a Qard-ul-Hasan deposit.  Explain the concept of Wakalah or agency.  Explain the concept of a Tawarruq contract.  Explain the concept of a Ju’alah contract.

Shirkah and its Two Categories

Shirkah is proportionate ownership between two or more people who combine their wealth to establish a business firm and decide to share their profits and losses. Shirkah categories:

 Shirkatulmilk  Shirkatul‘aqd

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

Freewill or Optional ownership: A and B jointly receive a gift or bequest, or they jointly purchase an article. Compulsive ownership: A and B inherit a property or their capital becomes indivisible without their action.

In this type of ownership,

 A and B are indebted to each other.  A cannot avail benefits from B’s property without permission.

This partnership is bound by a contract. It can be categorised into:

 Shirkatulamwal: Each partner contributes capital.  Shirkatula‘mal: Each partner contributes services.  Shirkatulwujooh: Each partner trades commodities independently in the market.

The Concept of Mudarabah

Mudarabah is a type of Shirkah in which:

 One partner or group of partners provides capital to an agent or manager called Mudarib for investment in a business venture.

 The profit and loss from the venture is shared among the partners in an agreed ratio.

 If there is a profit, the Mudarib is paid for the effort invested in running the venture. If there is a loss, the Mudarib loses the remuneration.

Click the Resources button at the top of the screen to view the finance flow in a Mudarabah contract in which the bank’s client is a Mudarib.

Raising Capital for Mudarabah Five restrictions imposed by Islamic law on Mudarabah capital are listed below.

 Mudarabah capital should be in the form of only legal tender money, not commodities.  Mudarabah capital should be free from debt and liabilities.  For profit-sharing with the Mudarib, an investor cannot: o Give two different amounts of capital to the Mudarib on unequal terms of profit- sharing. o Cite different periods. o Use different transactions.

Types and Conditions of a Mudarabah Contract

Mudarabah business can be restricted or unrestricted but must be according to the customary practice of Mudarabah contracts.

Restricted Mudarabah The Mudarib undertakes a business based on the terms and conditions set by the provider of capital.

Unrestricted Mudarabah The Mudarib can invest funds by own choice.

Mudarabah contracts are therefore conditional or unconditional. Conditions include nature of work, place of work and period of work. Special conditions may also be placed regarding who to do business with and goods in which to do business.

Let’s look at the rights of the Rabbul-māl and the restrictions that the Rabbul-māl can impose on the Mudarib.

Rights of the investor of capital are as follows:

 They can appoint banks as investment agents.  The Rabbul-māl may specify: o The time limit for the contract. o The goods permissible or not permissible for trade. o The place to do business in or places to be avoided. o The entities to avoid relationships with.  The Rabbul-māl may also:  Stop the agent from entering into another Mudarabah with another party.  Require the Mudarib to fulfil their fiduciary responsibilities.  Order the Mudarib to sell goods if the profit at the time is likely to be substantial. The investor can enforce unbiased conditions on a Mudarib only in the interest of the business. The Mudarib cannot:

 Violate the investor’s conditions and restrictions.  Buy goods at more than market price or sell goods at lesser than market price.  Donate funds or waive receivables without the investor’s permission.

Profit and Loss Under Mudarabah

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

Profit-Sharing Ratio

 All parties can mutually decide on the profit-sharing ratio in different scenarios. The ratio can be equal or in different proportions. However, a lump sum amount as profit is not permitted.  The ratio can be changed at any time but is effective for the period agreed upon. If the parties cannot agree on the ratio, the profit is to be distributed according to traditional practice.

Profit-Sharing Period

 If a Mudarabah contract accrues profits, it can be shared among partners after a period treated as closing of accounts. Provisional withdrawal of profit is permitted and must be adjusted during final settlement.

 The Mudarib can claim a share of profit when the business operations of the Mudarabah have realised profit, but this is subject to the interim profits being retained to protect the capital. The Mudarib’s profit accrues only after the Mudarabah is liquidated and investors recover their capital and profit.

Loss-Sharing

Loss can be compensated by the profit of the future business operation or the contingency reserves created in the past.

The Concept of Musharakah

Shirkatulamwal All the partners investing in a business own it in the ratio of their capital. Shirkah al-‘Inan Two entities may invest different amounts of capital or merely act as partners. They are then agents of each other, not as guarantors. Musharakah A general partnership that combines the above two concepts is called a Musharakah partnership. The profits are shared according to an agreed ratio but losses are shared in the ratio of their ownership. A bank and its customer may often enter into a Musharakah agreement. Both parties contribute capital and entrepreneurial expertise.

Let’s see a basic Musharakah financing structure between a bank and its client.

Step 1:

Based on a business plan, the bank and the client decide to jointly contribute to the capital of a joint venture. Step 2:

Once the business venture is set up, the bank and its client manage its operations together, sharing the responsibilities as per pre-signed terms and conditions.

Step 3: Profits are shared as per pre-signed terms and conditions.

Step 4: Losses are shared in proportion to the capital contributed. This effectively reduces the asset value but retains their respective shares.

As in any contract in Islamic finance, a Shirkah-based contract must be free of coercion, misrepresentation, deception and so on. A Musharakah contract is valid if conditions related to the following are fulfilled.

1. Conditions with Respect to Partners

2. Rules Relating to Musharakah Capital

3. Mutual Relationship Among Partners and Musharakah Management Rules 4. Treatment of Profit and Loss

5. Guarantees in Shirkah Contracts

6. Maturity/Termination of Musharakah

Capital Under Musharakah Opinion of Maliki, Hanbali and Shafi‘e Jurists:

In Musharakah, a partner can invest money or prevalent currency or even goods as capital of a venture. Its value should be clear.

Opinion of Hanafi Jurists:

How much a partner has invested need not be known at the time of the contract; it must be known before the business starts. Of course, it cannot be a debt or a nonexistent commodity.

The forms of capital can change according to the ‘Urf of the place.

Opinion of Contemporary Jurists:

They agree that the value of goods should be assessed in monetary terms. Debt cannot become a part of partnership capital until it is received by the investors.

Shirkah rules require that the partners must merge and commingle their capital.

Commingling means the following.

 Individual ownership turns into collective ownership of the joint venture.

 In addition, if the value of Musharakah assets appreciates, the new value represents the rights of all the partners in the ratio of capital investment made by each.

Commingling does not mean capital should be cash, identical goods or transfer of either cash or goods into the partnership capital when the contract is signed.

The merger of capital can be:

 Actual  Constructive, using valuation standards such as market value or money value if the capital is in the form of goods

Profit and Loss Under Musharakah

If the share of partners in capital in a Musharakah business is unequal, the share in profits and losses must also be unequal. However, the share of profit for all partners should be determined clearly.

Imam Ahmad and Imam Abu Hanifa hold that if the ratio of profit is not agreed when the contract is being executed, the contract becomes invalid under the Sharī‘ah.

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

Most Islamic jurists believe that:  The ratio of profit and loss may be different from the ratio of the capital invested by each partner.  The difference can be on the basis of the labour invested by each partner.

Here’s what important Islamic jurists think:  Imams Malik, Shafi‘e and Zufar: Each partner will get profit exactly in the proportion of his investment.  Imam Ahmad and most Hanafi jurists: The ratio of profit may be different the ratio of capital investment, provided all partners freely agree on the ratio.  Imam Abu Hanifa: Profit ratio may differ from investment ratio. However, if a partner is only a dormant partner and will not work for the Musharakah, that partner’s share of the profit cannot be more than the share of invested capital.  Hanbali jurists: Even a sleeping partner may get a bigger share in profit than the share in capital.  All jurists: The profit-share of a partner may be less than the share in capital.

All contemporary jurists believe that:  Profit may be shared differently from the ratio of capital  Loss must be shared exactly according to the ratio of capital invested by the partners.

According to this rule, contracts can:  Specify that profit-shares must relate to the actual profit accrued to the business, not to the amount of capital invested by any partner.  Not define profit as a percentage of the capital or as a fixed sum.  Specify the percentage of profit that each partner will receive.

This rule specifies the profit/loss relationship with labour invested in the following manner.  The partner investing less capital but more labour can get equal or more share in than other partners.  The partner investing equal capital but more labour must get a bigger share of the profit.  Loss must be shared exactly according to the share of the capital, regardless of who works more.

This rule indicates the following treatment for premature use of profit:  Lump sum withdrawal of profit is allowed before closure of accounts.  Drawn amount will be adjusted from the partner’s share of profit during final settlement.  In case of shortfall in actual profit, extra profit withdrawn will be recovered from their share of capital. This rule about changes in contracts indicates that at any time the partners can change:  The terms of the partnership contract.  The ratio of profit-sharing, provided profit is not already realised.

This rule pertains to the terms of profit/loss-sharing for a Shirkatulwajooh partnership, in which individuals pool their creditworthiness for the benefit of the business.

The rule indicates that:  Loss-sharing ratio can differ from the profit-sharing ratio.  Loss-sharing ratio can be based on the ratio of the assets purchased on credit by each partner.  No lump sum profit for a partner can be specified in the contract.

Comparison of Musharakah and Mudarabah Musharakah and Mudarabah are different from each other. Let’s see some aspects in which they differ.

Musharakah All the partners:  Invest in the business.  Can participate in the management of the business.  Can work for the business.

Mudarabah All partners, except the Mudarib, invest in the business.

The investors have:  No right to participate in management, except on pre-agreed terms.  The right to ensure that the Mudarib is executing fiduciary responsibilities defined in the agreement.

Musharakah All the partners share the loss in the proportion of their investment. Mudarabah Loss is shared by investors only, except when it can be proved that the loss has been caused due to the Mudarib’s negligence or dishonesty. In such a case, the Mudarib is liable for the loss.

Musharakah The liability of the partners is unlimited, except when all partners have agreed that none of them will incur any debt during business. If a partner violates this agreement, then he is responsible for all liabilities exceeding the assets.

Mudarabah The liability of the investor is limited to the extent of their investment, unless they have permitted the Mudarib to incur on their behalf.

Musharakah Profit can be distributed annually, quarterly, or monthly based on the valuation of assets. Mudarabah Profits can be finally distributed place only after the Mudarabah business is officially liquidated. However, interim payment of profit is possible subject to adjustment against final settlement.

Musharakah All partners jointly own all assets based on their share of investment. Each one of them can benefit from appreciated value of the assets, even if business sales haven’t generated profits.

Musharakah does not require any valuation of assets during dissolution.

Mudarabah

The investor solely owns all the goods/assets purchased by the Mudarib. The Mudarib can earn a share in the profit only if the assets are sold profitably.

If the Mudarabah business is dissolved, its assets and profit can be distributed only after evaluating its monetary value.

With regard to perpetual Mudarabah, constructive liquidation of assets by determining the market value of non-liquid assets is permitted.

Mudarabah and Musharakah In Mudarabah, all the investments come from the partner and the Mudarib is responsible for only management. In some situations, the Mudarib can also invest some amount in the Mudarabah after permission by the Rabbul- māl. This arrangement combines a Musharakah and a Mudarabah. In this contract, the Mudarib becomes both a partner in the business and a worker. As long as the Mudarib stays invested, rights and liabilities are governed by the rules of Musharakah business. Let’s see how this works in the case of a bank acting as the Mudarib for a group of investors.

 Group of investors: $100,000

 Bank’s own money: $50,000

 Bank’s agreed profit as Mudarib: 50 % of total profit

Suppose the business earns $ 3,000 as profit.

 Bank’s proportion of profit as an investor: $1,000 ($3,000/3)

 Profit-share for investors: $1,000 ($2,000/2)

 Bank’s profit as Mudarib: $1,000 ($2,000/2)

 Bank’s total profit: $2,000

The Wadiah Wad Dhamanah Deposit

A current essentially provides for safekeeping of one’s deposits, free of cost, while a savings deposit account serves the purpose of safekeeping one’s surplus funds and providing modest returns.

Withdrawals are guaranteed and honoured by the bank. To enable easy withdrawal, additional features include:  Checking facility  ATM and charge cards  Traveller’s  Remittances  Phone banking and branch service  Standing instructions  Statement request facility  Balance enquiry facility Some Islamic banks base these deposits on the principle of Wadiah-wad-dhamanah or guaranteed deposits. The features of this mechanism are:  Deposits are held as Amanah or in trust and used by the bank at its own risk.  Depositor does not share the risk or return. Profit or loss from the investment of these funds belongs entirely to the bank.  Deposits and withdrawals are unconditional.

Banks in South East Asia primarily use the Wadiah mechanism. The bank guarantees the principal amount and any-time withdrawal of funds from this account.

Banks offer gifts to a depositor as return for the Wadiah but cannot promise the gift in the contract.

While this product may be safe and convenient, Islamic banks must:  Seek permission from depositors to use their funds and claim ownership over profits earned from such use.  Reward customers by returning a portion of the profits at its discretion.  Guarantee partial or full withdrawal.  Provide depositors with all withdrawal facilities.

The Mudarabah-based model:  Requires depositors to appoint the bank as Mudarib for investing funds.  Offers safe custody and modest return.  Allows depositors to withdraw funds at will.  Uses the minimum balance maintained for a fixed period to calculate profits.  Uses different profit-sharing ratios over time.

A good example of this model is a savings account offered by a leading Islamic bank in Malaysia.

The Qard-ul-Hasan Deposit Current deposits are also treated as Qard or benevolent by the depositor. The bank operates a "Qard-ul-Hasan current account" and is free to use these funds at its own risk. The depositor, as the lender, cannot insist on a return as this leads to Ribâ. Any benefit that the depositor receives as a part of the agreement amounts to Ribâ.

Marketing challenges may force banks to promise additional benefits on a Qard-ul-Hasan deposit to attract more customers. However, these benefits go against the spirit of this mechanism and are not approved by Islamic scholars.

The Qard-ul-Hasan model can be applied to a savings account as well. It’s used primarily by Iranian banks. Although the depositors are not entitled to dividends, banks provide a variety of benefits, including non-contractual gifts.

The Concept of Wakalah (Agency) Wakalah means looking after, taking custody, applying skill or remedying on behalf of others. Wakalah is also a responsibility. It is therefore, essential for a Wakil to fulfil his duty in the way a trustee fulfils his responsibility in the case of Amanah.

Wakalah-based services will be dealt with in detail in Chapter 8 of this course, Controversial Financing & Fee-based Products.

The types of Wakalah are:  Wakil-bil-Kusoomah—for disputes  Wakil-bil-Taqazi al Dayn—for debt receipt  Wakil-bil-Qabaza al Dayn—for debt collection  Wakil-bil-Bai‘ –for trading  Wakil-bil-Shira—for purchasing

The subject matter of agency should be defined. Agency is not permitted for acts that:  Are prohibited in the Sharī‘ah.  Cannot be delegated. An agent must:  Act according to the instructions of the principal.  Show due care and skill.  Not delegate the job to another person without the consent of the principal.  Avoid conflicts of interest. A Wakalah contract ends by:  Mutual agreement.  Unilateral termination.  Discharging of obligation.  Destruction of the subject matter.  Death or loss of legal capacity.

An agency contract may be specific or general. The nature of the job to be done has to be defined in both types to avoid disputes. General Agency Contract: In which an entity simply appoints an agent to purchase goods, as and when desired by it Specific Agency Contract: In which an entity asks an agent to sell a particular asset at a given price or as per its instruction

IFIs use a Wakalah contract along with:  Murabaha  Salam  Istisna‘a  Ijarah  Diminishing Musharakah

A Wakalah is useful for activities such as:  Letter of Credit (LoC)  Payment and collection of bills  Fund management  Securitisation

A Wakalah contract is both commutative and non-commutative. Islamic banks generally:  Do not pay a fee to clients who perform duties on their behalf.  Charge fees for agency services rendered by them on behalf of their clients.

Islamic banks may manage funds on behalf of clients through a service called Wakalatul Istismar. From this, banks can get a fixed fee regardless of the profit or loss on the relevant portfolio. The fee can be a lump sum, a percentage of investment amount, or of the NAV provided the method is disclosed in the prospectus of the fund.

The Concept of a Tawarruq Contract Tawarruq means to buy on credit and sell at spot value with the objective of getting cash. This implies that the buyer is not interested in the commodity but the liquidity it provides.

Tawarruq-based services are covered in detail in Chapter 8 of this course, Controversial Financing & Fee-based Products.

Transactions Permitted:  Sale to a third party in the market  If a Mutawarriq, the entity seeking cash, appoints the bank as an agent to sell goods to the Mutawarriq, but the agency only occurs after unconditional sale  Tawarruq of shares of joint stock companies, Ijarah Sukuk (assets and services) and “bundles of assets”, comprising real assets as well as cash and receivables

Transactions Not Permitted:  Sale to the entity from whom the goods are purchased on credit (‘Inah)  If a bank employs the Mutawarriq, the entity seeking cash, as its agent to purchase the commodity on its behalf with the intent to sell the same back to the entity  If a Mutawarriq, the entity seeking cash, appoints the bank as an agent to sell goods to the Mutawarriq and the agency is specified in the sale contract  If Tawarruq is executed through a national or international commodity exchange, where brokers only provide agency services and goods remain where they are without transfer of ownership from the seller to the buyer Some Islamic banks use Tawarruq to place and obtain funds, thereby earning fixed returns. This practice is widely used in the Middle East as Commodity Murabaha or Shares Murabaha.

Acceptable Tawarruq arrangements are executed as follows: 1. A bank needing funds and another bank seeking to place funds selects any commodity/stocks that are highly liquid. 2. The second bank acquires the commodity from the market by paying cash. 3. The first bank purchases it from the second bank on credit (Murabaha). 4. After taking delivery, the first bank sells it in the market at spot price.

Tawarruq transactions should be:  Implemented as more than a mere exchange of papers between two brokers and one or two banks.  Used only in extreme cases where no interest-free option is available.  Strictly monitored by Sharī‘ah boards of IFIs.

The Concept of a Ju’alah Contract

Ju’alah is a contract in which one party, called the Ja‘il, promises a specific reward, called the Jua‘l to anyone who may be able to realise a specific or uncertain result. Promising a reward for finding a stolen car is an example of this contract.

Ju’alah is permitted by the Holy Qur’ān and the Sunnah but was originally restricted to a reward for the return of a runaway slave.

Ju’alah can be used by IFIs if:

 The required end result of the transaction is alone specified.  A desired result cannot be achieved using Ijarah.  Overdue debts need to be recovered.  Other services where the subject cannot be specified in detail have to be provided.

Financial services based on Ju’alah include:  Collection of Debts  Securing Permissible Financing Facility  Brokerage

For collecting debts, the reward is:  Related to realisation of all or part of the debt.  Calculated as a percentage of the amount collected on the basis of Ju’alah.  May be paid in advance fully or partially or before the work is completed, but is paid “on account” only. When used to secure permissible financing, Ju’alah contracts may involve services such as preparation of feasibility reports. When used in brokerage activities, Ju’alah contracts grant the award to the entity executing the contract only when the broker’s customer signs a purchase contract intermediated by the broker.

Chapter Summary You have completed the chapter, A Framework for the Islamic Financial System-Part 4. The key points of this chapter are as follows:

 Shirkah is proportionate ownership between two or more people who combine their wealth to establish a business concern and decide to share their profits and losses. Shirkah is categorised as Shirkatulmilk and Shirkatul‘aqd.  Mudarabah is a type of Shirkah in which one partner or group of partners provides capital to an agent or manager for investment in a business venture. In Mudarabah, the profit from the venture is shared among the partners on an agreed ratio. The Mudarib is paid for the effort invested in running the venture or may receive a share of the profit if the Mudarib is also part owner.  There are several restrictions on capital invested in Mudarabah and sharing of profit/loss. Restrictions may apply also to the type of business, place of business, parties involved, or the manner in which the Mudarib uses or manages the funds.  In a Musharakah partnership, the profits are shared according to an agreed ratio but losses are shared in the ratio of their ownership.  Several conditions and restrictions may apply to partners in a Musharakah, management of the business, treatment of profit and loss, share of each partner in profit/loss guarantees of capital and termination of the contract.  Musharakah and Mudarabah contracts are different in terms of partnership, profit/loss treatment, rights and liabilities of partners. However, they can be combined effectively as well.  IFIs can provide based on Wakalah (agency contracts) & Ju’alah and deposit products based on Wadiah or Qard Hasan concept. Both current and savings deposit products can be created. A Wakalah contract can be used together with Murabaha, Mushrakah, Salam etc.  Tawarruq means to buy on credit and sell at spot value with the objective of getting cash. Tawarruq products are popular in South East Asia and are generally permitted by Islamic jurists with some restrictions.  Ju’alah is a contract in which one party, called the Ja‘il, promises a specific reward for any entity that can realise a specific or uncertain result.

Key Terms

Amanah

Bai‘Salam

Ijarah

Istijrar

‘Inah Istisna‘a

Ju‘alah

Kafala

Mudarabah

Mudarib

Murabaha

Musharakah

Mutawarriq

Qard al-Hasan

Rabbul-māl

Ribâ

Shirkah

Shirkah al-‘Inan

Shirkatulamwal

Shirkatul‘aqd

Shirkatulmilk

Sunnah

Tawarruq

‘Urf

Wadiah

Wadiah-wad-dhamanah

Wakalah

Chapter 7

Chapter Introduction Islamic Banking System and its Financial Products.

In a modern economy, financial systems play a vital role in:

 Allocating financial resources.  Enabling financial intermediation through financial markets and institutions, and Managing financial issues, risk management tools and operations related to financial intermediation.

In a financial system, the role of intermediaries is different from economic agents because they help to:

 Transfer resources from SSUs to the corporate sector and other sectors seeking funds.  Allow households and firms to share risks through smoothing of household expenses.

Learning Objectives

On completing this chapter, you will be able to:  Explain the three main functions of financial intermediaries.  Distinguish among the three types of intermediation contracts permitted by the Sharī‘ah.  Recall the historical use of Mudarabah and Musharakah modes of financing.  Distinguish between the historical form and the modern form of a Mudarabah contract  Explain the four distinct features of a Mudarabah contract.  Distinguish among the four types of trust-based intermediation contracts in an Islamic financial system.  Distinguish among the three types of security-based intermediation contracts in an Islamic financial system.  Identify a general structure and three theoretical models for an Islamic Financial Institution (IFI).  Explain the two-tier Mudarabah, two-windows and Wakalah-based models of business for an IFI.  Identify the risks and mitigation strategies for the two business models for an IFI.  Identify the nature of assets and liabilities in the general structure of an IFI.  Describe two types of investment accounts that an IFI can offer to customers.  Describe the choices for investments that are available to an IFI.  Distinguish between the categories of IFIs based on the services they provide. Functions of Financial Intermediaries The functions of financial intermediaries are asset transformation, payment system, and brokerage.

Through asset transformation, financial intermediaries help to:

 Meet the demand and supply of financial assets and liabilities and  Transform maturity value of assets and liabilities. Financial intermediaries offer an orderly payment system through services such as transfer, electronic funds transfer, settlement, etc.

Financial intermediaries also offer brokerage or match-making between the borrower and the lender. This helps to meet the need and fulfilment of insubstantial and reliable assets and liabilities. These services include collaterals, guarantees, financial advice, and custodial services.

The concept of financial intermediation has been altered significantly in the modern economic era due to:

 Macroeconomic policies  Liberalisation of capital accounts  De-regulation  Advances in financial theory, and  Technological advancements. To compete successfully, FIs in advanced economies especially have evolved a new approach to intermediation that offers market-based transactions and fee-based services.

But what about financial intermediation in Islamic societies?

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

 Executed cross-border payments safely between borrowers and lenders,  Operated through an organised network and  Helped to overcome liquidity shortages.

Intermediation Contracts Permitted by the Sharī‘ah Intermediation contracts permitted by Sharī‘ah stabilise and handle risks in the financial system by:

 Forming a partnership of capital and entrepreneurial skills  Depositing assets with intermediaries on the basis of trust and  Guaranteeing financial performance. Therefore, intermediation contracts facilitate transparent transactions through partnership, trust and security. Partnership Intermediation contracts based on the principles of partnership are Mudarabah and Musharakah.

Mudarabah is a trustee finance contract that allows a profitable partnership between a capital owner and an agent with skills.

Musharakah is an equity partnership that merges the principles of investment and management. A Musharakah is essentially a hybrid of Mudarabah and Shirkah.

Trust Intermediation contracts based on the principles of trust are Wadiah, Amanah, Wakalah, and Ju’alah. These contracts are established on custodial relationship between the borrower and lender.

 A Wadiah deposit is one in which one’s property is entrusted to another for safekeeping and use without the trustee availing a return.  An Amanah contract is a trust deposit in which one’s property is entrusted to another only for safekeeping and not use as in the case of Wadiah. The client will be charged a fee for Amanah deposits and does not have a free current account.  A Wakalah contract is used when an agent is assigned the role of performing tasks based only on instructions provided.  Ju’alah or service fee contract is used when a service is offered for a pre-determined fee or commission.

Security Intermediation contracts based on the principles of security are Kafala, Rahn and Hawala.  Kafala or suretyship requires a third party to offer surety in case a financial liability is not met by the borrower.  Rahn or pledge is a contract in which the borrower pledges an asset to as an assurance of repayment of liabilities.  Hawala or transfer of debt is a contract that releases a principal debtor from financial obligations by shifting them to another entity. Historical vs. Modern Mudarabah History records the use of Mudarabah and Musharakah since medieval Islamic era. As early as the seventh century AD, tax revenues were being transferred from the region now known as Iraq to the region now known as the Kingdom of Saudi Arabia. Musharakah was used in trade between the regions now known as Egypt and Syria.

These partnerships brought together the three vital factors of production, such as capital, labour and entrepreneurship. The concept was adopted by Europeans between the eleventh and twelfth century. The Europeans made huge profits by directing funds from small investors into large business operations, eventually leading to the concept of the joint stock corporation.

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

Historical Mudarabah In historical Mudarabah, the owner of funds entrusted them to a Mudarib or agent to trade and return the principal together with a profit.

The contract of Mudarabah allowed the agent to receive a share of the profit, but the loss was borne only by the investor.

The practice of Mudarabah dates back to the holy Prophet himself (pbuh) who was his wife’s agent during his extensive trade expeditions.

Modern Mudarabah In modern Mudarabah, the agent determines the manner of investing and share profits according to a pre-defined ratio.

The loss is still the investor’s risk.

This arrangement forms the basis of modern day Islamic banking, where a recognised bank, acting as a Mudarib, uses the investor’s money on profitable projects to fetch good capital returns for the investor.

Distinct Features of a Mudarabah Contract

The four distinct features of a Mudarabah contract are:

 Control   Multiple Tiers  Negligence Risk

Regular Mudarabah contract: The agent is free to choose from a range of available investing options.

Restricted Mudarabah: The agent’s decisions are limited by the investor’s conditions and preferences.

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

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

 All profit needs to be shared between the agent and the investor.  Losses must be borne by the investor, unless caused by the agent’s negligence or misconduct.

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

• Proportions and ratios rather than absolute numbers • Specific profit-sharing formula cited in the agreement • Difference between the ratio of profit distribution and ratio of the capital invested • Balance available after the investor has retrieved his capital

Interim returns are adjusted against expected future profit during contract closure.

Islamic banks work on a network created by the agent. With the freedom granted to an agent, he forms a network of active and passive investors who entrust him with their capital. The Mudarib can also identify more businesses into which the capital can be invested.

Investors can minimise the risk of negligence by investigating the agent’s past performance, whereas agents can screen projects on the basis of risk and potential returns. In addition, banks when acting as Mudaribs, may ask for collateral from the businesses in which they invest.

There are no reserve requirements for investment balances since these would violate Basel II & Basel III requirements.

Trust-based Intermediation Contracts

The four types of trust-based intermediation contracts are:

 Wadiah (Deposits)  Amanah (Trust)  Wakalah (Representation)  Ju’alah (Service fee)

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

In a Wadiah contract, an entity’s property is entrusted to another entity for safekeeping and use without the trustee availing a return.

 Liabilities are shared based on the specific terms of a contract.  With prior consent of the owner, the trustee can use the property in an appropriate manner. In an Amanah contract, an individual’s property is entrusted to another only for safekeeping.

 The trustee cannot use it as in the case of Wadiah.  The trustee is held liable for losses due to negligence.

Demand deposits of an Islamic bank are offered through Amanah contracts.

In a Wakalah contract, the agent or Wakil, is assigned to perform tasks only according to the instructions provided by the investor, unlike in a Mudarabah.

In a Ju’alah contract, a service is offered for a pre-determined fee or commission.

 Services covered include asset management, consulting, advisory and custodial services.  This contract can be used for services related to an object that may not exist or be under the control of a party.

Security-Based Intermediation Contracts The three types of security-based intermediation contracts are:

 Kafala (Suretyship)  Rahn (Pledge)  Hawala (Transfer of debt)

Kafala or suretyship requires a third party to offer surety in case a financial liability is not met by the debtor. On behalf of the debtor, the guarantor vows timely repayment of all financial claims.

Important features:

 It does not release the primary debtor from liability; it is only an additional guarantee.  More than one Kafala can be provided for the same liability.  Joint surety is allowed.  Any extension of repayment deadline for the main liability implies an extension for the Kafala also.  Fulfilment of Kafala does not imply fulfilment of the primary liability.

Rahn or pledge is a contract where the borrower pledges an asset to assure the lender of repayment of liabilities. The lender can recover the pledged asset if the loan is not repaid. Important features:

 Only assets with potential sale value are accepted as collateral.  Different creditors may secure a joint pledge from a single debtor.  If the pledge is accepted by the lender, it does not imply cancellation of the liability.  If at the repayment date, the debtor refuses to pay, the creditor can ask a court to force the debtor to sell the asset or to sell it themselves.

Hawala or transfer of debt releases a principal debtor from financial obligations by shifting it on another entity, whereas Kafala does not permit this release.

Business Models for Islamic Financial Institutions (IFIs) Intermediation, transaction and financial contracts help Islamic Financial Institutions (IFIs) to:  Cater to a diverse audience  Mobilise resources  Execute intermediation  Design business models for IFIs  Offer a wide range of commercial and products and services

The three business models derived from financial intermediation are:

 Two-tier Mudarabah model  Two-windows model  Wakalah-based model

If the participant fails to disclose material facts, or if the operator fails to do so, the actions expected are listed on screen.

The Two-windows Business Model

In the two-windows business model, liabilities and assets of the bank balance sheet are divided into two windows.  The first window consists of demand deposits or Amanah.  The second window comprises investment balances.  There is no reserve requirement for the second window.  The depositor pays a fee for bank’s safekeeping services.  The bank grants interest-free loans based on available funds in the depositor’s account.  The depositor can select a suitable window.

The two-windows business model restricts the bank from using the deposited money, unlike in the West where banks are free to use available reserves.

Risks and Mitigation The two-tier Mudarabah model and the two-windows business model:

 Consider losses from investment activities as an outcome of the depreciation value of the depositor’s wealth.

 Minimise the probability of such losses through meticulous selection, monitoring, control, and diversification of bank’s investment portfolios.

The risk in the first model is more when compared to second model as it is applicable only to investment deposits.

The risk can be mitigated using the bank’s direct and indirect control on the agent or entrepreneur’s behaviour through explicit terms cited in the contract or implicit reward- punishment system.

Conceptual Balance Sheet of an IFI The conceptual balance sheet of an IFI:

 Provides an overview of the structure, operations and capabilities of intermediation outlined by Islamic banks.

 Uses diversification and portfolio management technique to:

o Design a portfolio of trade-related and asset-backed securities.

o Offer short-term deposits with minimal financial risks.

o Facilitate system-wide payment supported by real assets, like the typical deposit- accepting function of conventional commercial banks.

The Types of Investment Accounts at an IFI

The four types of accounts offered to depositors are grouped as:

 Current

 Savings

 Investment

 Special Investment Accounts

Investment accounts are equity investments that fetch banks more returns when compared to current accounts.

An investment account offers:

 Services in different forms  Stipulated maturity period  Profit-return distribution between depositors and the bank  Pre-determined ratio of 80:20 for depositors and bank

Special investment accounts are specialised funds to finance different classes of assets. They offer:

 Customised accounts for corporate and high net-worth individuals  Special investment opportunities  Negotiable maturity and distribution value of profits  Banking services

Investment Choices for an IFI The assets side of the bank focuses on a diversified profile of asset classes. Therefore, unlike the liabilities side, it provides more scope for mobilising funds.

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

 Short-term  Medium-term  Longer-term

Short-term maturity investments enable clients to meet business needs. This type of investment is highly preferred over other investment options as it offers:

 Asset-backed securities derived from trade-related activities, such as Mudarabah, Bai’ al-Mu’ajjal or Bai’ Salam  Short-term maturity and limited risk investments.

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

 Asset-backed securities with a fixed or floating rate feature facilitating portfolio management  Additional investment opportunities, such as investing in conventional leases that can be modified This type of investment option is less preferred as:  Operating a lease involves purchase cost, safekeeping cost and disposal cost.  Disposing assets involves close watch on market trends.

Banks are required to engage in activities beyond intermediation.

Longer-term maturity investments in the form of Mudarabah and Musharakah allow the IFIs to customise Mudarabahs for assets classes to match the Mudarabahs on the liabilities side. It also gives them an option to participate in private equity activities in the form of Musharakah.

Categories of IFIs Apart from commercial banks, IFIs are broadly categorised as:

 Islamic Windows  Islamic Investment Banks and Funds  Islamic Mortgage Companies  Takaful Companies (Islamic Insurance Institutions)  Mudarabah Companies

The decline in quality investment opportunities paved the way for Western banks in the Islamic world.

 Western banks offered Islamic products to attract customers. In lieu, non-Western conventional banks offered Sharī‘ah-compliant products to retain depositors.  Islamic Windows evolved as exclusive set-ups available within the conventional banking framework.

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

The 1990s witnessed Islamic banks leading financial markets.

The services offered by Islamic investment banks include:

 Innovative large-scale transactions for projects  Mobilising and redirecting funds to Muslim countries  Increasing direct investments from foreign countries Developing national and regional capital markets through public listing of companies

The four mortgage models are based on:

 Ijarah or lease  Musharakah or equity partnership  Mudarabah contract  Musharakah or equity membership

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

 Takaful entitles participants to avail a plum share of the profit generated.  Takaful companies own reserves from conventional mutual and insurance companies to supplement contributions if claims exceed premiums. A Mudarabah company is an autonomous legal entity run by a fund management company.

 It is funded by the sponsor’s subscribed capital and by Mudarabah investment certificates obtained through public offering.

 Profit from investments is distributed among subscribers and the manager based on contribution and services respectively.

 Mudarabah is classified based on its investment purpose as multi-purpose and specific- purpose.  The concept is sustained with respect to the use and abuse of profits.

Chapter Summary You have completed the chapter, Islamic Banking System and its Financial Products. The key points of this chapter are as follows:

 The three main functions of financial intermediaries are asset transformation, payment system, and brokerage.  Intermediation contracts facilitate transparent transactions through partnership, trust and security.  In historical Mudarabah, partnerships are determined based on vital factors of production, whereas in modern Mudarabah, the agent determines the terms of sharing profit and loss.  The four distinct features of a Mudarabah contract are control, profit and loss sharing, profit distribution, multiple tiers and negligence risk.  The four types of trust-based intermediation contracts are Wadiah, Amanah, Wakalah and Ju’alah.  The three types of security-based intermediation contracts are Kafala, Rahn, and Hawala.  The three business models derived from financial instruments are two-tier Mudarabah model, two-windows model and Wakalah-based model.  In the two-tier Mudarabah model, funds mobilisation and funds utilisation among the depositor, bank and entrepreneur is based on the profit-sharing concept.  In the two-windows business model liabilities and assets of the bank balance sheet are divided into two windows to handle reserve requirement with ease.  The two-tier Mudarabah model and the two-windows business model minimise the probability of losses through meticulous selection, monitoring, control, and diversification of bank’s investment portfolios.  The conceptual balance sheet of IFI provides an overview of the structure, operations and capabilities of intermediation outlined by Islamic banks.  Investment accounts are equity investments that fetch banks more returns when compared to current accounts.

 The investment options available on the assets side are based on the maturity period as short-term maturity, medium-term maturity and longer-term maturity investments.  Apart from commercial banks, IFIs are broadly categorised as Islamic Windows, Islamic Investment Banks and Funds, Islamic Mortgage Companies, Takaful Companies and Mudarabah Companies.

Key Terms

Amanah

Bai‘Mu’ajjal

Bai‘Salam

Hawala

Ijarah

Istisna‘a

Ju‘alah

Kafala

Mudarabah

Mudarib

Murabaha

Musharakah

Qard ul-Hasan

Rabbul-māl

Rahn

Ribâ

Sarraf

Sunnah

Wadiah

Wakalah

Wakil-bil-Kusoomah

Wakil-bil-Taqazi al Dayn Wakil-bil-Qabaza al Dayn

Wakil-bil-Bai‘

Wakil-bil-Shira

Chapter 8

Chapter Introduction Controversial Financing and Fee-based Products.

While attempting to maximise profit, many Islamic commercial banks have devised controversial debt-based mechanisms. Mainstream Islamic scholars consider these mechanisms to be in violation of the Sharī‘ah’s rules. These debt-based concepts are:

 Repurchase (Bai’ al-Einah)  Bill discounting (Bai’ al-Dayn)  Tripartite resale (Tawarruq)

Normally, a bank acts as an intermediary in certain kinds of transactions to ensure an atmosphere of security and confidence among both sellers and buyers. In these situations, the bank either extends a short-term loan based on interest to its customer or acts as a guarantor of its customer’s liability. The first service is provided through a Letter of Credit (LoC).

For Islamic banks, since interest is forbidden, the mechanism of Wakalah or acting as an agency can be used and a fee charged.

The second service requires a Letter of Guarantee (LoG). For Islamic banks, the mechanism of Kafala is the appropriate way to provide this service.

Learning Objectives

On completing this chapter, you will be able to:  Describe the process of Bai’ al-Einah.  Identify the controversial aspects of Bai’ al-Einah.  Explain the specification of a credit card based on Bai’ al-Einah.  Explain the process of Bai’ al-Dayn.  Identify the controversial aspects of Bai’ al-Dayn.  Explain the concept of Tawarruq.  Describe the working of a credit card based on Tawarruq.  Identify the issues likely when managing Tawarruq-based products.  Describe the Sharī‘ah-compliant process for Islamic banks of providing an LoC.  Explain the Sharī‘ah-compliant process for Islamic banks and uses of an LoG.  Identify other fee based services provided by Islamic banks.

Bai’ al-Einah (Repurchase)

Repurchase or Bai’ al-Einah is popular among Islamic commercial banks in South East Asia. In this, the bank purchases a commodity from its client on a spot basis and sells it back to the client at a cost-plus price and on a deferred basis. This mechanism is used to raise short-term working capital or short-term . Suppose that a client needs an amount C. Let’s look at how banks use Bai’ al-Einah to provide the client with these funds.

Note: A Murabaha contract can be converted into a Bai’ al-Einah if the identity of the vendor is not different from the client. Murabaha contracts are covered in more detail in Chapter 4 of this course, A Framework for the Islamic Financial System-Part 2.

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

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

The client buys back the same commodity X from the bank at an inflated price, C + I, on a deferred basis.

Controversial Aspects of Bai’ al-Einah

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

Although the value of a commodity is used as a basis for the amount of funds, the commodity itself is not sold or repurchased. Only funds flow between the client and the bank.

In addition, the amount effectively borrowed or the deferred repurchase price need not be related to the market price of the commodity. The client doesn’t even need to own the commodity.

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

2. The client gives an amount C+I to the bank on deferred payment.

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

1. A client borrows an amount C from the bank.

2. The client pays C + I on maturity to the bank.

The rate of profit in Bai’ al-Einah is indistinguishable from Ribâ on a conventional loan. When renewed unlimited number of times, a Bai’ al-Einah based loan works like a regular, compound interest loan. This is, of course, prohibited by the Sharī‘ah!

A Credit Card Based on Bai’ al-Einah Using Bai’ al-Einah, the bank can aim for a certain profit while still being able to finance any amount for any maturity. This allows the design of even a credit card that has none of the risk associated with a normal credit card for the bank. This concept uses two types of contracts - Wadiah and a Qard ul-Hasan or overdraft facility.

Wadiah contracts and Qard ul-Hasan contracts are covered in detail in Chapter 6 of this course, A Framework for the Islamic Financial System-Part 4. Let’s see how Bai’ al-Einah works.

This consists of two simultaneous steps. a) The bank agrees to sell land to the customer at price P. b) It signs another agreement to repurchase the land at lower price R.

The difference in price is the bank’s maximum, pre-determined profit.

The bank disburses proceeds of the second agreement into the customer’s Wadiah account created and maintained by the bank.

The customer uses their card for retail purchases and cash withdrawals just like a conventional credit card, except that the cash held in his Wadiah account now backs each transaction. The customer can use the Qard ul-Hasan facility also.

At the end of every month, the value of total transactions by the customer is computed. Any overdraft must be repaid but the bank cannot charge interest or fees. The bank’s profit is calculated monthly based on monthly outstanding or total monthly transactions. The customer renews the Wadiah account every month.

Note: The lack of fees doesn’t affect the bank’s revenue. In conventional finance as well, most credit card revenue comes from the fees retailers have to pay networks such as Visa, Discover, JCB or Mastercard for offering the payments facilities and guaranteeing the payment. Fees that a credit card holder may be required to pay are only a minor source of revenue.

Bai’ al-Dayn (Bill Discounting)

As you may be aware, bill discounting is quite commonplace in conventional banking. In Islamic finance, this is referred to as Bai’ al-Dayn. This mechanism is used as a means of raising working capital and financing foreign trade.

Let’s recall the steps involved.

A seller draws up a bill of exchange asking the buyer to pay a certain amount, M, after a certain period, t, called maturity.

There are two options available for the seller.

 The seller can wait till maturity and get the full maturity value, M.  Alternatively, the seller can sell the bill to a bank at a discounted value, N. The discount is determined by the rate of interest and the date difference between purchase by the bank and the maturity.

If the seller discounts the bill, the bank presents the bill to the buyer at maturity and receives the maturity value, M. The bank’s profit is M-N. Controversial Aspects of Bai’ al-Dayn Let’s now see how some Islamic banks may be violating the Sharī‘ah’s rules when they use bill discounting or Bai’ al-Dayn.

Mainstream Islamic scholars insist that the sale or transfer of debt must be at par. No discount is allowed between the price at purchase by the bank and the maturity value.

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

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

1. A company may assign its accounts receivables to an Islamic bank. 2. The bank now has the right to collect the receivables and provides funds against the receivables. 3. In return, the bank can charge a fee under the Sharī‘ah’s rules. However, charging interest on the loan it gives to the company is a Ribâ transaction.

Tawarruq Tawarruq is an example of Hiyal, or a legal device, that has been permitted by Islamic scholars under certain conditions. Tawarruq becomes a Sharī‘ah-compliant source of funds by combining two separate sale and purchase transactions.

An individual who requires funds purchases goods on a deferred payment basis. The individual then sells the goods in the market immediately in order to obtain cash. This is regarded as Hiyal, since the individual doesn’t intend to buy or sell the commodity. He executes these purchase and sale transactions only to obtain cash.

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

The basics of a Tawarruq contract are covered in Chapter 1, An Overview of an Islamic Financial System and in Chapter 6 of this course, A Framework for the Islamic Financial System-Part 4.

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

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

The bank resells the goods to the vendor at P* and provides the money to its customer. P* may be different from P.

A Credit Card Based on Tawarruq

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

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

The bank then creates a guaranteed deposit account under the Wadiah principle for the customer. The customer uses their card for retail purchases and cash withdrawals just like a conventional credit card, except that the cash held in his Wadiah account now backs each transaction.

At the end of every month, the value of total transactions by the customer is computed. A fresh Tawarruq for this value is undertaken to replenish the deposit account.

Issues in Managing Tawarruq Products Let us now look at some issues that arise while managing Tawarruq-based products. Scholars have permitted Tawarruq as long as it does not involve Ribâ, is Sharī‘ah-compliant and fulfils certain requirements.

The requirements are: 1. Three parties must be involved, else this will be regarded as Bai’ al-Einah. 2. The purchase by the bank and the sale to client must be at different times. 3. The sale by the bank to client and sale by the client in the market must be at different times.

A time gap creates price risk for the parties and ensures that the profit is a compensation for risk borne and therefore is free from Ribâ.

There are three amounts involved:  P (amount requested by the client)  P* (amount paid by the vendor to the bank on resale of commodity X)  P+I (amount to be repaid by the client to the bank on deferred basis)

Tawarruq is permitted only if these prices are related to the market price, cash or deferred, of the commodity. It is not permitted if the parties arrange prices such that:  Deferred price comprises loan amount plus interest.  Cash purchase from the vendor or cash sale to the vendor is for the same amount that the client wants from the bank. To know the basics of Tawarruq, refer to Chapter 1, An Overview of an Islamic Financial System, and Chapter 6, A Framework for the Islamic Financial System-Part 4.

If banks claim that the terms of the Tawarruq-based product are similar to terms of other conventional financing products, clients must question how financial products that are prone to market risk can offer the same conditions as other products that are not prone to risk.

Letter of Credit Under Wakalah A Letter of Credit is a document issued by a bank for use in trade finance. It works as an assurance that the buyer will pay the amount agreed to the seller.

Conventional banks provide a short-term loan to buyers as part of this service and charge interest on it. However, due to the Sharī‘ah’s rules, Islamic banks can provide the Letter of Credit, but not the interest-earning loan. Therefore, Islamic banks can use the mechanism of Wakalah, that is, acting as an agency or Wakil for its customer. The bank may then charge a fee or commission for the services provided. There is no interest involved.

The basics of the Wakalah contract and its applications are covered in detail in Chapter 6 of this course, A Framework for the Islamic Financial System-Part 4.

Let’s see how this mechanism works.

A customer of bank A wants to purchase goods worth X from a vendor V on credit of 90 days. The vendor agrees to supply these goods only if a Letter of Credit for 90 days for the full amount is given.

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

The customer appoints Bank A as its agent or Wakil for the purpose of executing the transaction.

Bank A asks the customer to place a deposit for the amount X, which it accepts under the principle of al-Wadiah.

The bank establishes the Letter of Credit and pays the bank that is acting as the vendor’s Wakil. This payment is made by using the customer’s deposit.

Subsequently, the bank releases pertinent documents to its customer.

The bank charges fees and commissions to customer for its services under the principle of agency fee or Ujr.

Letter of Guarantee Under Kafala In international trade, a guarantee of payment is often required when the sellers and the buyers do not know each other. Banks provide such a guarantee to the seller on behalf of the buyer. It eliminates the risk, for the seller, of not receiving the payment for the goods sold.

Islamic banks have been providing such a facility in the areas of trade finance, construction, project related finance, shipping and other activities. Under a strict interpretation of the Sharī‘ah, a guarantor cannot charge a fee for a voluntary service, unless the service is a necessity.

Since the guarantee is a necessity in modern trade, Islamic banks can follow the Sharī‘ah- compliant process called Kafala and charge a fee for this service on grounds of Darura.

The Kafala contract is discussed in detail in Chapter 7 of this course, Islamic Banking System and its Financial Products. Let’s see how this works.

A customer of an Islamic bank wants to buy a product on credit from a company C that it has not traded with previously. Company C needs a guarantee of payment.

On basis of its customer’s request, the bank provides a Letter of Guarantee to company C on behalf of its customer.

The bank asks its customer to place a certain amount of deposit for this facility, which the bank accepts under the principle of Wadiah wad Dhamanah.

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

Other Fee-based Services Islamic banks provide fee (Ujr)-based services such as:

 Custody of negotiable tools, including shares and bonds and collection of payments (based on Wakalah where the bank is the client’s Wakil)

 Internal (domestic) and external transfer operations (based on Wakalah where the bank is the client’s Wakil)

 Hiring strong boxes, or coffers (based on Amanah or Ijarah)

 Administration of assets, estates, wills etc (based on Wakalah where the bank is the client’s Wakil).

Islamic banks also offer fee -based services in real estate, property management and project management to customers irrespective of whether they avail financing or not. These services are natural extensions of their financing activities. Let’s look in some detail at one such example from a leading bank in the UAE.

Property management services include: 1. Marketing assets. 2. Ensuring full occupancy and maximising returns. 3. Collecting rent. 4. Conducting general and preventive maintenance. 5. Assisting clients in purchase, sale, or rent of assets. 6. Providing location and construction advice and plot appraisal.

Project management services may include:

 Project Planning  Cost Planning  Contract Procurement  Co-ordinating Construction and Development

Chapter Summary

You have completed the chapter, Controversial Financing & Fee-based Products. The key points of this chapter are as follows:

 Bai’ al-Einah is a popular mechanism where a bank buys goods from clients on a spot basis and sells it back to them at cost-plus price, on a deferred basis. In this mechanism, the money borrowed need not be related to the price of the commodity and the rate of profit is indistinguishable from Ribâ on a conventional loan.  A credit card based on Bai’ al-Einah uses two types of contracts, the Wadiah deposit and the Qard ul-Hasan or overdraft facility.  The two controversial aspects of Bai’ al-Dayn are bill discounting and factoring.

 In bill discounting, the sale or transfer of debt must be at par and if the bank buys the bill of exchange at a discount, it is effectively engaging in Ribâ-based transactions.  In factoring, a company may assign its accounts receivables to an Islamic bank and can obtain funds against the receivables. While the bank can charge a fee, charging interest on the loan it gives to the company is a Ribâ transaction.  An individual requiring funds purchases goods on a deferred payment basis and then sells the same in the market in order to obtain liquid cash. This is regarded as Hiyal.  Tawarruq is a classic example of Hiyal that has been permitted, by Islamic scholars under certain conditions. Tawarruq becomes a Sharī‘ah-compliant source of funds by combining two separate sale and purchase transactions.  In Tawarruq, there has to be a time gap between the sale-purchase transactions between the three parties. This gap is important to create price risk and ensure that the profit from the transaction is a compensation for risk borne and therefore, is free from Ribâ.  For Tawarruq to be permissible, the three parties, bank, client and vendor may not enter into a prior agreement.  A Letter of Credit is a document issued by a bank for use in trade finance. It works as an assurance that the buyer will pay the amount agreed to the seller.  A Letter of Guarantee (LoG) is a document issued by a bank, to the seller, on behalf of the buyer. It eliminates the risk of not receiving the payment for the goods sold.  Islamic banks provide fee or Ujr-based services such as custody of negotiable tools, internal and external transfer operations, hiring coffers and administration of assets, estates, wills etc. They also offer fee-based services such as real estate, property management and project management.

Key Terms Amanah

Bai’ al-Einah

Bai’ al-Dayn

Ijarah

Kafala Mudarabah

Murabaha

Qard ul-Hasan

Ribâ

Tawarruq

Wadiah

Wakalah

Wakil-bil-Kusoomah

Wakil-bil-Taqazi al Dayn

Wakil-bil-Qabaza al Dayn

Wakil-bil-Bai‘

Wakil-bil-Shira

Sunnah Wadiah

Wakalah

Wakil-bil-Kusoomah

Wakil-bil-Taqazi al Dayn

Wakil-bil-Qabaza al Dayn

Wakil-bil-Bai‘

Wakil-bil-Shira