Essentials of Islamic Banking and Finance

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Islamic modes of Financing
Essentials of Islamic Banking and Finance IQRA
University Gulshan Campus IRSHAD AHMAD AIJAZ
irshad786_at_gmail.com
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Contents of the lecture

• Mode of financing
• Islamic modes
• Trade based modes of Financing
• Rental based mode of financing
• Participatory mode of financing
• Q A

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Mode of financing

• Mode of financing
• Mode of financing means way of supplying funds to
  those who need funds
• Supply of fund from a financial institution to a
  company is called financing
• Conventional banks supply funds under one and
  only mode of financing that is LENDING of money
• Every banking product, whether it is a car loan,
  industry loan, investment loan, personal loan or
  a governmental loan, is offered under this mode

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Islamic mode of financing

• Islamic mode of financing
• Islamic modes of financing mean the way of
  supplying funds that is acceptable to Islam
• As we have learned Islamic mode of financing
  could not be based on lending of money as lending
  of money is not a remunerative way of financing
• Prohibition of interest does not allow
  utilization of loan/lending as mode of earning
• Therefore, there must be a way of funding that
  does not contain element of interest
• There are three type of financing available under
  Islamic concept of funds supply
• Trade-based modes of financing
• Rental-based mode of financing and
• Participation-based of financing

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Financial activities
Exchange of goods or services
Ijarah (services rendering)
Murabahah (cost disclosed sale)
Musawamah (simple bargain sale)
Salam (future sale)
Istisnaa' (Manufacturing Sale)
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Trade-based modes of financing

• Trade-based mode of Financing means a way of
  financing in which Islamic banks provide
  financing through sale and purchase of
  commodities and assets
• Trade-based modes are secure modes because they
  create debt and payables upon debtors/customers
• Islamic banks buy a commodity/asset (directly or
  through its agent) from the market and sells it
  to customers on deferred payment basis
  (instalments)
• The agent may be a an employee on Islamic bank, a
  third party or the customer himself as well
• All conditions should be observed carefully in
  sale financing.

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Trade based modes of Financing

• There are four kinds of Trade-based modes of
  financing which are very common
• MURABAHAHA
• Costprofit transaction in which both are
  disclosed to the buyer
• MUSAWAMAH
• A simple sale transaction in which a price is
  quoted to customer without any disclosure to the
  buyer
• SALAM
• A kind of sale in which price is paid in advance
  for a specific commodity to be delivered in
  future
• ISTISNAA'
• A sale transaction for assets that require
  manufacturing.

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Trade based modes of financing

• The customer expresses its wish to buy a certain
  thing from the bank and the bank buys it from
  market and sells it on instalments
• All modes follow laws and rules of Islamic Sale
  contract with little or no modifications
• Each mode has separate set of additional rules
  which needs to be followed strictly
• Any error may lead to make the transaction a void
  sale
• Credit Risk is lower in this kind of financing
  therefore Islamic Banks prefers it
• The rate once fixed in these modes could not be
  changed
• The concept of credit sale applies here in these
  modes
• Islamic banks earn money through cash purchase
  and credit sale
• Profit is difference between cash purchase and
  credit sale

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Trade based modes of financing

• Sometimes it is argued that the time has effects
  on calculation of profit in case of credit sale
• We will analyze this question in following
  slides

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Price difference in Credit and Cash sale

• A common question to Islamic banks Why the price
  is high in case of credit sale? This excess is as
  good as charging of interest
• But the question is too simple to reply
• The main concept is that is there any room for
  time in pricing?
• Meaning can a seller consider 'time' as one of
  the decisive factor for pricing a commodity or
  asset?
• The answer is yes, the is one of the main factors
  that play role in determining the price
• The difference of price between whole sale and
  retail is due to volume which is turnover of X
  (quantity) in a given time

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Price difference in Credit and Cash sale

• The fast moving or perishable items are not
  charged high profit and return
• Slow moving and storable items are charged higher
  profits and return
• The reason is 'TIME'
• So the time is not something that should always
  be neglected in pricing or determining the value
• The generic vale of interest is its linkage with
  time and not with real assets and commodity
• If the time increases the value will follow suite.

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Fixation of return/profit in trade-based modes

• Non-fixation of price in a Sale transaction means
  no precise determination of price which is an
  essential element of Islamic Sale Contract
• So non-fixation in sale is not allowed
• While fixation in partnership is as good as
  considering something unconfirmed as confirmed
  which is no doubt injustice with one of the
  pertners
• So non-fixation here is the acceptable way.

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Fixinf of return/profit in trade-based modes

• A repeated question is that the return/profit is
  fixed in trade-based modes of financing while
  Islam prohibits fixinf of profit
• So what about famous Islamic concept of
  non-fixation of the profit rate?
• The actual reason of prohibition is not FIXATION
  or NON-FIXATION
• In fact the element of GHARAR is not acceptable
  in financial transaction
• Gharar sometime appears in fixation and sometime
  in non-fixation.

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Murabahah and Musawamah
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Murabahah definition and concept

• Murabahah is one of the kinds of sales
• It comes under trade-based modes of financing
• Murabahah means selling a commodity or asset on
  disclosure of cost and profit basis, which
  means the seller discloses the cost and the added
  profit to buyer
• So the distinguishing feature of Murabahah from
  ordinary sale is that the seller is bound to
  discloses the cost and profit both to the buyer.
• If he does not disclose the cost the sale will
  not be a Murabahah sale

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Murabahah definition and concept

• The seller (bank) sells a specific commodity or
  asset as per the laws and rules of Islamic sale
  (pertaining to Price, Subject Matter, Wordings
  and Contractors)
• The cost and profit are disclosed to the buyer
• The buyer shows his agreement with the price for
  that commodity /asset
• Lastly the buyer takes delivery of the asset
  (possession, physical or constructive) and the
  sale is concluded
• The payment of price should be according to the
  rules and laws set for Islamic sale and purchase
• As per the rules set for sale and purchase either
  the price or the delivery of the sold goods (not
  both) could be deferred

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Murabahah definition and concept

• As any other sale the payment of Price in
  Murabahah could be in three ways
• Spot payment (Al-Bai' ul Muajjal - immediate
  delivery and payment)
• Deferred for a specific future date (Al-Bai' ul
  Muwajjal - full payment at a future date)
• Deferred for a period of time (Al-bai' ul
  Muwajjal - sale on instalment basis payment in
  tranches, similar to purchase on instalments)

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Murabahah definition and concept

• As we have discussed Islamic bank is one of the
  players in financial markets
• Therefore product of Murabahah used in Islamic
  Banking as a mode of finance is slightly
  different from a simple Murabahah used in normal
  trade.
• Banking Murabahah is a contract wherein Islamic
  Bank purchases a commodity or an asset from a
  third party (supplier/ vendor)
• This purchase happens upon request of the
  customer
• After purchase of the required asset Islamic bank
  sells the same to the customer usually against a
  deferred payment Bai Muajjal (sale on
  instalments)
• The whole process is called Murabahah to the
  Purchase Orderer
• It is a bunch of contracts completed in steps and
  ultimately suffices the financial needs of the
  customer.

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Murabahah definition and concept

• Some important features of the Murabahah are
• As Banking Murabahah is a kind of sale, there
  must be a seller (bank) and a buyer (customer)
  and something that could be bought and sold
• In such transactions the Bank is the seller, the
  customer is buyer and a commodity/goods are
  exchanged between them
• In case there is nothing that could be sold and
  purchased Murrabahah is not possible
• WC finance /Overheads financing etc. etc. are not
  possible under Murabahah since there is no sale
  and purchase.
• Because it is a sale from bank to customer the
  Bank is required to purchase the commodity
  directly or directly from the market/seller
  before selling it to the customer

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Process flow
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Murabahah step by step

• Step 1
• Client and Bank sign an agreement to enter into
  Murabahah.

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Murabahah step by step

• Step 2
• Client appointed as agent to purchase goods on
  behalf of Bank

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Murabahah step by step

• Step 3
• Bank gives money to directly to supplier or to
  the client for purchase of goodsClient appointed
  as agent to purchase goods on behalf of Bank

BANK
CLIENT
AGREEMENT TO MURABAHAH
AGENCY AGREEMENT
SUPPLIER
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Murabahah step by step

• Step 3
• Client pays agreed price to bank according to an
  agreed schedule. Usually on a deferred payment
  basis (Bai Muwajjal) in tranches

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Application
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Murabahah Application

• Murabahah can be used to finance the real
  purchase needs of customer
• It could be used for assets which are acceptable
  to Shariah and has a tangible form.
• Therefore, Murabahah can be used to finance the
  purchase of
• Raw Material
• Equipment
• Consumer Goods
• Personal loans
• Credit cards.

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Musawamah

• Musawamah is also one kind of sale
• Musawamah is also one kind of sale
• This is a simple sale we do in our daily routine
  life
• The difference is that the quoted price does not
  require any break-up of cost and profit
• All other details are same as for Murabahah
• The process flow is also same and the payment
  method may also be of same nature.

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Questions