Essentials of Islamic Banking and Finance

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Salam and Istisnaa'
Essentials of Islamic Banking and Finance IRSHAD
AHMAD AIJAZ irshad786_at_gmail.com
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Salam
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Scope of presentation

• Introduction
• Definition of Salam
• Conditions of Salam
• Comparison with Murabahah
• Parallel Salam
• Parallel Salam important points
• Application and
• Risks and its mitigations.

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Introduction

• Basic principle for validity of a sale in
  Shari'ah is that
• The commodity must be existing
• Non-existing goods are not eligible for sale
• The seller must have ownership of the commodity
• Short sale (selling of what is not owned by
  seller) is not allowed
• The commodity must be in the physical or
  constructive possession of the seller
• Selling of what is not possessed by seller is not
  allowed
• All sale transactions should conform to these
  rules
• There are only two exceptions to these principles
  in Shari'ah and they are
• Bai Salam and
• Bai Istisna'
• Both these are sales of special nature and are
  exceptions to the general rules of sale.

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Introduction

• Salam is a type of Sale in which
• the seller undertakes to supply some specific
  goods to the buyer at a future date, against an
  agreed price which is fully paid in advance and
  the delivery of the sold commodity is deferred
• So there are three distinguishing features of
  Salam
• The subject matter (commodity to be
  purchased/sold) is delivered in future
• The price is paid full in advance
• The goods for sale will be specific
• Another name of Salam is Salaf, meaning of both
  are same

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Explanation of Salam

• Before prohibition of interest, farmers in
  Madinah Munawwarah used to obtain interest-based
  loans for their agricultural and routine life
  needs
• After prohibition of interest, the farmers faced
  hardship
• Similarly trade caravans of Arabs used to get
  interest based loans for purchasing the
  commodities for trade
• After prohibition of interest, the traders have
  also faced difficulties
• To solve this problem of Ummat, Holy Prophet ( ?
  ) allowed Bai' Salam
• The purpose of this permission was to ease the
  financial needs of small farmers and traders
• Salam transactions has been allowed by the Holy
  Prophet ( ? ) with some conditions

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Explanation of Salam

• By the permissibility of Salam it becomes
  beneficial for both buyer and seller
• It is beneficial to the seller because he
  receives the price in advance and it is
  beneficial to the buyer because the advance Salam
  price is usually lower than the spot price
• Since Salam is an exception to the general rules
  of sale and it is allowed before existence of
  goods, the element of Ghare is obvious here
• To minimize the element of Gharar certain
  conditions have been laid down by Shari'ah
• The element of Gharar for this special type of
  sale has been lowered down by imposing some
  conditions

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Conditions of Salam

• Conditions for validity of Salam are
• The Salam price must be paid in full at the time
  of effecting sale
• Because, in the absence of full payment it will
  be selling debt (commodity whose delivery is
  deferred) against debt (price deferred) which is
  prohibited
• Also this is against the basic wisdom behind
  permissibility of Salam which is fulfilling the
  instant needs of the farmers and traders
• If the price is not paid in advance this purpose
  can not be achieved
• Salam can be effected only in those commodities
  that can be exactly specified in quantity and
  quality
• It means only those goods can be sold under Salam
  transaction which fall under the category of
  Dhawatul-Amthal ( ???? ?????? )
• The term Dhawatul-Amthal refers to such
  commodities, the units of which are homogeneous
  in characteristics
• It means the commodities which are traded by
  counting, measuring or weighing according to
  usage and customs of trade
• For example wheat, rice, cotton and barley

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Conditions of Salam

• Conditions for validity of Salam (contd.)
• On the other hand, Salam is not allowed in
  heterogeneous ( ???? ????? ) goods
• Heterogeneous goods are those goods the units of
  which are different among each other in
  characteristics. Meaning thereby each piece is
  different, in size, weight and value
• For example animals and precious stones are not
  possible to precisely defined beforehand.
• Subject matter of Salam should be of common
  nature
• Therefore Salam cannot be effected on a
  particular commodity of a particular field or
  farm
• The reason is that it is not necessary that the
  farm or the tree would be able to produce the
  required commodity or fruit
• Alternatively, one can define a particular type
  of the commodity for which Salam is being done.
• For example Rice Irri or Basmati etc. etc.

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Conditions of Salam

• Conditions for validity of Salam (contd.)
• Both the quality and quantity of the goods should
  be very clearly agreed upon
• All the possible details in this respect must be
  expressly mentioned
• For example if the commodity is quantified in
  weight in the market, its weight must be
  determined and if it is quantified through
  measures, its exact measure should be known.
  Therefore, if something is sold by measuring it
  cannot be sold by weighing in a Salam
  transaction
• The exact date and place of delivery must be
  specified in the contract
• The date may be in range form (e.g. from 10 to 15
  on July)
• The place should be specified as per custom
• Salam cannot be effected in respect of things
  which must be delivered on spot
• Gold with silver or wheat with barley are example
  of it. According to Shari'ah delivery of these
  goods should be be simultaneous

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Conditions of Salam

• Conditions for validity of Salam (contd.)
• The commodity which is the subject of Salam
  contract is normally available in the markets at
  the time of delivery
• Salam of Mangoes in January is invalid Salam
• Delivery of goods to buyer is mandatory
• The seller should hand over commodities to buyer
  at the time of delivery. He can not give money
  back to the buyer on the basis of set-off
• Buyer can not contractually bind the seller to
  buy-back the sold commodity. This will be a case
  of implicit interest (Heelah)
• Similarly the seller can not contractually bind
  the buyer to sell-back the sold commodity to
  seller, because it would be conditional sale
• However, after the delivery, both may enter in a
  transaction of sale with mutual consent,
  independently from Salam sale.
• The buyer shall not sell or transfer ownership of
  the goods before taking possession (actual or
  constructive) of these goods
• This would be case of short-selling

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Comparison with Murabahah

• Salam
• In Salam Price is paid at Spot
• In Salam delivery of subject is deferred.

• Murabahah
• In Murabahah Price is deferred
• The delivery of subject matter is at spot.

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PARALLEL SALAM
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Parallel Salam

• Parallel Salam is not a kind of Salam
• It is an arrangement by buyer to sell the
  commodity he purchased from some one
• The buyer can not sell the commodity before he
  takes the possession from seller in a Salam
  contract as we discussed earlier
• But the buyer may sell the commodity he bought it
  on Salm to another person on Salam basis
• This arrangement is called 'Parallel Salam'

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Parallel Salam

• Lets assume Mr. 'Ahmed' enters into a Salam
  Contract with Mr. 'Basheer' to purchase one
  thousand bales of cotton at a price 100,000/ per
  bale to be delivered on 20 August
• In this contract (Salam A)
• Mr. 'Ahmed' is a Purchaser/Buyer and
• Mr. 'Basheer' is a Seller
• Mr. 'Ahmed' can enter into another Salam with Mr.
  'Khalid' to sell the same cotton at a price of
  105,000/ per bale on a 21 August
• In this contract (Salam B)
• Mr. 'A' is a Seller and
• Mr. 'Khalid' is a Purchaser.

Mr Basheer
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Parallel Salam important points

• Parallel Salam is allowed with a third party
  only
• The seller in the first contract cannot be made
  purchaser in the parallel contract of Salam
• It will be a buy-back arrangement, which is not
  permissible
• If the purchaser in the second contract is a
  separate legal entity, then it is necessary that
  it should not be a subsidary or sister concern of
  the seller company in the first contract
• The arrangement will not be allowed because in
  practical sense it will be a 'buy-back'
  arrangement.

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Istisnaa'
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Scope of presentation

• Introduction of Istisnaa'
• Definition
• Explanation of Istisnaa', its rules and
  requirements
• Comparison with other modes
• Parallel Istisnaa'
• Application of Istisnaa'
• Risks analysis and mitigations
• Q A.

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Introduction

• As we discussed earlier two types of sales are
  exceptions from general rules for sale
• Istisnaa' is the second exception where sale of a
  subject matter which is not there at the time of
  transaction, has been allowed
• In fact permissibility of Istisnaa' is very
  logical and understandable
• In routine life any person may need a thing which
  requires manufacturing
• The manufacturer is not ready to manufacture
  before commitment from a buyer to buy
• Keeping this need in view Islam has permitted
  Istisnaa' transaction

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Definition

• Istisnaa' is 'an order from purchaser (buyer) to
  a manufacturer (seller) to produce a specific
  good for him (buyer) against mutually agreed
  price and period for manufacturing and delivery'
• So the main feature is manufacturing of the sold
  good
• Istisnaa' is only possible in goods which require
  manufacturing
• There is flexibility in payment of price
• It is may be paid according to any schedule by
  mutual consent (In advance, in tranches or at the
  time of delivery of the goods)

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Features of Istisnaa'

• Essential requirements for Istisnaa'
• Goods / commodities should require manufacturing
• Manufacturing means
• Any type of work that change the material
  significantly
• Like work of carpenter
• Value addition in which material changes its
  values
• Like powdering of liquid milk
• Manufacturer (seller) must use his own material
• If the material is provided by the buyer then
  this will be case of Services Ijarah and not of
  Istisnaa'
• The commodity must be known and specified in
  terms of kind, type, quality and quantity
• Ambiguity in these elements lead to Gharar

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Features of Istisnaa'

• Essential requirements for Istisnaa' (contd)
• Nature of price in Istisnaa'
• As other kind of sales, price of goods sold under
  Istisnaa' could be anything i. e. money,
  commodity and usufruct (Manafi')
• Price of the goods in Istisnaa'
• Price in Istisnaa' should be preferably fixed
• Price in Istisnaa' may be tied up with the time
  of delivery
• For example the buyer may fix 'X' price for
  delivery in 10 days and 'Y' price (reduced price)
  if the manufacturer delays delivery from the
  agreed time schedule
• The reason for this flexibility is resemblance of
  Istisnaa' with Ijarah
• Payment of Price of Istisnaa'
• The price can be paid immediately (spot) or
• Can be paid at delivery (deferred) or
• Could be paid in installments. The installments
  may be tied up with different stages of
  manufacturing/projects

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Features of Istisnaa'

• Essential requirements for Istisnaa'
• Goods / commodities should require manufacturing
• Manufacturing means
• Any type of work that change the material
  significantly
• Like work of carpenter
• Value addition in which material changes its
  values
• Like powdering of liquid milk
• Manufacturer (seller) must use his own material
• If the material is provided by the buyer then
  this will be case of Services Ijarah and not of
  Istisnaa'
• The commodity must be known and specified in
  terms of kind, type, quality and quantity
• Ambiguity in these elements lead to Gharar

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Istisnaa' Comparison(Istisnaa' and Salam)

• Istisnaa'
• The subject matter of an Istisnaa' contract is
  always something which requires manufacturing
• Price may be paid under any agreed schedule
• Contract may be canceled unilaterally before the
  manufacturer starts work
• May change with the consent of the contractors

• Salam
• Subject of Salam could be anything which can
  satisfy Salam conditions laid down by Shari'ah.
• Price must be paid in full in advance
• Salam contract, once effected, cannot be
  canceled unilaterally
• Determining the time of delivery is an essential
  part in Salam

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Istisnaa' Comparison (Istisnaa' and Ijarah)

• Istisnaa'
• In Istinsa' manufacturer agrees to produce the
  required goods using his own material.
• Therefore, the material in Istisnaa' should be
  provided by the manufacturer himself.

• Ijarah
• In Ijarah the manufacturer utilizes his labour
  and skills.
• Therefore, if the raw material is provided by the
  customer and manufacturer uses his labor and
  skills only, the transaction would be of Ijarah
  and not istisnaa'.

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PARALLEL ISTISNAA'
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Parallel Istisnaa'

• Parallel Istisnaa'
• Like Salam parallel Istisnaa' is not a kind of
  Istisnaa'
• It is parallel arrangement for an other Istisnaa'
  transaction that follows first Istisnaa'
• The second transaction is also an Istisnaa'
  transaction in all manners and conditions
• This arrangement of two transaction has been
  introduced to reduce the risk of buyer (Bank) for
  holding the commodities/goods.
• In a Parallel Istisnaa' contract, the buyer
  enters into a Parallel Istisnaa' contract in
  which he is a seller to a another buyer
• Applying to banking, in one of these two
  transactions, the Bank is the buyer and in the
  second it is the seller.

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Parallel Istisnaa'

• Conditions for parallel Istisnaa'
• Each of the two contracts must be independent of
  the other
• They cannot be tied up in a manner that the
  rights and obligations of one contract are
  dependent on the rights and obligations of the
  parallel contract
• Similar to Parallel Salam, Parallel Istisna is
  allowed with a third party only
• Therefore, Parallel Istisnaa' to the same party
  (seller in first Istisnaa') is not allowed.

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Questions