06 lecture, eif - fall 2013

Essentials of Islamic Banking and FinanceIQRA University Gulshan Campus

Talha Saleem Kapadia [email protected]

Islamic modes of Financing

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;

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;

Mode of financing

Islamic modes 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; andParticipation-based of financing;

Islamic modes of financing

Financial activities

Exchange of goods or services

Murabahah (cost disclosed sale)

Musawamah (simple bargain sale)

Salam (future sale)

Istisnaa' (Manufacturing Sale)

Ijarah (services rendering)

PartnershipGiftLoan

Capital provisioning

TemproryPermanent

Remunerative (partnership based financing)

Non-remunerative

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.

Trade based modes of financing

There are four kinds of Trade-based modes of financing which are very common:– MURABAHAHA;

Cost+profit 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.


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;


Sometimes it is argued that the time has effects on calculation of profit in case of credit sale;

We will analyse this question in following slides;

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, time is one of the main factor 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;

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;

Price difference in Credit and Cash sale

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 partners;

So non-fixation here is the acceptable way.

Fixation 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 fixing 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.

Fixing of return/profit in trade-based modes

Murabahah and Musawamah

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;


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;


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);

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.



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 indirectly from the market/seller before selling it to the customer;

Process flow

BANKBANK CLIENTCLIENTAGREEMENT TO MURABAHAH

Murabahah – step by step

Step # 1:– Client and Bank sign an agreement to enter into

Murabahah.


AGENCY AGREEMENT


Step # 2:– Client appointed as agent to purchase goods on behalf

of Bank;


AGENCY AGREEMENT

SUPPLIERSUPPLIERPAYMENT OF PRICE OF GOODS TO THE

SUPPLIER OR AGENT (COUSTOMEROR THIRD PARTY)


Step # 3:– Bank gives money to directly to supplier or to the client

for purchase of goods; Client appointed as agent to purchase goods on behalf of Bank;

BANKBANK CLIENTCLIENTPAYMENT OF PRICE IN ANAGREED PERIOD OF TIME

AND INSTALMENTS


Step # 3:– Client pays agreed price to bank according to an agreed

schedule. Usually on a deferred payment basis (Bai Muwajjal) in tranches;

Application

Murabahah can be used to finance the real purchase needs of customer;

It could be used for assets which are acceptable to Shari’ah and has a tangible form.

Therefore, Murabahah can be used to finance the purchase of:– Raw Material;– Equipment;– Consumer Goods;

Murabahah cannot be used to finance:– Personal loans;– Credit cards.

Murabahah – Application

Musawamah

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.

Questions

06 lecture, eif - fall 2013

Documents

islamic mode of financing

sale financing

assetstradebased modes

based modes of financingtrade

kind of financing

secure modes

modes of financingthere

instalmentsall modes