the principles-of-islamic-finance

الرحيم الرحمن الله بسم

The Principles of Islamic Finance

Islamic Banking (IB)

Definition:Islamic banking can be defined as: a form of modern banking based on Islamic legal concepts using risk- sharing as its main method excluding financing based on fixed pre- determined return.


The purpose of the Islamic financial system:

The purpose of the Islamic financial system is, as with conventional finance, to mobilize global resources to promote and sustain globaland regional development.

Islamic Finance taps the vast pool of savings held by Muslims, and puts these savings to productive use for the benefit of Islamic and other societies.



Principles that underlie the methodology of Islamic finance:

1 - Prohibition of Riba

2 - Prohibition of Gharar


Riba is understandable given that the payment and receipt of interest are central to all conventional banking.

Riba literally means increase,addition,expansion or growth. It is a typical increase or growth , which has been prohibited by Islam.

Riba technically refers to the premium that must be paid by the borrower to he lender along with the principle amount as a condition for the loan or for an extension in its maturity. in this case Riba obviously means interest.

Islam made a clear distinction between trade and Riba. Trading is encouraged but Riba is prohibited.

Islam does not consider money as a commodity so that there should be a price for its use.

Money is a medium of exchange i.e. Haman in asset-oriented economy , and a store of value.

The prohibition can be expressed in more technical terms by saying that while money is recognised in Islam as a means of exchange it may not lawfully be Regarded as a commodity for exchange.

The important difference between trade and Riba is that the business risk in trading is allocated more evenly among all the parties involved, whereas in Riba operations the business risk lies heavily, if not solely, on the borrower.


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The prohibition of Riba implies that:

The fixing in advance of a positive return on a loan as a reward for waiting is not permitted by Islam.

It makes no difference whether the return is :• a fixed or variable percent of the principle • or an absolute amount to be paid in advance or on maturity, • or a gift or service as a condition for the loan.


Gharar

- Ignorance of the goods or price,

- or false description of the goods.

- selling of goods that the seller is not in a position to deliver.

Gharar is a type of exchange in which one or both parties stand to be deceived through ignorance of an essential element of the exchange

The element of speculation inherent in derivatives trading means that such transactions fall into the category of Gharar and are therefore prohibited.


Sources of Funds in Islamic Banks

-Current Accounts

-All Islamic banks operate current accounts on behalf of their clients : individuals and business firms .

-These accounts are operated for the safe custody of deposits and for the convenience of customers .

The bank guarantees the full return of these deposits on demand and thedepositor does not gain any share of the profit or any other return in any form.


There are two dominant views about current accounts:

1- To treat demand deposits as Amanah. A "Trust Account" instead of a current account

In such case the bank does not have the authority to use them without first obtaining the specific permission of the owner of the funds.


2- The other view is to treat demand deposits as Qard Hasan (or interest free loan).

According to this view the bank is free to utilize these funds at its own risk without return to, or authorization from, the depositors.


INVESTMENT ACCOUNTS

In Islamic banks, Investment accounts (Profit and Loss Sharing (PLS) Accounts) play the same role as term deposits or time deposits in the conventional system .

The two differ in the following manner:

Fixed time accountsInvestment accounts

InterestProfit

Income pre-determineddetermination expected return percentage

Principle and return are guaranteedno guarantee except in cases of

misconduct or mismanagement

Maturitymaturity as well as on the basis of purpose


Different Kinds of Investment Deposits:

1 .Joint/ General Investment Accounts2 .Limited Period Investment Accounts

3 .Unlimited Period Investment Accounts4 .Specified Investment Accounts

The main characteristics of investment deposits can be described as follow:


Uses of Funds in Islamic Banking

Islamic banks use many techniques to utilize the raised funds. Such techniques, called modes of finance, are used as alternatives to interest -

based financing.

This is a sale of goods whose specifications are determined at the time of the contract, for a cash price paid in advance, and whose delivery will be at a future date .

The seller of the goods must make delivery of the goods of determined specification on a definite future due date. The goods need not be already manufactured at the time of the sale contract.

Bai'salam

Bai’salam

Finance Industrial sector

Agriculture sector



Definition:Istisna is an agreement meeting the Client's need for an item, equipment ,building, or project, which needs to be constructed, manufactured, fabricated ,

or assembled.

Istisna

Istisna

Manufacturing goodHouse under construction

Securitization

Definition:A Musharakah is a joint venture where by all partners (BANK /CLIENT) participate in providing the financial resources for the business. the Client to start and/or

operate a business or industry, or undertake any other type of business venture .The bank and the Client agree to manage the business enterprise according tothe terms of the agreement.

Musharakah

Musharakah

Permanent Musharakah inequity

DiminishingMusharakah

One of Musharakahtransaction

Financing workingcapital

Substitute for overdraft


Basic Principles Of Musharakah:

Financing through Musharakah means participation in the business.

An investor/financier must share the loss incurred by the business to

the extent of his financing.

The partners are at liberty to determine, with mutual consent, the

Ratio of profit allocated to each one of them, which may differ from

the ratio of investment.

The loss suffered by each partner must be exactly in the proportion of

his investment.


The usage of Musharakah in financing business:

Project financing

Financing of a single transaction

Securitization of Musharakah

Financing of Working Capital

Musharaka

Murabaha

Definition:Murabaha is a sale contract between the Bank as seller of goods and Client as purchaser, based on the disclosure of initial price to client. Bank purchases Goods on spot at the request of the Client, and then sells same to him on credit at a mutually agreed marked-up price.

Murabaha Financing Process

Customer Bank1

Supplier

Price

Goods

Promise to

Purchase

Promise to

Purchase

Sale Contract

(Musawama)

Sale Contract

(Musawama)

2

3

4

Customer Bank

Goods

Sale Contract(Murabaha)


Inst

allm

ents

5

6

7

(Buyer) (Seller)

(Buyer) (Seller)

Price


Any Murabaha transaction will typically involve a number of steps, which are broadly as follows:

1. The purchaser/ client submits an order to the bank to purchase the

goods they require.

2. The bank agrees to finance the purchase of proposed goods.

3. The bank prepares and sends an offer to the purchaser /client.

4. The purchaser accepts the offer, which binds it contractually to

purchase the goods.

5. the bank pays the supplier and purchases the goods using spot payment.

6. The purchaser, acting for himself, enters into a contract to buy the goods from the bank.

7. the purchaser purchases the goods from the bank for immediate delivery with deferred payment.

8. On the due date, the purchase price plus the mark-up is due.

Murabaha

Personal Murabaha Commercial Murabaha Murabaha LC’s

Liquidation of Musharaka

Contracts

Utilization Assets of investment funds&

Portfolio

Murabaha can be used to finance various needs of clients:


Definition:

Mudarabah is a mode of financing in which the bank provides the needed finance, while the Client provides the professional, managerial, and technical

know-how for starting and/or operating a business enterprise or project .The profit is shared in a pre-agreed ratio.

Mudarabah

Characteristics that distinguish Mudarabah from Musharakah :

a. The investment in a Mudarabah is provided by one partner only, whereas in a Musharakah it is supplied by all the partners.

b. In a Mudarabah the management of the investment is the sole responsibility of the mudarib, while in a Musharakah the partners all participate in the management of the business.

c. The loss in a Mudarabah is carried by the Rab'ul Mal alone, as the Mudarib has nothing to lose. In a Musharakah the proportion of loss is determined by the size of the investment .

d. A Mudarabah is a limited liability investment, whereas a Musharakah is not.

e. The assets acquired by a mudarib for the rab'ul mal are the sole possession of the latter, and the former can only profit by shrewd disposal of the assets . In a Musharakah the assets acquired are the joint possessions of all the partners in the deal.

Mudarabah uses in Islamic

Banking

Raising funds from clients

Structuring investment portfolios

Finance Clients

Structuring investment funds

Ijara

Under the terms of an Ijara transaction the investor, or lessor, would purchase equipment from a manufacturer and lease it on to the company, or lessee, for an Agreed period of time.

During this pre-determined period, the title to the underlying assets will remain in the hands of the lessor, whereas the actual possession and usage of the asset would be for the benefit of the lessee.

Ijara Financing

Lessee

Ijara(Lease)

Lessor

Leased Asset

Rental Payments

Offer &

Acceptance

During the life of the asset the risk of ownership remains with the lessor, while the lessee is responsible for use of the asset.

Over the life of the asset, the lessee will pay pre-agreed rentals to the lessor at a frequency mutually agreed upon by the two parties.

Important differences between a conventional lease and Ijara :

• In a conventional lease arrangement penalties will be incurred for late payment of an installment, which are stated as a percentage of the total. As this equates to an interest payment, it is prohibited under Shariah.

• Under shari'ah, original agreements can not be altered to reflect rescheduling. This can be done only in cases of mutual agreement to cancel the old agreement and to draw up a new one.

• Under conventional lease contract the lessee is responsible to insure the leased asset, where in an Islamic lease contract, the lessor holds the responsibility of paying the insurance since he owns the leased asset.

Customer Bank1

Landlord

Price

Promise to Lease

Promise to Lease

Sale Contract

Sale Contract2

3

4

Buildings

(Buyer) (Seller)

Customer BankLease

contract

Lease contract

Ren

tal P

aym

ents

5

6

7

(Lessee) (Lessor)

Buildings

Ijara Financing Process

Salam

Salam is a sale whereby the seller undertakes to supply some specific goods to the Buyer at a future date in exchange for an advanced price fully paid on the spot.

The permissibility of Salam was an exception to the general rule that prohibits forward sales. For that, it was subjected to some strict conditions.

These conditions are as follows:

1. The payment of the price by the buyer should be at the time of effecting the sale.

2. Such sale is permissible only in the commodities whose quality and quantity can be specified exactly. For example, precious stones cannot be sold on the basis of Salam, because every piece of precious stone is normally different from the other.

3. It cannot be effected on a commodity whose supply is not certain. For example, if the seller undertakes to supply rice or wheat of a particular field, or the fruit of a particular tree, the Salam will not be valid.

4. The quality and quantity of the commodity sought to be sold by Salam must be fully specified. The exact date and place of delivery must be specified in the contract

5. It is not permissible for the buyer of a Salam commodity to sell it before receiving it because that is similar to the prohibited sale of debts before holding.

Usage of Salam:

Salam sale has been found suitable for the finance of agricultural operations.

It is also used to finance commercial and industrial activities, especially phases prior to production and export of commodities and that is by purchasing them on Salam and marketing them at a profit.

The Salam sale is also used by banks in financing craftsmen and

small producers by supplying them with inputs of production as a

Salam capital in exchange for some of their commodities to remarket.

The scope of Salam sale is large enough to cover the needs of

various people such as farmers, industrialists, contractors or traders.

It can cover the finance of operational costs and capital goods.

Istisna’a

Istisna’a is the second kind of sale where a commodity is transacted before it comes into existence. It entails ordering a manufacturer to manufacture specific goods for the purchaser. If the manufacturer undertakes to manufacture the goods for him, the transaction of Istisna’a comes into existence.

It is necessary for the validity of Istisna’a that:

A. The price is fixed with the consent of both parties.

B. The specification of the commodity intended to be manufactured is fully settled between them.

The contract of Istisna’a creates a moral obligation on the

manufacturer to manufacture the goods, but before he starts the

work ,any one of the parties may cancel the contract after giving

notice to the other.

However, after the manufacturer has started the work, the contract

cannot be cancelled unilaterally.

In Istisna’a, the party placing the order has the right to retract if

the commodity does not conform to the specification demanded.

In Istisna’a the price could be in advance or in installments or

deferred but the time of payment should be fixed.

Istisna’a Financing

Manufacturer ClientBank

Usage Of Istisna:

Istisna can be used for providing the facility of financing in certain

transactions, especially in the housing finance.

It is not necessary that the financier himself constructs the house.

He can enter into a parallel contract of Istisna with a third party,

or may hire the services of a contractor. In order to secure the

payments of installments, the bank , as a security, may keep the

title deeds of the house or land, or any other property , until the

client pays the last installment.

The instrument of Istisna may also be used for project

financing on similar lines.


Tawaroq is a financial product to satisfy customer cash needs compliant with Shariah rules. Under such program the bank purchases certain goods

on spot basis either from local or international markets and sells them to customers on credit.

The customer in his turn resells the goods to a third party to obtain cash.

TAWAROQ

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Definition:

Tawaroq means converting an asset into “wareq” or money.

Supplier(Seller)

Sale

Customer(Buyer)

GoodsDeferred payment(Ex.110)

Offer &

Acceptance

Customer(Seller)

Sale

3rd Party(Buyer)

GoodsSpot

payment(Ex.100)

Offer &

Acceptance

Supplier(Seller)

Sale

Customer(Buyer)

GoodsDeferred payment(Ex.110)

Offer &

Acceptance

Customer(Seller)

Sale

Supplier(Buyer)

GoodsSpot

payment(Ex.100)

Offer &

Acceptance

Tawaroq Structure

Inah Sale (Prohibited)

Tawaroq Financing

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Tawaroq Financing

Customer(1st Party)

Supplier(2nd Party)

Purchase Contract(Deferred Payment

Ex. SR 110)

Purchase Contract(Deferred Payment

Ex. SR 110)

Sale Contract(Cash

Payment Ex. SR 100)

Sale Contract(Cash

Payment Ex. SR 100)

Inah Sale (Prohibited)

End Result: SR 110 – SR 100 = SR 10 (Interest)

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Tawaroq Financing

Tawaroq Structure (international Commodity)

Broker 2(4th Party)

Broker 1(3rd Party)

Customer(1st Party)

Bank(2nd Party)

Promise to

Purchase

Promise to

Purchase

Purchase Contract

Purchase Contract



Deferred Installment Payments

Agency Agreement

Agency Agreement

Sale Contract

Sale Contract

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Tawaroq Financing

Tawaroq Structure (Local Commodity)

Broker 2(4th Party)

Local Supplier(3rd Party)

Customer(1st Party)

Bank(2nd Party)

Promise to

Purchase

Promise to

Purchase

Purchase Contract

Purchase Contract



Deferred Installment Payments

Agency Agreement

Agency Agreement

Sale Contract

Sale Contract


Thank You

the principles-of-islamic-finance

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