Islamic banking is banking system that is
consistent with the principles of Islamic law
and Shariah and its practical application through the
development of Islamic economics. As such, a more
correct term for 'Islamic banking' is „ Shariah
compliant finance'. Sharia prohibits the fixed or
floating payment or acceptance of specific interest
or fees (known as riba, or usury) for loans of money.
Investing in businesses that provide goods or
services considered contrary to Islamic principles is
also Haraam ("sinful and prohibited").
Riba (Charging of Interest)
Maysir or Speculation
Implying social justice and general welfare
Conforming to Sharia
Qard-e-hasna (benevolent loan)
Profit and loss sharing (PLS)
Prohibited Investments and Permissibility of
The word "riba" means interest, usury, excess, increase or
premium that must be paid by the borrower to the lender
Riba is the predetermined return on the use of money
when money begets money, without being exchanged for
goods or services, or without indulging in any productive
activity, it is called Riba
The term riba include the following points too:
any form of unfair trade, market manipulation or
engaging a market participant to trade under duress
risk-free debt contracts
Islam recognizes the time value of money, but only when it
acts as capital, not when it is "potential" capital.
Gharar (Uncertainty): The existence of uncertainty in a
contract is prohibited because it requires the occurrence of an
event which may not ultimately occur. “Full disclosure” by
both parties is the norm in contractual relationships. Any
type of transaction where the (i) subject matter, (ii) the price,
or both are not determined and fixed in advance amounts to
Maysir(Speculation): Speculation is similar to
gambling, and therefore is prohibited. Derivative transactions
like Options, Futures, Swaps and forward contracts (that
ensure profit) are considered un-Islamic. They are also
considered un-Islamic because for most of them, rates are
determined by interest differentials
Zakat: A taxation system inherent in the Islamic system
based on the principles of social justice and equity.
Implying social justice and general welfare: The basic
principle is that everybody should be able to fulfill at least
the basic needs.
Conforming to Shariah: The Quran and Hadith clearly
specify the guidelines for individual, social,
organizational, governmental behaviour, and thus become
the basic pillar for any Islamic system, with the banking
and financial system being no exception.
Qard-e-Hasna (benevolent loan), or Qard Hassan: Qard-
e-Hasna means an interest free loan and is the only type of
loan permitted by the Shariah. The guiding principle again
is the social justice and general welfare.
Profit and loss sharing (PLS): It is an alternative to
Prohibited Investments and Permissibility of Activities:
Investments should only support Halal (permitted)
activities. So, investments involving products like pork,
alcohol, pornography, arms & ammunitions, Cinema,
Tobacco, Conventional Financial Services and activities
like gambling are prohibited.
Hoarding: Hoarding money is considered improper in
Islam; money is merely a means of exchange and should
not be treated as a commodity. Islam encourages Trade
and Enterprise, which can generate wealth for the benefits
of the community as a whole with PLS as its core.
SOURCE OF FUNDS USE OF FUNDS
SPECIAL INVEST. ACC
IJARAH WA IQTINA (hire
LOAN ON SERVICE
INTEREST FREE LOANS.
Very Similar to standard commercial banks
No return paid back to depositors
Are Current deposits a loan to the bank from
Are Current deposits a trust by depositors to banks ?
Use of Current deposits by the banks on their own
Saving deposits without authorization to invest
Saving deposits with authorization to invest
Return to depositors who provide authorization to
Saving deposits as a part of trust accounts.
Saving deposit as Notice account
Concept of Wakalah
The bank acts as a wakeel. Implements the
instruction of the Mawakkil.
investment, Specify, purpose, sector, industry, or
The bank gets a fee for the services rendered.
Full profit or loss goes to the depositor. The bank
will share in loss only in case of proven neglect.
In a Murabaha transaction, the bank finances the purchase of
an asset by buying it on behalf of its client. The bank then
adds a "mark-up" in its sale price to its client who pays for it
on a deferred basis.
Islamic banks are supposed to take a genuine commercial
risk between the purchase of the asset from the seller and the
sale of the asset to the person requiring the goods.
Title to the goods financed may pass to the bank's client at
the outset or on deferred payment
Applications of Murabaha
1-In domestic trade 3-consumer durables
2-In foreign trade 4-In financing real
It involves leasing of machinery, equipment,
buildings and other capital assets. The financier
purchases the asset and leases it to the end-user for
an agreed rental which may be fixed in advance or
subject to occasional review by a mutually
acceptable third party, e.g. an international firm of
accountants. Insuring of the asset remains a
This is a leasing structure coupled with a right
available to the lessee to purchase the asset at the
end of the lease period (Bay‟ al Wafa). The lessee
agrees to make payments into an Islamic investment
account (with right to all profits) to be used in or
towards financing the ultimate purchase of the asset.
The instrument has been used increasingly in a
range of asset classes including ships, aircrafts,
telecom equipment and power station turbines, etc.
It is a short-term commodity finance contract
usually of agricultural or manufactured products
Pays to the seller full negotiated price of a product
delivery at a later date
quality and quantity of the sold products are specified.
The counter-party risk in Al Salam is one-sided as it lies
with the buyer unless security is provided by the seller.
bank paying for the producer's goods at a discount
In Salam, purchased goods
are deferred, price is paid
In Salam price has to be
paid in full in advance.
Salam is not executed in
the particular commodity
but commodity is specified
Salam cannot be effected
in respect of things, which
must be delivered at spot.
e.g. Salam b/w wheat and
In Murabaha purchased
goods are delivered at
spot, price may be either
on spot or deferred.
In Murabaha price may be
on spot or deferred.
Murabaha can be executed
in particular commodity.
Murabaha can be executed
in those things.
1.Only for the quality and quantity of commodities which
have been specified exactly.
2.The quality of the commodity is fully specified, leaving no
3.The quantity of the commodity is agreed upon in
unequivocal (clear) terms. If the commodity is quantified
in weights according to the usage of its traders, its weight
must be determined, and if it is quantified through
measures, its exact measure should be known.
4.The exact date and place of delivery must be specified in
5. Salam cannot be effected in respect of things which must
be delivered at spot. It must be in an agreed period of
6.Salam cannot be effected on a particular commodity
or on a product of a particular field or farm.
For example, if the seller undertakes to supply the
wheat of a particular field, or the fruit of a particular
tree, the salam will not be valid, because there is a
possibility that the crop of that particular field or the
fruit of that tree is destroyed before
delivery, and, given such possibility, the delivery
remains uncertain. The same rule is applicable to
every commodity the supply of which is not certain.
“Pak Hassan have 5 acres of land that could be cultivated
with paddy. He could produce 5 tonne of paddy in 6 months.
However, Pak Hassan does not have enough money to start
the project. He approaches an Islamic bank for financing.
The bank bought 5 tonne of paddy from Pak Hassan using a
Salam contract at a price of RM 1.20/kg. The market price of
paddy was RM 1.80/kg. Therefore the bank paid the total
selling price (1.20 x 5,000 kg = RM6,000) to Pak Hassan on
Pak Hassan used this money to start his project. The project
cost was RM 3,500.
After 6 months. Pak Hassan delivered 5 tonne of paddy to
the Islamic bank.”
Pak Hassan would gain a gross profit of RM 2,500 (Salam
price – Project Cost).
The Islamic bank could make profit by selling the paddy
in the market at RM1.80/kg. Then, the bank would
enjoy a gross profit of RM3,000 [(1.80-1.20)x5000 kg].
Both parties in Salam will face the risk of price
If the price of paddy goes up, Pak Hassan would have to
forego the opportunity of making higher profit because
he has sold the paddy to the bank at the salam
price, while the bank may enjoy a higher profit than the
On the other hand if the paddy price goes down to say
RM1.00/kg, then Pak Hassan will be in a comfortable
position because he has already sold to the bank at
RM1.20/kg. The bank will now face the risk of loss
because it could not recover its cost.
To manage the risks in first salam contract, the bank will
usually enter into a parallel salam i.e. the bank will find
another party (maybe paddy wholeseller) and enter into a
another salam contract so, it could sell the paddy to the
wholeseller at a fixed price.
Parallel salam – when there are 3 parties involved in salam
Assume the wholesale price of paddy is RM 1.50/kg.
Pak Hassan sold to the bank 5 tonne of paddy at RM1.2/kg
on Salam basis.
The bank paid Pak Hassan RM6,000 on Day 1.
The bank sold the 5 tonne of paddy to the wholeseller at
RM1.40/kg on Salam basis.
The transaction between Pak Hassan and the Islamic
bank is the first Salam (Salam 1) while the transaction
between the Islamic bank and the wholeseller is the
second Salam (Salam 2).
This is known as Parallel or back to back salam.
One important note is that, if Pak Hassan fails to deliver
in the first Salam, the bank would still have to honor the
That‟s why it is important to finance generic goods
using Salam, because the bank could buy paddy in the
open market and still honor the second Salam in the
event, if the first Salam fails.
It involves a deferred delivery sale contract similar to
It is also similar to conventional work-in-progress
financing of capital projects like construction
It is also used for trade finance such as pre-shipment
the seller ( Al Sani‟), based upon an order from
purchaser (Al Mustasni‟), undertakes to manufacture or
have manufactured/ acquired the subject item (Al
Masnoo‟) as per purchaser‟s specifications.
The price, payment structure and the date of delivery are
fixed in advance
Being a construction or manufacturing contract, Istisna’ is
very suitable for project financing.
Example: Commercial or residential buildings, road
construction, aircraft and vessel construction
The seller could either manufacture the commodity on his
own or he could find another sub-contractor to do the job.
This will result in parallel or back to back istisna‟.
Client asks the bank to construct a house for him with clear
specification. The cost to construct the house is RM300,000.
The bank agrees and signs an Istisna‟ contract with the
client. (The bank is the seller in the first Istisna‟. The selling
price that the bank charges is RM450,000 – i.e. Cost of
construction plus profit to the bank).
The bank then finds a contractor for the construction
and asks him to handle the project.
The contractor agrees and signs an Istisna‟ contract with
the bank. (Now the contractor is the seller in the second
Istisna‟. The contractor charges the full construction
cost, say RM400,000 ).
Upon completion, the contractor delivers to the bank
and the bank delivers to the client.
Payment in this contract could be very flexible.
Banks would release progressive payment i.e. payment
according to stages of completion of construction.
Being the seller in the first Istisna‟, the bank is liable to
any non-completion of the house or any non-
conformance to specification risk.
Therefore, it is very important to have a project
management team to ensure the selection of projects to
be financed using Istisna‟ is carefully made.
Payment is in staggered
cancelled before the
manufacturer starts the work.
The asset manufactured must
meet specification of the order
and the buyer has the right not
to take possession of the asset if
the specifications are not met.
The time of delivery is not
Any penalty for charged late
delivery can reduce the price of
an Istisna contract
Bai As Salam
May or may not manufacturing
paid in full in advance
once effected, cannot be
The object of the Salam is a
liability on the seller to
deliver, thus should be in the
form of fungible goods i.e.
easily replaced from the market
should the seller be unable to
The time of delivery is an
essential part of the sale in
Salam while it is not necessary
The penalty amount is paid to
charity (not taken as benefit for
Jo’alah: A party undertakes to pay another party a specified
amount of money as a fee for rendering a specified service in
accordance with the terms of the contract stipulated between
the two parties. This mode usually applies to transactions
such as consultations and professional services, fund
placements, and trust services.
Certificates of sale: It has been suggested that consumers
buying consumables on credit would issue 'certificates of
sale' similar to letters of credit. These could be encashed by
the seller at the bank at a discount. This seems very similar in
structure to Bai salam.
Syndication: Islamic Financial Institutions are increasingly
prepared to participate in large project financing, and are
getting ready to compete with their conventional
counterparts. The syndication works on the techniques
discussed above, most popular being the Mudarabah contract
modified to suit the technicalities.
Sukuk is the Arabic name for a financial certificate or an
Islamic bond. It is not a fixed-income, & not interest-bearing
Sukuk refer to securitization, a process in which ownership
of the underlying assets is transferred to a large number of
Mudharabah is a proﬁt sharing arrangement between two
parties,that is, an investor and the entrepreneur. The investor
will supply the entrepreneur with funds for his business
and gets a return on the funds he puts into the business
based on a proﬁt sharing ratio that has been agreed earlier.
The principle of Mudharabah can be applied to Islamic banking
operations in 2 ways:
1)between a bank (as the entrepreneur)and the capital provider
2) between a bank (as capitalprovider) and the entrepreneur.
Losses suffered shall be borne by the capital provider.
1) You supply funds to the bank after agreeing on
the terms of the Mudharabah arrangement.
2) Bank invests funds in assets or in projects.
3) Business may make proﬁt or incur loss.
4) Proﬁt is shared between you and your bank
based on a preagreed ratio.
5) Any loss will be borne by you. This will reduce
the value of the assets/ investments and
hence,the amount of funds you have supplied
to the bank
In the context of business and
trade,Musharakah refers to a partnership or a
joint business venture to make proﬁt. Proﬁts
made will be shared by the partners based on
an agreed ratio which may not be in the same
proportion as the amount of investment
made by the partners. However, losses
incurred will be shared based on the ratio of
funds invested by each partner
Two partners start business in Shirkah to
One of the partners undertakes to
purchase the share of another partner gradually
every month or each year.
1. Valuation of plot will be made. This value will be
investment of client in Musharakah Agreement and
bank‟s financing for construction will be investment
2. Musharakah Agreement will be signed between
bank and client in which investment of everyone
will be agreed. It will also be agreed that client as
working partner will be responsible for
3. Both the partners will be owner of the property
in same ratio as ratio of investment.
4. The property will be in the name of the client.
5. This is Shirkat-ul-Milk.
6. According to the ratio of ownership, each one is
responsible for the loss.
7. Bank will divide its own part of asset into
units, which is promised by the client to
purchase on pre-agreed price.
8. After completion of house, Ijarah Agreement
will be signed and bank will give his share of
house on rent. Before completion of
construction, rent cannot be charged.
9. Rent may be fixed on prevailing market value or
with mutual consent.
10. Bank‟s monthly profit may also be decided, as
monthly rent of the house and principal amount will
be recovered in the unit price.
11. In Ijarah Agreement, a lump sum amount of rent is
necessary to be fixed for a certain period. Rent for
the rest of the period, may be linked with agreed
12.Before one year, client cannot purchase
13.Each unit will be purchased on the basis
of Offer & Acceptance.
Liquidity originated market risk
Transformation of credit risk to
market risk and market risk to credit
risk at various stages of a contract
Bundling of credit risk and market
Market risk arising from owning the
underlying non-financial asset until
maturity of a contract or until the
ownership is transferred to customer
Treatment of default
In traditional banks, market risk is
mostly in the trading book
In Islamic banks, market risk is
concentrated in the banking book due to
Murabahah, Ijara, Salam, Musharakah
and Mudharabah in the banking book
Hence it is unique for Islamic banks that
market risk and credit risk are strongly
An unexpected loss in a bank’s income due
to delay in repayment or non-repayment in
full by the client as contractually agreed
Default risk covers over 80% of risks in an
average bank’s banking book asset
It is the cause of over 80% cases of bank
Default risk, also causes market risk and
Treatment of default: In Islam, compensation-
based restructuring of credit is the most well
known form of Riba, namely, Riba Al Jahiliyah
– this highly necessitates credit risk
Moral issues in loan loss reserves
Collateral quality (restrictions on use of
Insurance – clients’ insurance and facilities
Diverse modes and bundled risks
Mudharabah / Musharakah
Default event undefined
Collateral not allowed
Salam / Istisna’
Counterparty performance risk
Separation of market risk from default risk
Catastrophic risk high
Baseline default risk, but counterparty risk due
to embedded option (Murabahah, binding non-
binding matter) also exists
Conglomeration of risks – each mode having
various risks, credit, liquidity, market, reputation,