10297972islamic banking

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INTRODUCTION TO ISLAMIC FINANCING
Shlomo Ovadiah

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Subjects
The ownership of wealth .................................................................................................2
Islamic vs materialistic perspective..........................................................................3
Islam and socio-economic justice .........................................................................................4
The rationale of prohibition of Riba...........................................................................5
The prohibition of Maysir and Gharar.......................................................................7
Islamic Banks as financial intermediaries.............................................................8
The Islamic Development Bank .................................................................................10
Operations and objectives ............................................................................................11
Valid sale transactions ....................................................................................................13
Loans and Debts..................................................................................................................14
Responsabilities of debtors and creditors ...........................................................16
Mudarabah..............................................................................................................................18
Musharakah ...........................................................................................................................19
Difference between Musharakah and Mudarabah ......................................................20
Diminishing Musharakah......................................................................................................21
The process of islamic bank's financing through Diminishing Musharakah......22
Murabahah ................................................................................................................................24
Concerns ....................................................................................................................................25
Risk Management techniques ............................................................................................26
Salam ..........................................................................................................................................28
Parallel Salam ..........................................................................................................................29
Risk management in Salam................................................................................................30
Istisna'a......................................................................................................................................31
Ijarah ..........................................................................................................................................32
Valid lease .................................................................................................................................33

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Ijarah Muntahia-bi-tamleek................................................................................................34
Potential of Ijarah...................................................................................................................35
Wakalah .....................................................................................................................................37
Musawamah..............................................................................................................................39
Kafalah........................................................................................................................................40
Tawarruq....................................................................................................................................41
Istijrar .........................................................................................................................................42
ua'lah...........................................................................................................................................43
Islamic banks commercial transactions .........................................................................44
Modes of investment and finance used by Islamic Banks.......................................45
Depositis ....................................................................................................................................46
Current account deposits.....................................................................................................48
Interest-bearing deposits ....................................................................................................50
Deposit-management based on Mudarabah.................................................................51
Protection of risk-averse depositors................................................................................52
Halal credit cards ....................................................................................................................53
Interaction with conventional system.............................................................................55
Cooperation ..............................................................................................................................55
Fee-based services.................................................................................................................57
Letter of Credit ........................................................................................................................58
Bank guarantee .......................................................................................................................60
Ijarah financing .......................................................................................................................61
Musharakah and Mudarabah ..............................................................................................63
Scope of Musharakah and Mudarabah certificates ....................................................64
Diminishing Musharakah......................................................................................................66
Replacing conventional system .........................................................................................67
Participative modes ...............................................................................................................68
Venture capital ........................................................................................................................69
Shareholding in Islam ...........................................................................................................70

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Islamic Unit Trusts .................................................................................................................71
Islamic Unit Trusts / Ethical Unit Trusts ........................................................................72
Screening of Islamic investments ....................................................................................73
Indexation of financial obligations ...................................................................................75
Dow Jones Islamic Market Indexes .................................................................................77
LIBOR Indexes.........................................................................................................................78
Islamic Forex............................................................................................................................79
Sharia'h Boards .......................................................................................................................83
Shari’ah compliance...................................................................................................................83
Supervision ...............................................................................................................................84
Financial accounting ..............................................................................................................86
Financial statements .............................................................................................................87
Issue of taxation .....................................................................................................................88
Starting an Islamic Bank .....................................................................................................89
Education and training..........................................................................................................90
Central Banks...........................................................................................................................91
Takaful Agreements...............................................................................................................93
Specifities ..................................................................................................................................94
Distribution of surplus ..........................................................................................................95
Tabarru'......................................................................................................................................95
Takaful ........................................................................................................................................96
Differences between conventional insurance and Takaful ......................................96
Takaful Business Models ......................................................................................................98
Choice of the model...............................................................................................................98
Family Takaful and General Takaful ..............................................................................101
General insurance ................................................................................................................102
Aspects of General Takaful ...............................................................................................102
Life insurance .........................................................................................................................103
Importance of Family Takaful ..........................................................................................103

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Takaful Funds.........................................................................................................................104
Reinsurance ............................................................................................................................106
Corporate Governance in Takaful...................................................................................107
Sharia'h Auditing in Takaful .............................................................................................107
Regulatory implications ......................................................................................................108

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The ownership of wealth
Islam has a unique dispensation on the concept of wealth, its ownership and distribution. Wealth
in Islam is not an end in itself, but a means to higher values. It should be earned, invested and
spend in the correct avenues, and it should reward the individual, his family, and the society as
a whole. Itsrewards also span this life as well as the hereafter.
According to the Islamic concept, wealth is considered as an endowment or a gift from God and
human beings are considered as trustees on God’s resources on earth. These resources are to be
wisely treated, not abused, destroyed, wasted or left to idle. This dual ownership mitigates the
selfish and unfair tendencies that often result from a mistaken notion of absolute ownership.
However, Islam doesn’t oppose any material pursuit neither it is against the accumulation of
wealth. The only concern it put forward is the danger of obsessive preoccupation in accumulating
and conglomerating wealth to the extent sidelining spirituality.
Islam also provides a broad foundation of the distribution of income and wealth to avoid its
accumulation. It does not advocate equal distribution of wealth in the sense that all individuals
should have the same means from livelihood, but guarantees a process of distribution where all
participants in the marketplace are rewarded for being exposed to risk and liability. Land, labour
and capital jointly create value and the capital owner has to share in the profit as well as in the
loss.
Besides, Islam compulsorily retains a share of produced wealth by paying the Zakat (Charity) to
the needy and other charitable deeds; and therefore spreads out wealth in the community. The
institution of Zakat is not only a source of alleviating the sufferings of the poor, but also provides
an incentive to invest the surplus wealth in the real sectors of the economy. Muslims are yet
encouraged to voluntary give part of their income as a waqf for social economic welfare.
Moreover, the abolition of Riba prevents unfair lending schemes which penalize the poor and
allows for those possible alternatives of investment which distribute the return on capital on a
broader basis.
Finally, the law of inheritance in Islam ensures that accumulated wealth and large holdings would
be divided into relatively smaller fragments.

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Islamic vs materialistic perspective
The primary difference between Islamic economics and all materialist ones is that that economic
well being is not viewed in Islam as the ultimate end of human life and cannot be the true
purpose of life. Economic endeavours become a delusion if human beings lose sight of the real
purpose in their pursuit. Instead Islam insists on the concept of human Welfare that has both
a material and spiritual dimensions.
In addition, unlike the materialistic perspective, the Shari’ah considers that the main economic
problemthat mankind will ever face is that of distribution of wealth and not of production. In the
eyes of the conventional economics systems, there is relative scarcity of resources available on
the earth, and people’s demands for these resources are endless. Hence individuals and
organisations should concentrate on more and more production. Whereas, Islam makes a
distinction between basic needs such as food, clothing and shelter, and comfortable wants that
are not necessities in life. It considers that there are enough resources to satisfy the basic needs
of each and every individual and to satisfy some of their luxurious wants and that economic
problem is that of distribution and not production. Islam advocates specific regulations by which
wealth can be acquired, used and disposed of. It is through that specific economic system that
economic justice in society is maintained.
In the Islamic perspective, there are people who acquire wealth by engaging in the production
process and others who have an indirect access to wealth in the form of Zakat,
Waqf, inheritance, etc. which are given to the poor, the needy and later generations.
Notwithstanding this, Islam it gives full incentives to individuals to fully participate in the
economy and it does not impose a maximum on the total of wealth that individuals or
organisations can own. Rather, it controls the means of ownership such that everybody gets the
right to wealth in a just manner. Through these ownership principles, Islam guarantees that
everyone gets what is rightfully due to him from God, unlike the capitalist system where only
those who take part in the production process have the right to wealth.
Additionally, Interest rates form the backbone of the capitalist system in many fields. It is used
as a tool to regulate economic growth and monetary supply by acting as an incentive for those
who have surplus money to save. In Islam interest is prohibited; Investment, according to the
Shari'ah, should offer individuals the opportunity to profit, not by lending at a guaranteed rate of
return, but by sharing in ownership, and thus committing to share in the risks associated with
ownership. The abolition of Riba avoids inequitable lending transactions which penalize the
deprived part of the society. By this means, Islamic economics seeks to provide for a just and
equitable distribution of wealth and aims at re-establishing a socio-economic balance, with a
clear bias in favour of the poor and the needy.

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Islam and socio-economic justice
The Shari’ah has laid down certain principles and limits for the economic activity so that the
entire framework of production, trade and distribution of wealth may conform to the Islamic
standard of justice and equity.
According to the Islamic perspective, God has created for mankind the earth and all its
resources. It is, therefore, the legacy of every human being to try to secure his share of this
world’s wealth. The role of humankind is no more than that of caretakers. This concept of dual
ownership between human being and God is one of the special features of the Islamic economic
system. While, the personal right to own is protected and endorsed by Islam, the Shari’ah
tempers human ownership by the understanding that everything belongs to God. What appears
to be ownership is in fact a matter of trusteeship, whereby man has temporary authority to
handle and benefit from goods.
In addition, Islam aims at striking a balance between the individual and the community. In fact,
the Islamic framework has adopted a fair approach which promotes individual freedom and at
the same timeensures that such freedom is positively contributing to the welfare of the
community as a whole. Accordingly, the individual has freedom of enterprise and competition
within an atmosphere of morality, fairness and social harmony and where participants should be
just and kind to one another.
Besides, there is great emphasis in Islam on social and economic justice. This justice is possible
only when all sections of society can fulfil their economic needs. Therefore, even people who are
unable to take part in the economic competition and those who need help to get started in it
should have their chances to exist as well. The goals of socio-economic justice and equitable
distribution of income and wealth are integral parts of the moral philosophy of Islam. The poor
and the needy are entitled to a share of the society’s wealth. Thus, Zakat has central importance
in Islamic society. Everybody is permitted to accumulate wealth that is left over after meeting
one’s legitimate and reasonable commitments and after giving a percentage of one's income
to charity. Another major tool for achieving socio-economic justice is the prohibition of Riba to
avoid any unfair advantage in exchange dealings between parties.

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The rationale of prohibition of Riba
Riba, which means not only usury, but all forms of unearned income, has been strictly prohibited
by Islam. Although the Qur’an did not specify any particular kind of riba, Muslim scholars have
categorized it in two types: riba al-nasi’ah, and riba al-fadl. Riba al-nasi’ah refers to the interest
on loans; its prohibition essentially implies that the fixing in advance of a positive return on a
loan as a reward for waiting is not permitted in Islam. Riba al-fadl is the excess over and above
the loan paid in kind. It lies in the payment of an addition by the debtor to the creditor in
exchange of commodities of the same kind. The Shari’ah wishes to eliminate not merely the
exploitation that is intrinsic in the institution of interest, but also that which is inherent in all
forms of unjust exchange in business transactions.
Despite the fact that interest occupies a central position in modern economic system and that it
became the very life blood of the existing financial institutions, Islam considers that the principle
of charging interest is quite opposite of that of business in the spirit of sharing and cooperation
and that lending on interest is not as a business in the real sense.
In legalizing trade and condemning interest, Islam considers that there are fundamental
differences between the nature of profit resulting from interest charges and that earned by
trade. In interest-based transactions, there may be no equitable division of profit between the
buyer who makes a profit on the sale of good purchased, and the seller who derives a profit in
consideration of the labour and time spent in procuring the goods. Moreover, there could be no
end for an interest-based transaction, since there could always be interests of unpaid interests
as long as the principle amount loaned is not fully returned. This could, in extreme cases, create
un-repayable debt for generations
The rationale for the prohibition of interest the Islamic economic framework highlights how the
risk-reward sharing would be more conductive to the realization of equity and the promotion of
entrepreneurship. In fact, the interest-based banking system relies heavily on collateral and
gives inadequate consideration to the strength of the project or the ultimate use of the
financing. Even though collateral and cash flow are indispensable for ensuring repayment of
loans, giving them undue weight result in a relative misestimating of the purpose for which
borrowing takes place. Hence, that system tends to enforce the unequal distribution of capital by
allocating financial resources mainly to the rich, who have the collateral and cash flow.
Islam considers even interest-based loans taken for investment in a productive activity as not
equitable because in the profits that may accrue from it is not required to be known forehand
and if there is a loss, the entrepreneur has to bear the entire loss in spite of all the risk and
engagement he took, whereas the money lender, who did less sacrifice than the entrepreneur,
gets an effortless profit determined by a positive rate. In Islam both risks and rewards should be
shared by the different parties.
And since the unrestricted power of the creditor to make profit from interest has no regard to

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the financial ability of the debtor to repay indebtedness, middle-class consumers, as well as the
developing countries, could be caught up in a never-ending debt-trap. And because the Riba
system encourages living beyond one’s means for both individuals and governments, it results in
an accentuation of macroeconomics, inflation and external imbalances in addition of squeezing
the resources available for development. This leads some poorer countries to the over-
exploitation of their earth’s resources and thus to the destruction of the ecological system.
Moreover, the high degree of interest rate volatility in the modern economies injects great
uncertainty into the investment markets and makes it difficult for entrepreneurs to have a long-
term investment vision and to make their decisions with confidence. This turbulence in the
financial markets and the rise to fictitious assets tend to aggravate economic instability.

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The prohibition of Maysir and Gharar
The Arabic word Gharar is a fairly broad concept that literally means deceit, risk, fraud,
uncertainty or hazard that might lead to destruction or loss. Gharar in Islam refers to any
transaction of probable objects whose existence or description are not certain, due to lack of
information and knowledge of the ultimate outcome of the contract or the nature and quality of
the subject matter of it. For example, the Prophet (pbuh) has forbidden the purchase of the
unborn animal in the mother’s womb, the sale of the milk in the udder without measurement,
the purchase of spoils of war prior to distribution, the purchase of charities prior to their receipt,
and the purchase of the catch of a diver.
Islam has clearly forbidden all business transactions, which leads to exploitation and injustice in
any form to any of the parties of a contract. It seeks protecting the different parties from deceit
and ignorance by forbidding Gharar in any commercial exchange contracts that are not free from
hazard, risk or speculation about the essential elements in the transaction to either party, or
uncertainty of the ability of one party to honour its rights and obligations. It requires that all
Islamic financial and business transactions must be based on transparency, accuracy, and
disclosure of all necessary information so that no one party has advantages over the other
party.
The rationale behind the prohibition of Gharar is to ensure full consent and satisfaction of the
parties in a contract. Full consent can only be achieved in full disclosure and transparency and
through perfect knowledge from contracting parties of the counter values intended to be
exchanged. The prohibition of Gharar protects against unexpected losses and the possible
disagreements regarding qualities or incompleteness of information.
Instead, the Shari’ah promotes the principle of profit-loss sharing between banks and
entrepreneurs as an approach to encourage the spirit of brotherhood and cooperation
in business relationships. Mutual risk-sharing could help absorbing the weight of loss by sharing
it equitably between all parties. However, risk and uncertainty are conditioned by enough
adequacy and accuracy of information to make reasonable estimates of the outcomes. Tolerable
risk and uncertainties cannot exist in contractual obligations.
Islam has also categorically and firmly prohibited all forms of gambling. Maysir and Qimar are
forms of gambling transactions that are considered as totally inequitable in Islam. Maysir refers
to the easy acquisition of wealth by chance, whether or not it deprives the other’s right. Qimar
means the game of chance in which one gains at the cost of others.
Even though, gambling consists in a form of speculation and that There should not be any place
for commercial operations in Islam as it is purely speculative. The prohibited speculation under
the Shari’ah is not that, which relies on the analysis of a lot of economic and financial data and

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which involves the investment of assets, skills and labour. Rather, it is one involving an
effortless gain similar to a gambling scheme or activity. This is because the buyer is engaged in
a transaction aimed at making profit through trading and not through dishonest appropriation of
the property of others.
Islamic Banks as financial intermediaries
The fact that Shari'ah strictly prohibits interest-based transactions does not imply that it
excludes financial intermediation. In fact, Islamic banks form a part and parcel and
interconnecting medium of the Islamic developmental framework. This intermediation seeks to
enhance the efficiency of the saving/investment process by eliminating the mismatches in the
requirements/availability of financial resources of borrowers/entrepreneurs and the disparity in
risk preferences between small savers and entrepreneurs.
The intermediation function of Islamic banks is very important. They are responsible for
identifying good projects for financing as well as for monitoring their progress and ensuring
proper accounting and auditing. But as an intermediary, they should play no part in managing
the project or in making policy decisions that is the exclusive domain of the entrepreneur. This
allows them to have a factual picture of the health of the projects in where they invest.
Besides, the profit-sharing principle being in the core of the Islamic financial model puts justice
and fairness in the midpoint of this intermediation since it contributes to a more equitable
distribution of income and wealth. This is not the case of debt-financing model that penalizes
entrepreneurship by obliging it to return the principal even when part of it is lost due to
circumstances beyond the entrepreneur’s control. Besides, when a project fails and a business
person defaults, the financial intermediary must also default, and the ripple effects destabilize
the whole system. Islamic finance is more efficient in that it allocates funds on the basis of the
productivity of projects rather than on the criterion of the creditworthiness of project holders.
In addition, by applying general Shari’ah precepts, Islamic banks also aim to contribute towards
the economic development of the countries wherein they operate. By creating an environment
which would draw more funds for Musharakah /Mudarabah-based financing of productive
projects and by investing in real-sector businesses, implementing trading, leasing, real-estate
related contracts and using Islamic modes of financing that avoids interest and speculation,
Islamic banks lead to increases in production and employment and therefore become agencies of
sustainability of the socioeconomic order as much as they are investment oriented financial
intermediaries.
The PLS modes used by Islamic banks could be applied for project financing, import/export
financing, working capital financing and for financing of more specific transactions in short,
medium, and long-term. Socio-economic projects, such as infrastructure projects, could also be
developed on this principle. Banks could use a form a consortium or issue certificates to the
public for subscription if they need large amounts of money.

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The PLS mode of financing could be complemented by non-PLS modes to provide flexibility to
meet the needs of different sectors and economic agents in the society. This could be done
through trade, Ijara and leasing or via other techniques such as Murabaha and Salam that could
help in job creation and liquidity needs fulfilment. These mark-up modes put side by side with a
profit-sharing system contribute to the growth of micro / SME sectors, to capital accumulation in
the economy and to the alleviation of poverty.

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The Islamic Development Bank
The Islamic Development Bank, a specialized institution of the Organization of the Islamic
Conference (OIC), is an international financing institution. Its purpose is to foster the economic
development and social progress of Muslim countries and Muslim Communities in accordance
with the principles of the Shari’ah and to bridge the gap between rich and poor member-
countries.
The IDB is the first international financial institution to commit itself to conduct its activities in
conformity with the Shari’ah. As a result, the prohibition of Riba in Islam and the implications
thereof have motivated certain conceptual and operational features which distinguish the IDB
from other international development banks and other institutions having similar purposes. The
Bank is authorized to accept deposits and to mobilize financial resources only through Shari'ah
compatible modes and is authorized to levy a service fee to cover its administrative expenses
instead of working on the basis of interest. The major source of IDB’s finance has been the
capital subscriptions of its members. Repayment of existing lines of credit enabled to have
additional funds to support the activities of the IDB after the initial capital injections. And as the
bank is providing temporary assistance rather than making grants, the capital is revolving and
replenishes itself.
One of the strategic objectives of IDB is to improve and enhance the level of intra trade among
its member countries from the developing world. Therefore, the bank assists in the promotion of
foreign trade among Muslim countries, by providing financial assistance to
member countries and Muslim communities in non-member countries and by developing human
capital.
The IDB also acts as a catalyst in these intra trade activities by participating in equity capital
through investment in economic and social infrastructure projects and by granting loans for
productive projects in the private and public sectors. Equity-financing and profit-sharing
functions are the primary modes of operational financing and loan-financing adopted by the
IDB.
Furthermore, one of IDB’s missions is to undertake research to enable the economic, financial
andbanking activities in Muslim countries to conform to the Shari’ah and to develop Islamic
finance as a competitive advantage. In fact, thanks to the role played by the IDB, the Islamic
baking world has stepped up efforts to standardize regulation and supervision. The bank plays a
key role in developing internationally acceptable standards and procedures and strengthening
the sector’s architecture in different countries.

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Operations and objectives
The purpose of the Islamic Development Bank since its foundation is to foster the economic
development and social progress of member Muslim majority countries as well as Muslim
communities in non-membercountries individually as well as jointly in accordance with the
principles of Shari'ah. This is what distinguishes the IDB from other regional and international
developmental institution; in fact it is obliged by its own charter to follow the Shari’ah in all of its
functions and operations. The Islamic prohibition of interest and the implications thereof have
forced the IDB to have certain distinguishing conceptual and operational features. The IDB
foresees different ways of financial involvement with its clientele from the ways of the
conventional multinational development banks. The equity participation and profit sharing
functions of the bank together with the Shari’ah implied restrictions on the powers of the Bank in
so far as accepting deposits, raising funds and suitably investing funds not needed in its
operations are concerned, are some of the major issues that the bank had to consider in its
planning stages. Among activities undertaken by IDB there are participation in equity capital of
productive projects, investment in economic and social infrastructure projects, the promotion of
foreign trade, primarily in capital goods and acceptance of deposits or the raising of funds in any
other manner
Unlike other multilateral financial institutions, the IDB finances its operations through a number
of modes of finance that are compatible with Shari’ah. Loan financing is mainly intended for
social, economic and infrastructure projects that are unlikely to be revenue generating and have
a long implementation phase. These include schools, water supplies, health centres, hospitals,
rural electrification, roads, ports, airports, irrigation schemes and land development. In addition,
the IDB participates in the share capital of new or existing enterprises, through equity
participation, even though a ruling of the Islamic Fiqh Academy prohibits equity participation
with companies that use interest-based financing, therefore, the IDB has taken initiatives to
assist successful companies in utilising alternative Shari’ah-compatible modes of financing in
close collaboration with Islamic banks. Leasing is another mode of financing used by the IDB
because it meets the objective of providing finance for development projects that are sufficiently
remunerative to meet market criteria. Leasing involves the purchase and subsequent transfer of
the right of usage of equipment to the beneficiary for a specific period of time, during which the
IDB retains ownership of the asset. Application of mark-up rate is determined on the basis of
sector as well as on rate of return of a project. Instalment sale has also become a most
significant mode of financing because of its operational flexibility. Through this mode, IDB
purchases equipment and machinery, reselling it to the beneficiary at a higher price. The main
operational difference between this mode and lease financing is that ownership of the asset is
transferred to the beneficiary on delivery in the case of instalment sale. Besides, the purpose of
the Longer Term Trade Financing Scheme is to promote the export of non-traditional goods
among OIC member countries through the provision of necessary funds. The scheme has its own
independent budget and resources. It is managed and operated under the supervision of the
IDB. Moreover, IDB provides technical assistance to member countries for identification,

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preparation and implementation of projects as well as for institution building. Priority for
technical assistance is given to LDMCs as well as regional projects. The assistance is extended in
the form of a loan, grant or both. IDB also finances consultancy services to assist its own staff in
project preparation and follow-up; it encourages the establishment of a Federation of
Consultants from Islamic countries, and provides continuous support for the Federation’s
activities. Furthermore, the main window for providing funds to the private sector is the
extension of lines of finance to National Development Financial Institutions (NDFIs) in
member countries. This mechanism helps aims at assisting development in small and medium
scale enterprises. Lines are utilised through equity participation, leasing and instalment sale
operations. New procedures have even been added to provide greater flexibility and incentives
for the effective utilisation of IDB lines by introducing free limits; higher remuneration for
national development banks; two levels of upper and lower limits for financing sub-projects,
depending on the nature of the nationaldevelopment bank; and shortening the period for
processing sub-projects.
IDB has been successful in applying Islamic principles in the field of finance despite the fact that
the benefits to the poorer Islamic countries have been limited. It plays a central role in the
development of the Islamic financial sector globally through co-operations with central banks;
with national development banks and financial institutions and with regional and international
financial agencies. In fact, Regular meetings are held between the Governors of central banks
and the representatives of OIC membercountries to discuss ways and means of improving co-
operation among the financial institutions of member countries. The IDB also expands co-
operation with the national development banks of the member countries to grant lines of equity,
lines of leasing and lines of instalment sales to these banks so that they can advance finance to
viable local projects. This provides the banks with hard currency and facilitates financing
operations for the IDB. And the bank helps to promote a greater flow of resources to its
member countries from other financial agencies, through its co-financing arrangements
with regionaland international financial institutions such as the OPEC Fund, the BADEA and the
Arab Fund for Economic Aid and Social Development.

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Valid sale transactions
Transactions in Islam could be classified in five categories: prohibited, reprehensible, indifferent,
meritorious, and obligatory. Islam recommends avoiding reprehensible transactions and
encourages meritorious acts; indifferent acts (Mubah) are Shari’ah neutral. While, prohibited
activities have to be avoided in every respect, and obligatory acts must be carried upon and
never to be ignored;
However, the underlying principle in Islamic contracts is permissibility and validity. And since
most of the new banking and financial transactions did not even exist as such when classical law
held sway, any of these transactions would be considered as valid unless there is an explicit text
or religious rule proving its prohibition and voiding. Therefore, Islamic banks enter into different
concepts while doing thebusiness, namely promises or contracts.
Islamic banks use the concept of promise, made unilaterally by the client or the seller, in many
types oftransactions such as Murabaha to purchase orderer, Ijara muntahiah bittamlik, sale
and lease back, diminishing Musharakah, Salam and Istisna´a. And according to the Muslim
jurists, a promise is morally binding on the promisor, unless there is a valid justification. It
would be also legally binding if it is made conditional upon the fulfilment of an obligation, and if
the promisee has already sustained costs on the basis of that promise. The binding nature of the
promise means that it should be either fulfilled or compensated for damages caused by the
unjustifiable non-fulfillment. In case of some promises, Islamic banks take token or earnest
money from the promisee to guarantee their sincerity in the purchase the relevant asset.
Contracts in Islamic banking are used for trade, lease, partnership, agency, loans, guarantee,
etc. These contracts include Amānah, Qard, Mudarabah, Bai´, Ijara, Shirkah, Ujrah, Wakalah,
Kafalah, Ju´alah, Hawalah, etc. Exchange of ownership in the form of trade involves mutual
exchange of property rights along with usufruct, the asset and its usufruct are both transferred
to the buyer following the sale agreement irrespective of cash payment having been made
immediately or in the future. In addition, the ownership of the asset and its transfer from the
seller to the buyer is an important aspect for Islamic banking transactions since risk remains
with the party who owns the asset at a point of time following the transaction. For example, in
the case of Ijara, the lessor gives the usufruct against rental but retains the ownership along
with liabilities relating to ownership.
Moreover, Islamic banks should respect necessary conditions for a valid sale to legalize the
transaction. In fact, both the buyer and the seller must willingly agree to all details of the
transaction, both participants should be allowed to engage in the transaction, both parties in the
transaction must own the property they are trading or have the permission of the owner to sell
the asset on behalf of him, sold goods must be permissible and should be handed over at the
time of the sale and both the goods and the price must be something clearly known to both
participants in a sale.

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Loans and Debts
There are different ways through which funds could be raised to meet individuals and
organisations needs and funding requirements. Raising loans is one of the various ways these
requirements can be fulfilled. In the terminology of Islamic framework, Qard and Dayn relate to
the giving or taking of loans. However, the word Dayn has a broader connotation then the word
Qard. Dayn incurs in any way which leaves a debt as a liability to another party to be paid later
without any profit over the principal amounts. Whereas, Qard could be defined as an interest-
free loan for needy borrowers extended on a goodwillbasis; in particular Qard al Hasan provides
funds for humanitarian and welfare purposes without any profit accruing to the lender.
In fact, Qard consists on giving ownership of anything having value for the benefit of another by
way of virtue. The ownership of the loaned objects is transferred to the borrower who can use,
buy, sell, or donate them as the borrower wishes. Qard is only applied when one gets obliged
to return the equivalent of the thing taken and repayment is for the same amount as the amount
lent. Goods of the same kind will be paid back on demand or at the settled time. Qard should not
bring any return or addition to the lender because that would be equivalent to taking Riba.
However, a borrower can pay more than the amount borrowed, but it must not be stipulated in
the contract. Further, the date of payment of the loan may or may not be included in the Qard
contract as the lender can demand repayment at any time. And the loan should not be
conditional upon any other contract, such as Bai´ and vice-versa.
Ariyya is another structure of borrowing goods in a virtuous act. However, in the case of Ariyya,
the exact borrowed commodity has to be returned to its owner, not any replacement. While in
Qard, the same kind of the loaned commodity with essentially the same nature or character
could be paid back.
On the other hand, a Dayn is the result of any contract or credit transaction. The created debts
ought to be returned without any profit over their principal amounts. Salaf is a form of Dayn that
is similar to Salam. It is used for a loan of fixed tenure and in that sense it is closer to Dayn;
Salaf includes loans for short, intermediate and long term loans and the price of
the commodity is paid in advance, while it is delivered at a future date. The amount given as
Salaf cannot be called back before its due date. Therefore, this creates a liability for the seller to
supply the commodity in the future.
In addition, in all credit transactions, Islam recommends witnesses and documentation. This
provides safeguards against disputes and allows credit transactions for a fixed or known time
period. And since Islamic banks can neither pay interest nor charge any return on loans, they
have the right to ask for collateral to ensure recovery of the loan amount. In fact, the client
cannot refuse to repay the loan or debt in case he has incurred loss in the business conducted
with the bank’s loan. Also, The Shari´ah puts a great deal of emphasis on repayment of
loans/debts and the borrower also has a moral obligation to repay a loan. For that reason, banks
can include, with mutual consent of the clients, a penalty clause in the credit contract to mitigate
the risk of default, but the penalty charged on any default has to go tocharity.

19
With regard to a possible rebate that could be given to the debtor for repaying the loan earlier
than the due date, the Shari´ah considers that as a reduction of interest in the financing costs
arising from prepayment of the amount that would be stipulated in a contract. And, there is
unanimity about the illegality of remitting a part of the debt payable by anyone and getting the
remaining part. However, Muslim jurists have differentiated between loans or debts that have
become due or can be called back at any time (Duyoon Haalah), and loans where time of
payment settled between the creditor and the debtor and the debt is not yet due (Duyun
Mu’ajjalah). Duyoon Haalah are allowed by almost all Muslim jurists on the rationale that in such
loans, delay is not the right of the debtor. In fact, rebate should neither be provided in the
agreement nor be made a condition in the loan contract. In opposition, remission of a part of a
debt not yet due involves Riba.

20
Responsabilities of debtors and creditors
The fulfilment of one's obligation under all contracts is a religious duty in Islam. Therefore, the
Shari’ah defines specific rights and responsibilities of debtors and creditors. The most important
duty of the debtor is to repay the loan in fulfilment of the promise or contract made with the
creditor. God’s punishment will be severe to the borrower whose intention is to blemish or to
usurp the loan. And the main duty of the creditor is not charge interest on the principal amount
of the loan because those who charge Riba are compared in Quran to those controlled by the
devil's influence.
In fact, Islamic teachings stress that a borrower, when accepting loans, must be firmly
determined to make repayment. The debtor should not only pay the debt in time, but also
express gratitude to the creditor while repaying the borrowed amount. And if the debtor refuses
to pay even though he has the means, he would be a perpetrator of injustice who exposes
himself to possible punishment. In fact, in Shariáh, if a debtor default wilfully, he can be
arrested, punished and dealt with harshly.
In addition, Islam condemns the person who delays the payment of his dues without a valid
cause. He could be admonished, disgraced or even jailed and if necessary could be disposed of
his asset to pay the debt. A monetary fine, on the other hand, wouldn’t be a lawful option, since
this would amount to a monetary penalty for delayed payment, which is Riba. However, Islam
makes a distinction between debtors who default by Procrastination and those who default by
necessity. The Qur'an recommends that the latter deserves compassion and is to be given be
given respite until he is able to pay. In extreme circumstances, creditors are exhorted to forgive
the debt, which can be counted towards obligatory Zakat or as a donation.
However, Islamic jurists see no harm if it is agreed between the parties that some indirect
benefits do not involve any cost for the borrower. For example, debt could be paid in the form of
cheques and drafts or in some other currencies if it is in the interest of both the parties.
In the case of a debt with a settlement date, the creditor is not entitled to ask for earlier
repayment, so long as the debtor does not transgress the terms and conditions. But, if the
creditor is not disposed to give more time for repayment, he cannot be compelled to do so and
the debtor would then be liable to repay the debt at the falling due from whatever he has
beyond his basic needs.
In addition, Shariáh allows creditors to ask for collateral to ensure recovery of the amount in
the case of failure by borrowers to fulfil their obligation for the repayment of the debt. The
subject of the sale could be the subject of a pledge made to the extent of the debt. In fact, a
pledge is permissible in the Shariáh, whether a person is on a journey or at home and even
between a Muslim and a non-Muslim. The ownership of the pledged goods remains with the
pledger, who takes on the risk of losing the pledgedcommodity while the pledgee holds the
goods on trust. Hence, if the pledged goods are lost without any fault of the pledgee, the loss
would be that of the debtor. And if the due debt is not paid, the pledgee can apply to the court

21
to have the pledged good sold and the debt recovered out of the sale.

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Mudarabah
Mudarabah is a contractual relationship executed between two parties, one supplying the capital
(rabbulmal) and the other supplying the labor and skill as agent or manager (mudarib), for
investing in a pre-determined activity, which grants each party a share of the earnings as
determined at the time of the investment. This practice existed in the pre-Islamic period and
Muslim jurists of all the major legalschools are agreed on the legitimacy of Mudarabah
transactions. Mudarabah business can be of two types: restricted, if the capital-provider
specifies any particular business in which the capital is to be invested, and un-restricted if the
capital-provider authorizes the mudarib to invest the funds in anybusiness he deems fit.
Profit is shared between Both the parties according to a pre-determined profit sharing ratio. The
profit sharing ratio has to be mutually consented upon and explicitly stated at the time of
contracting and has to be a proportion of the profits. And the payment of profit to the financier
cannot be in the form of a fixed amount or any percentage of the capital employed.
Furthermore, the earned profits cannot be distributed until all the expenses have been paid, in
accordance with custom and the original agreement.
Being a manager to the financier, the mudarib undertakes the business and shares in the profit.
He is considered as a trustee with respect to the capital invested, his actions must, therefore, be
conforming to the overall purpose of the contract and within the recognized commercial practice.
The rabbulmal can also contribute his labor subject to the permission of the mudarib. In
addition, the mudarib does not share in any financial losses which are borne solely by the
rabbulmal. The mudarib‘s losses are deemed to be the opportunity cost of the manager's
workforce which has failed to generate sufficient revenues for a business the profits of which are
shared by both in accordance with agreed terms.
The Mudarabah contract can be terminated by either of the two parties at any time as long as a
notice, per the contract terms, is given to the other party. A maximum term of the Mudarabah
contract can be set automatically where after the contract is terminated. Furthermore, for the
purpose of periodic profit distribution in a running business before the termination of business,
the business has to be liquidated constructively by way of valuation of the assets by the mutual
agreement of the partners. A final settlement is only possible at the time of the termination of
the business.

23
Musharakah
Musharakah is a type of Shirkah al-Amwal which literally means sharing. In the context of
business, it refers to a joint enterprise in which parties share the profit and loss of the
enterprise. It plays a vital role in financing business operations based on Islamic principles,
which prohibit making a profit on interest from loans. Musharakah may sometimes include
Shirkah al-Amal, where a joint partnership is formed to render some services without requiring
any capital investment.
Musharakah allows each party involved in a business to share in the profits and risks. Instead of
charging interest as a creditor, the financier will achieve a return in the form of a portion of the
actual profits earned, according to a predetermined ratio. However, unlike a traditional creditor,
the financier will also share in any losses. The relationship established between parties, in
Musharakah, is by a mutual contract; hence, all the necessary ingredients of a valid contract
must be present. However, there are number of conditions that apply specifically to the contract
of Musharakah.
In fact, the capital to be invested in a joint venture can be unequal between the partners and
should preferably be in cash. If it were to be based on commodities or other Shari’ah-compliant
assets, the market value prevalent at the time of the contract would have to be appropriately
valued with the mutual consent of all the partners in order to determine the share of each of
them. The commodity should be compensable by similar commodities or assets in quality or
quantity, in case it could be destroyed. Otherwise, its price should be paid. The capital may also
be in the form of equal units or shares representing currency. And if partnership capital involves
a variety of currencies, it must be translated into the currency of the enterprise at the current
rate. Finally, Debts or receivables alone cannot form part of the capital until they are received,
although, they may become part of the capital contribution where they become inseparable from
the other assets of the business.
Moreover, the proportion of profit to be distributed among the partners must be determined and
agreed upon at the time of the contract. Otherwise the contract wouldn’t be valid. And it is
necessary that each partner’s share in the profit is exactly equal to the proportion of initial
investment into the partnership. The ratio of profit distribution may vary, however, for non-
active partners, who only contribute capital. A party which has no capital invested in an
enterprise does not have to share its loss. The partnership would also be invalid if a partner
were to receive regular payments of a fixed, pre-determined amount as a percentage of its
investment. In addition, a person can become a partner in a running business having fixed
assets by investing capital in cash or kind; it is also allowed to merge various partnership
businesses. Valuation of the fixed assets will be based on their fair value agreed upon by the
partners.
Further, Musharakah is not a binding contract and any partner may unilaterally terminate it
unless provided otherwise in the contract. It is agreed upon by the Muslim jurists that a
partnership is terminated if one of the partners terminates the partnership or if one of the

24
partners dies or becomes insane. If the remaining partners want to continue the business under
any of these cases, it is possible with mutual agreement. The remaining partners would have to
purchase the share of the out-going partner.
Difference between Musharakah and Mudarabah
Mudarabah is a special kind of partnership where one partner (rabbulmal) provides the capital to
the other (mudarib) for investment in a commercial enterprise. A Mudarabah arrangement
differs from the Musharakah in the following major ways:
 The investment in Musharakah comes from all the partners, while in Mudarabah;
investment is the sole responsibility of rabbulmal.
 In Musharakah, all the partners can participate in the management of the business;
while in Mudarabah, rabbulmal has no right to participate in the management which is
carried out by the mudarib only.
 In Musharakah all the partners share the loss to the extent of the ratio of their
investment while in Mudarabah the loss, if any, is suffered by the rabbulmal only,
because the mudarib does not invest anything. His loss is restricted to the fact that his
labour has gone in vain.
 The liability of the partners in Musharakah is normally unlimited. Therefore, if
the business goes in liquidation, and if all the partners have agreed that no partner shall
incur any debt during the course of business, then the exceeding liabilities would be
borne by that partner alone who has incurred a debt on the business in violation of the
condition. Contrary to this is the case of Mudarabah where the liability of rabbulmal is
limited to his investment, unless he has permitted the mudarib to incur debts on his
behalf.
 In Musharakah, as soon as the partners put their capital in a joint pool, all the assets of
the Musharakah become jointly owned by all of them according to the proportion of their
respective investment. Therefore, each one of them can benefit from the appreciation in
the value of the assets, even if profit has not accrued through sales. In the case of
Mudarabah, all the goods purchased by the mudarib are solely owned by the rabbulmal,
and the mudarib can earn his share in the profit only in case he sells the goods
profitably.

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Diminishing Musharakah
Diminishing Musharakah is a form of partnership, which ends with the complete ownership of a
partner who purchases the share of another partner in that project by a redeeming mechanism
agreed between both of them. Diminishing Musharakah is used mostly when one party who
wants to own an asset or acommercial business which does not have adequate funds to pay the
full price; and takes the assistance of financing from another party. The share of the financier is
divided into a number of units and it is understood that the client will purchase the units of the
share of the financier one by one periodically, thus increasing his own share till all the units of
the financier are purchased by the client so as to make him the sole owner of the asset. In this
kind of partnership, all partners are co-owners of each and every part of the joint property or
asset on a pro-rata basis and one partner cannot make a claim to a specific part of the property
or asset leaving the other parts for other partners.
Diminishing Musharakah can be conducted through shirkah al-aqd; in that case, the ratio of
profit distribution for each partner can be disproportionate to the ratio of equity of both parties
and has to be stipulated at the time of execution of the contract. In case of loss, it should be
necessarily allocated in accordance with the ratio of equity at the time when the loss was
incurred. The lessee partner can promise to buy periodically the share of the financer partner
according to the market value or at a price to be agreed at the time of the sale. The price of
share units cannot be fixed in the promise to sell
Diminishing Musharakah can also be conducted through shirkah al-milk, the ratio of profit
distribution doesn’t need to be stipulated in the arrangement. Each partner will own the risk as
well as the reward in proportionate to their individual share in the property or asset. The
financing partner can lease its share to the other party and receive a rental for use of the leased
part. The other party goes on paying therental and purchasing the share of the financier partner
in the form of ownership units, the rentalpayments will go on decreasing. He will also get the
benefit of having the use of his part without paying any rent. One partner cannot purchase the
ownership units representing the share of the co-partner at a pre-agreed price.
A contract of Diminishing Musharakah could take different shapes in different sub-contracts
which come to play their role at different stages: partnership by ownership between two or more
persons, leasing of the share of one partner in the asset to the other partner, and the sell of the
share of one partner to the others. These sub-contracts are considered permissible in the
Shari’ah given that one contract is not dependent on another and particularly when assets are
sold or leased to partners. If all these sub-contracts have been combined by making each one of
them a condition to the other, then this is not allowed, because it is a well settled rule in
Shari‘ah that one transaction cannot be made a pre-condition for another. Thus, the relationship
between the parties in a Diminishing Musharakah arrangement in the first stage is that of lessor
and lessee and at the later stage is that of seller and buyer.
The proposed scheme, in case of Diminishing Musharakah, suggests that instead of making
transactions conditional to each other, there should be promises from the client, firstly, to take

26
share of the financier on lease and pay the agreed rent, and secondly, to purchase different
units of the share of the financier at different stages at the price prevailing at the time of the
sale. While the Islamic bank will be making a binding promise to offer a specific part of its
ownership of the project for sale on a specified future date, at a price that will be determined at
the time of the actual sale.
In addition, Diminishing Musharakah may be used in various cases of finance, particularly for
financing of assets that can be leased. And as a variable or floating rate of return is possible in
transactions involving leasing, Islamic banks can use it for long-term financing even in
economies having an inflationary trend. For example, financial institutions can use Diminishing
Musharakah for providing house financing, auto financing, plants and machinery financing,
factory/building financing and financing of all other fixed assets. Financing on the basis of in thus
form of partnership can take different structures depending upon the assets involved. For
example, in home financing, in house financing, the facility can be provided for buying a house
for occupation, for the construction of a house, for the renovation of a house already occupied
and for replacing interest-based housing mortgages with a balance transfer facility (BTF).
Moreover, the bank and the client bear the asset risk proportionately in Diminishing
Musharakah; And in case the client is not able to purchase the bank’s units of ownership for a
certain period, the bank will not incur loss as the rentals will continue to accrue.
The process of islamic bank's financing through
Diminishing Musharakah
Islamic banks can use Diminishing Musharakah in various cases: to provide house financing,
auto financing, plants and machinery financing, etc.
In the case of house financing for the purchase of a property, a joint ownership in proportionate
shares to the level of the Islamic bank investment in the purchased property is created; a legal
mortgage is taken on the client’s beneficial share to secure the obligation to the bank under the
financing arrangement; the bank gives its undivided share on lease to the client. While, the
client pays rent to the bank for the usage of its share of the property until the client has
acquired the complete ownership. At that time the ownership of the property will be transferred
to the client as the sole owner. The steps involved in a Diminishing Musharakah in the case of
the purchase of a house are as follows:
First the client approaches an Islamic bank for the purchase of the property that he already
identified; he agrees to invest a certain amount towards the purchase and applies to the bank
for financing the balance amount. If the bank is satisfied about the title to the house and
the future cash flow of the client, a Diminishing Musharakah agreement is created in terms of
which the client and the bank become co-owners in the house on the basis of shirkah al-milk.
The vendor of the property sells it directly to the bank, in which the legal title to the property is
vested; and the client as the eventual owner has immediate rights to occupation. The two
parties agree at the start that their respective shares in the property shall be pro-rata,

27
concerning their contributions towards the purchase price paid to the vendor.
The parties also agree that during the course of their partnership, which has an agreed date of
termination, the client will purchase the financier's share in the property in instalments and for
the price that the financier had paid for such share on the initial date of acquisition. As the client
increases its share in the property, the bank's share correspondingly decreases by the same
amount. In parallel to the Diminishing Musharakah agreement, the bank grants to the client a
lease in respect of its share in the property. The lease is effective for as long as the bank has a
share in the property. The arrangement also contains details about the nature of security /
guarantee to be provided by the client and is normally an equitable mortgage on the financed
property that encumbers the property as security for the repayment.
Finally, as security for the client's obligations to make payments of rent under the lease, the
bank may require any additional security to secure its interest, particularly in view of the
financial position of the client; this would be stipulated in the agreement.
The balance transfer facility (BTF) that replaces interest-based mortgage by a Shari’ah compliant
house finance, also involves Diminishing Musharakah since it includes a sale and lease back. The
fact that the client is already living in the house, the bank can start taking rent for occupying the
part in the bank’s ownership from the first month after the first disbursement of the amount is
made to the client.
The client will sell some Units of the ownership of the house to an Islamic bank, against which
the client had previously availed interest-based finance; He will repay the interest-based finance
to the original lender bank; While, the Islamic bank will take rent on its share of the joint
ownership.
The client will regularly pay the rentals and will also periodically purchase the bank’s units of
ownership by additional payments to the bank; the rental payment is reduced with the client’s
ownership increasing over a period of time. This process will continue until the bank’s share of
the ownership title in the house is completely transferred to the client. And if the client’s cash
flow allows to purchase more Units, the Islamic banks may normally allow the purchase of up to
3 Units at a time at the agreed price and if the client intends to purchase more than that
number, the bank will undertake a current valuation of the house and will share in the
appreciation on its part of the investment up to a limited extent, giving the remainder to the
client.

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Murabahah
Murabaha is a form of sale where the cost of the goods to be sold as well as the profit on the
sale is known to both parties. The purchase and selling price and the profit margin must be
clearly stated at the time of the sale agreement. Payment of the Murabaha price may be in spot,
in instalments or in lump sum after a certain period of time.
Murabaha has been adopted as a mode of interest-free financing by a large number of Islamic
banks to finance the purchase of the consumer goods, intermediary or capital goods, real estate,
raw materials,machinery and equipment. It may also be used for trade financing needs such as
import of goods or pre-shipment export finance. However, the subject of Murabaha must exist
and be in the ownership of the bank at the time of sale in a physical or constructive possession
form; and these assets must be something of value that is classified as property in Islamic
jurisprudence and must not be forbiddencommodities. Debt instruments and monetary units that
are subject to the rules of Bai´ al Sarf cannot be sold through Murabaha.
Islamic banks are required to take the genuine commercial risk between the purchase of the
asset from the seller and the sale of the asset to the person requiring the goods. The bank is
compensated for the time value of its money in the form of the profit margin. However, it is not
compensated for the time value of money outside of the contracted term. In fact, the bank
cannot charge additional profit on late payments; the asset remains as a mortgage with the
bank until the Murabaha is paid in full; and there must not be any reference to the time of
payment by the buyer to keep the transaction free from interest.
In addition, Islamic Banks should not simply provide funds through Murabaha; they have also to
be involved in the trading process of their client’s business. They also need to ensure that the
transaction is genuine and avoid the possibility of misuse of the funds by the client. In fact, the
purchase price is paid directly by the bank to the seller or supplier, even though, the client may
serve as the agent of the bank for onward. The purchase by the bank should be evidenced by
invoices or other documents provided by the supplier to ensure that all conditions of a valid
Murabaha have been fulfilled. Also the bank should arbitrarily inspect the purchased goods at
their place of storage to ensure that the supplier and the client do not do any under-hand
dealing, in fact, the client should not be a dual agent undertaking both the purchase and sale in
a transaction.
Murabaha is not a loan given on interest. It is a credit sale that enables banks’ clients to make a
purchase without having to take out an interest-bearing loan. The parties negotiate the profit
margin to be paid on the cost of the original purchase, and not the cost price. If payment of the
sale price is deferred, Murabaha becomes Muajjal, which is legal from the point of view of the
Shari’ah. This one of the features that makes Murabaha attractive as a mode of financing in
modern financing transactions: It is a sale transaction effected on the basis of deferred
payment. The price should be fixed at the time of the original contract of sale and the due
date of payment must be explicitly set. It has to be a fixed sum including the cost of goods to
the seller and an agreed amount of profit over the cost that can also be based on a percentage

29
of the cost price to the seller. The Murabaha selling price includes a mark-up agreed upon and
added to the actual cost incurred by the seller; No additional profit can be paid over and above
the contract price.
To determine the amount of profit on the purchase of the goods and onward sale to the client,
the bank may take into consideration different factors such as the period for deferred payment.
The difference in price is not meant as a reward for time to reflect sale In fact, the jurists agree
that a seller can indicate two prices, one for cash and the other for a credit transaction, since it a
genuine market practice ruled by supply and demand; but one of the two prices must be settled
on at the time of contract. In fact, the credit price of a commodity may be more than its cash
price at any one point of time, while, in a forward purchase, the price for future delivery of the
goods may be less than the cash price. This practice is quite different from a loan or debt, on
which any addition is prohibited.
A Murabaha transaction, as used by Islamic Banks is quite different from a traditional Murabaha.
In fact, Islamic banks do not normally maintain an inventory of goods; rather they purchase the
goods on the specific request of their clients. They take a binding promise to purchase from the
client that he would purchase the goods when the same are acquired by the bank. This promise
can be incorporated into the purchase request of the client to enable the bank to purchase the
goods for the client, either directly or through an agent. The bank can keep an option to rescind
the purchase for return of the goods within a specified period (Khiyar-e-Shart) as a risk
management measure in the event that the client fails to purchase the goods from the bank.
Khiyar can be used as a risk mitigation tool for the goods acquired at the risk and cost of the
bank until the goods are sold to the client or returned to the supplier. In addition, Islamic banks
can use different structures to provide financing by way of credit sales to their clients. The bank
may purchase the goods direct from the supplier for sale onwards to the clients. Islamic banks
can also conduct their trading activities either through the client acting as an agent of the bank
or through third party agents appointed by the bank. Islamic banks may appoint qualified
suppliers as third party agents to undertake the purchases as and when required. They may
establish specific purpose companies, a limited number of the bank’s employees with relevant
specialised expertise may be entrusted to trade in the goods required by their clients.
In the case of default by the client in the payment on the due date, the price selling price cannot
be increased. However, contemporary Muslim jurists agreed that banks can impose a late
payment penalty on delinquent clients. It may be a percentage on the overdue amount which
cannot compounded. The penalty amounts must only be used for charitable purposes. Islamic
banks can also ask for liquidated damages from the client through the courts, in case of default;
and they can sell any held collateralwithout the intervention of the court.
Concerns
Shari´ah scholars generally consider Murabaha to be a border-line technique because its
transactions may give the appearance of a fixed-income loan with a fixed rate of profit
determined by the profit margin agreed by the parties. However, the fixing of a profit margin per
se is not a problem, as prices have to be fixed in all valid trade bargains and at no point money

30
is treated as a commodity in the Murabaha transaction, as it is in a conventional loan. In fact, in
Murabaha, the Islamic bank buys an item at one price and sells it to someone at a higher price,
allowing them to pay the client for it over time. While in Riba, conventional banks lend someone
some money and require them to pay back a greater value of money than what they borrowed.
Moreover, the exchange in respect of a loan, wherein any excess is prohibited, occurs between
acommodity and its like, while in a Murabaha transaction, exchange takes place between two
differentcommodities: money is first exchanged for goods purchased and then goods are sold for
money. Therefore, the difference between the purchase price and the sale price does not amount
to Riba and legitimizes the profit derived from trading. Goods traded in Murabaha should be real,
they must exist at the time of the sale and in the ownership of the seller when selling to another
party. Further, interest charged on a loan is payable to the lender unlike in a sale contract where
the price is liable to change; if it rises, the purchaser gains on purchasing goods on deferred
payment basis, but if the price declines, it is the seller who gains on selling the goods on
deferred payment basis at a higher price.
In addition, the use of Murabaha implies a risk of destruction or loss of goods occurring during a
period where the bank owns the goods acquired for their clients. Thus the mark-up could be
justified by the liability for the goods assumed by the bank until the client purchases them at a
higher price on a future date. Besides, the promise from the client to buy the commodity from
the bank is not a legal binding; therefore, the client may go back on his promise and the bank
risks the loss of the amount it has spent. The goods are also subjected to no acceptance by the
client if there is any hidden defect.
Another concern in the light of the Shari´ah for using Murabaha is the pre-payment rebate. In
fact, Shari´ah scholars may consider it similar to interest-based instalments sale techniques,
where the rebate allowed for early settlement of a financing is intended to reflect a refund of
unearned interest. In Murabaha, the rebate shouldn’t be already stipulated in the contract.
Therefore, there is no commitment from the bank in respect of any discount in the price of a
Murabaha transaction, the bank has discretion on whether to allow a rebate or not if the client
makes an early payment. In any case, the profit on a Murabaha sale on a deferred payment
basis is not based on a monetary value of time.
Risk Management techniques
Murabaha mode of financing is adopted by the Islamic banks to satisfy a variety of financing
requirements of their clients in various and diverse sectors. It can be used to provide finance for
the purchase of consumer durable or to finance the purchase of machinery, equipment and raw
material for manufacture, etc. This mode is highly suitable for providing short-term working
capital in financing projects. It can also be used for import and export trade as well as for local
trade.
However, Murabaha may not be suitable for housing or other long term investments in
economies with a high rate of inflation. The reason for that is that the bank might face a greater

31
risk in the possible return if the general rate in the market increases owing to inflationary
pressures. Murabaha can still be used for mortgage financing for longer periods ranging in
economies where inflation is not a major issue. Also, Murabaha is not the right mode to provide
financing for the purchase of easily perishable items.
Nevertheless, Islamic banks must bear a certain amount of risk associated with Murabaha
transactions in order to legitimize their returns. They use some techniques to manage and
mitigate each type of the common risks. In order to ensure that the bank's gains are above all
suspicions of Riba, the bank reduces Shari´ah non-compliance risk by making direct payment to
the supplier, it requires the invoice from the seller for the goods purchased, the date of which
not before the offer and acceptance is carried out and not later than the declaration and it also
arranges for the random physical inspection of the goods. This technique seeks to avoid that the
client has already purchased the goods and subsequently wants the financing to make payment
to the supplier. The bank can also obtain Takaful Insurance to reduce in-transit risk of
destruction or loss of goods occurring without the agent’s negligence. The bank may ask the
client to provide security through any assets of the client and stipulates a penalty payment
clause in the contract that in the event of payment defaults. Murabaha does not allow additional
charges in case of instalments. The amount of the Murabaha price remains unchanged. Long-
term Murabaha may be avoided to guard against rate of return risk.
Moreover, the bank may obtain a performance bond from the supplier to prevent from non-
performance risk by the supplier where he may not perform an obligation to supply the goods.
The client can undertake to guarantee the performance of the supplier. Similarly, for the non-
performance risk by the client where the he may refuse to purchase the goods when acquired by
the bank at the client’s request, the bank should secure a promise from the client to purchase
the goods. Furthermore, the bank can ask for Hamish Jiddiyah to recover its possible loss.
Hamish Jiddiyah can also be used to prevent from a legal risk in case the client does not
purchase the goods, as the initial agreement is only a promise by the client to buy and for the
bank to sell; the bank who purchases the goods required by the client, may have to be involved
in litigation.
In addition, there is a greater fiduciary risk where the client is appointed as agent to purchase
and take possession of the goods on behalf of the bank; this could result in the client failing to
administer the trust and agency accounts. To guard against such risk, bank may provide in the
Murabaha contract that the client would be liable for any such loss. There is also a liquidity risk,
since Murabaha receivables are debts payable on maturity. Therefore, they cannot be sold at a
price different from the face value in a secondary market if the repayment date has to be
extended. Similarly, if the client is unable to pay the amount on time, which is essentially a
credit risk, it can give also rise to a liquidity risk for the bank until the payment is made by the
client.

32
Salam
Salam is a forward financing transaction, where the financial institution pays in advance for
buying specified assets, which the seller will supply on a pre-agreed date. What is given in
exchange for the advance payment of the price should not in itself be in the nature of money.
For the payment in advance, the contracting parties stipulate a future date for the supply of
goods of specified quantity and quality.
Salam may be considered as a kind of debt, because the object of the Salam contract is the
liability of the seller, up to the agreed future date, to deliver the object for which advanced
payment of the price has already been made. There is consensus among Muslim jurists on the
permissibility of Salam, notwithstanding the general principle of the Shari´ah that does not
permit the sale of a commodity which is not in the possession of the seller, because the object of
the contract is that the goods are a recompense for the price paid in advance, just as the price is
recompense paid for getting the goods in advance. The transaction is considered Salam if the
buyer has paid the purchase price to the seller in full at the time of sale. The idea of Salam is to
provide a mechanism that ensures that the seller has the liquidity they expected from entering
into the transaction in the first place. Muslim jurists are unanimous that full payment of the
purchase price is key for Salam to exist. However, Salam cannot take place in money
or currencies as these are subject to rules relating to bai al-sarf, wherein exchange has to be
simultaneous.
Because the Salam contract deals with the delivery of an asset which is not in existence, the
Shari´ah highlights that strict rules must be adhered to in order to ensure that the right of all
parties are protected. In fact, it is necessary that the quality of the commodity is fully specified
leaving no ambiguity which may lead to a dispute. All the possible details in this respect must be
expressly mentioned. Salam can be effected in those commodities only the quality and quantity
of which can be specified exactly. Thecommodity should be generally available in the market at
the time of delivery. And all goods that can be categorized as belonging to the same species can
be the subject of Salam. However, Salam cannot take place between identical goods. Besides,
the time and place of delivery of the goods should be precisely fixed; and the quality and the
quantity of the goods should be clearly specified. The specification of goods should particularly
cover all those characteristics which could cause variation in price.
Other rules applied to Salam contract, is that the seller in Salam need not be the manufacturer
or producer of the asset. The seller may be an agent to deliver the asset. Furthermore, a Salam
contract can stipulate that that, in the event of late delivery of the goods, the supplier pays a
certain amount as a penalty to the buyer, which amount must be used for a charitable purpose;
it cannot be taken into the buyer’s income. The buyer has also the right to demand security or
collateral from the seller to ensure that the seller delivers the goods on the agreed date, the
buyer has the right to dispose of the securityand purchase the specified goods from the market;
the buyer is entitled to deduct the advance payment from the proceeds of the security realised
and return any surplus to the seller.

33
Istisnaá, like salam, is a special kind of sale contract where a sale is transacted before the
goods come into existence. However, there are several points of difference between Istisna’a
and Salam. In fact, the subject of Istisna’a is always a thing which needs manufacturing, while
Salam can be effected on anything, no matter whether it needs manufacturing or not. Also, it is
necessary for Salam that the priceis paid in full in advance, while it is not necessary in Istisna’a
where payment can be made in staggered basis. And the object of the Salam is a liability on the
seller to deliver, thus should be in the form of fungible. Under the Istisna’a, 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. In addition, the time of delivery is an
essential part of the sale in Salam while it is not necessary in Istisna’a that the time of delivery
is fixed. Any penalty for charged late delivery can reduce the price of an Istisna’a contract but in
a Salam, the penalty amount is paid should not be taken as benefit for the buyer.
Parallel Salam
Selling the goods purchased in a Salam contract prior to taking delivery is not generally allowed
in Shariáh. Instead, it is allowed for the Islamic bank to make parallel Salam contracts for the
same goods to be delivered even at the date and time of delivery of the original Salam. In this
an arrangement, there must be two different and independent contacts; one where the bank is a
buyer and the other in which it is a seller. The two contracts cannot be tied up in a manner that
the rights and obligations of one contact are dependent on the rights and obligations of the
parallel contract. And each contract should have its own force and its performance should not be
contingent on the other.
For Example, if A has purchased from B 100 tons of wheat by way of Salam to be delivered on
31st December, A can contract a parallel Salam with C to deliver to him 100 tons of wheat on
the same date. But while contracting Parallel Salam with C, the delivery of wheat to C cannot be
conditioned with taking delivery from B. Therefore, even if B did not deliver wheat on 31st
December, A has the duty to deliver the agreed quantity of wheat to C. He can seek whatever
recourse he has against B, but he cannot rid himself from his liability to deliver wheat to C.
Similarly, if B has delivered defective goods which do not conform to the agreed specifications, A
is still obliged to deliver the goods to C according to the specifications agreed with him.
After purchasing a commodity by way of Salam, the Islamic Bank may sell it through a parallel
contract of Salam for the same date of delivery. The period of Salam in the parallel transaction
being shorter, theprice may be a little higher than the price of the first transaction, and the
difference between the two prices shall be the profit earned by the institution. Generally, the
shorter the period of Salam contract, the higher the price and the greater the profit.
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, because it will be a buy-back contract, which is not
permissible in Shariáh. Each one of the two contracts entered into by a bank should be
independent of the other, but the bank, as seller, can sell the goods on parallel Salam on similar
conditions and specifications as previously purchased on the first Salam contract without making
one contract dependent on the other. If the purchaser in the second contract is a

34
separate legal entity, but it is fully owned by the seller in the first contract the arrangement will
not be allowed, because in practical terms it will amount to ‘buy-back’ arrangement. For
example A has purchased W quantity of wheat by way of Salam from a company B. C is a
subsidiary of B, which is a separate legal entity, but is fully owned by B, then A cannot contract
the parallel Salam with C. However, if C is not wholly owned by B, A can contract parallel Salam
with it, even if there are some common shareholders between B and C.
However, some parallel contract arrangements may not be an attractive mode of disposal of
goods for Islamic banks, as the advance payment of the price in the first Salam contract would
be disinvested when the buyer in the parallel contract made the advance payment to the bank
for the purchase of the goods under the parallel contract.
Risk management in Salam
Islamic banks need to take special care in Salam operations. They face a number of risks.
Counter-party Risk is one of some common risks in Salam-based financing, in fact, the client
may default after taking the payment in advance. Commodity Price Risk, where at the time the
goods are received the price may be lower than the price that was originally expected, is another
risk associated to Salam. There is also Quality Risk, low investment Return or Loss, which occurs
when goods received are not of desired quality or unacceptable for the potential buyer. The bank
might also not be able to market the goods in time, resulting in possible asset loss for the unsold
goods and locking funds in the goods until they are sold, this is Asset-Holding Risk that implies
possible extra expenses on storage and Takaful. And in case the Islamic bank has to purchase
goods from the market in parallel Salam, where the third party fails to supply the specified
goods under the parallel contract, the bank faces an Asset-Replacement Risk. Finally, parallel
Salam, if original Salam seller has not delivered the goods as expected, it is considered as
Fiduciary Risk.
In order to manage and mitigate the above risks, Islamic banks need to take proper measures.
In fact Islamic banks purchase only goods that have good marketing potential; they take proper
security and a performance bond; they require from the prospective buyers a sufficient amount
of earnest money in deposit and a binding promise to purchase these goods; they also insert a
penalty clause in the Salam contract to protect themselves from a late delivery from the
supplier; and they accomplish the responsibility of parallel Salam by purchasing similar goods
from the market on spot to supply these to the buyer and recover the loss, if any, from the
seller in the original Salam.

35
Istisna'a
Istisna’a is a Shari’ah mode of financing widely used by Islamic banks and financial
institutions to finance different kind of projects: housing, construction of buildings, plants, roads,
etc, manufacturing of aircrafts, ships, machines and equipment, etc. It can also be used for
export financing as well as to meet working capital requirements in industries where sale orders
are received in advance. Banks may undertake financing based on Istisnaá by getting the
subject of Istisna’a manufactured through another such contract. Accordingly, they can serve
both as manufacturers and purchasers. However, Istisnaá can not be used for natural things or
products that are not manufactured, such as animals, fruits, etc.
In particular, Istisna’a can be potentially used by Islamic banks to finance industries where
productions can be monitored by measurement and specifications, such as in the food
processing industry; or in high technology industries such as the aircraft, locomotive
and shipbuilding industries, and to provide financing for the various types of machines produced
in big factories or workshops. The Istisna’a contract can also be drawn-up for real estate
developments on designated land owned either by the purchaser or the contractor, or on land in
which either of them owns the usufruct. It involves the construction of specified buildings such
as factories, hospitals, schools and universities. For Buildings that will be built and sold according
to specifications, the contract of Istisna’a does not specify a particular identified place.
Nevertheless, Islamic banks need to take special care in istisnaá-based financing. They face a
number of risks. These risks include Settlement Risk, Price Risk, Delivery Risk, Possession Risk
and Market Risk. They use some common techniques to mitigate these risks. For example,
Banks can request a propercollateral or a performance bond, they can get technical expertise in
the relevant areas, they adopt a timely and effective marketing ensuring cost effectiveness, they
cover themselves using Takaful insurance, or they choose creditworthy clients and by adopting
suitable capital budgeting and liquidity management policies. Also, for early disposal of the
goods purchased under Istisnaá contract, Islamic banks can take a “promise to purchase” from
a third party or make arrangements for sale through an agency to reduce that risk.
In addition, the bank, in the position of manufacturer, must assume liability for the ownership
risk prior to delivering the object of the Istisna’a to the buyer, as well as the risk of theft or any
abnormal damage. It cannot absolve itself from any loss on this account.

36
Ijarah
Leasing is an agreement that permits one party (the lessee) to use an asset or property owned
by another party (the lessor) for an agreed-upon price over a fixed period of time. It is a form
of asset finance which has the benefit of using assets without the requirements of ownership.
The lessee acquires the asset he needs without borrowing on interest and receives the benefits
of use while the lessor receives the value of regular rental payments for a specified period plus
the residual value of the asset. The lease may be written either for a short-term or for a long-
term and its rules are similar to those governing sale because in both cases there is a transfer of
one thing between two parties for valuable consideration. However, leasing differs from sale as
its mechanism allows the separation between ownership and use; in fact, it does not involve
transferring the corpus or ownership of an asset which remains with the lessor.
There are generally two types of leases: a finance lease and an operating lease. A finance lease
is mainly a method of raising long-term finance to pay for assets. It provides the lessor with full
recovery of its investment and a reasonable profit over the initial non-cancelable lease term.
This mode enables enterprises, especially SMEs, to acquire assets, such as capital goods and
high cost equipment, for which they do not have the funds to make a large up-front payment
that would otherwise be involved in a direct purchase. In this type of lease, the lessor retains
ownership of the equipment but transfers to the lessee substantially all of the risks
and rewards of ownership of the asset. The lessee is responsible for the insurance, registration
and maintenance of the equipment.
Financial leases have some similar feature to secured loans. Both allow a business to use an
asset, such as equipment, over a fixed period, in return for regular payments.
The business client chooses the equipment it requires and the bank buys it on behalf of
the business. After all the payments have been made, the business client becomes the owner of
the equipment. The lessor's rate of return is fixed and is not dependent upon the asset-value,
performance, or any other extraneous costs. The fixed lease rentals give rise to an ascertainable
rate of return on investment. Therefore, by spreading payments out over the lifecycle of the
asset, the business is able to align the cost with the benefit derived from the use of the leased
asset. The lessor generally would not provide any services relating to operation of the asset. In
addition, financial leases are non-cancellable; in fact, the lessee cannot return the asset and not
pay the whole of the lessor's investment.
On the other hand, when a risk is involving other than a plain financial risk in a lease, it is an
operating lease. In fact, an operating lease is similar to a rental agreement, and is not a finance
lease for the purpose of acquiring assets; operating leases take innumerable forms based on the
risks the lessor takes or avoids, and the involvement of the lessor in operation of the asset.
Operating leases are also referred to as a “non-full payout” leases, because the amount of the
rental does not cover the lessor’s full capital outlay for the expected economic life of an asset,
the minimum lease payments over the lease term are such as to secure for the lessor the
recovery of his capital outlay plus a market return on funds invested and the lease period is
always less than the working life of the asset.

37
The basic features that differentiate an operating lease from a financial lease are related to
whether the lessor or the lessee takes on the risks of ownership of the leased assets. In fact
operating leases do not put the lessee in the position of a virtual owner; the lessee is simply
using the asset for an agreed period. Also, there is always a dependence on the lessee's
commitment to pay, as a result, the lessor also takes is asset-based. Its rate of return in an
operating lease is dependent upon the asset value, performance, or costs relating to the asset;
and is always a matter of probabilities and uncertainty.
Therefore, in an operating lease, the lessor normally holds a stock of assets with high degree of
marketability to provide to other entities. He may also provide any services relating to these
assets, such as maintenance or operations. The assets remain property of the lessor who has
the option to re-lease them every time the lease period terminates. Accordingly, the lessor bears
the risk of obsolescence, recession or diminishing demand. In contrast, a financial lease provider
operates like a lender except that the lessor has the additional collateral of legal ownership of
the assets without any of the risks associated with ownership.
Valid lease
Since leasing is a variety of sale, it is lawful in everything that can lawfully be bought and sold,
and the rules of Shari´ah pertaining to sale are also generally applicable to leasing. In fact, any
Islamic financing mode should be asset-based there has to be an element of risk taking. In fact,
the profit is generated when an asset having intrinsic utility is sold or offered for use; and one
cannot claim a profit without bearing the risk connected to the transaction. Therefore, most of
the rules relating to the contract of sale come into existence also apply to Ijarah or Islamic
leasing. Muslim jurists have, however, singled out some conditions the validity of an Ijarah
contract with respect to the asset or service hired and the rental.
The first conditions required in a valid Ijarah are that the two sides of the exchange must both
be known and specified in such a way that eliminates the possibility of disagreement and
dispute; that the usufruct in question has a financial or market value; The assets from which it is
almost impossible to derive any benefit from its use, cannot become the subject of Ijarah; and
also the agreement does not involve unlawful activities and substances. The contracted usufruct
and the rent should be ascertained clearly and agreed in advance, either for the full period of the
lease or for a specified period in absolute terms.
Since leasing transfers the ownership of usufruct from the lessor to the lessee, the former must
not only own the assets involved but also be able to transfer the ownership of its benefits to the
lessee. If a particular asset is specified for Ijarah, the lease contract cannot be executed before
getting of the asset or its usufruct. It is also a requirement of a valid Ijarah that the lease period
must be specified and that the lessor retains ownership of the leased asset during the entire
period of the lease. Liabilities arising from ownership will be borne by the lessor, while the
liabilities relating to the use of the property leased asset will be borne by the lessee. The lessee
is liable for any loss to the leased asset due to negligence, but he cannot be made liable for loss
caused by factors beyond its control.

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