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Joint Director-
Puhlicatiorzs & Islamic Economics Division
Research Department, Bangladesh Bank
Dhaka, Bangladesh
1. Introduction
The elimination of interest is one of the basic requirements for the establishment of
an Islamic economic order. In recent years, a good deal of attention has been paid by
Muslim experts in economics, banking and finance to find ways and means of doing
away with interest. One important aspect to this ini~iative is laid upon the
development of risk return bearing financial instruments that can provide investors as
well as banks with a sufficient degree of liquidity, security and profitability to
encourage their constituents for making effective investment decision. This paper
seeks to point out the nature (definition and types) of the Islamic financial instruments
which have already been introduced in some Muslim countries and the possible
instruments proposed by the Islamic economists so far.
Since an Islamic economy is essentially a share economy based on profit, rent and
dividends, as reflected through different investment contracts, it should be possible to
develop a framework of Islamic securities investment-based on Mushurakah,
Mudclrabah and Murclbahah concepts and other modes of Islamic financing (e.g. Bai'
Al-Salam). Since the cost of investment in securities based on these concepts is mainly
a function of the rate of return, Islamic instruments can have a built in stabilising
influence on investments and they would also be less prone to speculation. In this
connection, it may be mentioned that the underlying principles of advanced sale (i.e.
Bai' Al-Salam), sale on deferred payment (i.e. Bai' Al-Mu'ajjal) can possibly be
operationalised in the conduct of Islamic financial markets. A brief review of some of
the existing financial instruments issued by banks, investment companies and
governments, are analysed in the following paragraphs.
* Paper Presented at a 3-day Workshop on Developing Islamic Financial Instruments held at the
Conference Room of the Bangladesh Bank. Dhaka on September 9-1 1, 1995 jointly organised by
Bangladesh Bank and Islamic Research and Training Institute, IDB, Jeddah, Saudi Arabia.
Review of Islamic Economics, Vo1.4, No.1
The scope of financial instruments is quite wide. For practical reasons, the Islamic
financial instruments are not classified in a haphazard way as short, medium and long
term but such a classification would depend on the nature of investment itself. In
Muddrabah, for example, the whole deal should be liquidated for the purpose of
realizing profits or losses. Salam dealing is another type of contract that can be
classified, by its nature, as a short-term investment. On the other hand, we find that
Musharakah can be treated as a long-term investment if it is permanent or as a
medium-term investment if it takes the form of decreasing participation. If there is an
Islamic capital market, there would be no big difference between short-term,
medium-term and long-term investments. All these differences would lose their
importance when the investor can sell, at any time, his portions in the various
investments, either in the form of Mudarabah, Mushcirakah, Murabahah or
Salam.
4. Practical Experience
Some of the Muslim countries like Pakistan, Iran, Malaysia, U.A.E, Jordan and
Sudan have introduced many Islamic financial instruments in order to mobilize the
idle resources for long-term productive and development activities on the basis of
Islamic principles. Islamic financial instruments which have been introduced in these
countries differ in nature and characteristics from the interest based ones. The modus
operandi of those financial instruments are mostly based on Mudarahah mode of
finance.
5. Definition of Mudiirabah
Mudarabah is a form of partnership where one of the contracting parties called the
Sahib al-Ma1 or the Rahb al-Mal' (the financier), provides a specified amount of
capital and acts like a sleeping or dormant partner while the other party, called the
Mudarib (entrepreneur), provides the entrepreneurship and management for carrying
out any venture, trade, industry or service with the objectives of earning profits. The
Islamic Financial Instruments: Definition and Types
Mudcirib is in the nature of a trustee as well as an agent of the business. The Mudcirib is
required to work with honesty and sincerity and to exercise the maximum possible care
and precaution in the discharge of his functions. If he is guilty of wilful negligence,
fraud or misrepresentation, he is himself responsible for the consequences, and the
resulting loss, if any, can not be charged to the Mudcirabah account.
Mudcirabah is also synonymously termed as 'Qircid' and Mudcirib as 'Muqcirid'. In
general, the Hanafiyyah, Hambaliyyah and Zaydiyyah schools of Muslim Jurisprud-
ence have used the term Mudarabah, while the MBlikiyyah and ShBfi'iyyah have
preferred the term 'Qircid'.
6. Pakistan
Muddrabah Certificates
MudaTabah certificate is, however, one of the instruments which has already been
introduced in Pakistan under the special law called 'The Mudcirabah companies and
Mudcirabah (Flotation and Control) Ordinance, 1980'. The law was subsequently
supplemented by the Muddrabah Companies and Mudcirabah Rules, 198 1. The
Mudcirabah law provides the necessary legal framework for the Flotation of
Mudcirabahs in Pakistan. Under this law, management companies, banks and
financial institutions can register themselves as Muddrabah companies and float a
Mudcirabah for a specific or general purpose. The objects of any Mudcirahah will be
restricted only to such business as are permitted under Islamic Shari'ah. In order to
ensure that Mudcirabahs are not used in any activity that is repugnant to the tenets of
Islam, the prospectus of each Muddrabah will need a prior clearance from a Religious
Board. Furthermore, after the Mudcirabah goes into operation, the law imposes
additional responsibility on the auditors to certify that all business conducted,
investments made and expenditure incurred are in accordance with the objects, terms
and conditions of the Muddrabah. To safeguard the interest of the Muddrabah
certificate holders, a number of protective clauses have been provided including
quicker and simpler adjustment by a tribunal. In order to promote the growth of
Mudcirabahs and keep in view the larger interest of Mudcirabah certificate holders,
the entire income of Mudcirahah funds has been exempted from income tax, provided
that 90 per cent of the income is distributed to the Mudcirabah certificate
holders.
Types of Muddrabah
There are, however, two types of Mudcirabah existing in Pakistan:
1. Multi-purpose Mudcirabah: That is to say a Mudcirabah having more than one
specific purpose or objective.
2. Specific Purpose Mudcirabah: That is to say a Mudcirabah having one specific
purpose or objective.
Review of Islamic Economics, Vo1.4, No.1
banks and DFIs in Pakistan. Neither this mode has been recommended by the SBP nor
it has any legal basis. It was innovated by a DFIs in 1984-85 and afterwards became a
major mode of term finance in place of PTCs. The borrowing company sells the item
concerned that it had agreed to purchase merely as a consequence of a paper deal with
the firm supplying the item, to the financing institution for a certain "Sale price" and
then again purchases the same from the financing institution for a sum called
"purchase price" which is paid in instalments in accordance with the redemption dates
of the TFCs issued by the borrowing company. If TFCs are not redeemed on the due
date the borrower is required to pay to the holder of such TFCs an amount equivalent
to 20 per cent of the TFCs' face value.
7. Jordan
MuqrZradah Bonds
The Islamic Development Bank (IDB), generally encourages its member countries
to adopt the Islamic techniques in financing and development of projects. In response
to this, Hashemite Kingdom of Jordan promulgated the Muqciradah Bonds Act in
1981. The Jordanian ministry of Awqaf adopted this technique to finance a project to
set up a commercial centre (commercial shops, offices, car parks etc.).
Salient Features
"Muqdradah Bonds" as the term denotes, are based on the conclusion of a
legitimate "Muqclradah" (i.e. Muddrahah) with capital on one hand and labour on the
other and the shares of profits are determined beforehand by a definite prop~rtionof
the total. The main purpose underlying the issuance of Muqdradah Bonds is the
financing of a given project with the object of executing the project, utilizing it and
making profits. As an incentive to the subscriber of Muqciradah Bonds, Article 10 of
the Act stipulates that profits realised from investment in Muqdradah Bonds are not
subject to income tax and that the Government guarantees the principal amount of the
bonds. Article 18 of the Act also permits dealing with "Muqdradah Bonds" in Amman
Stock Market according to its rules and regulations. It also permits the transfer of
ownership of the bonds in accordance with these rules.
8. Malaysia
(i.e. in cases where the tenure of the issue is for 1 year.) The dividend rate is
determined by the Dividend Committee which comprises representatives from
Treasury Office, Bank Negara Malaysia, the Economic Planning Unit and the Islamic
Centre. The factors that are normally taken into consideration in deciding the dividend
rate are the country's economic performance, inflation rate, equivalent return on the
Government Instruments ... etc.
The Government Investment Certificate is a qualified security for the purposes of
complying with the Liquid Assets Requirement to be maintained by the financial
institutions. With regard to this, Bank Negara provides the discount window facility
for the financial institutions to buy or sell the GICs with Bank Negara. The trading of
the Government Investments Certificates will be based on the Expected Dividend
Rate and the formula for the price computation is as follows:
(axb)+lx100
Price =
(36500)
where a = Expected Dividend Rate
b = Number of days from the issue date or last dividend date to the value date
of the transaction.
Example: If the Expected Dividend Rate of 1 year GIC is 6% p.a. and the issue date of
this GIC was on June 30, 1994 and transacted on December 2, 1994, The
price will be computed as follows:
(6~155)+1xlOO
Price =
(36500)
= 102.55
If the investor purchased GICs of RM 1 million, the amount of proceed to be settled
would be RM 1,025,500.00. (Note the expected dividend rate is reviewed on a
monthly basis).
Government Investment Certificate is one of the alternative instruments used by the
Government to finance its deficit other than the issuance of Malaysian Government
Securities (interest bearing instruments) and Malaysian Treasury Bills. At present
GICs are playing an important role in developing the Islamic Banking Scheme of
Malaysia whereby the Islamic financial institutions would be able to park its excess
cash surpluses which would also enhance their return on their investment.
9. Iran
Participation Bonds
Tehran Municipality of Iran has recently (Approx. in September, 1994) issued a
bond named "Participation Bond" in accordance with Islamic principles for financing
the project of reconstruction of Navab Highway. The essential features of the bond are
as follows:
Review of Islamic Economics, Vo1.4, No.1
Participation Bonds are issued in accordance with the Islamic Principles and
on the basis of investment in economic projects with positive rate of return.
The return should be divided between the investors and the issuer of the bonds,
who is also responsible for the completion of the project.
Participation Bonds can be issued, both by the' public and the private
sector.
In each case there should be an underwriter who accepts the floatation of the
bonds and the purchase of the issued bonds not purchased by the general
public.
For each case, the issuer should guarantee a minimum amount of profit
obtainable from the related project. Profits over and above the guaranteed
level should be distributed after the completion of the project. If the projected
minimum profit is not realized, the entire responsibility of provision of funds
for payment of the guaranteed return would fall on the issuer.
The bond should be for the purpose of financing a specific project and cannot
be used otherwise.
The bonds are issued together with special coupons for collection of returns.
Due dates of such coupons are specified at the time of the issue.
Such bonds are issued without name and on bearer basis.
The bonds are negotiable and can be transacted through Tehran Stock
Exchange.
In case of Participation Bonds issued by Tehran Municipality, the specific
details are as follows:
1. Maximum amount to be issued is Rls. 250 billion and the issue would
be in four consecutive series. So far only the first series have been
issued.
2. Bank Melli is the underwriter and, hence, the agent responsible for
floating this bond.
3. All bonds issued during the first round were sold at the time of issue.
So far there has been no secondary dealing at the Tehran Stock
Exchange.
4. As profits are paid through coupons, the face value would be identical
to the redemption value.
5 . The expected rate of return to the project is checked by the authorities
of Bank Melli. The auditor has approved that the rate of profit should
be around 25 per cent.
6. The Municipality has signed a contract with Bank Melli authorizing
the bank to pay a minimum guaranteed interest of 20 per cent.
Islamic Financial Instruments: Definition and types
(b) The MudcIrabah funds shall be operated and managed in a weekly cycle
governed by a computerised system to compute expenses and allocate
profits.
(c) Proceeds of what Allah bestows as profit shall be distributed, on a weekly
basis; 75% to the investor and 25% to the company.
(d) Subscription to this MudcIrabah is free from issuance fee.
(e) The investor may redeem, all or part of hisher equity, within a week of
submitting a request to this effect.
equivalent currency. The participant may redeem Mudarahah units owned for at least
twenty four months in whole or in any part from liquid assets. Profit is distributed as
follows:
70% for the participant.
30% for the manager (IICG).
C(i) The Seventh Islamic Mudarabah for Investment, Savings and Takafol
1 ) This Mudcirabah is the Islamic alternative to conventional life insurance which
is not acceptable to Islamic Shari'ah as it involves Gharar, gambling, and Riba
(usury).
2) This Mudarahah offers the subscribers the benefit of investing and at the same
time saving their instalments together with the accumulated profits. It also has another
privilege which is Takafol by part of the accrued profits of the subscribers in favour of
the family of any participant who may die during the time of hisher participation.
3) Eligibility to this Mudarahah is restricted to Muslims, males or females,
provided they belong to the age group of 20 to 56 years.
4) A male is entitled to buy a maximum of four certificates while a female is
entitled to buy only two.
5 ) The participant shall pay an annual instalment on the value of the certificate
plus 30% issuance fee. The total value of the certificate is sub-divided on the number
of years that remain before the participant reaches the age of sixty, rounding up the
amount to the nearest figure.
6) A schedule showing the age and number of premiums and the value of the
annual premium and the acceptable currencies is jointly worked out to serve the
purpose. The participant shall accordingly continue to pay the premium until he/she
reaches the age of 60.
7) The participant is eligible to withdraw but not before the termination of the
second year of hisher membership; only then shall the company pay him back 95% of
the amount due (instalments + profit).
8) The participant shall enjoy the privilege of Takafol (solidarity) upon
completion of hisher first year of membership, provided that he/she is regularly
paying hisher premiums. In case of hisher death, the Company shall reimburse the
legal and authorized heirs all paid-out premiums and their due profits, plus the
premium the deceased participant should have paid until the age of 60 in TakGfol
(solidarity) from the profits of other participants.
9) A set of legal conditions is incorporated in the MudLfrahahcontract by virtue
of which the participant shall be deprived of the privilege of Takafol if helshe fails to
abide by them.
10) If the participant continues to pay all the instalments due until helshe reaches
the age of 60, he/she shall be entitled to recover them all, plus the accumulated
profits.
11) Investment dividend shall be shared at the ratio of 1/10 to the Company and
9/10 to the participants.
Islamic Financial Instruments: Definition and tTypes
12. Switzerland
Islamic securities: one prominent branch of Dar Al-Ma1 Al-Islami Group "Faisal
Islamic Finance (Switzerland) S.A." has issued Islamic securities as one of the
instruments in their financial packages. Due to the non-availability of data and
information regarding this securities, it is not possible to give details about it.
Review of Islamic Economics, Vo1.4, No.1
It is evident from the above that though it was little, the Muslim theoreticians and
practitioners have helped to develop these instruments. These have proved to be
effective instrumei~ts for investment-related financing. To meet the changing
environment of financial markets some Muslim economists have suggested for
devising new types of financial instruments. Dr. M.A. Mannan of IDB suggested 10
broad variables of new financial instruments, such as:
1. Loan Certificates
2. Index-Linked Loan Certificates
3. Islamic Commercial Papers
4. Integrated Investment Bonds
5. Profit Sharing Certificates
6. Expected Rate of Dividend Certificates
7. Rent Sharing Certificates
8. Firm Commitment Certificates
9. Zakah Certificates
10. Human Capital Ceflificates
Another economist of IDB, Mohamn~adEl-Hennawi has suggested two types of
certificates which will provide the stability of resources to the Islamic banks and
enhance their development role. The suggested instruments are:
I. Islamic Certificates of Deposit (ICD) and
2. Islamic Investment Certificates (assigned to a particular project or a
group of projects).
The Islamic Research and Training Institute (IRTI) of IDB is also continuing its
efforts in developing new types of financial instruments compatible with Shur-i'ahwhich
would enable it to increase its own resources in order to meet the growing needs of its
member countries for financing. To this end, an effort has been made by the IRTI in 1991
in announcing its financial assistance for the Muslim economists and researchers to
write research papers on development of appropriate Islamic financial instruments for
foreign resource mobilization. The suggested Islamic financial instruments are:
I. Net Income Sharing Instruments
2. Gross Income Sharing Instruments
3. Sale-Based Instruments
4. Conlmodity-Linked Bonds (yet to be examined)
5. Indexed Bonds (yet to be examined)
6. Equity Bonds (yet to be examined)
Conclusion