M.B.

MOHAMED YAZAR
IIBI/PGD/1932/10
98, MOSQUE ROAD.
DALKOTUWA
WELAMBODA.
SRI LANKA
yaz_studies@yahoo.com

Islamic Economics &

Finance
Module -03
Lesson 4: Islamic Banks Fee-Based Services and Operations

Tutor: Muhammad Nasir

Lesson 04, Question 01
Letter of Credit and Islamic Banks
A Letter of Credit (L/C) is a commitment, usually by a bank on behalf of a its client, to pay a
supplier of goods, a stated amount of money under specified conditions such as on shipment of
the specified goods. It is a form of financial guarantee covering the buyer's risk and guarantee-
ing payment to the seller; the bank will only make payment after the presentation of the ship-
ping and other stipulated documents, which complies with the terms and conditions of the L/C.

L/Cs is widely used in financing foreign trade to guarantee payment to a exporter after ship-
ment is effected. The issuing banks are taking a risk in case the bank makes a payment under
the L/C and the client defaults. Therefore, before issuing a L/C, the bank assesses the client’s
financial position to find out whether the client’s creditworthiness and the ability to pay. The
bank may consider taking a security to minimise any potential loss.

By the use of L/C, exporters can obtain a quick, secure and guaranteed payment of goods from
a bank. The import client of the bank gives a written undertaking in favor of an exporter or a
local supplier guaranteeing payment on sight or payable after a determinable period after
shipment for purchase of goods from an exporter.

Islamic banks are not treating the L/C as a guarantee but considering as a fee based banking
service to facilitate trade. Islamic banks usually issue L/Cs on the basis of Wakalah, Murabaha or
Musharakah. All operations must fulfill the requirements of the Shari´ah. The processing of L/Cs
usually involve two banks, the L/C opening bank and the correspondent bank to whom the L/C
is sent for advising the exporter.

When Islamic banks using the Wakalah concept, the bank acts as the agent of the importer. The
client deposits with the full amount of the L/C to cover the import transaction and the bank
opens the L/C. After shipment of goods and submission of documents by the exporter, the bank
makes payment using the client’s deposit. The bank charges a fee/commission for its services.

In the case on LC using Murabaha, the procedures of Murabaha still apply except that payment
to the bank is not deferred. The Islamic bank opens the L/C and, after shipment of goods and
submission of stipulated documents, it makes payment to the exporter, using the bank’s own
funds; bank takes the delivery of the goods on arrival and sells the imported goods to the client
under the murabaha. The difference between the selling price to importer and the payment for
exporter is the margin ob bank. The client repays the bank on a deferred basis as agreed.

In the case of a Letter of Credit with Musharakah, the importer deposits with the bank an
agreed share of the cost of the imported goods, representing the importer’s share in the trans-
action. After shipment of the goods and submission of the documents, the bank makes full
payment to the exporter, using the importer’s deposit and the bank’s own funds for the bal-
ance. After the imported goods are sold at the market price, the bank and the client share the
profit at a pre-agreed ratio. The importer may also purchase the bank’s share of the imported
goods at the market price.

Islamic banks are allowed to charge a handling commission/fee, as a service charge for
processing L/Cs, documentation and payments; the amount various according to the service
and to the L/C amount involved. For example, the bank can also charge its client an issuing
commission, plus other charges such as postage, an advising fee, or a confirmation fee. These
fees are usually not relative to the amount of the L/C and its duration. The bank may also
charge an amendment fee in case the exporter requires amendments to the L/C terms. It may
also charge a commission for accepting the Bill of Exchange, as it becomes the bank’s obligation
to make the payment on the due date.

Sources:
PGD-Module3, lesson 4-IIBI-uk
Understanding Islamic Finance – Muhammad Ayyub

Lesson 04, Question 02

Today’s business has exceeded the border and expanded to international level. Businesses are
related to more than one country as well as more than one currency. To facilitate the business
in its maxim level, banks provides more important services to its customers by being a interme-
diater between different currencies and the charge for the services they provide. As conven-
tional banks, an Islamic bank also facilitates the international business by handling different
currencies and able to charge commission or fixed flat rate for the services.
As the effect of globalisation, commercial banks plays key role in trade services between expor-
ter and importer when cross border trade. Banks provides services such as Letter of credit, bank
guarantees, and documentary bills for collection, fund transfers and remittance services.

Letter of Credit is a financial guarantee issued by banks for exporter on behalf of its client. By
issuing LC, bank guaranteeing the payment to exporter on the present of shipping documents.
Islamic banks issue the LC under the concept of Kafalah and charge fixed fee or commission for
the services provide. Islamic scholars allowing this, because banks are taking credit risk over its
client.

Bank Guarantee also forms of financial guarantee, given by banks to exporter behalf of its
client. Its guarantee the payment for exporter, when the importer defaults to make payment.
Banks securing the exporter and make the payment for him on the defaults of importer. Banks
charge fixed fee or commission for the services provide under the concept of kafalah. Shariah
allows the banks to charge payment, because the banks take liability risk and some administra-
tion expenses incurred.
When the trade party’s has more understanding and trade history, they may not request for
bank guarantee or LC to avoid unnecessary banks charges. Banks simple provide services by
transferring documents to corresponding bank and collecting payment under the documentary
bills or DAP (document against payment) basis. Banks simply charge flat fee or commission for
the services provide. Shariah allowing this under the concept of jualah.

Apart from this banks handle various financial instruments for the collection of cash payments
for their customers. Such cheques, bank drafts, traveler’s cheques, payment orders, foreign
currency, cash, etc. for example the expatriate worker from Saudi Arabia sending money to Sri
Lanka through e-remittance. The remitters bank charge fixed rate (10 SR – its vary with bank to
bank and location) for the services provide.

And additionally Islamic banks exchange different currencies on the spot in transactions such as
a bank transfer or remittance expressed in a foreign currency, payment for goods imported
from another country, payment for services billed in a foreign currency, in the case of a sell or a
purchase of a foreign currency in cash or traveler’s cheque or bank draft against another cur-
rency, or when a client deposits a cheque or bank draft made out in a foreign currency and re-
quires payment in local currency.

In addition to spot transactions, a Foreign exchange (FX) transaction may be undertaken by

banks on the basis of forward contracts, futures contracts, option contracts, swap contracts and
currency arbitrage. Some of these transactions are controversial as Islamic financial instru-
ments, because it is arguable that the element of speculation and interest is built into these
contracts.

There are normally no up-front costs involved with FX transactions; Islamic banks still derive a
financial benefit by incorporating a margin into the transaction or the contract rate. The bank’s
rate may be different from the market rate prevailing at that time, whereby the bank makes a
profit on a transaction.

Sources:
IIBI-PGD-moudle3, Lesson4
Understanding Islamic Finance by Muhammad Ayub
Lesson 04, Question 03

Islamic banks offer fee-based services similar to conventional banks. These services may gener-
ate various types of fees and commissions, but it must not involve charging interest in any form
or other non-permissible activities. The fee-based services and operations of Islamic banks in-
clude bank transfers, issuing credit cards and offering collection and safe-custody services.

Like conventional banks, Islamic banks can charge their customers a fixed fee or commission for
providing a bank transfers service both inside and outside of the country. The fee charged must
involve no interest. It can be vary according to location. For example if the person working in
Saudi Arabia wanted to transfer money to Sri Lanka. He walks to the bank and instructing to
remit the amount in local Account as Sri Lankan rupees. Banks acting as an agent, of its client
and transferring the amount through corresponding bank. Bank’s charge fixed rate ten riyal for
the services provided. Shariah approve this under the concept of wakalah. And foreign ex-
change rules also apply for this transaction. And also its is fair that charging flat fee, hence the
interest is prohibited, while banks has administration and some other expenses. This also appli-
cable for some other services such remittance and fund transfer.

Islamic banks issue credit card under the concept of kafalah (guaranteeing payment), wakalah
(agency) and qard. As conventional banks, Islamic banks cannot charge interest or hidden
charges on credit card. As we discussed in previous lesson, banks guaranteeing the payment for
the merchant (or seller) for the purchases of credit cardholder by using the credit card. Islamic
scholars allow charging the fee for kafalah services. And bank being an agent for the purchases
through supplying the card to the cardholder and also it can act as an agent for merchant. And
it’s fair to charge a fixed fee or commission for the services of wakalah. But in the case of con-
ventional credit card, banks charge interest for the due amount or debt amount. And addition-
ally banks charge membership fee from card holder for the services provided by the bank for
the benefit of card holder. Agency commission applicable as ujrah from merchant at the time of
settlement, banks charge this to being a financial intermediate between cardholder and mer-
chant it can be a percentage of purchase amount.

Islamic banks provide safe custody services to their clients whereby it is possible for items of
value, including valuable documents, jewelleries and other possessions to be securely stored
inside bank’s premises. The Islamic bank charges a fee for providing this service. However, the
bank does not insure any responsibility for, any items held in safe custody on behalf of clients.
Banks charge fixed fee or rent according the period of time provide the services. Its fair that
charging a amount for safe custody services, due to the use of bank premises and bank has
some cost to protect the things and the administration cost also incurred.

Sources:
IIBI-PGD, Module3, Lesson4