Islamic Modes of Financing

Essentials of Islamic Finance

IQRA University Gulshan Campus MBA Spring, 2016

Muhammad Yaseen
yaseenbiniqbal@gmail.com
Essentials of Islamic Finance IU Gulshan Campus, Slide # 1

Mode of Financing

Mode of financing:
Mode of financing means way of supplying funds to
those who need funds;
Supply of fund from a financial institution to a
company is called indirect financing;
Conventional banks supply funds under one and
only mode of financing that is LENDING of money;
Every conventional banking product, whether it is a
car loan, industry loan, investment loan, personal
loan or a governmental loan, is offered under this
mode;
Essentials of Islamic Finance IU Gulshan Campus, Slide # 2

Islamic Modes of Financing

Islamic modes of financing:

Islamic modes of financing mean the way of supplying funds
that is acceptable to Islam;
As we have learned Islamic mode of financing could not be
based on lending of money as lending of money is not a
remunerative way of financing;
Prohibition of interest does not allow utilization of loan/lending
as mode of earning;
Therefore, there must be a way of funding that does not
contain element of interest;
There are three type of financing available under Islamic
concept of funds supply:
Trade-based modes of financing;
Rental-based mode of financing; and
Participation-based of financing;
Essentials of Islamic Finance IU Gulshan Campus, Slide # 3

Financial Activities
Capital
provisioning

Exchange of goods or
services
Ijarah (services
rendering)

Nonremunerative

Murabahah (cost
disclosed sale)

Remunerative (partnership based

financing)
Partnership

Loan

Salam (Future sale)

Gift

Permanent

Musawamah (simple
bargain sale)

Temporary

Istisnaa' (Manufacturing
Sale)

Essentials of Islamic Finance IU Gulshan Campus, Slide # 4

Trade-Based Modes of Financing

Trade-based mode of Financing means a way of financing in

which Islamic banks provide financing through sale and
purchase of commodities and assets;

Trade-based modes are secure modes because they create debt

and payables upon debtors/customers;

Islamic banks buy a commodity/asset (directly or through its

agent) from the market and sells it to customers on deferred
payment basis (instalments);

The agent may be a an employee on Islamic bank, a third party

or the customer himself as well;

All conditions should be observed carefully in sale financing.

Essentials of Islamic Finance IU Gulshan Campus, Slide # 5

Trade-Based Modes of Financing

There are four kinds of Trade-based modes of financing which are

very common:
MURABAHAHA;
Cost +profit transaction in which both are disclosed to the buyer;

MUSAWAMAH;
A simple sale transaction in which a price is quoted to customer
without any disclosure to the buyer;

SALAM;
A kind of sale in which price is paid in advance for a specific
commodity to be delivered in future;

ISTISNAA';
A sale transaction for assets that require manufacturing.
Essentials of Islamic Finance IU Gulshan Campus, Slide # 6

Trade Based Modes of Financing

The customer expresses its wish to buy a certain thing from the
bank and the bank buys it from market and sells it on instalments;

All modes follow laws and rules of Islamic Sale contract.

Each mode has separate set of additional rules which needs to be

followed strictly; Any error may lead to make the transaction a void
sale;

Credit Risk is lower in this kind of financing therefore Islamic Banks

prefers it;

The rate once fixed in these modes could not be changed;

Islamic banks earn money through cash purchase and credit sale;

Profit is difference between cash purchase and credit sale;

Essentials of Islamic Finance IU Gulshan Campus, Slide # 7

Trade Based Modes of Financing

Sometimes it is argued that the time has effects
on calculation of profit in case of credit sale;
We will analyse this question in following slides;

Essentials of Islamic Finance IU Gulshan Campus, Slide # 8

Price Difference in Credit and Cash sale

A common question to Islamic banks: Why the price is high
in case of credit sale? This excess is as good as charging of
interest;
But the question is too simple to reply;
The main concept is that: is there any room for time in
pricing?
Meaning can a seller consider 'time' as one of the decisive
factor for pricing a commodity or asset?
The answer is yes, time is one of the main factor that play
role in determining the price;
of Islamic
Finance
IU Gulshan
Slide # 9
The difference of price between wholeEssentials
sale
and
retail
isCampus,
due

Price Difference in Credit and Cash

sale
The fast moving or perishable items are not charged high
profit and return;
Slow moving and storable items are charged higher profits
and return;
The reason is 'TIME';
So the time is not something that should always be
neglected in pricing or determining the value;
The generic vale of interest is its linkage with time and not
with real assets and commodity;
Essentials of Islamic Finance IU Gulshan Campus, Slide # 10

Fixation of Return/Profit in Trade-Based Modes

Non-fixation of price in a Sale transaction means no precise
determination of price which is an essential element of
Islamic Sale Contract;
So non-fixation in sale is not allowed;
While fixation in partnership is as good as considering
something unconfirmed as confirmed which is no doubt
injustice with one of the partners;
So non-fixation here is the acceptable way.

Essentials of Islamic Finance IU Gulshan Campus, Slide # 11

Fixing of Return/Profit in Trade-Based Modes`

A repeated question is that the return/profit is fixed in
trade-based modes of financing while Islam prohibits fixing
of profit;
So what about famous Islamic concept of non-fixation of
the profit rate?
The actual reason of prohibition is not FIXATION or NONFIXATION;
In fact the element of GHARAR is not acceptable in financial
transaction;
Gharar sometime appears in fixation and sometime in nonEssentials of Islamic Finance IU Gulshan Campus, Slide # 12

Murabahah and Musawamah

Essentials of Islamic Finance IU Gulshan Campus, Slide # 13

Murabahah Definition and

Concept

Murabahah is one of the kinds of sales;

It comes under trade-based modes of financing;

Murabahah means selling a commodity or asset on

disclosure of cost and profit basis, which means the seller
discloses the cost and the added profit to buyer;

So the distinguishing feature of Murabahah from ordinary

sale is that the seller is bound to discloses the cost and
profit both to the buyer.

If he does not disclose the cost the sale will not be a

Murabahah sale;
Essentials of Islamic Finance IU Gulshan Campus, Slide # 14

Murabahah Definition and Concept

As any other sale the payment of Price in

Murabahah could be in three ways:
Spot payment (Al-Bai' ul Muajjal - immediate delivery
and payment);
Deferred for a specific future date (Al-Bai' ul Muwajjal full payment at a future date);
Deferred for a period of time (Al-bai' ul Muwajjal - sale on
instalment basis payment in tranches, similar to
purchase on instalments);

Essentials of Islamic Finance IU Gulshan Campus, Slide # 15

Murabahah Definition and Concept

Some important features of the Murabahah are:
As Banking Murabahah is a kind of sale, there must be a seller (bank)
and a buyer (customer) and something that could be bought and sold;
In such transactions the Bank is the seller, the customer is buyer and
a commodity/goods are exchanged between them;
In case there is nothing that could be sold and purchased Murrabahah
is not possible;
WC finance /Overheads financing etc. etc. are not possible under
Murabahah since there is no sale and purchase.
Because it is a sale from bank to customer the Bank is required to
purchase the commodity directly from the market/seller before selling
it to the customer;
Essentials of Islamic Finance IU Gulshan Campus, Slide # 16

Step by Step Murabaha Financing

Essentials of Islamic Finance IU Gulshan Campus, Slide # 17

1. Client and bank sign an agreement to enter into

Murabaha (MMFA).

Bank

Agreement to
Murabaha

Client

Essentials of Islamic Finance IU Gulshan Campus, Slide # 18

2. Client appointed as agent to purchase goods on

banks behalf

Bank

Agency
Agreement

Client

Essentials of Islamic Finance IU Gulshan Campus, Slide # 19

3. Upon submission of Order form Bank gives

money to agent/supplier for purchase of goods.

Bank

Agreement to
Murabaha

Client

Agency
Agreement
Disbursement to the agent or
supplier
Supplie
r
Essentials of Islamic Finance IU Gulshan Campus, Slide # 20

4. The agent takes possession of goods on banks

behalf and informs bank through a Declaration

form.
Transfer of
Risk

Bank

Vendor

Delivery
of goods

Agent

Essentials of Islamic Finance IU Gulshan Campus, Slide # 21

5(a). Client makes an offer to purchase the goods

from
Contract.

bank

through

Bank

Murabaha

Client
Offer to
purchase

Essentials of Islamic Finance IU Gulshan Campus, Slide # 22

5(b). Bank accepts the offer and sale is concluded.

Murabaha Contract
+
Transfer of Title
Bank

Client

Essentials of Islamic Finance IU Gulshan Campus, Slide # 23

6. Client pays agreed price to bank according to an

agreed schedule. Usually on a deferred payment

basis (Bai Muajjal)

Bank

Client
Payment of Price

Essentials of Islamic Finance IU Gulshan Campus, Slide # 24

Application

Essentials of Islamic Finance IU Gulshan Campus, Slide # 25

Murabahah
Application

Murabahah can be used to finance the real purchase needs of

customer;
It could be used for assets which are acceptable to Shariah and

has a tangible form.

Therefore, Murabahah can be used to finance the purchase of:
Raw Material;
Equipment;
Consumer Goods;
Murabahah cannot be used to Finance:
Personal loans;
Credit cards.

Essentials of Islamic Finance IU Gulshan Campus, Slide # 26

Issues in Murabaha

27
Essentials of Islamic Finance IU Gulshan Campus, Slide # 27

Issues in
Murabaha
1. Timing of Declaration
A Murabaha financing arrangement consists of a series
of documents to be executed at various stages, the
sequence and timing of which is extremely important.
Through declaration client and the bank execute an
important step of a valid Murabaha sale i.e. Offer &
Acceptance
Declaration is to be signed by the customer when it
has purchased and taken possession of the goods as
the Banks agent.
28
Essentials of Islamic Finance IU Gulshan Campus, Slide # 28

Issues in
Murabaha

1. Timing of Declaration.(Cont..)
Declaration must be signed while the goods are still in
existence and have not been used in the production
process or sold to some other entity.
As a general rule of thumb declaration must be
received within 1 month or 1/4th of the Murabaha
tenor, which ever comes first.
The importance of proper timing of declaration can be
understood better by the example of a Nikah contract.
29
Essentials of Islamic Finance IU Gulshan Campus, Slide # 29

Issues in
Murabaha
2. Rollover in Murabaha
Rollover in Murabaha is not possible since each Murabaha
transaction is for the purchase of a particular asset. A new
Murabaha can only be executed for the purchase of new assets.
It is advisable that whenever practicable there must be a gap of
1-2 days between maturity of the previous Murabaha and
disbursement of the new one.

30
Essentials of Islamic Finance IU Gulshan Campus, Slide # 30

Issues in
Murabaha
3. Rebate on early payments
These are strictly prohibited by our Shariah
Board since they make the Murabaha
transaction similar to conventional debt.

31
Essentials of Islamic Finance IU Gulshan Campus, Slide # 31

Issues in
Murabaha
4.
Penalty on late payments
As soon as the Murabaha is executed (declaration signed) the
Murabaha price becomes a receivable (Dayn) for the Bank.
As per the rules of Islamic fiqh any amount charged over and above
the dayn amount will be Riba.
Hence we cannot charge any late payment charges.
We may, however, ask the customer to pay a forced charity in case
of overdues so as to create a disincentive for him to delay the
payment

32
Essentials of Islamic Finance IU Gulshan Campus, Slide # 32

Issues in
Murabaha
5.
Subject matter of Murabaha
Murabaha cannot be done in all commodities, e.g. Murabaha
can not be done in currencies. As per general rules of sale
subject matter must be:
In existence
- Having intrinsic utility
- Usable for a Halal purpose (buyer must intend
to use it
for the same purpose)
- Capable of ownership/delivery
- Specified and quantified at the time of sale
- Must be in Banks ownership/possession at the time of
sale

33
Essentials of Islamic Finance IU Gulshan Campus, Slide # 33

Issues in
Murabaha

6. Purchase Evidence
In order to ensure that the customer actually
purchased the assets as claimed, the customer is
required to submit asset purchase evidence along with
declaration.
The purchase evidence must confirm that the asset
purchase took place after the agency agreement.
Asset purchase may be in the form of Invoices,
delivery orders, truck receipts etc.
34
Essentials of Islamic Finance IU Gulshan Campus, Slide # 34

Issues in
Murabaha
6. Purchase Evidence..(Cont..)
In some cases, however, it may be too burdensome
for the client to submit all the invoices as the
number of invoices may run into hundreds.
For e.g. cotton or sugar purchases are generally in
small quantities from various sources and hence
for each Sub-Murabaha there may be too many
invoices to submit.

35
Essentials of Islamic Finance IU Gulshan Campus, Slide # 35

Issues in
Murabaha

7. Direct Payment in Murabaha

Currently in almost all cases the disbursement is
made to the customer as an agent.
In order to ensure transparency of the Murabaha it
is better that we disburse the funds directly to the
customer.
Shariah board has also instructed us to increase
the percentage of direct payment Murabahas as a
% of total Murabahas
36
Essentials of Islamic Finance IU Gulshan Campus, Slide # 36

Issues in
Murabaha
7.Direct Payment in

Murabaha..(Cont)

Direct payment can be made in the following ways:

The bank can pay the supplier directly via cash, cheque,
pay-order etc.
The bank may credit the Murabaha funds in the
customers account and only allow him to
issue
payorders/demand drafts from his account favoring the
asset suppliers.

37
Essentials of Islamic Finance IU Gulshan Campus, Slide # 37

Musawamah
Musawamah is also one kind of sale;
This is a simple sale we do in our daily routine life;
The difference is that the quoted price does not require
any break-up of cost and profit;
All other details are same as for Murabahah;
The process flow is also same and the payment method
may also be of same nature.

Essentials of Islamic Finance IU Gulshan Campus, Slide # 38

Questions?

Essentials of Islamic Finance IU Gulshan Campus, Slide # 39