Financial Instruments of Islamic

Banking and Finance

 Learning Objective 3.1
Describe the sources and
Sources and Uses of Funds by uses of funds and the
operation of bank accounts
Islamic Banks by Islamic banks.

Sources of Funds

Two major sources

1. Transaction deposits: risk-free funds which do not yield
return e.g. current accounts based on the wadi’ah concept

2. Investment deposits: profit-making but have risk of

capital loss, depending on amount invested by bank
 Learning Objective 3.1
Describe the sources and
Sources and Uses of Funds by uses of funds and the
operation of bank accounts
Islamic Banks by Islamic banks.

Other sources
1. Current Accounts: account opened by individuals,
companies and firms by depositing cash, cheques and/or
bills (based on concept of wadi’ah)

2. Saving Account: funds deposited in saving account yield

some returns depending on bank financial results. Based on
wadi’ah, mudarabah and musharakah concepts

3. Investment Account: the most important source of funds

for Islamic banks; the customer and the bank enter into a
joint-venture agreement, based on mudarabah concept
 Learning Objective 3.1
Describe the sources and
Sources and Uses of Funds by uses of funds and the
operation of bank accounts
Islamic Banks by Islamic banks.

Application of Funds

• Islamic banks apply funds to raise profits in different ways

• The main channels for the outflow of the funds include the:
- musharakah
- mudarabah
murabahah (cost-plus financing)
- ijarah (lease)
- istisna’ (manufacturing contract)
- bay salam
- bay mu’ajjal (deferred sale contract) models
 Learning Objective 3.2
Understand how exchange-
Concept of Exchange-Based Contract based contracts are used as
financial instruments in
Islamic finance

Bay Dayn Position of the Four Major Muslim Schools

• Shafi’i School: Sale of debt is allowed to a third party only

if the debt was initially guaranteed and was sold in
exchange for goods to be delivered immediately

• Hanafi School: Sale of debt not allowed in Islamic

commercial transactions

• Maliki School: Sale of debt allowed subject to conditions

• Hanbali School: divides the sale of debt into two:

- confirmed debts can be sold on the spot

- unconfirmed debts are not tradable
 Learning Objective 3.2
Understand how exchange-
Concept of Exchange-Based Contract based contracts are used as
financial instruments in
Islamic finance

Bay al-Inah (Sale with immediate repurchase)

• Bay al-Inah: Where a commodity is sold on a cash basis;

the seller immediately repurchases the same commodity on
a deferred payment basis at a price higher than the initial
cash price

• Used in different real estate and house financing situations

• Bay al-inah is controversial in the global Islamic finance

industry
 Learning Objective 3.2
Understand how exchange-
Concept of Exchange-Based Contract based contracts are used as
financial instruments in
Islamic finance

Bay al-Inah (Sale with Immediate Repurchase)

Views on the Validity of Bay al-Inah

• The Shafi’i School: Bay al-inah contracts are permissible

in Islamic law

• The Maliki, Hanafi and Hanbali Schools: Bay al-inah is

not permissible in Islamic law because the motive of the
parties in such a contract is illegal

• The majority of jurists prohibit bay al-inah in Islamic

commercial activities because they believe it is tainted with
elements of interest
 Learning Objective 3.2
Understand how exchange-
Concept of Exchange-Based Contract based contracts are used as
financial instruments in
Islamic finance

Tawriq (Securitisation)

• Tawriq is a process of converting an asset into cash issued

as tradable certificates of investments (tradable in the
secondary market)

• Is the equivalent term for securitization in Islamic

commercial jurisprudence.

• The end product of tawriq is the issuance of sukuk or

sanadat to a large number of investors
 Learning Objective 3.2
Understand how exchange-
Concept of Exchange-Based Contract based contracts are used as
financial instruments in
Islamic finance

Parties to Tawriq

The most important parties in securitization are:

• Originator/Issuer of Sukuk: large corporations, governments

• Special Purpose Vehicle

• Investment Banks: Islamic banks or Islamic windows of

multinational banks

• Subscribers or Investors: individuals and corporate entities

 Learning Objective 3.2
Understand how exchange-
Concept of Exchange-Based Contract based contracts are used as
financial instruments in
Islamic finance

Sarf (Sale of Currency)

Validity of Foreign Exchange Contract in Islamic Law

• Trade in currency is permissible in Islamic law. “Gold for

gold, silver for silver, wheat for wheat, barley for barley,
dates for dates ... hand to hand ... ” (The Hadith)

• Limitation: the exchange must be done hand-to-hand in one

sitting if it involves different currencies

• If the currencies are the same, the currencies being

exchanged must be of equal amounts, and the exchange
must take place at the same sitting
 Learning Objective 3.2
Understand how exchange-
Concept of Exchange-Based Contract based contracts are used as
financial instruments in
Islamic finance

Tawarruq (Cash Financing or Reverse Murabahah)

• Hybrid sale contract where a customer approaches a financial
institution to purchase a commodity with payment arranged in
instalments and in turn sells the commodity to a third party for
cash
• Permissibility of Tawarruq is based on:
- The general principles of a typical contract of sale
- The absence of any bit of interest in this transaction (it does
not amount to riba)

• Permissibility of Tawarruq is subject to:

- The person must be in real need of money
- No other permissible alternative available
- The contract being free of any modicum of riba
- The customer having full possession of the commodity

Concept of Exchange-Based Contract
Learning Objective 3.2
Understand how exchange-
based contracts are used as
financial instruments in
Islamic finance

Figure 3.7:Permissible Reverse Murabahah (Tawarruq)

 Learning Objective 3.3
Understand how service-
Concept of Service-Based Contract based contracts are used as
financial instruments in
Islamic finance

Ju’alah (Commission or Reward)

• In the juristic sense, ju’alah is a one-sided contract where
reward/commission is given for accomplishment of a task

• The legality of the ju’alah contract is established in the

Qur’an and Sunnah

• There is an element of ju’alah in takaful contracts

• Ju’alah may be useful in the recovery of overdue debts

 Learning Objective 3.3
Understand how service-
Partnership Contracts in Islamic based contracts are used as
financial instruments in
Finance Islamic finance

Mudarabah (Trust Financing)

• Mudarabah is a form of partnership where one party (rab
al-mal) provides the funds and the other party (mudarib)
assumes the role of the entrepreneur through effective
management

• While rab al-mal is the sleeping partner in the partnership

contract, the mudarib is directly involved in the day-to-day
running of the business

• The parties share the profit of the business venture based

on agreed percentage and bear any loss incurred
• In the event of losses the entrepreneur loses his/her labour
and the financier loses the capital
 Mudaraba (Investment Partnership)

Share of profits

capital
Investor
Business
Profit
Mudarib management Venture
(entrepreneur)

Share of profits

Profit can not be a fixed amount (for PLS financing) but must be determined
by a pre-agreed ratio. In case of loss, the investor loses capital and the
mudarib loses time and effort. In the case of proven negligence by the
mudarib, the mudarib may be liable for capital as well.
 Learning Objective 3.3

Partnership Contracts in Islamic Understand how service-

based contracts are used as
Finance financial instruments in
Islamic finance

Legality of Mudarabah
The legality of mudarabah contract is established in the
Qur’an, Sunnah, practices of companions, and ijma

Types of Mudarabah
• Restricted (muqayyad)
• Unrestricted (mutlaq)

Termination of the Mudarabah Contractual Relationship

Either of the parties can terminate the contractual relationship
at any time subject to notice given to the other party within a
reasonable time prior to contract termination
 Learning Objective 3.4
Understand how
Partnership Contracts in Islamic partnership contracts are
used as financial
Finance instruments in Islamic
finance

Modern application of Mudarabah

Mudarabah in Islamic banking and finance is being used in:

- venture capital
- project financing
- unit trust
- General Investment Account (GIA)
- Specific Investment Account (SIA)
 Learning Objective 3.4
Understand how
Partnership Contracts in Islamic partnership contracts are
used as financial
Finance instruments in Islamic
finance

Musharakah (Partnership Contract)

• Musharakah is a word of Arabic origin meaning ‘sharing’

• It is a form of shirkat al-amwal where all partners invest

capital into the joint-venture

• Musharakah emphasises practical participation of parties in

the partnership business

• Musharakah is a form of partnership between two or more

parties based on mutual trust
 Learning Objective 3.4
Understand how
Partnership Contracts in Islamic partnership contracts are
used as financial
Finance instruments in Islamic
finance

Legality of musharakah contract

The legality of musharakah contract is established in the

Qur’an, Sunnah and the practices of the companions and
predecessors of the Prophet (PBUH).

Modern application of musharakah

Musharakah could be used effectively:
- For small and medium enterprise (SME)
- In the primary Islamic capital market (where sukuk
certificates are issued)
 Learning Objective 3.4
Understand how
Partnership Contracts in Islamic partnership contracts are
used as financial
Finance instruments in Islamic
finance

Differences between Musharakah and Mudarabah

Contracts

• Sources of financing the business

• Rights of partners to participate in the management of the
business
• Sharing profits and losses
• Liability of the partners
• Ownership of assets
 Learning Objective 3.4
Understand how
Partnership Contracts in Islamic partnership contracts are
used as financial
Finance instruments in Islamic
finance

Musharakah Mutanaqisah (Diminishing Partnership)

... is long-term financing; a bank’s share in the ownership of
a property decreases gradually due to the continuing sale of
its shares to the customer against the payment of
predetermined instalments
• Musharakah Mutanaqisah is a chain of three contracts:
- The first contract is that of joint ownership between a
client and an enterprise (financier)
- The second contract is a contract of lease between the
financier and the client under the joint ownership
- The third contract is where the client partner concludes
another contract with the financing partner
 Learning Objective 3.5
Supporting Contracts Know the nature of
supporting contracts in
Islamic finance, including
Hawalah (Transfer of Debt) the unilateral supporting
contracts.
In literal terms, hawalah means assignment, bill of
exchange, or promissory note.In the juristic sense, it is a
special type of security contract which simply means debt
assignment.
Essential Elements of Hawalah
• Muhal: The creditor/person to whom the transfer is made
• Muhil: The transferor or debtor who assigns the debt
• Muhal ‘alayhi: The transferee of the assigned debt
• Al-Muhal bihi: The transferred debt, assigned from one
debtor to another
• The debt owed by the transferee to the principal debtor
• Form of contract. The contract concludes with an offer from
the principal debtor and acceptance by transferee & creditor

Supporting Contracts
Figure 3.9: The Two-stage Hawalah
Arrangement
Learning Objective 3.5
Know the nature of
supporting contracts in
Islamic finance, including
the unilateral supporting
contracts.
 Learning Objective 3.5
Know the nature of
Supporting Contracts supporting contracts in
Islamic finance, including
the unilateral supporting
contracts.

Modern Application of Hawalah

The modern application of hawalah comprises:

- Bills of exchange (suftajah)
- Issuance of cheques against current account
- Endorsement of a negotiable instrument
- Transfer of money or remittance (al-sarf)
 Learning Objective 3.5
Know the nature of
Supporting Contracts supporting contracts in
Islamic finance, including
the unilateral supporting
contracts.

Rahn (Collateral/Pledge)
A collateral, pledge or mortgage offered as security for a debt
that allows the creditor to take away the debt from such
security in the event of any default on the part of the debtor

• The legality of rahn (mortgage) contract is established in the

Qur’an and Sunnah

• The significance of rahn contract is that it is a voluntary

charitable contract (tabaru’)
• The modern application of rahn contract employed in
contracts involving credit transactions such as deferred sale
or loans from IFIs
 Learning Objective 3.5
Supporting Contracts Know the nature of
supporting contracts in
Islamic finance, including
the unilateral supporting
contracts.

Muqasah (Setting-off)

Muqasah: A debt settlement through a counter-

transaction or offsetting

Types of Muqasah:
1. Muqasah al-Qanuniyyah (Legal Set-off)
2. Muqasah al-Talabiyyah (Set-off on Demand)
3. Muqasah al-Ittifaqiyyah (Consensual Set-off)

Types of debt that can be set off:

• Duyun al-naqd (currency debts)

• Duyun al-‘ard (commodity debts)
 Learning Objective 3.5
Know the nature of
Supporting Contracts supporting contracts in
Islamic finance, including
the unilateral supporting
contracts.

Legality of Muqasah

Three views have been expressed:

• First view: Muqasah is an approved method of settlement

of identical debts between two parties

• Second view: Muqasah is merely an exception to bay al-

dayn (sale of debts)

• Third view: Muqasah is a sale of debts by its real nature

because its subject matter is debt which is intangible
 Learning Objective 3.5
Know the nature of
Supporting Contracts supporting contracts in
Islamic finance, including
the unilateral supporting
contracts.

Kafalah (Guarantee)

Kafalah: A binding promise to be liable for the debt of a

principal debtor in case they default or fail to redeem the
debt but such liability does not relieve the principal debtor
from liability

Legality of Kafalah
The concept of guarantee has been in practice since the
time of the Prophet (PBUH)
 Learning Objective 3.5
Know the nature of
Supporting Contracts supporting contracts in
Islamic finance, including
the unilateral supporting
contracts.

Elements of Kafalah

• Makful ‘anhu (principal debtor or obligor or guaranteed)

• Kafil (surety or guarantor)

• Makful lahu (creditor or obligee)

• Makful bihi (object of guarantee)

• Sighah (expression)

Types of Kafalah
• kafalah bi al-nafs (physical guarantee)
• kafalah bi al-mal (financial guarantee)
 Learning Objective 3.5
Know the nature of
Supporting Contracts supporting contracts in
Islamic finance, including
the unilateral supporting
contracts.
Modern Application of Kafalah

The application of kafalah in modern Islamic financial institutions

can be seen in:

• Documentary credit system which is largely used in international

trade

• Credit card transactions

• Supporting guarantee contract for the following major contracts

in Islamic finance: mudarabah, murabahah, ijarahi, salam,
istisna, and musharakah
 Learning Objective 3.5
Know the nature of
Supporting Contracts supporting contracts in
Islamic finance, including
the unilateral supporting
contracts.

Wakalah (Agency)

Wakalah Contract establishing an agency relationship

between two parties for a purpose though such authority
may be general or specific. The principal party is the
muwakkil while the agent is the wakil

The legitimacy of the concept and practice of Wakalah is

established in the Qur’an and Sunnah

Modern Application of Wakalah is seen in:

- Modern Islamic banking, finance and takaful
- Corporate Wakalah
- Wakalah model of waqf
 Learning Objective 3.5
Know the nature of
Supporting Contracts supporting contracts in
Islamic finance, including
the unilateral supporting
contracts.

Wadi‘ah (Safekeeping)

Wadi‘ah is a contract that entrusts one’s precious property or

money to the care of another, usually a trusted person or a
secured corporate entity i. e. the bank
• Muslim jurists unanimous in legality of wadi‘ah contract
• Wadi‘ah is used in both current accounts and savings
account
The modern types of Wadi‘ah
- Wadi‘ah yad al-amanah (Safe-keeping under a trust)
- Wadi‘ah yad al-damanah (Safe-keeping with Guarantee)
 Learning Objective 3.5
Know the nature of
Supporting Contracts supporting contracts in
Islamic finance, including
the unilateral supporting
contracts.

Concept of Unilateral Supporting Contract

Contracts made unilaterally without the usual offer and

acceptance at the session of contract
- Waqf (endowment)
- Ibra’ (foregoing of right)
- Hibah (gift)
- Wa’ad (promise)
- Tabarru’ (donation)
 Learning Objective 3.5

Supporting Contracts Know the nature of

supporting contracts in
Islamic finance, including
the unilateral supporting
contracts.
Waqf (Endowment)
Waqf: A charitable endowment in perpetuity for a specific
purpose. It assists the poor and the less privileged in the
society or benefits society at large

Ibra’ (Forgoing of Right)

Ibra’ can be defined as the waiving of one’s financial right or
ownership in totality or partially
Situations where the Islamic bank is inclined to use ibra':

- When the debtor is unable to redeem the debt

- When the customer makes an early settlement of a debt
as means to encourage such practices
 Learning Objective 3.5
Know the nature of
Supporting Contracts supporting contracts in
Islamic finance, including
the unilateral supporting
contracts.

Hibah (Gift)

Hibah is the gratuitous transfer of property from one person

to another without any formal material consideration

• Hibah is used by Islamic financial institutions as a

supporting Sharī‘ah instrument in other transactions such as
al-ijarah thumma al-bay
 Learning Objective 3.5
Know the nature of
Supporting Contracts supporting contracts in
Islamic finance, including
the unilateral supporting
contracts.

Wa’ad (Promise)
Wa’ad: A promise or undertaking by a party to carry out a
unilateral contract

Examples of Wa'ad:
- Murabahah transactions
- al-ijarah thumma al-bay’ contracts

Muwa’adah which is a derivative of wa’ad is a bilateral

promise in a contractual form which may be conditional or
unconditional
 Learning Objective 3.5
Know the nature of
Supporting Contracts supporting contracts in
Islamic finance, including
the unilateral supporting
contracts.

Divergent Opinions of the Muslim Jurists on the Binding

Nature of Wa’ad

• Fulfilling wa’ad is recommended in financial transactions

(Shafi’i school, some Maliki jurists, and Abu Hanifah

• Fulfilling wa’ad is obligatory and it is usually enforceable

(majority of the Maliki scholars)

• Wa'ad is binding and enforceable except in cases where

it is otherwise justified (Ibn Shubrimah)
 Learning Objective 3.5
Know the nature of
Supporting Contracts supporting contracts in
Islamic finance, including
the unilateral supporting
contracts.

Tabarru’ (Donation)

• Tabarru’: a gratuitous contract/donation which is unilateral

but supportive of underlying contracts such as takaful

• Ownership in the subject matter of tabarru’ is transferred at

the time of donation from the donor to the done

• The concept of tabarru’ is applicable in takaful, as well as in

waqf donations managed by an Islamic financial institution
for the benefit of the beneficiary
 Assignment

• Bay al-dayn
• Hawalah
• Bay al-Inah
• Hibah
• Bay al-salam
• Hilah
• Bay al-sarf
• Ibra’
• Bill of Exchange
• Ijarah
• Debt-based financing
• Ijarah mawsufah fi
instruments
dhimmah
• Dual banking system
• Ijarah muntahia bi al-tamlik
• Equity capital
• Ijarah thumma al-bay’
• General investment account
• Ijma
(GIA)
Key Terms and Concepts

• Islamic capital market • Mudarib

• Islamic finance windows • Muqasah
• Istihsan • Murabahah
• Istisna’ • Musharakah
• Ju’alah • Participation term
certificate (PTC)
• Kafalah
• Promissory note
• Legal capacity
• Rabb al-mal
• Majlis al-‘aqd
• Rahn
• Margin of profit
• Real capital
• Mudarabah
Key Terms and Concepts

• Riba • Takaful
• Secondary market • Tawarruq
• Sharī‘ah Supervisory • Tawriq
Council
• Ujrah
• Short-term liquidity
• Wa’ad
• Special investment account
• Wadi’ah
(SIA)
• Wakalah
• Special purpose vehicle
• Waqf
• Sukuk
• Tabarru’