An Introduction to Islamic Finance

By Abdul Qayyum
Definition:
Conventional Financial Institution
It treats money as a commodity and earns profit from pricing it,
Subject matter is Money,
Most Transactions are interest based.
Islamic Financial Institution
It earns profit from participating in the real assets, by sharing risk and reward through
pricing of goods and services,
Subject matter is Real Assets,
No Interest based contracts.

Islamic Financial Institution’s Assets or

Investable Funds Side
Equity Based Instruments
• Musharakah
• Mudarabah
• Diminishing Musharakah
Trade/Sale Based Instruments
• Murabaha
• Bai-Muajjal
• Salam
• Istisna
Rental Based Instrument
• Ijarah (Islamic Leasing)

Islamic Financial Institution’s

Liabilities/Deposits Side
Qard-e-hassan A/c
Mudaraba A/c
Musharakah A/c
Term certificates (Profit & Loss sharing base) etc.

Musharakah
“A relationship between persons who agree to share the profits of a business
carried on by all or any of them acting for all”.
• Out of various kinds of Shirka; Shirkatul Inan is of relevance to
partnership business by banks and joint commercial enterprises.
• In Musharakah, ratio of profit distribution may differ from ratio of invest
but the loss must be divided exactly in accordance with the ratio of
capital.
• Capital should preferably be in the nature of currency or in the form of
equal units representing currency called shares.
• It is not allowed to fix a lump sum amount or any rate of profit tied up
with investment of any partner.
• If the liabilities of a business exceed its assets and the business goes in
liquidation, all the exceeding liabilities shall be borne by all the partners.
• If management is carried out only by one of the partners, the ratio of profit
allocated to sleeping partners shall not exceed the ratio of his investment.

Mudarabah
“Contract of sharing the profit/loss of a business in which one party
contributes with capital and other with his labour”
• In Mudarabah, one party provides the necessary capital and the other
provides human capital.
• It provides the basis of the relationship between banks, depositors and
entrepreneurs.
• The amount of investment shall be precisely determined and free from all
liabilities.
• Entrepreneur can be a natural person, a group of persons, or a legal entity.
• Profit to be divided in strict proportion agreed at the time of contract.
• The operational loss is to be suffered by Rabbul-Maal (Investor) only
Mudarib (Worker) will suffer the loss in terms of his un-rewarded labour.
• Liability of Rabb-ul-maal is limited to his investment, unless he has
permitted Mudarib to incur debt on his behalf.
• It can be agreed that no party shall terminate the contract during a
specified period except in specified circumstances.

Diminishing Musharakah
In DM “A financier and his client participate either in the
joint commercial enterprise. The share of the financier is further divided into
a number of units and it is understood that the client will purchase the units
of the share of the fancier one by one periodically, thus increasing his own
share until all the units of the financier are purchased by him so as to make
him the sole owner of the property or the commercial enterprise” OR
A DM contract contains a provision according to which a party in a
partnership agrees to sell a certain part of his ownership to the other party
periodically.
• Jurists allow a financier partner to give his undivided share on lease to
the partner using the asset e.g. house.
• Banks will liquidate their investment in the project and make the client
partner sole owner of the project/asset.
• In Iran: They create a joint ownership for installation of a project; after
completion banks sell their part of the ownership and recover the invested
amount along with return to be accrued in future.

Murabaha
“It is a particular kind of sale where the seller expressly mentions the cost of
the sold commodity he has incurred and sells it to another person by adding
some profit thereon. Thus Murabaha is not a loan given on interest: it is a sale
of a commodity for cash price”.

o Subject matter should be Halal other than currency, gold and things
where the ownership/Possession of the bank and its transfer to the
customer is ambiguous. Example of such assets includes gas and oil in the
pipeline.
o Description of assets should be quantified and specified.
o Declaration, offer and acceptance should be signed when customer has
purchased and taken the delivery of goods and those goods are in
ownership and possession of the agent / bank.
o It should be ensured that the goods are not already in the ownership of
the client.
o The Bank must retained copy of invoices. It is desirable that bank should
inspect the goods physically.
o Date on invoice must not be later than the declaration.
o Sale agreement (acceptance part of the declaration) must be signed after
the agent has delivered the declaration.
o Any receipt of delivery to or possession (physical possession and
constructive possession) of bank or its agent must be dated before he sells
to the client on Murabaha basis.
o Murabaha transaction should not be role over.

Bai-Muajjal (sale on installments)

• It is a particular kind of sale and not a loan given on a return but margin
of profit is stipulated between the buyer and the seller; price paid by
buyer is deferred, due date is fixed in an unambiguous manner.
• Deferred price can be more than the cash price. But should be certain and
settled at the time of sale once for all cannot be decreased in case of earlier
payment nor can be increased in case of default.
• Goods to be traded should be real, tangible goods and not papers of debt
or credit documents.
• Seller must have a good title and should take physical (can also be
constructive) possession of the goods before selling to client.
• In case of default, defaulter may be subjected to different punishments,
penalty for charity for the poor, not a source of further return to the seller.
• In case of default, contract cannot be rolled over because the goods once
sold by the bank are property of the client.
• Buy-back arrangement prohibited.
• Promissory note or bill of exchange resulting from the credit sale cannot
be sold on a price different from the face value & not return can be
charged over the note.
• Client can purchase the commodity as agent of bank and take possession;
at this stage the commodity must remain in the risk of the bank.

Salam (Advance Payment - Deferred Delivery)

• Seller undertakes to supply specified/quantified goods at a future date;
advance price fully paid at the spot.
• Salam allowed by the Holy Prophet (s.a.w.s.) subject to some strict
conditions based on as an exception to meet the needs of the small farmers
who needed money.
• Otherwise sale of debt against debt expressly prohibited by the Holy
Prophet (s.a.w.s.).
• Salam cannot be effect for things, which must be delivered at the spot. If
gold is purchased with exchange of silver, delivery of both should be
simultaneous.
• Date and place of delivery must be specified in the contract.
• Financial institutions will receive certain commodities, not money, from
their client.
• For a parallel contract of Salam the two contracts should be independent
and separately enforceable.
• In case of a number of commodities, the amount and delivery period
should be separately fixed.

Istisna
“It is a sale transaction where a commodity is transacted before it comes into
existence. It is an order to a manufacturer to manufacture a specific
commodity for the purchaser. The manufacturer uses his own material to
manufacture the required goods”
• Conditions of Istisna are same as conditions of sale, except the fact that in
Istisna a commodity is transacted before it comes into existence.
• Therefore all conditions of sale should be complied while executing Istisna
transaction except the delivery condition.
• Ensure that the bank didn’t sale the goods of Istisna before possession.

Ijarah/ Islamic Leasing

“In leasing an owner of property transfers usufruct of property to another
person for an agreed period, at an agreed consideration”
• Any thing that cannot be used without consuming cannot be leased out
like money, edibles, fuel, etc.
• Until such time that assets to be leased are delivered to the lessee, lease
rentals do not become due and payable.
• During the entire term of lease, the lessor must retain title to the assets,
and bear all risks and rewards pertaining to ownership; Damage caused to
the leased asset due to fault or negligence of the lessee shall be borne by
the lessee.
• Lessee is also responsible for all risks and consequences in relation to third
party liability, arising from or incidental to operation or use of the leased
assets.
• The insurance of the leased asset should be in the name of lessor and the
cost of such insurance borne by him.
• Any express or implied condition that title of asset will pass on to the
Lessee at the end of the leased period is not in accordance to Sharia’h
principles. If to be sold, price should be determined at the time of expiry
with consent of the Lessee, keeping in view of the working condition of
the Asset.
• Either party can make a unilateral promise to buy/sell the assets upon
expiry of the term of lease, or earlier provided that the lease agreement
shall not be conditional upon such sale.
• The amount of rental must be agreed in advance in an unambiguous
manner either for the full term of the lease or for a specific period in
absolute terms.