Islamic Finance

Islamic Finance

Anatomy Of Islamic Finance (2)

Anatomy Of Islamic Finance (2)

9/17/2021 9:07:00 AM

Anatomy Of Islamic Finance (2)

4-Operational Modes Although any of the existing/new operational modes under Islamic finance can be developed and practiced, however Shari’a compliance in

 Selling ModesIslamic financing is different from conventional banking as its design is not meant for providing commercial loans (personal as well as business). To meet this requirement of modern banking supply of assets to customers by following trading rules of Shari’a is being used by Islamic finance industry. Under these modes of operations, Islamic banks are more of trading houses/supplier of goods than financial institutions. Under these modes of operations, Islamic financial institutions purchase goods from manufacturers/suppliers by making cash payment and then deliver to customers on credit. Differences in prices of goods purchased and sold make their profits.

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Bai Murabaha is a form of sales made on the basis of cost plus profit. Cost of purchase as well as profit charged by the bank is required to be disclosed to the customer. Under this mode of financing a customer request an Islamic financial institution to provide a specific asset on credit. Bank purchases required asset from supplier for spot payment and sell to customer on credit. Prices is payable either in installments or lump sum as agreed between the parties. This mode of financing is very popular in Islamic banking industry given the more of similarities than differences with conventional loans. The major difference with conventional loans is Asset based nature of the transaction. Bai Muajal differs from Murabaha only in disclosure of cost to customer.

Bai Salam is a sales transaction whereby a specified asset is purchased by making spot payment of the price with delivery asset at a foreseeable future date. This mode of financing is designed for agricultural financing, where by farmers get cash in advance for delivery of goods at the time of harvesting. Banks dispose of salam goods in the market after receipt from farmers. Differences in prices of sale and purchase make their profits. headtopics.com

Bai Istisna’a is a concept of sales under Islamic financial system, which is being used for manufacturing goods. Accordingly a customer places an order for manufacturing of a specific product to a manufacturer/supplier and delivery date is fixed. Price can be paid in advance, in installments or at the time of delivery as agreed between parties. Islamic banks use this mode of financing for extending credits to manufacturing sector by providing cash in advance for exchange of goods at a foreseeable future date. After receipt of goods from supplier, Islamic banks dispose in the market and differences in purchase and sales prices make their profits. There is no restriction from Shari’a point of view in getting help from customers by banks in execution of any of sales transactions mentioned above subject to bearing ownership risk and reward. (e.g. a customer can be asked to select a commodity and supplier under Murabaha; a customer can be requested to find purchaser of goods under Salam and Istisna’a on behalf of the bank).

 Rental Mode (Ijarah)Ijarah is a rental contract whereby IFI leases an asset for a specific rent and period to the client. Ownership risks of the asset are born by IFI while expenses relating to use the asset are the responsibility of client. The difference between Ijarah and sale is that ownership in Ijarah remains with lesser while in case of sales it is transferred to purchaser. Ending Ijarah in sale of asset is allowed by IFA through a separate contract at completion of term of lease. Contract can be executed prior to purchase and possession of asset. Consumables cannot be leased out. Right of lessee to use the asset is restricted to lease agreement or/and as per normal course of business. Lessee is liable for any harm to the asset caused by any misuse or negligence on his part. Rentals of joint property are shared according to equity. A joint owner can rent his share only to the co partner. Inter Bank Rate can be used as a benchmark for amount of rentals. At the completion of Ijarah term either asset is returned to IFI or purchased by client (Shari’a standard 9). Ijarah has replaced successfully the facility of leasing under conventional financial system.

 Profit & Loss Sharing Modes (Musharak & Mudaraba) Musharaka means partnership in capital. According to Hadith Qudasi (revelation reported by Prophet Muhammad PBUH) “Indeed, Allah the Exalted says: I am the third of the two partners so long as the one does not cheat the other, and when he cheats, I withdraw myself” (Khan, 1989). Literal meaning of Musharaka is sharing. Its root in Arabic language “Shirka” means being a partner. Musharaka means a joint enterprise formed conducting some business in which all partners share the profit according to pre agreed ratio while loss is shared according to the ratio of contribution (Meezan bank guide 2002). For a valid Musharaka fulfillment of certain conditions required. First is there must be an agreement written (verbal) among the partners stating clearly the terms and conditions including management, capital contributions, profit and loss sharing among the partners. Second capital can be contributed in cash as well as in assets. However once an asset is contributed as capital that belongs to firm and contributing partner is relieved from the bar of risks and returns attached with ownership. Third profit is distributed according to agreement of partnership however sleeping partner cannot claim share in profit more than his proportionate share in equity. None of the partner can guarantee the capital or profit share to any other partner (Shari’a standard 12). Under Musharaka IFIs are receiving deposits and finances business requirements for profit and loss sharing.

Mudaraba is a type of partnership whereby skill and money brought together to conduct business. Profit is shared according to agreement while loss is born by capital provider only. Under this scheme of financing IFIs provide capital to financially weak but skilful people to do the business and share outcome with IFIs. This scheme is also used in deposit collection. Mudaraba contract can be restricted or unrestricted. No one can claim a lump sum amount of profit it must be based on actual outcome (Shari’a standard 13). headtopics.com

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 Capital Market Operations (Equities & Sukuk)There are many liquidity instruments available for conventional financial industry (including government securities, corporate bonds etc.), however Islamic banks are restricted to get benefit due to interest based operations. Investment in equities through stock exchange is the only avenue of investment left with Islamic banks as for liquidity management is concerned, however, as we know Islamic financial institutions are required to ensure Shari’a compliance in all of their operations, hence, IFIs are not free to invest in any security issued on profit and loss sharing basis. Shari’a compliance of the company issuing securities with variable returns is required.

Ideally a security should have two features at least to be called as Shari’a compliant, including Halal business (business of the company should not consist of an activity which is prohibited by Islamic law e.g. liquor, pornography, pork, speculation, hoarding etc.etc.) and free from interest in its operations.(e.g interest received on bank deposits, interest paid on overdrafts and loans, discounting of bills of exchange, interest paid on bonds and even dividend on preferred stocks are all interest based transactions and contradict with Shari’a compliant financial system). If we filter the investment opportunities available at hand with these two criteria, we will find none or a very minor number of companies meeting both criteria. Even if we found a small number of companies meeting both criteria, the issue of listing with stock exchange (which is vital for ready market to convert into cash) and low financial performance of these companies might hinder investment by IFIs.

This led the Shari’a experts and finance professionals to pay due consideration to underlying problem of liquidity management by IFIs and come up with solutions. Any of the solution to the problem through financial engineering is deemed fit if it is not violating basic principles of Islamic financing. Investment in marketable equity securities of public companies is permitted in Shari’a being providing variable returns. However, adherence of underlying company to Shari’a principles of trade and commerce is required in order to make its equity security Shari’a compliant. There are dozens Islamic indexes operating globally with set criteria for a company to be qualified as Shari’a compliant. Filtering criteria of FTSE NASDAQ Dubai Shariah Index is reported as under (There are differences in filtering criteria of different Islamic indexes, see for detail Derigs & Marzban, 2008).

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