ISLAMIC BANKING AND ITS MODE OF INVESTMENTS
NASSIRUDDIN AHMED
Islam is not just a religion but a complete, comprehensive and exhaustive worldview providing exact answers to all the questions and queries of mankind – spiritual and practical. The primary sources of knowledge, concept and guidelines are the Qur’an and Sunnah. The scholars of Islamic law have worked in the light of Sharia to develop guidelines and a legal framework for a modern Islamic economy.
It is commonly known that Islam has strictly prohibited interest. It restricts both the giving and charging of interest. The Arabic word in Qur’an for interest is Riba, which also includes usury.
The Islamic Fiqh Academy, established by the Organisation of Islamic Conference (OIC) in its second session in 1985, declared that: “any increase or profit on a loan which has matured, in return for an extension of the maturity date, in case the borrower is unable to pay, and any increase or profit on the loan at the inception of the loan agreement, are both forms of usury/Riba which is prohibited under the Sharia.”
The definition of an Islamic bank as approved by the OIC is: “a financial institution whose status, rules and procedures expressly state its commitment to the principle of Islamic Sharia and to the banning of the receipt and payment of interest on any of its operations”.
Islamic Banking may be termed as Partnership/Profit and Loss sharing Banking, and is an economic and financial system that is based upon the economic and social order of Islam. Islamic banks are banking institutions that extend all types of modern banking services within an Islamic framework.
From the definition given above, it is clear that an Islamic bank is not only a financial intermediary, it involves direct participation in business on the principles of sharing profit and loss in order to ensure social equity and justice.
Islamic Banks, like other banks, are in the business of the management of money. They perform a socially useful function in transferring financial resources from surplus units to deficit units. That is why Islamic banks are termed financial intermediaries. Conventional banks perform these functions on the basis of interest/usury; but Islamic banks carry out the same functions by developing a new relationship with the clients without Riba.
Islamic banking did not start at the national level. At the beginning, almost all Islamic banks started individually or under joint entrepreneurship, during the second half of the seventies. These individual banks had to operate within the fiscal policy of the respective countries and had to face competition with the interest-based banks, which were well organised and equipped.
There are Muslim countries where interest-free Islamic banking and the interest-based Western system of banking, are both functioning side by side.
During the last twenty years a good number of Islamic financial institutions have been established in Muslim and non-Muslim countries, these financial institutions include Islamic banks. Islamic investment companies and Islamic insurance and reinsurance companies.
Islamic banking at the national level was started in the early eighties in Pakistan followed by Iran and Sudan. At the moment, more than 267 Islamic Banks, financial institutions and insurance and re-insurance companies are functioning in different countries of the world.
Islamic Modes of Investment
Islamic banks collect money from the depositors on the basis of Mudaraba and invest the same in different projects/business/trading under different investment techniques using the funds under triple Mudaraba. The triple Mudaraba involves a multitude of investors (depositors) who in turn pool this capital and entrust it to another Mudarib or to a multitude of Mudaribs. This is the main feature of triple Mudaraba.
Other types of Islamic investments are as follows:
a) Murabaha (sale on profit mark-up)
Murabaha is one of the most widely used modes of finance undertaken by Islamic banks. About 70 to 80 percent of the financial operations of most of the Islamic banks belong to this category. It is suitable for investment for financing industry, agriculture, trade or any other sectors. It enables the client/investor to obtain finished goods, raw materials, machinery or equipment from the local market or through import by opening letters of credit under Murabaha (Commercial).
Murabaha is a kind of sale transaction. Under this system of investment, a sale transaction takes place between client and bank. The client requests the bank to purchase certain goods with a price confirmed by the client from a supplier/seller The bank itself or through an agent (may be client himself) collects all the information about the nature and specification of the goods, the price, terms of delivery etc.
Murabaha is also a double sale and buy. Under this technique, the bank buys the goods upon the client’s request then sells the goods to him. The goods are purchased by the customer, from the bank, within a fixed period of time or by instalment with a price that includes cost of goods plus mark-up profit. The profit mark-up as fixed before the deal and cannot be increased even if the client does not take delivery within the scheduled time.
When Murabaha sale is made on deferred payment basis, this is called Murabaha-biMuajjal. Under this sale, the bank sells the commodity to the client on the basis of deferred payment against an agreed price, which includes the price and markup profit.
Murabaha sale is also one kind of absolute sale, which is divided into four kinds in respect of price (i) Bargain Sale; (ii) Tawlia Sale; (iii) Discount Sale and (iv) Murabaha Sale, the salient features of which are given below:
(i) Bargain Sale: Selling of commodity at a price already agreed upon irrespective of its purchased price.
(ii) Tawlia Sale (respective sale): Selling the commodity at purchased price without any addition or discount.
(iii) Discount Sale: Selling the commodity at a purchased price allowing certain discount.
(iv) Murabaha Sale: Selling a commodity at a purchased price plus certain profit as agreed upon. This profit margin may be determined on a percentage of the purchased price or a lump-sum agreed to.
The last three sales are called “Amana (honesty) Sales”.
Murabaha Sale is of two kinds:
1. Ordinary Murabaha: In this sale two parties are involved – the seller and the buyer. Seller as an ordinary trader buys the commodity, and displays the same for Murabaha sale at an agreed price and profit without depending on any prior commitment of purchase from anybody.
2. Murabaha Sale with promise: Under this sale three parties are involved the seller, the buyer and the bank as an intermediary trader between the buyer and the seller. In this sale the bank does not purchase the goods on behalf of the seller unless buyer gives prior promise to purchase the same.
Due to successful operation of Islamic banking, particularly using the fund in a profitable way through Murabaha finance techniques, conventional banks of Western and European countries have started taking advantage of Islamic financing techniques by opening an “Islamic Window”.
b) Bai Muajjal (Sale on deferred payment basis)
It is a contract of credit sale under which the price of the item involved is payable on or before a specified future date either in lump sum or in instalments, wherein the client desires to purchase raw materials, finished goods, spares, machinery equipment or any other goods.
Under this system, the client requests the bank to purchase the items and sell it to him at a price with profit. The ownership including possession of the sold goods is transferred to the client. This system is widely used in Pakistan and Bangladesh. Although this mode of financing is permissible under the Sharia as a very special case; it should not be used indiscriminately since the fixed mark-up profit attached to it is nearer to interest.
Salient Features of Bai-Muajjal Deal
1. The bank is under obligation to advise the cost of goods/items and profit margin separately to the client.
2. Sale price of the goods is payable by the client at a certain future date, in lump sum or in instalments.
3. The deal, being a credit sale, ownership and possession of the sold items is transferred to the client by the bank prior to receipt of sale price.
4. There should be three distinctly separate parties involved in the sale agreement: (a) the bank, (b) the client and (c) the supplier of goods.
5. Once the agreement is made then bank will not share in any loss or re-fix the sale-price of commodity at a lower rate, nor can it add any profit when the client earns a higher rate of profit, due to the increase of the price of goods in the market.
6. The Bank cannot charge a penalty or similar fee from the client, if the client pays later than the date mentioned in the agreement. However, if the client defaults, the bank can sell the concerned hypothecated items to a third party by giving prior notice to the client and adjusting the bank’s investment. In such a case, the bank will also fall back upon the collateral securities given by the client.
To be in conformity with Sharia, it is necessary that the sale item should come into the possession of the bank before being handed over to the client (Third Party), however, it would be sufficient for this purpose if the supplier bank hands it over to any person authorised by the bank on its behalf, including the person who has purchased the item in question. Although, it would not be advisable to use it widely or indiscriminately, in view of the danger attached to it of opening a back door for dealing in interest.
c) Mudaraba (the hiring of capital)
Mudaraba is also called Qirad or Muqarada. These terms are interchangeable without any essential difference in meaning. Th e divergence in terminology was in fact due to geographical factors. The terms Qirad and Muqarada were used and originated in Arabian countries while the Mudaraba term was originated in Iraq.
Mudaraba is one of the most well-known investments permissible under Islamic Sharia and widely used by all countries where Islamic system of banking is functioning. Mudaraba finance combines financial experience with business experience.
Mudaraba is a contract in profit-sharing where one party provides capital and the other labour. Under this system, banks provide the capital, clients provide the expertise, and the profit is shared according to an agreed ratio. In case of loss, the bank bears the financial risk and the Mudarib looses only his labour and his expected share of profit.
Characteristics of Mudaraba
1. Mudaraba is generally limited to self-liquidating transactions.
2. The assets of Mudaraba should be easily recognisable and must be realised and liquidated so that the proceeds can be easily distributed between the partners at the termination of operations, completion of deal, or the achievement of the Mudaraba objectives.
3. If the partners want to renew the Mudaraba, a new contract must be negotiated, but only after the old one has been terminated and the rights and liabilities of the parties concerned have been recognised and settled.
4. Mudaraba is generally limited to trading activities.
5. The entrepreneur has no right to mix the Mudaraba funds with his own funds, unless he was permitted to do so by the bank.
6. Before liquidation and distribution of profits, the Mudarib possesses an uncontested right not only to his share in profits but also to any gains or appreciation in the value of output or assets of the joint-venture that might occur during the life of the Mudaraba contract.
7. The Mudaraba accounts must be recorded properly and the books of accounts should be audited.
d) Musharaka (Partnership profit sharing)
This mode of finance is represented by two or more financers, which establish a new project or participate in an established one, and all partners are entitled to share the total profits of the venture according to a ratio as mutually agreed upon, allowing for managerial skills to be remunerated. However, the losses are shared exactly in proportion to capital proportion, and parties have the right to participate in the management of the project and at the same time they may also waive this right in favour of any specific partner.
There are two main types of Musharaka contracts: (i) constant (permanent) and (ii) decreasing (diminishing) participation.
In the first case, the bank participates in the equity and receives a share of profit on pro-rata basis annually, and period of termination of the contract is not specified. So, the contract may continue as long as the parties concerned agree to it.
The diminishing partnership of Musharaka is getting more popular in Islamic banks than permanent Musharaka because of its potential. In permanent Musharaka, funds are committed for a long period, but this is not so in the case of diminishing Musharaka.
Decreasing Musharaka allows equity participation in the first place and shared profit on pro-rata basis. This system also provides further payment of money over and above the bank’s share in the profit as a repayment of the part of equity held by the bank. In this manner, the equity held by the bank is reduced progressively with the passage of time. After the lapse of a certain period of time, the bank will have zero equity and will cease to be a partner.
Characteristics of Musharaka Financing
1. The bank is not guaranteed a fixed return on its participation.
2. Bank’s benefits in financing fixed assets or working capital or both lie in the profit-sharing scheme between the bank and the venture.
3. Profits are shared pro-rate with equity and are calculated for this purpose, after allowing for management fees and before depreciation and provisions, as non-cash items.
e) Salam Sale (Bai-Salam)
Salam is a sale of a commodity whose delivery will take place on a future date for a cash price, which means, it is a sale of a deferred commodity against a present price. The purchase of a deferred commodity for a present price is called a Salam of a Forward Trade Transaction.
Under this transaction the cost of the commodity is advanced in cash to the seller who agrees to deliver the commodity on a definite due date. The ‘deferred’ is the commodity sold and described and the ‘immediate’ is the price.
The Salam sale serves the interest of both the parties:
1. The Seller gets in advance the money he wants in exchange of his commitment to deliver the commodity at a definite future date. From the Salam sale, the seller gets benefit by covering his financial needs, which may be the expenses for productive activity, personal expenses or family expenses.
2. The Purchaser, and here it is the purchasing bank, gets the commodity it is planning to trade on in the time it decides. Because, when a Salam contract is effected, the commodity in question is called a “debt” on the seller who has to meet his obligation. Th e bank also benefits from the cheap prices. Usually, Salam sale is cheaper than cash sale. This way the bank remains in secured position against the fluctuations of prices.
The bank can sell in parallel, Salam commodity in the same kind as it has previously purchased on first Salam without making one contract depend on the other. The bank has also the option of waiting to receive the commodity and then sell it for cash or deferred payment.
f) Istisna Sale (Bai Istisna)
The majority of the jurists consider Istisna as one of the divisions of Salam, therefore, it should be treated under the definition of Salam. But the Hanafi School Fiqh declares Istisna an independent and separate contract. The jurists of the Hanafi School have given various definitions to Istisna, some of which are:
“It is a contract with a manufacturer to make something,” and “it is a contract on a commodity or liability with the stipulation of work”.
Under this contract the first party agrees to construct/manufacture a particular product, and deliver it to second party against a predetermined price. The price may not be required to be paid in advance. It may be paid in instalments, or can even be deferred until the desired product is delivered.
Following are the main features of Istisna contract:
1. Istisna contract is a sale contract. It is a contract of promise to deliver the finished goods.
2. The subject matter of the contract is the commodity ordered by the buyer to be manufactured and not the work or services of an artisan or manufacturer. Thus, it is different from the hire-contract.
3. The subject matter of the contract is deemed to be non-existent in the market at the time of contracting and the purpose of the contract is to manufacture a product and bring it into existence.
4. The product to be manufactured should be duly described in the contract in a clear manner
5. The realm of this contract is goods that are subject to manufacturing, it does not include any natural goods like fruits, cereals, sugar, milk etc.
6. No advance payment of money is required.
7. The contract of Istisna once signed becomes irrevocable. If the manufactured product does not conform with the description in the contract, the buyer has the option to accept or reject it.
8. The delivery time is not fixed under this contract, otherwise this arrangement would come under the purview of a Salam contract.
9. In Istisna, the material is arranged by the workman himself.
g) Leasing (Ijara)
In Arabic Leasing (Ijara) is defined as a contract between a leasing company (called “the Lessor”) of the one part and the user of the equipment – asset (called “the Lessee”) of the other part, whereby the lessee/loanee agrees to pay the Lessor an agreed amount of money as rentals over a specified period of time in consideration for the use of capital equipment owned by the Lessor.
The Lessor retains ownership of the equipment, and seeks to recover the capital cost of the equipment plus a profit margin out of the Lease rentals payable during the period of the Lease.
There are two types of Leases under this system of investment: (1) Operational Lease; and (2) Lease purchase.
1. Operational Lease
Under this system of finance. Islamic banks hold a number of various assets to respond to the needs of different customers. These assets have usually high degree of marketability. The bank rents these assets to its clients who want to utilise the same for a term to be agreed upon on payment of rental. After expiry of the lease period, the assets are returned to the bank. The bank then looks for a new lessee.
The distinguishing feature of this mode of finance is that the assets remain the property of the Islamic bank to put them up for rent every time the lease period expires so as not to remain unutilised for long periods of time.
Under this mode of finance, the bank bears the risk of recession or diminishing demand for these assets.
2. Lease Purchase
The lease purchase or lease out that ends with possession, is a new technique of investment innovated by Islamic banks. Under this system, the bank does not hold the asset; but purchases the asset as a response to request from a customer to own the assets through a lease that ends with possession.
Therefore, the asset will not remain as the property of the bank at the end of the lease period as is the case in the operation leases. As soon as the purchase amount of house-hold goods along with rental is paid off within the lease period, the ownership of the lease-hold item transfers to the lessee automatically as per contract.
h) Buy-Back (Bai bil-Wafa)
This is an Islamic mode of purchase and sale. Under this system clients sell some goods to banks and immediately buy-back the same at a higher price with mark-up profit and payable at a future date. Buy-Back arrangement is a sale agreement between the Bank and the customer for the purchase of certain goods by the bank, from a third party at customers’ request to sell the same to him with a mark-up profit to be paid after an agreed period of time.
The salient features of the law of buy-back are:
1. The seller, by returning the original price, can demand back the thing sold, and the buyer, by returning the thing sold, can demand back the price paid by him.
2. Neither the seller nor the purchaser can sell to a third party a thing sold on the condition of buy back.
3. If a condition is made that some of the benefit derived from the thing sold shall be for the benefit of the buyer, the condition will be honoured.
4. Until a buyer who has made a purchase under this arrangement has received what he has to receive, the other creditors of the seller cannot interfere with the property.
i) Hire Purchase
It is a contract under which the bank invests in equipment, machinery, building, transport, or other durable article for the client against an agreed rental, together with an undertaking from the client to make full payment of price to the Bank, either in lump sum or by periodical instalments, for the purpose of eventual purchase of the concerned rented article.
Important Features:
The Bank retains ownership of the asset and is entitled to receive agreed rental until full payment of purchase price is made.
Possession of asset is passed on to the client for his exclusive use. In case of investment in transport sector, the vehicle is registered in the joint name of the bank and the client; the Bank as the owner and the client as the hirer.
In case of Hire Purchase, the hirer acquires ownership of the asset on full payment of agreed value, but in case of leasing Operations, ownership of asset is not transferred to the lessee.
j) Qarz-Al-Hasana (Benevolent Loan)
Funds advanced by Islamic bank under Qarz-AI-Hasana are for humanitarian and welfare purposes. However, practice differs in this respect. Some Islamic banks provide Qarz-Al-Hasana (interest free loan) to the holder of investment accounts of the bank on compassionate grounds. Other banks also extend this loan to needy students and other economically weak sections of society.
These interest-free loans are also given to small producers, marginal groups of farmers and entrepreneurs who are not qualified to get loans from other sources. However, these loans are repayable as and when the borrower is able to pay without any profit.
k) Jualah
Jualah means a transaction based on commission basis. The concept of Jualah is similar to Istisna. In Istisna the seller provides a physical commodity; but in Jualah the seller provides a service. In a Jualah contract, a seller will offer a definite service to be provided as agreed upon whereas the buyer will pay a definite price for this service.
l) Muzarah
Under this contract banks are allowed to hand over to farmers land which they own or which is otherwise in their possession. The plot of land has to be completely specified in the contract and must be given for a specified period. The output from the land is shared by the bank and farmers in an agreed proportion.
m) Musaqah
Under this contract, Islamic banks provide farmers with orchards, gardens or trees, which they own or are otherwise in their possession. The harvest of the orchard or garden is divided among the contracted parties (bank and farmer) in a specified ratio.
In this paper, an attempt has been made to describe in detail the Islamic financing techniques used by Islamic financial institutions in different countries.
It may be mentioned here that Islamic banking is far more interesting and complex than conventional banking as far as financing techniques are concerned. However, it should be kept in mind that the dynamics of contemporary Islamic banking change at a fast rate under market demand, hence the financing techniques used by Islamic banks are also going through a significant change.
Edited By Asma Siddiqi
Institute Of Islamic Banking And Insurance London
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