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INDIVIDUAL ASSIGNMENT

INSTITUTE OF BANKERS OF SRI LANKA


College of Banking & Finance

Diploma in Islamic Banking & Finance 2015

3 Key Products Offered by Islamic Finance Companies/Bank Windows

Islamic Banking & Finance

Prepared by
Nuwan Tharanga Liyanage DIB/2015/15

Assignment Director
Mr. M F Burah

INSTITUTE OF BANKERS OF SRI LANKA


College of Banking & Finance

October 2015

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CONTENTS

1. What is Islamic Banking

2. Conceptual Framework Of Islamic Banking

3. Murabaha

4. Mudaraba

5. Musharaka

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1. What is Islamic Banking?
Islamic banking refers to a system of banking or banking activity that is consistent with the
principles of the Shari'ah (Islamic rulings) and its practical application through the development
of Islamic economics. The principles which emphasize moral and ethical values in all dealings
have wide universal appeal. Shari'ah prohibits the payment or acceptance of interest charges
(riba) for the lending and accepting of money, as well as carrying out trade and other activities
that provide goods or services considered contrary to its principles. While these principles were
used as the basis for a flourishing economy in earlier times, it is only in the late 20th century that
a number of Islamic banks were formed to provide an alternative basis to Muslims although
Islamic banking is not restricted to Muslims.

Islamic banking has the same purpose as conventional banking except that it operates in
accordance with the rules of Shariah, known as Fiqh al-Muamalat (Islamic rules on
transactions). Islamic banking activities must be practiced consistent with the Shariah and its
practical application through the development of Islamic economics. Many of these principles
upon which Islamic banking is based are commonly accepted all over the world, for centuries
rather than decades. These principles are not new but arguably, their original state has been
altered over the centuries.

The principle source of the Shariah is The Quran followed by the recorded sayings and actions
of Prophet Muhammad (pbuh) the Hadith. Where solutions to problems cannot be found in
these two sources, rulings are made based on the consensus of a community leaned scholars,
independent reasoning of an Islamic scholar and custom, so long as such rulings to not deviate
from the fundamental teachings in The Quran.

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2. CONCEPTUAL FRAMEWORK OF ISLAMIC BANKING

Deposit accounts Modes of Services


financing

Money Bill collections Trading in forex at


Transferss spot exchange
rates
Current Saving Investment
accounts accounts
account

Lending
Investment Trade financing
financing

Loans with a Overdrafts


service charge
No-cost loans
Mudarabaha
Musharaka Estimated rate of
return

Mark up Leasing Hire- Sell-and-buy- Letters of


purchase back credit
3. Murabaha
Summary Overview

Murabaha is a particular kind of sale, compliant with Shariaa, where the seller expressly
identifies the cost he has incurred for the commodities for sale and sells it to another person by
adding some profit or mark-up thereon which is known to the buyer. Murabaha is one of the most
popular modes used by Islamic banks to promote riba-free transactions.

What Does Murabaha Mean?

Murabaha is an Islamic financing structure, where an intermediary buys an asset with free and
clear title to it. The intermediary and prospective buyer then agree upon a sale price (including an
agreed upon profit for the intermediary) that can be made through a series of installments, or as a
lump sum payment.
Murabaha is not an interest-bearing loan, which would be considered riba (or excess), but is an
acceptable form of credit sale under Shariaa (Islamic religious law). It is important to note that
to prevent riba, the intermediary cannot be compensated in addition to the agreed upon terms of
the contract. For this reason, if the buyer is late in his payments, the intermediary cannot charge
any late penalties.
There are practical guidelines in place to help ensure that the Murabaha transaction between a
bank and a customer is one based on trade and not merely a financing transaction. For instance,
the bank must take constructive or actual possession of the good before selling it to the customer.
The bank can only impose penalties for late payment by agreeing to purify them by donating
them to charity.
Murabaha is often referred to as cost-plus financing and frequently appears as a form of trade
finance based upon letters of credit. In its simplest form, this contract involves the sale of an item
on a deferred basis. The item is delivered immediately and the price to be paid for the item
includes a mutually agreed margin of profit payable to the seller. In this contract, the market cost
price (true cost) of the item is shared with the buyer at the time of concluding the sale.
Today, Murabaha is used most to assist short-term trade transactions.

Financing Based On Murabahah Contract

Definition Financing is a provision of funds or claims in the form of:

a) profit sharing transaction in the form of Mudharabah and Musyarakah;

b) leasing transaction in the form of Ijarah

c) sale and purchase transaction in the form of Murabahah, Salam, and Istishna;
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d) lending transaction in the form of Qardh; and

e) leasing transaction in the form of Ijarah for multi service financing; based on agreement
between Islamic Bank and/or Islamic Business Unit and another party obligating the
party receiving financing and/or facility of funds to repay the funds after a specific term
with additional return in the form of ujroh, without additional return or profit sharing.

Feature and Mechanism

Bank shall act as the provider of fund in transaction

a) Murabahah with customer -Bank may partly or entirely finance the purchase of goods
with qualifications agreed in advance;
b) Bank shall have the obligation to provide fund for the realization of the goods
procurement ordered by customer, and
c) Bank may be able to give reasonable discount without prior agreement.

Objective/Benefits

1) For Bank

- as one of the forms in financing


- earning revenue in the form of margin.

2) For Customer

- one of the alternatives of procurement of certain goods by using bank financing.

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4. Mudaraba
Mudaraba refers to an investment, on the customers behalf, by a bank. It takes the form of a
contract between two parties, one providing the funds and the other providing the expertise, who
agree to the division of any profits made in advance. In other words, the bank would make
Shariaa-compliant investments and share the profits with the customer, in effect charging for the
time and effort. If no profit is made, the loss is borne by the customer and the bank takes no fee.

Mudaraba is a contract whereby one side (the investor or Rab ul Mall) contributes money and the
other side (the manager or Mudarib) does the work. The Rab ul Mall bears all losses, and the
Mudarib earns a profit share, if the project is profitable.

Mudaraba can be understood as being similar to the function of an asset manager. Legally the
Mudaraba contract is established as being permissible by the consensus of the Islamic scholars
and is not based on primary sources of the Shariaa.
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As the profits are shared with the manager (Mudarib) and the capital provider (Rab ul Mall), but
the losses are borne only by the capital provider, the Mudaraba mode is also named profit
sharing loss bearing. Before the manager gets his share, the losses (if any), however, need to
be recovered. A wage could be negotiated.

Restricted versus Unrestricted Mudaraba

Capital can be provided on an unrestricted basis for any purpose that the manager deems fitting
(an unrestricted Mudaraba is called a Mudaraba al Mutlaqah). Capital can also be granted with
conditions as to what the funds can be invested in: the latter is technically called restricted
Mudaraba (Mudaraba al Muqayyadah).

Two-tier Mudaraba

Two-tier Mudaraba was the initial concept for Islamic banking. The structure is set up so that the
Islamic bank is engaged in two different Mudaraba transactions, one with depositors and one
with those to whom it provides financing. The first Mudaraba is between the bank and the client
having surplus capital (depositors) and the second one is between the bank and the clients who
require financing.

The first-tier Mudaraba between depositors and the Islamic bank has depositors acting as Rab ul
Mall and the bank acting as the Mudarib. The depositors place their funds with the bank with no
guarantee of return of the principal and a return based on the profitability of the investments
made by the bank on their behalf. As with other Mudaraba, the depositors bear any losses and
share profits with the Islamic bank according to a pre-agreed ratio.

The second-tier Mudaraba between the Islamic bank and those receiving financing has the bank
acting as Rab ul Mall and the customer acting as Mudarib. The bank bears all losses except in
cases of fraud by the Mudarib and shares profits with the customer according to a pre-agreed
ratio.

Islamic Demand Deposit

A. Definition - Demand deposit is a deposit that can be withdrawn at any time using cheque,
other payment instruction, or by overbooking.

B. Contract

1) Wadiah - Goods or money custody between the owner and the entrusted party with the
obligation of the entrusted party to return the goods or money at any time.

2) Mudharabah Partnership between the fund owner (shahibul maal) and fund manager
(mudharib) by sharing the business profit according to the contract.

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C. Feature and Mechanism

Demand deposit based on Wadiah contract

- Bank shall act as the party receiving the funds and customer shall acts as the party
placing the funds;

- Bank may not make any promise of return or bonus to the customer;

- Bank may charge customer administration fee in the form of expenses directly related to
the account management fee such as chequebook printing expenses, stamp duty, printing
of transaction report and balance statement, opening and closing of account;

- Bank shall guarantee the return of funds to the customer; and

- The fund may be withdrawn by customer at any time.

Demand deposit based on Mudharabah contract

- Bank shall act as the fund manager (mudharib) and customer shall act as the fund owner
(shahibul maal);

- Profit sharing method shall be defined in accordance with the ratio agreed in advance;

- Bank may charge customer administration fee in the form of expenses directly related to
the account management fee such as chequebook printing expenses, stamp duty, printing
of transaction report and balance statement, opening and closing of account; and

- Bank is not permitted to reduce the ratio of customers profit without any prior approval
from the customer.

D. Objective/Benefit

1) For Bank

- sources of fund both in local and Foreign currency.

- sources of revenue in the form of fee (fee based income) from further activity conducted
by customer.

2) For Customer

- to facilitate payment activities and/or incoming payment

- to earn possible bonus or profit sharing

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ISLAMIC SAVING DEPOSIT

A. Definition - Saving deposit is a deposit that can be withdrawn based on specified


requirements agreed in advance, but cannot be withdrawn using cheque and or other
similar instruments.

B. Contract

1) Wadiah - Goods or money custody between the owner and the entrusted party with the
obligation of the entrusted party to return the goods or money at any time.

2) Mudharabah - Partnership between the fund owner (shahibul maal) and fund manager
(mudharib) by sharing the business profit according to the contract.

C. Feature and Mechanism Saving deposit based on Mudharabah contract

- Bank shall act as the fund manager (mudharib) and customer shall act as the fund owner
(shahibul maal);

- Profit sharing method shall be defined in accordance with the ratio agreed in advance;

- Fund withdrawal by customer may only be conducted based on the agreed term;

- Bank may charge customer administration fee in the form of expenses directly related to
the account management fee such as chequebook printing expenses, stamp duty, printing
of transaction report and balance statement, opening and closing of account; and

- Bank is not permitted to reduce the ratio of customers profit without any prior approval
from the customer.

D. Objective/Benefit

1) For Bank

- source of fund both in Local and Foreign currency.

- sources of revenue in the form of fee (fee based income) from further activity conducted
by customer.

2) For Customer

- to facilitate the liquidity management in terms of deposit, withdrawal, transfer and


flexible transaction payment.

- to earn possible bonus or profit sharing

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ISLAMIC TIME DEPOSIT

A. Definition - Time deposit is a deposit of funds that may only be withdrawn after a specified
term based on the agreement between the customer and the bank.

B. Contract

Mudharabah Partnership between the fund owner (shahibul maal) and fund manager
(mudharib) by sharing the business profit according to the contract.

C. Feature and Mechanism

- Bank shall act as the fund manager (mudharib) and customer shall act as the fund owner
(shahibul maal);

- Fund management by the Bank may be conducted with the restrictions defined by fund
owner (mudharabah muqayyadah) or conducted without any restriction from the fund
owner (mudharabah mutlaqah);

- Restrictions defined by customer should be clearly specified in Mudharabah


Muqayyadah agreement;

- Profit sharing method shall be defined in accordance with the ratio agreed in advance;

- Fund withdrawal by customer may only be conducted based on the agreed term;

- Bank may charge customer administration fee in the form of expenses directly related to
the account management fee such as chequebook printing expenses, stamp duty, printing
of transaction report and balance statement, opening and closing of account; and

- Bank is not permitted to reduce the ratio of customers profit without any prior approval
from the customer.

D. Objective/Benefit

1) For Bank

sources of fund both in Local and foreign currency with a particular tenor and a relatively
low fund fluctuation.

2) For Customer investment alternative that offers benefits in the form of profit sharing.

FINANCING BASED ON MUDHARABAH CONTRACT

A. Definition Financing is a provision of funds or claims in the form of:


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1. Profit sharing transaction in the form of Mudharabah and Musyarakah;

2. Leasing transaction in the form of Ijarah or lease and purchase transaction in the form of
Ijarah Muntahiyah bit Tamlik;

3. Sale and purchase transaction in the form of Murabahah, Salam, and Istishna;

4. Lending transaction in the form of Qardh; and

5. Leasing transaction in the form of Ijarah for multi service financing; based on agreement
between Islamic Bank and/or Islamic Business Unit and another party obligating the
party receiving financing and/or facility of funds to repay the funds after a specific term
with additional return in the form of ujroh, without additional return or profit sharing.

B. Feature and Mechanism

- Bank shall act as fund owner (shahibul maal) that provides funds for working capital, and
customer shall act as fund manager (mudharib) in the business activities:

- Bank shall retain rights in the supervision and development of customers business even
though it shall not directly participate in the management of customers business activities.
For example, Bank is entitled to review and to request evidence related to business report
based on reliable supporting documents;

- Profit sharing ratio from fund management shall be specified in advance;

- The agreed ratio of profit sharing may not be changed in the course of investment period,
unless upon mutual agreement of both parties;

- Term of financing based on Mudharabah, fund repayment and profit sharing ratio shall be
determined in accordance with the agreement between Bank and customer;

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5. Musharaka
Summary Overview

Musharaka means partnership. It involves an investor placing capital with another person and
both sharing the risk and reward. The difference between Musharaka arrangements and
conventional banking is that, with Musharaka, you can set any kind of profit sharing ratio, but
losses must be proportionate to the amount invested.

The literal meaning of the word Musharaka is sharing. Under Islamic law, Musharaka refers to a
joint partnership where two or more persons combine either their capital or labour, forming a
business in which all partners share the profit according to a specific ratio, while the loss is
shared according to the ratio of the contribution (meaning amount invested).

Musharaka is based on a mutual contract and, therefore, it needs to have the following features to
enable it to be valid:

Parties should be capable of entering into a contract (that is, they should be of legal age).

The contract must take place with the free consent of the parties (without any duress).

In Musharaka, every partner has a right to take part in the management, and to work for it.
However, the partners may agree upon a condition where the management is carried out by one
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of them, and no other partner works for the Musharaka. In such a case the sleeping (silent)
partner is entitled to the profit only to the extent of his investment, and the ratio of profit
allocated to him should not exceed the relative size of his investment in the business.

However, if all the partners agree to work for the joint venture, each one of them shall be treated
as the agent of the other in all matters of business, and work done by any of them in the normal
course of business is deemed as being authorised by all partners.

C. Asset of Musharakah

All assets of Musharakah are jointly owned in proportion to the capital of each partner.

D. Capital of Musharakah

All partners must contribute their capital in terms of money or species at an agreed
valuation. Share capital in a Musharakah can be contributed either in cash or in the form of
commodities. In the latter case, the market value of the commodities shall determine the
share of the partner

E. Distribution of Profit

a. The ratio of profit distribution must be agreed at the time of execution of the contract

b. The ratio must be determined as a proportion of the actual profit earned by the enterprise

c. Not as percentage of partners investment. Not in lump sum amount

d. A sleeping partner cannot share the profit more than the percentage of his capital.

Musharaka as used for Home Financing

When used in home financing Musharaka is applied as a diminishing partnership. In home


financing, the customer forms a partnership with the financial institution for the purchase of a
property. The financial institution rents out its part of the property to the client and receives
compensation in the form of rent, which is based on a mutually agreed fair market value. Any
amount paid above the rental value increases the customers share in the property and reduces the
share of the financial institution.

Musharakah can be successfully used to in the following areas:

a) Project financing

b) Working capital financing

c) Import Financing

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d) Export Financing

e) Running finance

f) Saving/Deposit account

g) Certificates of Investments

h) Term finance certificates

i) Inter bank financing

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