Islamic Financial Instruments

Najmul Hassan
General Manager, Corporate Banking & Business Development

Islamic Finance
Islamic Shariah is the set of rules & regulations which are to be followed by Islamic Banks. Scholars study these laws and guide the bank on how to apply them on day to day transactions.

BASIC RULES OF SALE

Rules of Sale
Since Murabaha is a sale transaction, rules of Shariah regarding sale need to be understood. Sale is defined in Shariah as Exchange of a thing of value, by another thing of value, with mutual consent

Legitimacy of sale
But Allah has permitted trade [2:275], But take witnesses whenever you make a commercial contract [2:282], But let there be among you traffic and trade by mutual good will [4:29], It is no crime for you to seek the bounty of your Lord [2:198].

Rules of Sale
Rule 1 The subject of sale must exist at the time of sale Rule 2 The subject of sale must be in the ownership of seller at the time of sale. Hence, what is not owned by the seller cannot be sold.

Rules of Sale

Rule 3 The subject of sale must be in the physical or constructive ownership of seller at the time of sale. Constructive Possession means where the buyer has not taken physical delivery of goods, but the goods are under his control. And all rights and liabilities of the goods have passed to him,i.e. the goods are at his risk.
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Rules of Sale
Rule 4 The sale must be instant and absolute. Thus a sale attributed to a future date or a sale contingent on a future event is void.

Rules of Sale
Rule 5

The subject of sale should be an object of value. A thing having no value according to the usage of trade cannot be sold.
Rule 6 The subject of sale should not be a thing used for a Haram purpose, e.g. pork, wine etc. The subject should be Maal-e-mutaqawwam

Rules of Sale
Rule 7 The subject of sale should be specifically known and identified to the buyer. The subject of sale must be identified by pointing out or by detailed specification which can distinguish it from other things not sold. Rule 8 The delivery of the sold commodity to the buyer should be certain and should not depend on a contingency or chance.
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Rules of Sale
Rule 9 The certainty of price is a necessary condition for the validity of sale.

Rule 10
The sale must be unconditional. A conditional sale is invalid, unless the condition is recognized as a usual practice of trade

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MURABAHA

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Murabaha

Murabaha is a particular kind of sale and not a financing in its origin. Where the transaction is done on a cost plus profit basis i.e. the seller discloses the cost to the buyer and adds a certain profit to it to arrive at the final selling price.

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Murabaha

The distinguishing feature of Murabaha from ordinary sale is:

- The seller discloses the cost to the buyer. - And a known profit is added.

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Murabaha

Payment of Murabaha price may be:

1) At spot 2) In installments 3) In lump sum after a certain time Hence, Murabaha does not necessarily imply the concept of deferred payment.

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Murabaha
TYPES OF MURABAHA 1) Direct where the financier himself purchases directly from the market or 3rd party. 2) Indirect where the financier appoints the customer as an Agent to make purchases from the market before buying it from the bank.
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Sharia Source
The Holy Quran says And Allah has permitted trade (2:275) It is further mentionedBut let there be among you traffic and trade by mutual goodwill (4:29) According to Imam Shafi in Al-Umm: If an individual shows another a good and says: buy this, and I will give you this much profit in it; and then the second man buys it then the purchase is valid. If the first party said: I will give you this much profit in it , but I retain an option, then he may conclude the sale or leave it.(See Financial Transactions in Islamic Jurisprudence Vol1 Pg 361) 17

Sharia Source
As for making the promise to purchase the item once the bank acquires it binding on the ultimate buyer, we may take a ruling by Ibn Shabramah from the Maliki school that any promise that does not result in permitting that which is forbidden or forbidding that which is permitted is binding. The Malikis use this principle to make the promise binding, especially if the promise leads another entity to undertake a financial obligation.

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Sharia Source
In the first Conference in Dubai (1979), it was ruled that: This type of promise is legally binding on both parties based on the Maliki ruling, and religiously binding on both parties for all the other schools. In this regard, what is religiously binding can be made legally binding if this is beneficial and can be regulated legally.

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Sharia Source
The second Conference in Kuwait (1983) ruled thus: The conference determines that the mutual promises involved in murabaha sales to the one who orders the initial purchase is permitted after the bank owns and gains possession of the sold object, and then sells it to the one who ordered its purchase with the promised profit margin. This sale is valid as long as the bank is exposed to the risk of destruction of the goods prior to delivering it to the final buyer, as well as the obligation to accept the return of the goods if a concealed defect was found. .

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Sharia Source
Cost-plus, sale is a legally permissible contract by the testimony of the majority of jurists and companions of the Prophet (pbuh). This type of sale satisfies all the legal requirements for sale, and it provides a valuable service in economic markets since it allows those knowledgeable of market conditions to make a profit and those without such knowledge to obtain the goods at a good price. It was narrated that Ibn Masud (RA) ruled that there was no harm in declared lump-sum or percentage profit margins.
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Sharia Source
The conditions of murabaha are as follows: Knowledge of the initial price: The second buyer must know the price at which the seller obtained the object of sale, since knowledge of the price is a fundamental condition for the validity of sale. Knowledge of the profit margin: Since the profit margin is a component of the price at which the second buyer obtains the goods, knowledge of that margin is essential for knowledge of the price, which is in turn a condition of validity for the sale.

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Murabaha
The present day Murabaha transactions are being practiced under the guidelines given by Accounting & Auditing Organization of Islamic Financial Institutions (AAOIFI) and Islamic Fiqh Academy which have representation of scholars of all Islamic Fiqhs.

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Murabaha
Basic rules for Murabaha financing:

Asset to be sold must exist.

Sale price should be determined. Sale must be unconditional.

Assets to be sold: a) Cannot be used for un-Islamic purposes. b) Should be in ownership of the seller at the time of sale; physical or constructive.

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Murabaha
Basic rules for Murabaha financing: Re-negotiation of price after concluding the transaction and roll over of Murabaha are not permitted. Discounting of Murabaha instrument is not permitted.

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Step by step Murabaha financing

(under Agency arrangement)

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Murabaha

1. Client and bank sign an agreement to enter into Murabaha (MMFA).

Bank

Agreement to Murabaha

Client

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Murabaha

2. Client appointed as Agent to purchase goods on banks behalf

Bank

Agreement to Murabaha Agency Agreement

Client

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Murabaha

3. Bank gives money to Agent/supplier for purchase of goods.

Bank

Agreement to Murabaha Agency Agreement

Client

Disbursement to the agent or supplier

Supplier

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Murabaha

4. The agent takes possession of goods on banks behalf.

Transfer of Risk

Vendor

Delivery of goods

Bank

Agent

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Murabaha

5(a). Client makes an offer to purchase the goods from bank through a declaration.

Bank
Offer to purchase

Client

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Murabaha

5(b). Bank accepts the offer and sale is concluded.

Murabaha Agreement + Transfer of Title Bank Client

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Murabaha

6. Client pays agreed price to bank according to an agreed schedule. Usually on a deferred payment basis (Bai Muajjal)

Bank

Payment of Price

Client

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MURABAHA DOCUMENTATION

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Murabaha Documentation
There are a number of documents involved in a Murabaha financing transaction. The most essential of these documents are: Master Murabaha Financing Agreement Agency Agreement Order Form / Draw Down Notice Declaration Purchase Evidences Demand Promissory Note Payment Schedule
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Murabaha Documentation
Master Murabaha Financing Agreement (MMFA)
Its an agreement between the client and the Bank whereby the client agrees to purchase goods from the Bank from time to time as per terms and conditions of this agreement. This is an over all facility agreement under which various Sub-Murabahas may be executed from time to time.
Hence it needs to be signed once, i.e. at the time the facility is sanctioned.

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Murabaha Documentation
Agency Agreement
Through this agreement, the Bank appoints customer its agent to select and procure specified goods for the Bank. This agreement needs to be signed once, between the client and the bank to cover the specified agency period.The disbursement of funds is done under this agreement. The customer should define a comprehensive list of assets and commodities that he may procure during the course of business from time to time.
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Murabaha Documentation
Order Form
This document is executed at the time of each sub-Murabaha request i.e. each time when the customer requires funds for the purchase of assets.

Through this document customer requests the bank to purchase the assets from the supplier and undertakes that it will purchase the assets from the bank once the bank acquires them from the market.
The customer also undertakes to compensate for the actual loss the bank may suffer in case he fails to purchase the assets from the bank.

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Murabaha Documentation
Declaration
This is the most important part of the Murabaha process. Declaration is to be signed by the customer immediately after the purchase of goods as Banks agent but before the actual consumption. This document establishes the actual sale transaction, i.e. transfer of ownership of goods from the Bank to the customer

At this stage the specific details of the assets must be known i.e. quantity, quality, cost etc.
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Murabaha Documentation
Declaration
Purchase Evidences in the form of bills, sale invoice, sales tax invoice must be furnished along with the Declaration, specifying the full details of the goods purchased. The cost of goods must be inclusive of all cost including sales tax, transportation and handling etc. Proper timing of declaration is extremely important especially in cases of perishable or immediately consumable commodities. Murabaha price (Cost of Goods + Profit) should be determined at this stage and stated clearly in 40 the Declaration.

Murabaha Documentation
Payment Schedule
The Payment Schedule specifies the amount that the Client will make from time to time or at once towards the payment of Murabaha price. This shall be implemented after the execution of Declaration. The dates mentioned in the schedule corresponds to the day when the payment becomes due on the client.

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Practical Issues in Murabaha

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Issues in Murabaha
1. Timing of Declaration
A Murabaha financing arrangement consists of a series of documents to be executed at various stages, the sequence and timing of which is extremely important. Through declaration, the client and the bank execute an important step of a valid Murabaha sale i.e. Offer & Acceptance Declaration is to be signed by the customer when it has purchased and taken possession of the goods as the Banks agent. Declaration must be signed while the goods are still in existence and have not been used in the 43 production process or sold to some other entity.

Issues in Murabaha

2. Rollover in Murabaha
Rollover in Murabaha is not possible since each Murabaha transaction is for the purchase of a particular asset. A new Murabaha can only be executed for the purchase of new assets. It is advisable that there must be a gap of 1-2 days between maturity of the previous Murabaha and disbursement of the new one.

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Issues in Murabaha

3. Rebate on early payments

This is normally prohibited by Shariah Board since it can make the Murabaha transaction similar to conventional debt.

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Issues in Murabaha

4. Penalty on late payments

As soon as the Murabaha is executed (declaration signed) the Murabaha price becomes a receivable (Dayn) for the Bank. As per the rules of Islamic fiqh any amount charged over and above the dayn amount will be Riba. Hence bank cannot charge any late payment charges. The bank may, however, ask the customer to pay a forced charity in case of overdues so as to create a disincentive for him to delay the payment
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Issues in Murabaha
5. Subject matter of Murabaha

Murabaha cannot be done in all commodities, e.g. Murabaha can not be done in currencies. Murabaha cannot be used for paying utility bills, wages, overhead expenses, etc. As per general rules of sale subject matter must be: - In existence - Having intrinsic utility - Usable for a Halal purpose (buyer must intend to use it for the same purpose) - Capable of ownership/delivery - Specified and quantified at the time of sale - Must be in Banks ownership/possession at the 47 time of sale

Issues in Murabaha
6. Purchase Evidence
In order to ensure that the customer actually purchased the assets as claimed, the customer is required to submit asset purchase evidence along with declaration. The purchase evidence must confirm that the asset purchase took place after the agency agreement. Asset purchase may be in the form of Invoices, delivery orders, truck receipts etc.

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Issues in Murabaha
6. Purchase Evidence..(Contd)
In some cases, however, it may be too burdensome for the client to submit all the invoices as the number of invoices may run into hundreds.
For example, cotton purchases are generally in small quantities from various sources and hence for each Sub-Murabaha there may be too many invoices to submit. It is suggested to furnish samples of invoices along with summary of all purchases.
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Issues in Murabaha
7. Direct Payment in Murabaha
Currently in many cases the disbursement is made to the customer as an agent. In order to ensure transparency of the Murabaha it is better that the bank disburses the funds directly to the supplier.

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Issues in Murabaha

7. Direct Payment in Murabaha..(Contd)

Direct payment can be made in the following ways: - The bank can pay the supplier directly via cash, cheque, pay-order etc. - The bank may credit the Murabaha funds in the customers account and only allow him to issue pay orders/demand drafts from his account in favor of the suppliers.

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Applications of Murabaha
Purchase of raw material; for meeting working

capital needs of trade and industry.

Medium to long term requirements for purchase of land, building and equipment. Trade finance products including imports, exports and alternative to bill purchase.

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IJARAH

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Ijarah
Ijarah is a term of Islamic Fiqh Literally, it means To give something on rent The term Ijarah is used in two situations: 1. It means To employ the services of a person on wages e.g. A hires a porter at the airport to carry his luggage 2. Another type of Ijarah relates to paying rent for use of an asset or property defined as LAND in Islamic Economics
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Ijarah: Sharia Source

Leases, like sales, are among the contracts that are explicitly discussed in Islamic Law Leases differ from sales due to the time limitation involved in leases, in contrast to sales where no time limit is allowed.

The proof from the Sunnah is derived from the Hadith: Pay the hired worker his wages before his sweat dries off.

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Ijarah: Sharia Source

Narrated by Ahmad, Abu Dawud, and Al-Nasai with the wording: The farmers during the time of the Prophet (pbuh) used to pay rent for the land in water and seeds. He (pbuh) forbade them from doing that, and ordered them to use gold and silver (money) to pay the rent It is impermissible to charge a rental for gold or silver coins, or for any consumable good measurable by weight or volume.
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Ijarah as a mode of financing

Ijarah is an Islamic alternative of Leasing. Leasing backed by an acceptable contract is an acceptable transaction under Shariah. The question of whether or not the transaction

of leasing is Shariah compliant depends on the

terms and conditions of the contract. Several characteristics of conventional

agreements may not conform to Shariah thus

making the transaction un-Islamic and thereby invoking a prohibition.
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Key Differences

Risk and rewards of ownership lies with the owner i.e. any loss to the asset beyond the control of the lessee should be borne by the Lessor. Late payment penalty cannot be charged to the income of the Lessor.
Lease and Sale agreement should be separate and non contingent.
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Difference b/w Conventional Lease & Ijarah

Ijarah
Difference b/w Conventional Lease & Ijarah 1. The Lessor cannot increase the rent unilaterally 2. Expenses to be borne by the parties: Lessor- expenses relating to the corpus of the asset i.e. insurance, accidental repairs etc. will be borne by the lessor Lessee- actual operating/overhead expenses related to running the asset will be borne by the lessee
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Ijarah
Difference b/w Conventional Lease & Ijarah 3. Two contracts into one contract is not permissible in Shariah therefore, the bank cannot have the agreement of hire and purchase into one agreement, only the bank can undertake/promise to purchase the leased asset 4. Under conventional Lease, the Lease rental starts from the date of payment by Lessor.Under Shariah, the correct way to charge rent is after delivery of the asset to the Lessee. Because rent is charged for use of the asset
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Process of Ijarah

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Ijarah
MECHANICS

.
VENDOR ISLAMIC

.
BANK
Agreement-1

CUSTOMER

The customer approaches the Bank with the request for financing and enters into a promise to lease agreement.
The Bank purchases the item required for leasing and receives title of ownership from the vendor The Bank makes payment to the vendor
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Ijarah as a mode of financing

MECHANICS

.
VENDOR ISLAMIC BANK
Agreement-2

CUSTOMER

The Bank leases the asset to the customer after execution of lease agreement. The customer makes periodic payments as per contract Title transfers to the customer
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Types of Ijarah
1. Direct where the bank purchases an asset from a 3rd party and leases the same to the customer.

2. Sale

&

Leaseback

where

the

bank

purchases an asset already owned by the customer and leases back to the same person.

This is permissible with certain conditions.

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Rules of Ijarah

Rules of Ijarah
Ownership of the leased asset remains with the Lessor during the term of Ijarah. Since ownership of the leased asset remains with the Lessor, all rights and liabilities relating to

ownership are borne by the Lessor.

The period of Lease must be determined in clear terms. The Lessee is responsible for damage to the asset caused by fraud or negligence.
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Rules of Ijarah
Any damage to the asset not caused by the Lessees neglect, is to be borne by the Lessor. Normal maintenance is Lessees responsibility Lease rentals for the entire lease period must be

fixed;
a) Different amounts of rents can be fixed for different periods, but they must be known. b) The rent may be tied to a known benchmark, acceptable to both the parties.
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Rules of Ijarah
The Lease period will start when the asset has been delivered to the Lessee - in a usable condition - whether or not the Lessee has started using it

Insurance is a cost related to ownership of the

assets, and therefore should be borne by the Lessor

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Ijarah Documentation

Ijarah Documentation
Undertaking to Ijarah Ijarah Agreement Description of the Ijarah Asset Schedule of of Ijarah Rentals Receipt of Asset Demand Promissory Note Undertaking to Purchase Ijarah Asset Sale Deed

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Applications of Ijarah

For long and medium term fixed asset financing BMR

Retail products

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Ijarah as a mode of financing

Auto Finance Car Ijarah
First Islamic Car Financing Scheme

Free from Interest/Riba

It is not a Hire-Purchase agreement Product Features For all Locally manufactured new cars Term No advance Rental 3, 4 and 5 years No upfront Insurance Payment

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Diminishing Musharakah

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Musharakah
Musharakah is a form of partnership (Shirkat) between two or more parties whereby each party contributes to the capital of the partnership in equal or varying proportions either to establish a new venture or share in an existing one.

There are two types of Shirkah:

1. Shirkat-ul-Milk

2. Shirkat-ul-Aqd

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Musharakah
1. Shirkat-ul-Milk Joint ownership of two or more persons in a particular property.

2.

Shirkat-ul-Aqd A partnership affected by mutual contract. It can also be translated as a joint commercial enterprise.
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Diminishing Musharakah
In Diminishing Musharakah the bank and the client participate either in joint ownership of a property or an equipment, or in a joint commercial enterprise The share of the bank is divided into a number of units The client purchases these units one by one periodically until he is the sole owner of the property.

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Diminishing Musharakah
Most commonly, Diminishing Musharakah is used in cases of Shirkat-ul-Milk This concept is based on Declining ownership of the financier

Three components involved :

1. 2. 3.

Joint ownership of the Bank and the customer

Customer as a lessee uses the share of the bank

Redemption of the share of the Bank by the customer
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Diminishing Musharakah
Concept of Musha Musha means undivided ownership of the asset Lease of Musha It is allowed to lease Musha to other joint owner.

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Shariah Principles

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Shariah Principles
To create joint ownership in property is called Shirkat-ul-Milk and is expressly allowed by all schools of Islamic Jurisprudence. All Muslim Jurists agree on the permissibility of the Financier leasing his share in property to client and charging him rent i.e. the permissibility of leasing ones share to his partner.
Promise of client to purchase units of share of financier is also allowed.
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Shariah Principles
The Transactions cannot be combined in a single agreement and they have to be executed independently. This is because it is a well settled rule of Islamic Jurisprudence that one transaction cannot be made a condition for another. Instead of making the transactions a precondition for one another there can be onesided promises from one party to another

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Basic Structure

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Diminishing Musharaka
Joint Ownership
Rent

MBL

CUSTOMER

Musharaka
The customer approaches the Bank with the request for Project financing The Bank enters into a Musharaka (Joint Ownership) agreement with the customer and both of them pay their respective shares to the seller of the asset.

Customer pays rent for the use of banks share in the property

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Diminishing Musharaka
Joint Ownership

MBL

Gradual Transfer of Ownership

CUSTOMER

Musharaka
The customer approaches the Bank with the request for Project financing The Bank enters into a Musharaka (Joint Ownership) agreement with the customer and both of them pay their respective shares to the seller of the asset.

Customer pays rent for the use of banks share in the property
Ownership of the asset is gradually transferred to the customer upon payment of asset price.
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Legal Documentation

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Legal Documentation
1. Musharakah Agreement
Purpose: This is the main agreement that establishes the Banks share in the Musharakah Property. Components: - Both parties share - Musharakah Property detail 2. Payment Agreement (Rent Agreement) Purpose: This agreement is signed after Main Musharakah Agreement. Bank gives its share to the customer via this agreement. Components: - Rent Schedule - Formula of calculation
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Legal Documentation
3. Undertaking to Purchase Musharakah Units
Purpose: This is an undertaking by the customer to purchase Banks Musharakah units. Components:

- Normal Sale Price

- Additional Unit Purchase Price

4.

Undertaking to Sell Musharakah Units

Purpose: This is an undertaking Musharakah units from time to time.
Components: - Normal Sale Price

by

the

Bank

to

sell

its

- Additional Unit Purchase Price

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APPLICATION

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Application
Diminishing Musharakah is commonly used for the purpose of financing of fixed assets by various Islamic banks.

House financing Car Financing Plant and machinery financing Factory/Building financing Agriculture land financing All other fixed Assets
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Application
EasyHome - Islamic Housing Finance
First complete Islamic Home Finance

facility in Pakistan!
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Easy Renovate - Renovating a home is Easy &

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mortgage is Easy & Halal
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The Way Forward

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The Way Forward

Islamic banking is a viable alternative however it is still in the development stage and has to go a long way It needs to be supported in its mission to eliminate Riba from our business. Islamic options were unavailable in the past. Its not the case anymore. The onus is on us now.

Positive criticism is always welcome but one should not be judgmental before having any knowledge.
Ulema, bankers and professionals need to coordinate 95 more frequently to help R&D.

Jazak Allah & Thank you

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