Islamic Finance and Banking: Modes of Finance

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1 Islamic Finance and Banking: Modes of Finance Power point and Assessments Khalifa M Ali Hassanain

2 Copy Rights Notice Islamic research and Training Institute 2016 All rights reserved. All parts of this work are subject to sole ownership of Islamic research and Training Institute (hereinafter referred to as Copyright Holder ) and remains exclusive property of the Copyright Holder. No part of this work may be copied, reproduced, adapted, distributed, modified or used in any other manner or media without prior written authorization of the Copyright Holder. Any unauthorized use of this work shall amount to copyright infringement and may give rise to civil and criminal liability. Enquiries and communications concerning authorization of usage may be made to the following: Islamic Research and Training Institute Member of the Islamic Development Bank Group P.O.Box Jeddah Kingdom of Saudi Arabia irti@isdb.org Disclaimer The content of these course have been developed solely for educational and training purposes. They are meant to reflect the state of knowledge in the area they cover. The content does reflect the opinion of the Islamic Development Bank Group (IDBG) nor the Islamic Research and Training Institute (IRTI). Acknowledgement This textbook was developed as part of the IRTI e-learning Program (2010), which was established and managed by Dr. Ahmed Iskanderani and Dr. Khalifa M. Ali.

3 Table of Contents Chapter Chapter Introduction... 7 Learning Objectives... 7 Leasing or Ijarah Contracts... 8 Ijarah vs Bai Contracts... 8 Ijarah Structures: Operating Lease... 9 Ijarah Structures: Financial Lease Two More Types of Ijarah Structures Issues in Ijarah Contracts Modern Mode of Leasing Conventional vs Islamic Leasing Sale After Ijarah Ijarah Muntahia-bi-Tamleek Issues in Modern Ijarah Contracts The Concept of Ijarah Sukuk Deferred Delivery or Salam Contracts Essential Elements of a Salam Contract Application of Salam Contracts The Istisna a Contract The Istijrar Contract Chapter Summary Key Terms Chapter Chapter Introduction Learning Objectives Shirkah and its Two Categories The Concept of Mudarabah Raising Capital for Mudarabah Types and Conditions of a Mudarabah Contract Profit and Loss Under Mudarabah The Concept of Musharakah... 33

4 Capital Under Musharakah Profit and Loss Under Musharakah Comparison of Musharakah and Mudarabah Mudarabah and Musharakah The Wadiah Wad Dhamanah Deposit The Qard-ul-Hasan Deposit The Concept of Wakalah (Agency) The Concept of a Tawarruq Contract The Concept of a Ju alah Contract Chapter Summary Key Terms Chapter Chapter Introduction Functions of Financial Intermediaries Intermediation Contracts Permitted by the Sharī ah Historical vs. Modern Mudarabah Trust-based Intermediation Contracts Security-Based Intermediation Contracts Business Models for Islamic Financial Institutions (IFIs) The Two-windows Business Model In the two-windows business model, liabilities and assets of the bank balance sheet are divided into two windows Risks and Mitigation Conceptual Balance Sheet of an IFI The Types of Investment Accounts at an IFI Investment Choices for an IFI Categories of IFIs Chapter Summary Key Terms Chapter Chapter Introduction A Credit Card Based on Bai al-einah Controversial Aspects of Bai al-dayn... 63

5 Tawarruq Issues in Managing Tawarruq Products Letter of Credit Under Wakalah Letter of Guarantee Under Kafala Other Fee-based Services Key Terms... 67

6 Chapter 5

7 Chapter Introduction Hello and A Framework for the Islamic Financial System-Part 3. You learnt about the exchange and sale contracts such as Murabaha and Musharakah in the chapter A Framework for the Islamic Financial System-Part 2. In this chapter, you will learn about more types of contracts that the Sharī ah permits. These contracts are used for sale of the rights to an asset under various conditions. The contracts include Ijarah or leasing, Ijarah Muntahia-bi-Tamleek, Ijarah Sukuk, Salam, Istisna a and Istijrar. Learning Objectives On completing this lesson, you will be able to: Explain the concept of an Ijarah contract. Distinguish between Ijarah and Bai Mu ajjal contracts. Describe the various structures of an Ijarah contract. Explain the various issues that need to be managed for Ijarah contracts. Describe the types of modern Ijarah contracts. Distinguish between conventional and Islamic leasing contracts. Explain why the sale of an asset after the expiry of the Ijarah contract is compliant with the Sharī ah. Describe the process of the Ijarah Muntahia-bi-Tamleek arrangement. Explain the issues that need to be managed when executing modern Ijarah contracts. Describe the concept of Ijarah Sukuk. Recognise the potential of Ijarah contracts in financing medium and long term economic investments. Describe the structure of a Salam contract. Identify the essential elements of a Salam contract. Identify the conditions for and a special application of valid Salam contracts. Describe the structure, application, and risks of an Istisna a contract. Describe the structure of an Istijrar contract.

8 Leasing or Ijarah Contracts Ijarah means leasing or hiring of a physical asset. It has two parties: The Ajir or Mujir (lessor), usually a bank, which leases out its asset to its clients. The Mustajir (lessee), the bank s client who is in need of the assets. By paying a predetermined rent (Ujrah) for a specified time, the lessee receives known usufruct, that is, the benefits associated with the ownership of the assets. This is the essence of an Ijarah contract. The subject matter of Ijarah can be divided into two types: Property or assets whose usufruct is transferred to another person in exchange for rent. Example: Houses, vehicles, and residences. Labour involving employment of a person for a wage. Example: Work of an engineer, doctor, tailor, and carpenter. According to the Majallah code, a third type is leasing animals. The lessor, as owner of the asset, must bear the expenses and risks that are related to ownership. The consideration of lease is Ujrah (rent or hire of things) or Ajr (wages in hiring of people). Rent or wage agreed in the contract is called Ajr al-musammah. When decided by a judge or arbitrator, it is called Ajr al-mithl. Ijarah vs Bai Contracts Both Ijarah and Bai or sale contracts involve the transfer of something to another party for a valuable consideration. However, there are a few differences between Ijarah and Bai. Let s see how these differ in two vital characteristics. Bai After executing the sale, the purchaser: Becomes the owner of the property Assumes the risk and rewards of ownership. Ijarah The lessor remains the owner of the property; only the usufruct or right to use the property is transferred to the lessee. The Ijarah ceases to be in force if the lessee inherits or is gifted the property.

9 Bai The transfer of ownership is definite and immediately after the sale is executed. Ijarah Ijarah is time bound, that is, the lease has to terminate at some time. Ijarah Structures: Operating Lease Among the seven financing structures of Ijarah, in the first three structures, the ownership of the asset remains with the bank. This concept is known as an operating lease. In this structure, the bank owns the asset and leases it out to its client against predetermined rentals for an agreed period. This structure: Adheres entirely to the features of the classical Ijarah. Is the least popular structure. Steps: 1. The client approaches bank, which is also the vendor, identifies the asset, and collects relevant information, including rent. 2. The bank leases out the asset to client, permitting the client to possess and use the asset. 3. The client pays pre-determined rentals over a fixed period. 4. At the end of the period, the asset is returned to the bank. This structure, which consists of two phases, involves a vendor. Phase One: The bank purchases the asset needed by its client from the vendor. Phase Two: The bank leases out the asset to its client against a predetermined rent for a specified period. Steps: 1. The client approaches a vendor or supplier of the asset and collects all relevant information. 2. The client approaches the bank for Ijarah of the asset and assures the bank of leasing the asset from it once purchased. 3. The bank pays the vendor. 4. The vendor transfers ownership of asset to the bank. 5. The bank leases the asset and transfers possession and right of specified use to the client. 6. The client pays pre-determined rentals over a fixed period of time. 7. At the end of the period, the asset is returned to the bank. In this structure, the bank does not deal directly with the vendor. It appoints the client as its agent. This structure has two stages and correspondingly two relationships between the bank and the client.

10 First Stage: The client is an agent of the bank and buys the asset on behalf of the bank. The client will only carry out the functions of an agent. Second Stage: Steps: This begins when the client takes delivery from the supplier. The bank is the lessor and the client is the lessee. From the date of delivery of the asset, the client is liable to discharge his obligations as a lessee. 1. A mutual agreement is signed between the bank and client, in which the bank promises to lease and the client promises to take the asset on lease against predetermined rent for a specific period. 2. The bank appoints the client as its agent. 3. The client identifies the vendor, selects the asset on behalf of the bank and informs the bank of its particulars in writing. These include the vendor's name and its purchase price to the bank. 4. The vendor makes physical delivery of asset to the agent (client) of bank; trained staff from bank supervises this process. 5. The bank arranges payment to the vendor. 6. The agency contract comes to an end. The bank leases the asset and transfers possession and right of specified use to the client. 7. The client pays pre-determined rentals over a fixed period of time. 8. The asset is returned to the bank. Ijarah Structures: Financial Lease What happens if the asset has been built to specification? It s extremely difficult for the bank to find a second client willing to take such an asset on lease or even buy it. Financial leases help a bank avoid such scenarios. A bank can do two things to avoid the scenario mentioned earlier. 1. If the Ijarah period is the same as or close to the economic life of the asset, there would be very little residual value in the asset. The bank may therefore gift the asset to the client without any mutual consideration or even abandon the asset. The gift contract is independent of the Ijarah contract. 2. When there is a significant residual value at end of the Ijarah period, the bank may sell the asset to the client at a predetermined price. This arrangement is called lease-sale or Al-Ijarah-Thummal-Bai (AITAB). The sale contract is independent of the Ijarah contract.

11 The bank may even gift the asset to its client. Under both structures, the asset would continue to remain with the client. These are called financial lease structures. This structure involves an independent promise by the bank to gift or sell the asset at the end of the lease period to the client at a predetermined price. This deal works out for the client as the asset meets a specialised need of the client or because the price is below market price. Steps: 1. An agreement is signed between the bank and the client where the bank promises to lease the asset and the client promises to take the asset on lease against predetermined rent for a specific period. 2. The bank appoints the client as its agent. 3. The client identifies the vendor, selects the asset on behalf of the bank and informs the bank of its particulars in writing. These include the vendor's name and its purchase price. 4. The vendor makes physical delivery of asset to the agent (client) of bank; trained staff from bank supervises this process. 5. The bank arranges payment to the vendor. 6. The agency contract ends. The bank leases the asset and transfers possession and right of specified use to the client. 7. The client pays pre-determined rentals over a fixed period. 8. The bank transfers ownership of asset to client at the end of Ijarah period either through a gift or through sale. Click the Resources button at the top of the screen to see a case study of how a leading UAE bank has financed property through such an Ijarah structure. Another method of Ijarah that ends in transfer of ownership to the client is Ijarah with partnership (based on Musharakah or Mudarabah). It is quite common in equipment and housing finance. Steps: 1. The bank forms a partnership with the client based on Musharakah; the bank is the agent-manager of the partnership and undertakes subsequent activities in this capacity. 2. The bank purchases the property on behalf of the Musharakah. 3. The property is taken on lease by the client and generates rental income for the bank over a period. 4. The bank allocates the rentals between both parties; one portion goes back to the bank as its share in rental income. Another portion, which is the share of the client in rental income, is used to redeem part of the bank s stake in partnership. The bank transfers ownership of asset to the client when its stake is reduced to zero.

12 Two More Types of Ijarah Structures There are two more types of Ijarah financing structures. Let s look at each of them. Consider a situation in which a client needs to invest in a large plant and machinery. The finances required may be too huge for one bank to handle. Therefore, the bank may enter into a co-ijarah or a leveraged transaction with itself as Manager or Lead-Lessor. Ijarah can be leveraged by using debt in the total financing. The bank forms a Special Purpose Vehicle (SPV) or a master Ijarah agreement. Debt may be provided through Murabaha and Ijarah for specific components of the pool of assets under the master Ijarah agreement. Sub- Ijarah or Ijarah of a leased asset is allowed if it is provided in the Ijarah or if permission is obtained from the lessor. The rent of the two Ijarahs can be different. Additionally, a lessor can sell some or all of the leased assets to a third person whereby the new party takes on the role of the lessor. The total inflow of cash to the SPV is distributed among the co-lessors or investors according to the proportion of their shares in the leased assets. The bank or the lead-lessor may charge the other co-lessors or investors a management fee, which is deducted before the rentals are distributed. Steps: 1. The SPV or a master Ijarah agreement invites other financial institutions to contribute equity to the pool of capital required to finance the assets. This is done through modes that are permitted by Islam like Musharakah or Mudarabah. 2. The SPV buys the asset. 3. The SPV leases the asset and transfers possession and right of specified use to the client; the client pays known rentals over a fixed period of time. 4. The bank charges a management fee and a pro-rata share in rental. 5. The bank shares the balance with all parties as per agreement. 6. The bank retains pro-rata share in residual value. 7. The bank shares the balance with all parties as per agreement. In the structure of a sale-and-lease-back, the client continues to use the asset in lieu of periodic Ijarah rentals paid to the bank, which now owns the asset. Steps: 1. The client sells an asset it owns to bank on cash basis; while the ownership papers are transferred to the bank, possession of the asset remains with the client. 2. The client enters into an Ijarah contract with bank for the same asset. 3. The client pays fixed rent over fixed period of time. 4. The bank transfers ownership of asset to client at the end of Ijarah period either through gift or sale.

13 Issues in Ijarah Contracts There are seven issues that need to be managed for Ijarah contracts. These relate to: Execution of Contract Determination of Rent Sublease by Lessee Security and Liabilities Gharar Default Risk Termination Based on the nature of the asset, an Ijarah contract can be: Executed before or after the lessor possesses the asset. Enforced or commenced instantly or in the future. Future enforcement is permissible, if: The asset to be leased exists. The lessor continues to own the asset and takes on the risk of damage to the asset. The nature or quality of the asset is specified and destruction or damage to a particular unit of the asset does not terminate the contract. If a particular asset is specified for Ijarah, a lease contract cannot be executed before: The asset comes into existence. Owning the asset or its usufruct in the case of sub-lease. The following guidelines apply. If both parties agree and other conditions are met, the Sharī ah permits them to decide the rental based on aggregate cost of the purchase, construction, or installation of the asset. The price, leasing rate, or rental must be determined at the time of contracting for the whole period of Ijarah. The Ijarah period can be split into smaller intervals with floating but predetermined rates.

14 Criteria to modify the periodic rate: A well-defined and variable benchmark such as LIBOR A macroeconomic rate such as a Consumer Price Index (CPI) A specified percentage The increase or decrease in tax The rate of inflation Click the Resources button at the top of the screen to see a case study of an equipment finance product developed by Leading US-based NBFI. The following guidelines apply. The Sharī ah permits sub-lease by the lessee only if the lessor permits and it is provided in the lease agreement. The Sharī ah does not object if the rent from the sub-lessee is equal to or less than the rent payable to the owner/original lessor. There are different perspectives among Islamic jurists if the rent charged from the sub-lessee is higher than the rent payable to the owner. Sub-leasing is not allowed under these situations, the last two effectively being Ribâ-based transactions: There are a number of sub-lessees. The sub-lessor invites others to share the rentals without transferring partial ownership. The sub-lessor charges a fee to partners for sharing the rentals. The following guidelines apply because a leased asset is considered to be in Amanah. The lessee is a trustee and has a fiduciary responsibility to protect the asset. The lessor can ask the lessee to guarantee against damage to the asset and demand some form of security. The following principles apply because lease rent is a form of debt. If there is damage or if the lessee defaults on rent, the lessor can recover the costs from the security, excluding the opportunity cost. If any amount exceeding such costs is also collected, the lessor is indulging in Ribâ. Gharar in Ijarah occurs in the following situations: A sale contract is added to the original Ijarah contract.

15 Options are stipulated in the Ijarah contract make the contract complex. A forward sale contract such as the AITAB mechanism, which involves a mutual promise by the bank to sell and by its client to buy in future. Gharar in Ijarah does not occur if the sale, gift, or option (promise) is executed through a distinct agreement not linked to the Ijarah agreement. The following guidelines apply for managing risk of default by the lessee. Any charge by the bank for default by the lessee is a form of Ribâ. To deter exploitation by lessees, jurists allow the lessor to include a clause in the Ijarah agreement asking for a formula-based donation to a charity operated by the lessor in case of default. Where the lessee defaults deliberately, the lessor can recover its dues by taking possession of the leased asset or enforcing the collateral. The following guidelines apply for termination of an Ijarah contract. The Ijarah cannot be terminated without mutual consent, except if the lessee breaks any term of an Ijarah agreement. Under the framework of al-khiyar, Ijarah allows either or both the parties to confirm or rescind the contract within a specified period. Unlike in conventional leases, the lessee only needs to pay the rent due when the contract is terminated. If the lessor terminates the lease due to misuse or negligence by the lessee, the lessor can ask for compensation. Contracts may be terminated for any of the following reasons: If the asset is damaged such that it s no longer useful If the objective of the lease cannot be achieved If the asset is sold to the lessee If heirs to the lessee can no longer pay the rent after the demise of the lessee Modern Mode of Leasing Islamic Financial Institutions (IFIs) see a lot of opportunity in leasing because of its benefits and the asset-based nature of investments in Islamic finance. For IFIs, Ijarah operations can be conducted only by rules prescribed in Fiqh text. The three types of leasing contracts in modern Islamic finance are financial lease, security lease and operational lease. Financial lease is also called hire-purchase. In conventional financial lease: The lease period is such that the lessor can recover the cost of the asset and earn a market-based return on its capital. The banks or NBFIs pay the supplier, either directly or through the lessee.

16 The monthly rent is the total purchase cost plus interest divided by the lease period. Rents begin on the day on which the price is paid by the lessor. The lessee bears all the risks of ownership. Termination: Lease cannot be terminated before the expiry of the lease period without mutual consent. The lessee is allowed to purchase the asset before the lease is terminated. The lessor charges an extra amount for prior termination because the sale discontinues their regular income. If the lessee defaults, the lessor can take possession of the asset without a court order. The lessor can also sell the asset to a third party to raise cash in an emergency, provided the rental payments accrue to the new buyer. Conventional financial leases exploit the need of the lessee, who can end up paying far more than outright purchase on instalments. Security lease is also known as financing lease. Effectively, it is: A financing transaction. A security for the amount advanced. A mode of transferring all risks and rewards associated with ownership to the lessee. In an operational lease, the owner: Transfers only possession of the asset to the lessee in return for rental. Retains ownership and takes back the asset when the lease ends. The Sharī ah permits this transaction subject to other conditions being met. Operational lease is best for acquiring the use of assets that take a very long time to manufacture and require large amounts of money for purchase. More NBFIs than banks use this mode. They can: Lease a number of assets to meet the needs of different customers. Re-lease the assets once a lease expires. However, they have to bear the risk of obsolescence, recession or diminishing demand

17 Conventional vs Islamic Leasing There are four key differences between conventional and Islamic leasing. Let s look at each of them. In conventional leasing, once the leasing contract expires, the lessee becomes the owner of the leased good. This is done without additional charge or at a nominal price. In Ijarah hire purchase, both parties must agree from the beginning that: The Ijarah contract also includes sale of the asset. The amounts the lessee must pay periodically include rent and the cost of the asset. In Ijarah finance lease, the amount the lessee must pay periodically is the rental. However, the parties may not agree at the beginning of the contract that the lessee will become the owner when the contract terminates normally. In conventional leasing, the lessor: Charges rental from the date funds are transferred to the supplier of the asset. Leases an asset before buying it and gaining possession. The Sharī ah forbids such risk-less reward. It allows the lessor to charge rent only after it has taken delivery of the asset, thereby assuming risk of ownership. Conventional and Islamic leases differ primarily the way expenses are allocated. In conventional leasing, the lessor transfers all the risks to the lessee, especially when the lease contract also specifies the residual value of the asset. The Sharī ah stipulates that: The lessor must incur all expenses to rectify the defects that prevent the lessee from using the equipment. The lessee must incur daily maintenance and operational expenses. In conventional operating leases, the lessee bears all the risks and expenses. In Islamic operating leases: The lessor must maintain the asset and bear all the risks and costs of ownership. The lease period is different from the useful life of the leased asset and must be mutually renewed. Sale After Ijarah In both cash and credit sale, the buyer becomes the owner of the asset immediately after the sale. In Ijarah, the lessor continues to be the owner. The parties in an Ijarah cannot execute a sale contract effective from a future date to transfer ownership.

18 However, the lessor can separately and unilaterally promise to sell the asset when the lease terminates normally. The lessee is not obliged to purchase even if the lessor promises to sell. A bilateral promise to sell and buy the asset is forbidden because such a promise is essentially a contract, making the Ijarah a two-in-one contract. Similarly, instead of sale, the lessor can separately and unilaterally promise to gift the asset to the lessee at the end of the lease period. Since the periodic amount paid by the lessee usually covers the rent and a profit for the lessor, the lessee has the right to own the asset at the end of the lease. Islamic scholars recommend gifting the asset as the best way to transfer ownership since the cost has already been paid for. This arrangement is called Ijarah Muntahia-bi-Tamleek. Note that Ijarah Muntahia-bi-Tamleek does not violate Sharī ah rules due to the following reasons. The lessor fixes the periodic payment such that the cost and rent are received during the lease period. It comprises an Ijarah contract, which is immediately effective, and a unilateral promise to sell or gift the asset, not a contract to sell and buy at the end of the lease period. This arrangement does no injustice to either party. It does not involve Ribâ or any disputable element. For the lessee, it is only justified that they own the asset since they have already paid the cost in addition to the rental. Ijarah Muntahia-bi-Tamleek In Ijarah Muntahia-bi-Tamleek, the leasing contract is the real and major contract. It is subject to all the Sharī ah rules of an ordinary Ijarah contract. Standard Sharī ah principles such as defining the asset to be leased, its terms and essential prerequisites of contracts have to be adhered to. The five-step process that Islamic banks usually adopt is described on this screen. The client conveys the requirement to the bank and enters into a MoU. The bank asks for a promise of purchase from the lessee along with an amount called Hamish Jiddiyah to ensure that the client fulfils the promise. Acting as a trustee for the amount, the bank can: Invest it on the basis of Mudarabah. Invest it as a PLS deposit in the name of the client. Consider it as an advance payment of rental. If the bank uses the money in its business, it becomes the bank s liability.

19 The bank can purchase the asset directly or through an agent, who can be the bank s client itself. The client raises a letter of credit from the bank and places the order with the supplier. The bank reimburses all duties and taxes plus transportation and other charges levied by port authorities. If the client also specifies the supplier of the asset, the bank can get a bond from the client to the effect that the client will accept the asset when supplied. The bank, however, will take the risk and expenses of ownership. Unlike a Murabaha sale, the bank need not first take possession of the asset and then deliver it to the lessee. Unlike an MPO, the lease can start from the date the client receives the asset as an agent of the bank. The bank and client can create a Shirkatulmilk partnership (joint ownership) to purchase the asset. The bank can then lease its share to the client on the principle of Diminishing Musharakah. The rental should be in proportion to the bank s share in the ownership. If the client periodically purchases any part of the bank s share, the rental decrease proportionally. When the bank buys the asset and takes possession or the client-agent takes possession, the formal lease agreement is executed. Rent accrues to the bank from this point provided the asset is completely installed and ready for use. Rent accrues even if there is any delay in using the asset by the lessee due to a problem at their end. If the client defaults on rents, the bank can ask it to speed up payment for the rest of the period, provided the agreement allows such a demand. Effectively, this means the bank is terminating the lease ahead of the lease period. The bank can then take back the asset or the lessee can be made to purchase the asset, but only the due rent can be deducted from sale value. In addition, the lessor cannot earn income from penalties on rent defaults, therefore any penalty has to be donated to charity. Issues in Modern Ijarah Contracts Islamic With respect to modern leasing operations, Islamic banks face four sets of issues. These issues relate to: 1. Ownership Risk 2. Timing the Ijarah Contract 3. Cancellation of Lease 4. Return for the Bank To address these issues, IFIs must consider the following points when designing Ijarah contracts. 1. Risk cannot be separated from ownership.

20 2. Lease and sale are contracts of different natures. According to the Sharī ah principles for an Ijarah: The lessor must spend for large scale repair of damaged assets since any repairs benefit the lessor as the owner. The lessee is responsible only for normal operating maintenance. When the lessee is an agent of the lessor, the lessor is responsible for any damage to the asset when it is supplied, unless the agent s fault can be proved. If not, then the lessor must adjust the rent or expand the lease period to compensate the lessee for the period the asset cannot be used. Any clause in the contract seeking to transfer the ownership-related costs to the lessee is forbidden. In case of delayed delivery of the asset to the lessee, the lessor cannot charge any rent for the period between the execution of the Ijarah agreement and the date of delivery of the asset. To avoid such loss of rent,, the bank should only sign a promise to lease when the funds are disbursed to the supplier. The actual Ijarah agreement can be signed only when the asset is delivered. Rent can be calculated to cover the date difference between disbursal of funds and asset delivery. Sometimes the usufruct, which may be inherently risky, is less than expected due to any events beyond the control of the lessee. In such a case, the Sharī ah allows termination of the lease. For example, if a crop grown on leased land fails due to natural calamity, then the Ijarah on the leased land becomes invalid, and the lessee must receive a normal wage as an employee. During purchase of assets, because the bank is the owner, it is: Required to pay all expenses incurred in the process of purchase. Entitled to any discounts provided by the supplier of the asset. The bank may calculate rent to cover for such expenses. However, the return on the asset is not really fixed. For example, the cost of repair may be higher than any claim settled by the Takaful insurance company. You will learn more about the Takaful insurance framework from a conceptual perspective in Chapter 9 of this course, The Islamic Takaful System-Part 1, and from a product perspective also in Chapter 10, The Islamic Takaful System-Part 2.

21 The Concept of Ijarah Sukuk According to the Sharī ah s guidelines for an Ijarah contract: The lessor can sell the asset to a third party together with its rights and obligations. If the lessor doesn t transfer the ownership and only assigns rental to the third party, the lessor cannot charge money for this right. The new party to whom the lessor sells the asset gains the same rights as the old lessor but also carries all the old lessor s liabilities. But what if the lessor sells the asset to multiple investors in different ratios? Then, the lessor must grant leasing certificates to each investor called Ijarah Sukuk that show the proportional purchase of the asset. Each investor owns the asset to that extent and takes on the risk of ownership and maintenance to that extent. Ijarah Sukuk issues can be used to finance large corporate and government infrastructure projects. Ijarah Sukuk also helps IFIs in managing liquidity better. The Sukuk process is briefly illustrated on screen. You will learn in detail about Sukuks in Chapter 12 of this course, Islamic Investment Funds. Deferred Delivery or Salam Contracts Bai Salam or deferred delivery is a forward contract wherein the price is paid in advance at the time of signing the contract, but the goods are delivered later. Unlike Murabaha and Ijarah, Salam or Salaf was originally intended to finance small farmers and traders. Under a Salam agreement: 1. A client in need of short-term funds sells merchandise to the bank on a deferred delivery basis. The date of delivery is agreed at this time. It receives full price for the merchandise on the spot. 2. At the pre-agreed date, the client delivers the merchandise to the bank. The bank sells the merchandise in the market at the prevailing price. It can expect to make a profit because the spot price that it pays can be pegged lower than expected market price. Essential Elements of a Salam Contract The six elements required for a valid Salam contract are: Subject Matter Means of Payment

22 Period and Place of Delivery Khiyar or Options Conditions for Amending/Revoking the Salam Contract Penalty for Non-Performance The following comprise the subject matter of Salam: All goods that are quantifiable and can be qualitatively described Well-defined goods without specific units but with specifications that influence prices Fungible (Mithli) and similar goods Non-identical goods Standardised and available goods Gold, silver and metallic money like Fulus of copper or other metals The following types are not permitted: Goods that may not yield any produce Goods that are prone to subjective evaluation Paper currency The following are permitted as means of payment. Legal tender Goods in barter, if Ribâ is avoided Usufruct of assets The following are not permitted as means of payment. Outstanding loans on the seller or on a third party Payment delayed beyond three days as specified in the agreement and definitely not after delivery Partial payment In barter, advance payment in the form of the same species of goods in exchange of deferred delivery of similar goods Payment can be credited to a seller s account. The following principles apply for delivery of goods. It is important to fix the time and place of delivery of goods. The nature of the goods decides the due date and delivery mode.

23 If a place of delivery is not specified in the agreement, then the place where the contract was finalised will be regarded as the place of delivery. Goods are a responsibility of the seller before the delivery and of the buyer after the delivery. The Islamic law of option (Khiyar al-shart) is not permitted in Bai Salam as it upsets or delays a seller s ownership over the price of the goods. A buyer: Does not have the option of seeing (Khiyar al-ro yat). Has the option of defect (Khiyar al- Aib) and the option of specified quality, This means that a buyer can withdraw the sale if goods are found to be defective or fails to match the quality as agreed at the time of contract. Can only recover the price already paid for the goods, nothing more. A seller must deliver the goods as specified in the agreement. The following principles apply regarding amendment or revocation of the contract. A buyer cannot independently change any conditions of the contract once the seller has been paid. Both parties have the right to withdraw the contract with mutual consent with the buyer entitled to recover only the amount already paid. If the market price of the goods seems higher at the time of delivery than what a buyer has paid, a seller may want to withdraw the contract. A bank may want to withdraw from purchase if the price of the item decreases at the time of delivery. To avoid such scenarios, it is advisable to make the contract binding on both the parties, except if the goods are absent from the market or are inaccessible to the seller at the time of delivery. Guidelines regarding the seller s inability to deliver include the following. A seller may voluntarily agree in the contract to donate to the Charity Account, held by the bank, in case of a delay in delivery. If a seller fails due to bankruptcy, banks cannot penalise but may grant additional time, according to Clause 5/7 of the AAOIFI s Salam Standard. Application of Salam Contracts Application of Salam in Pre-Shipment Export Finance The bank receives an export letter of credit (LoC) in favour of its client for certain goods. This allows the bank to act as a seller towards the foreign buyer.

24 The bank agrees to buy the goods from its client under a Salam contract and makes advance payment to the client. The delivery date should be reasonably after the shipping date, and the port of delivery should be the same mentioned in the LoC. Once the client submits the in-order shipping documents such as bill of lading or certificate of origin, delivery is deemed to be satisfactory. The bank s profit is the difference between the agreed payment (pre-shipment finance) made by the bank to its client and the amount of the export LoC. The Istisna a Contract Under Istisna a, the seller undertakes to develop or manufacture a commodity for an agreed price and deliver after an agreed period. In Istisna a, nothing is exchanged at the time of contracting. The seller and the manufacturer can be different, which opens an opportunity for Islamic banks to take on the role of a seller and get the goods manufactured from another party. It signs two Istisna a agreements, one with the buyer and the other with the manufacturer. Under an Istisna a agreement: 1. The client asks the bank to develop an asset with clear specification. 2. The bank asks the manufacturer to develop the asset. 3. The manufacturer develops the asset and receives periodic payments from the bank at different stages of manufacturing. 4. At a pre-agreed date, the manufacturer delivers the asset to the bank. 5. The bank delivers the asset to the client. 6. The client pays in full or in parts over the agreed period of time. A big risk under Istisna a includes construction-related risks and risk of nonconformity to specifications. To mitigate this, the bank can include a penalty clause in the agreement and designate its client as an agent or a surveyor to oversee satisfactory completion of the job. Another type of risk under Istisna a is default and delinquencies risk. To protect itself against such outcomes, the bank can take a legal charge on the land, giving it the right to repossess the land. However, this is not a mortgage, which is the risk mitigation product for banks in conventional finance. It can also ask for a third party guarantee.

25 The Istijrar Contract Under Istijrar, the purchaser buys different quantities of a commodity from a single seller over a period. As Istijrar involves repeat purchases from a single seller, the Sharī ah permits flexible pricing and payment although the price may be determined in advance. This is subject to the absence of Gharar. The price may be paid at a future date and may be based on a normal price or the average market price. A master agreement in Istisjrar is signed for financing on an ongoing basis under appropriate normal modes. However, any formal or informal Murabaha or Salam contracts are operative, their conditions and the Sharī ah essentials have to be fulfilled. An example of an Istisjrar contract is one between any wholesale merchant and a retailer. Chapter Summary You have completed the chapter, A Framework for the Islamic Financial System Part 3. The key points of this chapter are as follows: Ijarah is a contract means leasing or hiring of a physical asset. The bank and the client are its two parties. In a Bai, the ownership of the property is transferred to the purchaser, whereas, in Ijarah, the property remains in the ownership of the lessor, and only its usufruct, i.e. the right to use it, is transferred to the lessee against an agreed consideration. Ijarah has seven financing structures. Execution of contract, determination of rent, sublease by lessee, security and liabilities, Gharar in Ijarah, default risk and termination of Ijarah are the seven issues that need to be managed for Ijarah contracts. Leasing operations by banks and financial institutions are governed by rules prescribed in Fiqh for Ijarah transactions. Financial lease, security lease and operational lease are the three types of leasing contracts. Transfer of ownership, rental, responsibility of expense and operating lease are the four key differences between conventional and Islamic leasing. In Ijarah, ownership remains with the lessor. Transfer of the ownership in the leased property cannot be made by executing a sale contract that will become effective on a future date. In addition to the rental, the lessee pays a sum, which goes toward buying the leased property. Upon making full payment along with rental, the ownership will transfer to him. In Ijarah Muntahia-bi-Tamleek, leasing is the real and major contract. Receiving Hamish Jiddiyah, purchasing the asset, creating partnership of ownership, formal

26 lease agreement and managing defaults in payment are the five steps taken to conduct Ijarah Muntahia-bi-Tamleek. Burden of assets, lack of knowledge on Ijarah, damage to the asset, cancellation of lease, default in payment, no fixed return to bank, are the six issues Islamic banks face in the leasing business. Ijarah Sukuk is a means of raising funds by selling an asset proportionally to several investors. Each of these receives a leasing certificate showing their proportion of the asset. Ijarah is the most important mode for financing operations of Islamic banks for meeting the needs of the retail, corporate and public sectors. It is used directly for plant and machinery, automobiles, housing and consumer durables and indirectly for Sukuk issues by the corporate and government sectors. Bai Salam or deferred delivery is a forward contract wherein the price was paid in advance at the time of making the contract for the prescribed goods to be delivered later. The six conditions required for a valid Salam contract are subject matter of Salam, payment of price, period and place of delivery, Khiyar in Salam, amending or revoking the Salam contract and penalty for non-performance. For the Salam to function smoothly, it is important that the commodity is freely available and tradable in the market. Its scope includes industrial and agricultural products and services. Under Istisna a, the seller undertakes to develop or manufacture a commodity for an agreed price and deliver after an agreed period. The unique feature of Istisna a is that nothing is exchanged at the time of contracting. Under Istijrar, the buyer purchases different quantities of a commodity from a single seller over a period, with flexibility in fixation and payment of price. Key Terms Ajir Ajr al-musammah or Ajr al-mithl Amanah Al-Ijarah-Thummal-Bai (AITAB) Bai Bithaman Ajil or BBA Bai al- Inah Bai Mu ajjal

27 Bai al-sarf Bai Salam Fiqh Fulus Gharar Hamish Jiddiyah Hawalah Ijarah Ijarah Muntahia-bi-Tamleek Ijarah Sukuk Istisna a Istijrar Khiyar Khiyar al- Aib Khiyar al-ro yat Khiyar al-shart Khiyar al-wasf Mabi Majallah Majhul Mithli Mudarabah Mudarib Murabaha Murabaha to Purchase Orderer (MPO) Musawamah

28 Musharakah Mustajir Ribâ Tawarruq Ujrah

29 Chapter 6

30 Chapter Introduction Hello and A Framework for the Islamic Financial System - Part 4. As you have learned in other chapters, in Islamic finance, willingness to share the risk to share profits is most important. Shirkah-based businesses are therefore a common mode. The basic principle underlying Shirkah is that a person who shares in profits must also bear the risks. Shirkah-based contracts include Mudarabah, Musharakah and Diminishing Mudarabah. Learning Objectives At the end of this chapter, you will be able to: Explain the concept of Shirkah and its two main categories. Explain the concept of a Mudarabah contract. Identify the restrictions on capital invested in a Mudarabah contract. Identify the types of Mudarabah and the conditions of a Mudarabah contract. Identify the rules relating to distribution of profit or loss under a Mudarabah contract. Explain the concept of a Musharakah contract. Explain the rules for capital being invested in a Musharakah contract. Identify the rules relating to distribution of profit or loss under a Musharakah contract. Distinguish between a Musharakah and a Mudarabah contract. Explain the working of a Mudarabah and Musharakah or Mudarabah with Musharakah contract. Explain the concept of a Wadiah wad Dhamanah deposit. Explain the concept of a Qard-ul-Hasan deposit. Explain the concept of Wakalah or agency. Explain the concept of a Tawarruq contract. Explain the concept of a Ju alah contract. Shirkah and its Two Categories Shirkah is proportionate ownership between two or more people who combine their wealth to establish a business firm and decide to share their profits and losses. Shirkah categories: Shirkatulmilk Shirkatul aqd This category refers to fusing of ownership through freewill or compulsion. Freewill or Optional ownership: A and B jointly receive a gift or bequest, or they jointly purchase an article.

31 Compulsive ownership: A and B inherit a property or their capital becomes indivisible without their action. In this type of ownership, A and B are indebted to each other. A cannot avail benefits from B s property without permission. This partnership is bound by a contract. It can be categorised into: Shirkatulamwal: Each partner contributes capital. Shirkatula mal: Each partner contributes services. Shirkatulwujooh: Each partner trades commodities independently in the market. The Concept of Mudarabah Mudarabah is a type of Shirkah in which: One partner or group of partners provides capital to an agent or manager called Mudarib for investment in a business venture. The profit and loss from the venture is shared among the partners in an agreed ratio. If there is a profit, the Mudarib is paid for the effort invested in running the venture. If there is a loss, the Mudarib loses the remuneration. Click the Resources button at the top of the screen to view the finance flow in a Mudarabah contract in which the bank s client is a Mudarib. Raising Capital for Mudarabah Five restrictions imposed by Islamic law on Mudarabah capital are listed below. Mudarabah capital should be in the form of only legal tender money, not commodities. Mudarabah capital should be free from debt and liabilities. For profit-sharing with the Mudarib, an investor cannot: o o o Give two different amounts of capital to the Mudarib on unequal terms of profitsharing. Cite different periods. Use different transactions. Types and Conditions of a Mudarabah Contract Mudarabah business can be restricted or unrestricted but must be according to the customary practice of Mudarabah contracts. Restricted Mudarabah

32 The Mudarib undertakes a business based on the terms and conditions set by the provider of capital. Unrestricted Mudarabah The Mudarib can invest funds by own choice. Mudarabah contracts are therefore conditional or unconditional. Conditions include nature of work, place of work and period of work. Special conditions may also be placed regarding who to do business with and goods in which to do business. Let s look at the rights of the Rabbul-māl and the restrictions that the Rabbul-māl can impose on the Mudarib. Rights of the investor of capital are as follows: They can appoint banks as investment agents. The Rabbul-māl may specify: o o o o The time limit for the contract. The goods permissible or not permissible for trade. The place to do business in or places to be avoided. The entities to avoid relationships with. The Rabbul-māl may also: Stop the agent from entering into another Mudarabah with another party. Require the Mudarib to fulfil their fiduciary responsibilities. Order the Mudarib to sell goods if the profit at the time is likely to be substantial. The investor can enforce unbiased conditions on a Mudarib only in the interest of the business. The Mudarib cannot: Violate the investor s conditions and restrictions. Buy goods at more than market price or sell goods at lesser than market price. Donate funds or waive receivables without the investor s permission. Profit and Loss Under Mudarabah The rules governing the distribution of profit or loss under a Mudarabah contract are as follows. Profit-Sharing Ratio All parties can mutually decide on the profit-sharing ratio in different scenarios. The ratio can be equal or in different proportions. However, a lump sum amount as profit is not permitted.

33 The ratio can be changed at any time but is effective for the period agreed upon. If the parties cannot agree on the ratio, the profit is to be distributed according to traditional practice. Profit-Sharing Period If a Mudarabah contract accrues profits, it can be shared among partners after a period treated as closing of accounts. Provisional withdrawal of profit is permitted and must be adjusted during final settlement. The Mudarib can claim a share of profit when the business operations of the Mudarabah have realised profit, but this is subject to the interim profits being retained to protect the capital. The Mudarib s profit accrues only after the Mudarabah is liquidated and investors recover their capital and profit. Loss-Sharing Loss can be compensated by the profit of the future business operation or the contingency reserves created in the past. The Concept of Musharakah Shirkatulamwal All the partners investing in a business own it in the ratio of their capital. Shirkah al- Inan Two entities may invest different amounts of capital or merely act as partners. They are then agents of each other, not as guarantors. Musharakah A general partnership that combines the above two concepts is called a Musharakah partnership. The profits are shared according to an agreed ratio but losses are shared in the ratio of their ownership. A bank and its customer may often enter into a Musharakah agreement. Both parties contribute capital and entrepreneurial expertise. Let s see a basic Musharakah financing structure between a bank and its client. Step 1: Based on a business plan, the bank and the client decide to jointly contribute to the capital of a joint venture. Step 2: Once the business venture is set up, the bank and its client manage its operations together, sharing the responsibilities as per pre-signed terms and conditions. Step 3: Profits are shared as per pre-signed terms and conditions. Step 4: