Instruments of Islamic banking in operation
This is a research-based article dealing with various aspects of Islamic finance
and its wider application in today’s banking environment.
The article has been divided in five parts; part-V (final) will be published in the
next issue of Business & Finance Review
By Dr Shahid Hasan Siddiqui
(I) Trade based modes
(i) Murabaha-Muajjal: murabaha means mutually stipulated margin of profit in a
sale transaction where the cost of the commodity is made known to the buyer.
The parties negotiate the profit margin on the known cost. If payment of the sale
price is deferred, it becomes murabaha-muajjal. Credit sale is allowed by the
texts of the Shariah. The installments sale with price higher than the cash market
price is also permitted as a normal reflection of market-based commercial
activities. The price and the due date of payment must be fixed in an
unambiguous manner. Other terms used for similar transactions are installments
sale, cost-plus/mark-up based sale, etc.
Murabaha, as in vogue in Islamic banking, is used with a prior promise to buy or
a request made by a person interested in acquiring goods on credit from a bank.
The customer is normally appointed as agent of the bank for purchase of the item
on it’s behalf. As such, it is called ‘murabaha to Purchase Orderer’ (MPO) which
normally comprises three separate agreements including promise to buy or to
sell, agency contract and the actual murabaha contract.
According to contemporary Shariah scholars, murabaha is legitimate provided the
risk of the asset being sold is borne by the bank until the possession is passed on
to the murabaha customer. For such a transaction to be legal, the bank must
purchase a commodity through a contract and sell it to the customer under a
separate contract. Murabaha can be used only where a commodity is intended to
be purchased by the customer. Banks can promise to sell something that is not
yet owned or possessed by them. However, the actual sale will have to be
effected through offer and acceptance after the commodity comes into the
physical or constructive possession of the seller (bank).
The ideal way of conducting murabaha is that the bank itself purchases the
commodity directly form the supplier and after taking it’s delivery, re-sells it on
murabaha basis. Alternatively, bank may take the services of a third party for the
acquisition of goods. Keeping in view the problems involved in purchasing directly
or through third party agent, the Shariah experts have allowed that a bank
makes the customer his agent to buy the commodity on it’s behalf. Whatever the
procedure for Shariah compliance, the commodity before selling it to the client
must remain at the risk of the bank, the seller in this finance-cum-trade
transaction. The appointment of customer as bank’s agent is not however,
considered desirable.
Banks should make sure that the client really intends to purchase the commodity.
The buy-back arrangement is not allowed. The purchase price should be paid
directly to the supplier instead of giving funds to the customer. The client should
not be made dual agent doing every thing himself and purchase by the bank
should be evidenced by invoices or similar other documents to ensure that all
conditions of valid murabaha are fulfilled. The commodity must come into the
possession of the bank, whether physical or constructive, in the sense that it
must be at bank’s risk. The bank should arrange for physical inspection on
random basis of the purchased commodities so that the supplier and the client
may not end up in any under-hand dealing.
In case of default, murabaha contract cannot be rolled over because the goods
once sold by the bank are property of the client and hence cannot be resold by
the bank. As the murabaha is basically a sale, all the necessary ingredients of
sale acceptable to Shariah must be duly observed otherwise it may involve an
element of riba. The fuqha have accordingly laid down strict parameters for its
permissibility. The following requirements should therefore, be strictly observed
by Islamic banks:
(a) The commodity being sold must be in existence at the time of sale.
(b) Seller must have a good title to the commodity and should be competent to
sell it.
(c) The commodity must be in physical or constructive possession of the seller.
The constructive possession means that although physical delivery of the
commodity has not been taken, it has come into bank’s control that has also
assumed the risk of it’s loss or destruction even though for a very short period.
(ii) Musawamah (Bargaining on Price)
Musawamah is a general and regular kind of sale in which price of the commodity
to be traded is bargained between seller and the buyer without any reference to
the price paid or cost incurred by the former. Thus, it is different from murabaha
in respect of pricing formula. Unlike murabaha, seller in musawamah is not
obliged to reveal his cost. Both the parties negotiate on the price. All other
conditions relevant to murabaha are valid for musawamah as well. Musawamah
can be used where the seller is not in a position to ascertain precisely the costs of
commodities that he is offering to sell.
Musawamah can be both cash and credit sale but, when used by banks, it will
generally be a deferred payment sale in which they will bargain with clients on
the price of the goods/assets. Islamic banks may sometimes get a discount from
the supplier over the normal retail price. If the purchase price or the actual profit
is not brought into the notice of the customer, such sale should be conducted
through musawamah and not murabaha.
(iii) Salam
Salam is a forward sale contract for future delivery of specified goods with upfront payment of price. It is also called Salaf or Taslif meaning a sale by advance
payment. Salam has been permitted by the holy Prophet (PBUH) notwithstanding
the general principle of the Shariah that the sale of a commodity which is not in
possession of the seller is not permitted. People in Madinah used to pay in
advance the price of fruits (or dates) to be delivered within one, two or three
years. But such a sale was carried out without specifying the measure, weight
and the date of delivery.
The holy Prophet ordained: Whoever pays money in advance (for dates) should
pay it for a known specified measure, weight and time. The list of items covered
by salam included wheat, barley, dates and grapes. The conquest of Syria added
new items like olive and dried large grape. The jurists have now expanded the list
to cover all homogeneous (mithly) commodities that can be precisely determined
in terms of quality and quantity. Monetary units, wherein exchange has to be
simultaneous, are excluded.
Salam can be applied in those commodities only that are normally available in the
market and whose quality and quantity can be specified exactly. It may include
any marketable goods with definable features, trade marks, etc. like raw
materials, agricultural produce or manufactured goods. The seller in salam need
not necessarily be a producer of the goods. He can enter into a salam contract for
supply of goods in future against full pre-payment.
Banks should not set-off their receivables for payment of salam price as salam
sale cannot be contracted against a loan, or partly cash and partly loan, in which
case the contract will be valid only to the extent of cash payment.
If the seller does not deliver the goods at agreed date, the buyer shall have the
options to wait until the commodity is available, to cancel the contract and
recover the paid price or to agree to a replacement with mutual consent and
subject to the relevant rules of exchange. It is pertinent to observe here that the
bank has a right to take the goods that it has purchased, it can purchase from the
proceeds of the security / pledge, but if it decides to get cash from the customer,
it has the right to get only the price given in advance at the time of the contract.
For disposal of goods purchased under salam, Islamic banks have a number of
options including: i) enter into a parallel salam contract, ii) agency contract with
any third party or with the customer (seller) to sell the goods on behalf of the
bank and / or iii) sale in the open market by the bank itself by entering into a
promise with any third party or direct selling upon taking the delivery. In case of
agency, the salam agreement and agency agreement should be separate and
independent from each other. The purchased goods cannot be sold back to the
salam seller. Hence, parallel salam cannot be entered into with the original seller
– prohibited due to being a buy-back. Bank may take promise from any third
party which would purchase the goods of stipulated specifications at any
stipulated price.
(iv) Istisna´a
Istisna´a, like salam, is a special kind of sale where sale of a commodity is
executed before it comes into existence. It is an agreement culminating into a
sale at an agreed price whereby the purchaser places an order to manufacture,
assemble, construct, or cause so to do, anything to be delivered at a future date.
Al-Saani (manufacturer) would arrange both the raw material and the labour. If
material is supplied by the purchaser, it will be the contract of Ujrah (Service
contract).
The seller may enter into a parallel contract with a manufacturer to provide the
subject matter of istisna´a. On this basis, the banks may undertake financing by
getting the subject of istisna´a manufactured through parallel istisna´a contracts.
Istisna´a contract must state the type, dimensions and specifications of the asset
/ property being manufactured, and time and place of delivery, whether the asset
has to be manufactured by any specific manufacturer, or by use of specific
materials, as may be agreed between the two parties.
It is not necessary in istisna´a that the price is paid in advance. Payments can be
made in installments within a fixed time period. Against the general rule set out
for salam, the jurists have legalised it on the basis of analogy and istihsan as
istisna´a involves personal labour, effort and commitment of the seller. The price
should be known in advance, which once settled, cannot be unilaterally increased
or decreased. However, as manufacturing of huge assets may involve longer
time, sometimes necessitating many changes, price can be readjusted by the
mutual consent of the contracting parties because of making material
modification in the commodity or due to unforeseen contingencies or changes in
prices of inputs.
Istisna´a contract may also contain a penalty clause stipulating an agreed
amount of money for compensating the purchaser adequately if the manufacturer
is late in delivering the asset. Such compensation is permissible only if the delay
is not caused by intervening contingencies (force majeure). In Fiqh, this principle
is termed as Shart-e-Jaz?i or the condition of decreasing the price on account of
delay in delivery of the subject matter of istisna´a.
The Parallel istisna´a contract should be without any condition or linkage with the
original istisna´a contract. The two contracts cannot be tied up in a manner that
the rights and obligations of one contract are dependant on the rights and
obligations of the other contract. Further, Parallel istisna´a is allowed with a third
party only.
The bank working as a manufacturer must assume liability for ownership risk,
maintenance and Takaful expenses prior to delivering the subject-matter to the
purchaser as well as the risk of theft or any damage.
(II) Ijarah based modes
Ijarah is a contract under which one party obtains the right of usufruct of an
asset owned by another party for an agreed period against an agreed
consideration namely rent. The term Ijarah is very much similar to the ‘leasing’.
The rules of Ijarah in the sense of leasing are similar to the rules of sales because
both cases involve transfer of some property to another. The only distinctive
feature is that in the case of sale, the corpus of property is transferred to the
purchaser while in the case of Ijarah, the corpus of the property remains in the
ownership of the lessor and only its usufruct is transferred. The following are two
basic differences between leasing by conventional banks and the Ijarah financing
by Islamic banks.
(i) In leasing, the lessee’s liability to pay rent starts from the date the payment
has been made by the conventional bank to the supplier and not from the date
the delivery of the asset is taken by the lessee. The Islamic bank however,
charges rent only from the date the delivery of the asset in working condition is
taken by the lessee and not from the date the price has been paid to the supplier.
(ii) In case of Ijarah, Islamic bank, being owner of the asset, assumes full risk of
the corpus of the leased asset. If the asset is destroyed during the period of
Ijarah contract or the asset looses it’s usufruct without misuse or negligence on
the part of the lessee, the Islamic bank cannot claim rent while interest-based
banks are entitled to receive interest in such cases also, unless there is a contract
to the contrary.
In its origin, leasing is one of the normal real sector business activities like sale
and not a mode of financing. Like conventional banks, Islamic banks are
extensively using leasing not only for the tax benefits available in case of leasing
but also for the reason that it has a number of flexibilities and wider potential for
promoting Islamic finance that is essentially real assets-based.
Ijarah is valid for things which possess Manafa´ah and which can be utilised but
their corpus or substance (‘Ayn) is not consumed. The goods like candles, yarn,
cotton, food or fuel are suitable for sale, not for leasing or hiring. Hence Dirhams,
Dinars, any other currencies, bullions etc that are ‘Ain, not usufruct and all those
goods taking benefit from which is not possible without consuming them cannot
be given on lease. Any form of perishable item may not also be a subject of
lease.
Rentals in Ijarah can be fixed for the whole lease period or floating / variable
subject to mutual understanding. It can be agreed upon that the rent shall be
increased after a specified period like a year or so. Contemporary scholars have
also allowed to tie up the rent with a well-defined reference rate or benchmark or
to enhance the rent periodically according to a mutually stipulated proportion
(e.g. 7.5 percent per year) subject to the condition that other requirements of
Shariah for a valid lease are duly fulfilled.