‫بسم هللا الرحمن الرحيم‬
The Principles of Islamic Finance
The Principles of Islamic Finance
Islamic Banking (IB)
Definition:
Islamic banking can be defined as: a form of modern banking based
on Islamic legal concepts using risk- sharing as its main method
excluding financing based on fixed pre- determined return.
The Principles of Islamic Finance
The purpose of the Islamic financial system:
The purpose of the Islamic financial system is, as with conventional
finance, to mobilize global resources to promote and sustain global
and regional development.
Islamic Finance taps the vast pool of savings held by
Muslims, and puts these savings to productive use for the
benefit of Islamic and other societies.
The Principles of Islamic Finance
Principles that underlie the methodology of Islamic finance:
1 - Prohibition of Riba
2 - Prohibition of Gharar
The Principles of Islamic Finance
Riba is understandable given that the payment and receipt of interest are
central to all conventional banking.
 Riba literally means increase,addition,expansion or growth. It is a
typical increase or growth , which has been prohibited by Islam.
 Riba technically refers to the premium that must be paid by the
borrower to he lender along with the principle amount as a condition
for the loan or for an extension in its maturity. in this case Riba
obviously means interest.
 Islam made a clear distinction between trade and Riba. Trading is
encouraged but Riba is prohibited.
The Principles of Islamic Finance
 Islam does not consider money as a commodity so that there
should be a price for its use.
 Money is a medium of exchange i.e. Haman in asset-oriented
economy , and a store of value.
 The prohibition can be expressed in more technical terms by
saying that while money is recognised in Islam as a means of
exchange it may not lawfully be Regarded as a commodity for
exchange.
 The important difference between trade and Riba is that the
business risk in trading is allocated more evenly among all the
parties involved, whereas in Riba operations the business risk
lies heavily, if not solely, on the borrower.
The Principles of Islamic Finance
The prohibition of Riba implies that:
The fixing in advance of a positive return on a loan as a reward for
waiting is not permitted by Islam.
It makes no difference whether the return is :
• a fixed or variable percent of the principle
• or an absolute
. amount to be paid in advance or on
maturity,
• or a gift or service as a condition for the loan.
The Principles of Islamic Finance
Gharar
Gharar is a type of exchange in which one or both parties
stand to be deceived through ignorance of an essential
element of the exchange
- Ignorance of the goods or price,
- or false description of the goods.
- selling of goods that the seller is not in a position to deliver.
The element of speculation inherent in derivatives trading means that such
transactions fall into the category of Gharar and are therefore prohibited.
The Principles of Islamic Finance
Sources of Funds in Islamic Banks
- Current Accounts
- All Islamic banks operate current accounts on behalf of their clients:
individuals and business firms.
- These accounts are operated for the safe custody of deposits and for the
convenience of customers.
The bank guarantees the full return of these deposits on demand and the
depositor does not gain any share of the profit or any other return in any form.
The Principles of Islamic Finance
There are two dominant views about current accounts:
1- To treat demand deposits as Amanah. A "Trust Account" instead
of a current account
In such case the bank does not have the authority to use them without
first obtaining the specific permission of the owner of the funds.
The Principles of Islamic Finance
2- The other view is to treat demand deposits as Qard Hasan (or interest free
loan).
According to this view the bank is free to utilize these funds at its own risk without
return to, or authorization from, the depositors.
The Principles of Islamic Finance
INVESTMENT ACCOUNTS
In Islamic banks, Investment accounts (Profit and Loss Sharing (PLS) Accounts) play the
same role as term deposits or time deposits in the conventional system.
The two differ in the following manner:
Investment accounts
Fixed time accounts
Interest
Profit
Income pre-determined
determination expected return
percentage
Principle and return are guaranteed
no guarantee except in cases of
misconduct or mismanagement
Maturity
maturity as well as on the basis of
purpose
The Principles of Islamic Finance
The main characteristics of investment deposits can be described as follow:
Different Kinds of Investment Deposits:
1.
2.
3.
4.
Joint/ General Investment Accounts
Limited Period Investment Accounts
Unlimited Period Investment Accounts
Specified Investment Accounts
The Principles of Islamic Finance
Uses of Funds in Islamic Banking
Islamic banks use many techniques to utilize the raised funds. Such
techniques, called modes of finance, are used as alternatives to interestbased financing.
The Principles of Islamic Finance
Bai'salam
This is a sale of goods whose specifications are determined at the time of the contract, for a
cash price paid in advance, and whose delivery will be at a future date.
The seller of the goods must make delivery of the goods of determined specification on a
definite future due date. The goods need not be already manufactured at the time of the sale
contract.
Bai’salam
Finance Industrial
sector
Agriculture sector
The Principles of Islamic Finance
Istisna
Definition:
Istisna is an agreement meeting the Client's need for an item, equipment,
building, or project, which needs to be constructed, manufactured, fabricated,
or assembled.
Istisna
Manufacturing good
House under
construction
Securitization
The Principles of Islamic Finance
Musharakah
Definition:
A Musharakah is a joint venture where by all partners (BANK /CLIENT)
participate in providing the financial resources for the business. the Client to start and/or
operate a business or industry, or undertake any other type of business venture.
The bank and the Client agree to manage the business enterprise according to
the terms of the agreement.
Musharakah
Permanent Musharakah
inequity
Diminishing
Musharakah
Financing working
capital
One of Musharakah
transaction
Substitute for
overdraft
The Principles of Islamic Finance
Basic Principles Of Musharakah:

Financing through Musharakah means participation in the business.

An investor/financier must share the loss incurred by the business to
the extent of his financing.
 The partners are at liberty to determine, with mutual consent, the
Ratio of profit allocated to each one of them, which may differ from
the ratio of investment.
 The loss suffered by each partner must be exactly in the proportion of
his investment.
The usage of Musharakah in financing business :
Musharaka
Securitization of
Musharakah
Project
financing
Financing of a
single
transaction
Financing of
Working
Capital
Murabaha
Definition:
Murabaha is a sale contract between the Bank as seller of
goods and Client as purchaser, based on the disclosure of initial price to client. Bank
purchases Goods on spot at the request of the Client, and then sells same to him on
credit at a mutually agreed marked-up price.
Murabaha Financing Process
1
Customer
Promise
to
Purchase
Bank
(Buyer)
2
Sale
Contract
(Musawama
)
Supplier
(Seller)
3
Price
4
Goods
Sale Contract
(Murabaha)
Customer
(Buyer)
Installments
Goods
Price
Bank
(Seller)
6
7
5
The Principles of Islamic Finance
Any Murabaha transaction will typically involve a number of steps,
which are broadly as follows:
1. The purchaser/ client submits an order to the bank to purchase the
goods they require.
2. The bank agrees to finance the purchase of proposed goods.
3. The bank prepares and sends an offer to the purchaser /client.
4. The purchaser accepts the offer, which binds it contractually to
purchase the goods.
5. the bank pays the supplier and purchases the goods using spot
payment.
6. The purchaser, acting for himself, enters into a contract to buy
the goods from the bank.
7. the purchaser purchases the goods from the bank for immediate
delivery with deferred payment.
8. On the due date, the purchase price plus the mark-up is due.
Murabaha can be used to finance various needs of clients:
Murabaha
Personal Murabaha
Commercial Murabaha
Liquidation of
Musharaka
Contracts
Murabaha LC’s
Utilization Assets of
investment funds &
Portfolio
The Principles of Islamic Finance
Mudarabah
Definition:
Mudarabah is a mode of financing in which the bank provides the needed
finance, while the Client provides the professional, managerial, and technical
know-how for starting and/or operating a business enterprise or project.
The profit is shared in a pre-agreed ratio.
Characteristics that distinguish Mudarabah from Musharakah :
a. The investment in a Mudarabah is provided by one partner only,
whereas in a Musharakah it is supplied by all the partners.
b. In a Mudarabah the management of the investment is the sole
responsibility of the mudarib, while in a Musharakah the partners all
participate in the management of the business.
c. The loss in a Mudarabah is carried by the Rab'ul Mal alone, as
the Mudarib has nothing to lose. In a Musharakah the proportion
of loss is determined by the size of the investment .
d. A Mudarabah is a limited liability investment, whereas a
Musharakah is not.
e. The assets acquired by a mudarib for the rab'ul mal are the sole
possession of the latter, and the former can only profit by shrewd
disposal of the assets . In a Musharakah the assets acquired are
the joint possessions of all the partners in the deal.
Structuring
investment funds
Raising
funds from
clients
Mudarabah
uses in
Islamic
Banking
Finance
Clients
Structuring
investment
portfolios
Ijara
Under the terms of an Ijara transaction the investor, or lessor, would
purchase equipment from a manufacturer and lease it on to the
company, or lessee, for an Agreed period of time.
During this pre-determined period, the title to the underlying
assets will remain in the hands of the lessor, whereas the actual
possession and usage of the asset would be for the benefit of the
lessee.
Ijara Financing
Offer
&
Acceptance
Lessee
Lessor
Ijara
(Lease)
Rental
Payments
Leased
Asset
Over the life of the asset, the lessee will pay pre-agreed
rentals to the lessor at a frequency mutually agreed upon by
the two parties.
During the life of the asset the risk of ownership remains with the
lessor, while the lessee is responsible for use of the asset.
Important differences between a conventional lease and Ijara :
•
In a conventional lease arrangement penalties will be incurred for late
payment of an installment, which are stated as a percentage of the
total. As this equates to an interest payment, it is prohibited under
Shariah.
•
Under shari'ah, original agreements can not be altered to reflect
rescheduling. This can be done only in cases of mutual agreement to
cancel the old agreement and to draw up a new one.
•
Under conventional lease contract the lessee is responsible to
insure the leased asset, where in an Islamic lease contract, the
lessor holds the responsibility of paying the insurance since he
owns the leased asset.
Ijara Financing Process
Promise
to Lease
1
Customer
Bank
Sale
Contract
2
Landlord
(Seller)
(Buyer)
3
Price
4
Buildings
Lease
contract
Customer
5
Bank
(Lessee)
(Lessor)
7
Rental Payments
6
Buildings
Salam
Salam is a sale whereby the seller undertakes to supply some specific
goods to the Buyer at a future date in exchange for an advanced price
fully paid on the spot.
The permissibility of Salam was an exception to the general rule that
prohibits forward sales. For that, it was subjected to some strict
conditions.
These conditions are as follows:
1. The payment of the price by the buyer should be at the time of
effecting the sale.
2. Such sale is permissible only in the commodities whose quality
and quantity can be specified exactly. For example, precious
stones cannot be sold on the basis of Salam, because every piece
of precious stone is normally different from the other.
3. It cannot be effected on a commodity whose supply is not certain.
For example, if the seller undertakes to supply rice or wheat of a
particular field, or the fruit of a particular tree, the Salam will not
be valid.
4. The quality and quantity of the commodity sought to be sold by
Salam must be fully specified. The exact date and place of
delivery must be specified in the contract
5. It is not permissible for the buyer of a Salam commodity to
sell it before receiving it because that is similar to the
prohibited sale of debts before holding.
Usage of Salam:
Salam sale has been found suitable for the finance of agricultural
operations.
It is also used to finance commercial and industrial activities,
especially phases prior to production and export of commodities
and that is by purchasing them on Salam and marketing them at
a profit.
 The Salam sale is also used by banks in financing craftsmen and
small producers by supplying them with inputs of production as a
Salam capital in exchange for some of their commodities to remarket.
 The scope of Salam sale is large enough to cover the needs of
various people such as farmers, industrialists, contractors or traders.
It can cover the finance of operational costs and capital goods.
Istisna’a
Istisna’a is the second kind of sale where a commodity is transacted
before it comes into existence. It entails ordering a manufacturer to
manufacture specific goods for the purchaser. If the manufacturer
undertakes to manufacture the goods for him, the transaction of
Istisna’a comes into existence.
It is necessary for the validity of Istisna’a that:
A. The price is fixed with the consent of both parties.
B. The specification of the commodity intended to be
manufactured is fully settled between them.
 The contract of Istisna’a creates a moral obligation on the
manufacturer to manufacture the goods, but before he starts the
work ,any one of the parties may cancel the contract after giving
notice to the other.
 However, after the manufacturer has started the work, the contract
cannot be cancelled unilaterally.
 In Istisna’a, the party placing the order has the right to retract if
the commodity does not conform to the specification demanded.
 In Istisna’a the price could be in advance or in installments or
deferred but the time of payment should be fixed.
Istisna’a Financing
Manufacturer
Bank
Client
Usage Of Istisna:
 Istisna can be used for providing the facility of financing in certain
transactions, especially in the housing finance.
 It is not necessary that the financier himself constructs the house.
He can enter into a parallel contract of Istisna with a third party,
or may hire the services of a contractor. In order to secure the
payments of installments, the bank , as a security, may keep the
title deeds of the house or land, or any other property , until the
client pays the last installment.
 The instrument of Istisna may also be used for project
financing on similar lines.
The Principles of Islamic Finance
TAWAROQ
Tawaroq is a financial product to satisfy customer cash needs compliant
with Shariah rules. Under such program the bank purchases certain goods
on spot basis either from local or international markets and sells them to
customers on credit.
The customer in his turn resells the goods to a third party to obtain cash.
Tawaroq Financing
Definition:
Tawaroq means converting an asset into “wareq” or money.
Offer
&
Acceptance
Supplier
(Seller)
Offer
&
Acceptance
Tawaroq Structure
Customer
(Buyer)
3rd Party
(Buyer)
Customer
(Seller)
Sale
Deferred
payment
(Ex.110)
Sale
Spot
payment
(Ex.100)
Goods
Inah Sale
(Prohibited)
Offer
&
Acceptance
Supplier
(Seller)
Customer
(Buyer)
Offer
&
Acceptance
Customer
(Seller)
Sale
Deferred
payment
(Ex.110)
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Goods
Supplier
(Buyer)
Sale
Goods
Spot
payment
(Ex.100)
Goods
43
Tawaroq Financing
Inah Sale (Prohibited)
Purchase Contract
(Deferred
Payment
Ex. SR 110)
Supplier
(2nd Party)
Customer
(1st Party)
Sale Contract
(Cash
Payment Ex.
SR 100)
End Result: SR 110 – SR 100 = SR 10 (Interest)
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Tawaroq Financing
Tawaroq Structure (international Commodity)
Purchase
Contract
Promise
to
Purchase
Customer
(1st Party)
Sale Contract
(Murabaha)
Bank
(2nd Party)
Agency
Agreement
Sale
Contract
Deferred
Installment
Payments
Broker 1
(3rd Party)
Broker 2
(4th Party)
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Tawaroq Financing
Tawaroq Structure (Local Commodity)
Purchase
Contract
Promise
to
Purchase
Customer
(1st Party)
Sale Contract
(Murabaha)
Bank
(2nd Party)
Agency
Agreement
Sale
Contract
Deferred
Installment
Payments
Local
Supplier
(3rd Party)
Broker 2
(4th Party)
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The Principles of Islamic Finance
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