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 slamic Finance


The purpose of the Islamic financial system:
The purpose of the slamic financial system is, as with conventional
finance, to mobilize global resources to promote and sustain
global
and regional development.
slamic Finance taps the vast pool of savings held by
Muslims, and puts these savings to productive use for the
benefit of slamic and other societies.
The Principles of slamic Finance
The Principles of slamic Finance
Principles that underlie the methodology of Islamic finance:
1 - Prohibition of Riba
2 - Prohibition of Gharar
The Principles of slamic 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. t is a

typical increase or growth , which has been prohibited by slam.

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.

slam made a clear distinction between trade and Riba. Trading is

encouraged but Riba is prohibited.

slam 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 slam 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 slamic Finance
.
The Principles of slamic Finance
The prohibition of Riba implies that:
The fixing in advance of a positive return on a loan as a reard for
aiting is not permitted by Islam!
It ma"es no difference hether 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 slamic Finance
Gharar
- gnorance of the goods or price,
-
or false description of the goods.
- selling of goods that the seller is not in a position to deliver.
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
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 slamic Finance
$ources of %unds in Islamic &an"s
- 'urrent (ccounts
- All slamic 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 slamic Finance
There are two dominant views about current accounts:
1- To treat demand deposits as Amanah. A "Trust Account" instead

of a current account
n 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 slamic 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 slamic Finance
I)*+$T,+)T (''-.)T$
n slamic banks, nvestment 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:
Fixed time accounts
Investment 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 slamic Finance
/ifferent 0inds of Investment /eposits :
1 . Joint/ General nvestment Accounts
2 . Limited Period nvestment Accounts
3 . Unlimited Period nvestment Accounts
4 . Specified nvestment Accounts
The main characteristics of investment deposits can be described as follow:
The Principles of slamic Finance
.ses of %unds in Islamic &an"ing
slamic banks use many techniques to utilize the raised funds. Such
techniques, called modes of finance, are used as alternatives to interest -
based financing .
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 .
&ai1salam
Bai'salam
Finance ndustrial
sector
Agriculture sector
The Principles of Islamic %inance
The Principles of Islamic %inance
Definition :
stisna 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
stisna
Manufacturing good
House under
construction
Securitization
Definition :
A Musharakah is a joint venture where by all partners (BANK /CLENT) 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 .
,ushara"ah
Musharakah
Permanent Musharakah
inequity
Diminishing
Musharakah
One of Musharakah
transaction
Financing working
capital
Substitute for
overdraft
The Principles of Islamic %inance
&asic Principles -f ,ushara"ah:

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 Principles of Islamic %inance
The usage of ,ushara"ah in financing business :
Project
financing
Financing of a
single
transaction
Securitization of
Musharakah
Financing of
Working
Capital
,ushara"a
,urabaha
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 .
,urabaha %inancing Process
Customer
Bank
1
Supplier
Price
Goods
Promise
to
Purchase
Promise
to
Purchase
Sale
Contract
(Musawama)
Sale
Contract
(Musawama)
2
3
4
Customer Bank
Goods
Sale Contract
(Murabaha)
Sale Contract
(Murabaha)

n
s
t
a
l
l
m
e
n
t
s
5
6
7
(Buyer) (Seller)
(Buyer)
(Seller)
Price
The Principles of Islamic %inance
(ny ,urabaha transaction ill typically involve a number of steps#
hich are broadly as follos:
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
Personal Murabaha Commercial Murabaha Murabaha LC's
Liquidation of
Musharaka
Contracts
Utilization Assets of
investment funds &
Portfolio
Murabaha can be used to finance various needs of clients :
The Principles of Islamic %inance
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 .
,udarabah
'haracteristics that distinguish ,udarabah from ,ushara"ah :
a. The investment in a Mudarabah is provided by one partner only,
whereas in a Musharakah it is supplied by all the partners.
b. n 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. n 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 . n a Musharakah the assets acquired are
the joint possessions of all the partners in the deal.
,udarabah
uses in
Islamic
&an"ing
Raising
funds from
clients
Structuring
investment
portfolios
Finance
Clients
Structuring
investment funds
I2ara
Under the terms of an jara 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.
I2ara %inancing
3essee
I2ara
43ease5
3essor
3eased
(sset
Rental
Payments
-ffer
6
(cceptance
During the life of the asset the risk of ownership remains with the
lessor, while the lessee is responsible for use of the 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.
mportant differences between a conventional lease and jara :
n 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 slamic lease contract, the
lessor holds the responsibility of paying the insurance since he
owns the leased asset.
Customer
Bank
1
Landlord
Price
Promise
to Lease
Promise
to Lease
Sale
Contract
Sale
Contract
2
3
4
Buildings
(Buyer)
(Seller)
Customer Bank
Lease
contract
Lease
contract
R
e
n
t
a
l

P
a
y
m
e
n
t
s
5
6
7
(Lessee)
(Lessor)
Buildings
I2ara %inancing Process
$alam
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 follos:
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. t 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. t 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.
.sage of $alam:
Salam sale has been found suitable for the finance of agricultural
operations.
t 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.

t can cover the finance of operational costs and capital goods.
Istisna7a
stisna'a is the second kind of sale where a commodity is transacted
before it comes into existence. t entails ordering a manufacturer to
manufacture specific goods for the purchaser. f the manufacturer
undertakes to manufacture the goods for him, the transaction of
stisna'a comes into existence.
t is necessary for the validity of stisna'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 stisna'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.
n stisna'a, the party placing the order has the right to retract if
the commodity does not conform to the specification demanded.
n stisna'a the price could be in advance or in installments or
deferred but the time of payment should be fixed.
Istisna7a %inancing
,anufacturer
'lient
&an"
.sage -f Istisna:
stisna can be used for providing the facility of financing in certain
transactions, especially in the housing finance.
t is not necessary that the financier himself constructs the house.
He can enter into a parallel contract of stisna with a third party,
or may hire the services of a contractor. n 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 stisna may also be used for project
financing on similar lines.
The Principles of Islamic %inance
Taaro8 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 .
T(9(R-:
43 27/04/14
Definition:
awaro! means converting an asset into "ware!# or money.
$upplier
4$eller5
$ale
'ustomer
4&uyer5
Goods
/eferred
payment
(Ex.110)
-ffer
6
(cceptance
'ustomer
4$eller5
$ale
;
rd
Party
4&uyer5
Goods
$pot
payment
(Ex.100)
-ffer
6
(cceptance
$upplier
4$eller5
$ale
'ustomer
4&uyer5
Goods
/eferred
payment
(Ex.110)
-ffer
6
(cceptance
'ustomer
4$eller5
$ale
$upplier
4&uyer5
Goods
$pot
payment
(Ex.100)
-ffer
6
(cceptance
awaro! $tructure
Inah $ale
%Prohibited&
Taaro8 %inancing
44
27/04/14
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'ustomer
(1
st
Party)
$upplier
(2
nd
Party)
Purchase Contract
(Deferred Payment
+x! $R 11<)
Purchase Contract
(Deferred Payment
+x! $R 11<)
Sale Contract
(Cash Payment
+x! $R 1<<)
Sale Contract
(Cash Payment
+x! $R 1<<)
Inah Sale %Prohibited&
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awaro! Financing
Ta'aro( Str!ct!re %international 'ommodity&
&ro"er 2
(4
th
Party)
&ro"er 1
(3
rd
Party)
'ustomer
(1
st
Party)
&an"
(2
nd
Party)
Promise to
Purchase
Promise to
Purchase
Purchase
Contract
Purchase
Contract
Sale Contract
(Murabaha)
Sale Contract
(Murabaha)
Deferred
nstallment
Payments
Agency
Agreement
Agency
Agreement
Sale
Contract
Sale
Contract
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awaro! Financing
Ta'aro( Str!ct!re %(ocal 'ommodity&
&ro"er 2
(4
th
Party)
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(3
rd
Party)
'ustomer
(1
st
Party)
&an"
(2
nd
Party)
Promise to
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Promise to
Purchase
Purchase
Contract
Purchase
Contract
Sale Contract
(Murabaha)
Sale Contract
(Murabaha)
Deferred
nstallment
Payments
Agency
Agreement
Agency
Agreement
Sale
Contract
Sale
Contract
The Principles of Islamic %inance
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