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Principles of Islamic Finance

Distance Learning Course

Salman Syed Ali


Purposes of Islamic Finance
Principles
Same as the objectives of entire shariah, that
is, protection of:
belief
life
property
progeny
intellect
Financial contracts are a subset of
Business contracts

Contracts Business

Financial Contracts
Shariah rules achieve these objectives
by making the contracts

easy to enforce
removing ambiguities
reducing envy
promoting justice
With due cognisance of the fact that
parties in a contract may possess

asymmetric information
imperfect information
incomplete information
manipulated information
differential abilities of information processing
differential abilities of decision sound making
Principles are Easy: Logical
and Systematic
General Principles of Contracts.
Conditions for Existence
Conditions for Validity
Principles Specific to Finance.
Implications of these principles.
General Principles: Conditions
for Existence of Contract

P1 Existence of parties to the contract.


P2 Existence of object of the contract.
P3 Existence of offer and acceptance.
Validity
P4 Free will
P5 All contracts are permissible unless
prohibited
P6 Should not be against the objectives
of shariah
P7 Free from riba
P8 No gharar
P9 Free from Khalabah ; I.e., wager,
games of chance
P10 Free from jahal ; I.e., ignorance
Principles more specific to
financial contracts
P11 Al Khiraju biddaman

P12 Prohibition of sale of debt with debt

P13 Prohibition of making one contract


contingent on the other
P14 Prohibition of combining two
mutually inconsistent contracts

P15 Prohibition of element of qimar or


gambling in the contract

P16 Debt is settled only by its payment


or forgiveness from the creditor
Implications
The effect of these principles will be
that:
1. Asset based securities
2. Fair distribution of risk
3. Financial sector growth harmonious with
real sector growth
4. Less degree of speculative price
movements
Implications (contd.)

5. A disadvantage: any packaging of risk


and return is not possible (with few
assets).
6. The possible types of securities
include:
variable returns securities (shares)
rent based securities (ijarah bonds)
trade based instruments (murabaha certificates,
salam etc)
many new hybrid securities combining the
f f d ff
Summary
Detailed guiding principles exist
Some ijtihad is needed to clarify and apply
them in present day financial practice
Beneficial effects of IF are likely
IF require appropriate institutions of
information processing, accounting, and
business norms as well as public will to
implement it
The End of Presentation

on
Principles of Islamic Finance
Modes of Islamic Finance
Distance Learning Course

Salman Syed Ali


Outline
Principles of Contracts Financing Modes:
Shirkah Musharakah
Mudaraba

Islamic Modes of Finance Trade Based Modes:


Bai Muajjal
>>>>>>
Bai Salam
Bai Istisna
Combination of Contracts Murabaha
Leasing Mode
SHIRKAH and its types

SHIRKAH

SHIRKAT-UL-MILK SHIRKAT-UL-AQD

SHIRKAT-UL-AMWAL SHIRKAT-UL-AMAL SHIRKAT-UL-WOJOOH


Musharakah (Partnership)
Mufawadah: All At conclusion/ winding-
partners are treated up of musharakah all
equally assets/liabilities are
Profit sharing ratio pre- distributed according to
determined (details) each partners share in
Amount of profit is not investment
pre-determined Any change in
All partners are trustees investment shares or
of each other mergers allowed only
with the permission of
all partners
Profit (LHS) and Loss (RHS)
Sharing Ratios
Profit Ratio directly Loss Ratio exactly according
proportional to each ones to the ratio of investment
investment (Maliki and
Shafei)
Profit Sharing Ration may
differ from ratio of investment
(Hanbali)
In normal conditions, profit
sharing ratio may differ.
However, in case of sleeping
partner this ratio has to be
strictly as the ratio of
investment (Hanafi)
Mudarabah
It is of two types
1. Limited to purpose or period
2. Open
Rules related to Mudarabah
All rules of shirakah carry over to
mudarabah
Normally, capital comes from one party
and work/effort from the other
(executive partner)
An executive partner can also put in his
capital if others agree
Mudarabah rules (contd.)

Profit can be shared on any pre-


negotiated ratio, but loss is
distributed according to the
investment share
Mudarib can enter into sub-
mudarabah, re-mudarabah or
musharkah with a third party with
prior approval
Uses of Musharakah and
Mudaraba
Project Finance
Securitization possible
Working Capital Financing
Ways to reduce moral hazard
Sharing of gross profits (not net profits)
Daily product method
Other possibilities: Diminishing
Musharakah
Trade Related Modes
Bai Muajjal
Bai Salam
Bai Istisna
Murabaha
Bai Muajjal
Price

Mr. A Mr. B

Object of sale
Rules for Bai Muajjal
Price is deferred.
Due date of payment has to be fixed with
certainty not with reference to some
probabilistic event.
Deferred price can be more than spot price
but should be fixed at the time of contract.
Once signed no adjustment in price is
possible relating to early or delayed
payments.
Bai Salam

Price

Mr. A Mr. B

Object of sale
Rules for Bai Salam
Spot payment of full price
Detailed specification of the subject
Time and place of delivery specified
Sold commodity must be found in the
markets throughout the period of salam
Resale without accepting delivery is
prohibited (*)
Bai Istisna
Applicable in manufactured items.
Price and the commodity both can be
deferred; it can be made in installments
Price known and the subject specified in
detail.
Sale is binding. Buyer can exit the
contract only if manufactured item is
not according to the specifications
Difference b/w Istisna and Salam
Istisna Salam

Subject of Needs Any thing


contract manufacturing

Price payment Can be in Paid in full


installments upfront

Unilateral Possible before Not Possible


Cancellation start of manufac.

Time of Delivery Not a binding Binding part


part of contract
Difference b/w Bai Muajjal and
Salam
Bai Muajjal Salam

Subject of Any existing thing Any thing


contract
Price payment Deferred (due Paid in full
date[s] upfront
unambiguously
fixed, not event
contingent)
Unilateral Possible before Not Possible
Cancellation start of manufac.
Time of Delivery Up-front Binding part
Murabaha
Originally a spot sale
Seller declares his cost
Asks a marked up price
Therefore, Murabaha is only valid when
exact cost can be ascertained.
Murabaha as Mode of Finance
Made possible by applying murabaha to
sales with a deferred price.
There are conditions to be observed for
validity of murabaha (see pages 13-14).
Murabaha procedure
1. Sign an agreement of promise to buy and
sell a specified commodity at an agreed
marked up price.

2. Client is appointed as agent

3. Client purchases the commodity on behalf


of the institution
Procedure (contd.)
4. Client informs the institution that
purchase has been made on its behalf,
and offers to buy for himself.

5. The institution accepts the offer, and


sale is complete.
Most Essential Element
Commodity must remain in the risk
(property) of the institution during the
period between the 3rd and the 5th
stage.
Varying nature of relationships

1 2
Promise I=Principal
not an actual sale Cli=Agent

3
4&5 I=Buyer
I=Seller/Creditor Sup=Seller
Cli=Buyer/Debtor
Ijarah based mode
Leasing
Hire-Purchase
Combination of Contracts
Islamic Financial Engineering
through combination of contracts
As a general rule all contracts are
permissible unless prohibited by Shariah
Separate contracts cannot be made
contingent on each other
Contracts can be combined as a bundle
However, some Sharia regulations must
be followed in combination of contracts
Bundled Contracts vs Contingent Contracts

Start Start

Contract 1 If contract 1 Dispute


No
Yes
Contract 2

If contract 2 Dispute
No
End: Successful Conclusion Yes

End: Successful Conclusion


Examples of Some Islamic
Regulations
Each contract in the bundled
contracts must be individually
Shariah compatible
The bundle as a whole must not
violate the purpose of Shariah
The combination must not be
explicitly prohibited
Examples of Explicitly Prohibited
Combinations
Two or more sales contracts cannot
be combined as contingent
contracts in a single contract
Sale and Loan contracts cannot be
combined
Two contradicting purpose contracts
cannot be combined
Examples of Permissible
Combinations
Sale and Ijarah contracts can be
combined
Shirakah and Mudarabah can be
combined
Murabaha and Shirakah can be
combined (to reduce moral hazard)
Loan and Shirakah may also be
combined (though there is some
difference of opinion)
Examples contd.
Shafai opinion Hanbali opinion
Leasing + Sale (OK) Sarf + Leasing (OK)
Saraf + Salam Sale or real asset +
(OK) Lease of another
Shirakah (nb) + asset (OK)
Mudarabah (nb)
(OK)
Juala (nb) + Sale
(b) (NO)
IFE through Khayar al-Shart
Risk management possible through such
options (Khayar al-Shart and Arbun)
These options are not independently
sellable but embedded part of contract
Example-1: Use of Khayar al-Shart in
Murabaha instead of use of binding
promise
Example-2: Investment Fund partially
invested in murabaha and partially in
arbun