MINHAJ UNIVERSITY LAHORE

Program: Islamic Banking & Finance

Semester : 5th

Student Name : Atta-UL-

Mustafa

Roll Number # 07

Assignment Topic : Nature of

Contracts

Subject : Fiqh ul Muamalat

Financial Contracts
Islamic financial instruments are based on the principles that they exclude
interest (riba), not possess major uncertainty (gharar) and not have gambling like
features (Maysir). Due to the prohibition of interest, Islamic banks or traditional banks
with windows for Islamic products cannot have fixed interest debt instruments. The
Islamic financial system instead proposes equity participation and risk sharing on the
part of banks and debtors (investors).
There are some widely used Islamic banking contracts which are commonly used
to provide Shariah compliant (i.e. based on Islamic principles) products for savings,
trade and investment. Like traditional banks Islamic banks also offer a range of financial
services and products. These are consumer financing, trade related financing and
investment type of modes of financing. Such modes of financing take the form of cost
plus sales (Murabaha), credit sales (bay ‘‘bithaman ajil’’), leasing (Ijarah), partnerships
(Modaraba and Musharakah) and some forward contracts (Salam and Istisna). In
addition, there are zero interest loans for poor farmers and needy students referred as
Qard-e-Hasna (benevolent loan).

1. Murabaha (trade with mark up or cost plus sale)

This type of Shariah (Islamic law) compliant contract is one of the most widely
used modes of financing by the Islamic banks. This instrument is being used for
financing of consumer durables, real estate and in the industry for purchasing raw
materials, machinery or equipment. However, it is most common and popular use is in
short-term trade financing including the financing of letters of credit. One can think of a
Murabaha facility to be akin to the consumer loans, lines of credit and working capital
facilities provided by conventional banks.
The vast majority of the financial transactions of Islamic banks are based on the
mark up or cost plus sale contract. One can view this markup sale contract to be an
interest based contract as it in fact charges interest but calls it pre-agreed profit – in this
case it is ex-ante profit and not realized profit as was originally stipulated under Islamic
law. Islamic scholars have defended this practice by stating that while Islam recognizes
trading and its associated profits it does not accept the concept of fixed return loan
contracts.

2. Bay ‘‘bi-thaman ajil’’ (credit sales)

 The cost plus profit (Murabaha) contract is hardly ever executed on spot through
immediate payments by the purchaser. A spot payment of the full amount of the loan
by the purchaser would mean that the bank loan is immediately paid off and the bank is
simply performing the role of an intermediary trader facilitating the delivery of goods
from seller to buyer and charging a profit mark up over cost for its middleman services.
The financial intermediary role i.e. the traditional role of banks and money lenders for
centuries can only be played by the bank if the loan payments are through installments
or in other words the bank is extending credit.
This is exactly what happens in the actual practice of Islamic banking in which the
more common and usual mode of payment for goods, machinery or equipment is
deferred payments through installments. These deferred payments at a higher price
than the cost price (incurred by the bank) can be interpreted to mean that Islamic
finance of deferred payments is very much like traditional loan installments charged at
an interest where the interest is the cost plus component (i.e. profit) of the Murabaha
contract. Not so, say Islamic jurists who allow for increase in price due to deferment;
see Usmani (1998) for legal explanations.

3. Musharaka (partnership or joint venture)

If the debtor (purchaser) does not seek hundred per cent bank financing of the
project but contributes some of his own equity capital, then such a contract is referred
as Musharakah. Even in this partnership a cost plus sale (Murabaha) contract will be
signed between the bank and the purchaser. However, now the purchaser (debtor) will
be exposed to the risk of capital loss on the capital committed by him, whereas the
debtor had no risk when 100 per cent of the capital was financed by the Islamic bank.
The two parties are again involved in a profit and loss sharing agreement in conformity
with Islamic principles of risk and reward sharing. The profits are shared in accordance
with pre-determined ratios while the losses are borne in proportion to equity
participation. Musharaka financing is used by banks for financing trade, imports and to
issue letters of credit and also in agriculture and industry.

4. Modaraba (profit and loss sharing)

This is also like a partnership contract except that in this there is no equity
partnership but only profit and loss sharing. Its counterpart in conventional business
structures would be limited partnership. One can think of bank deposits as a case of a
Modaraba contract between the bank and the customer. In this contract the bank lends
the entire capital to the investor/consumer (debtor) and the financial losses of the
debtor entrepreneur are borne entirely by the bank. Only in the event of
mismanagement or neglect is the customer held liable for the losses.
The Modaraba contract is reflected in the balance sheet of the bank on both the
asset and the liability side. On the liability side it is an unrestricted Modaraba in which
the depositors agree that the bank is free to choose the investments that it will make
with their deposit money and agree to share the profits earned by the bank. On the
asset side it is a restricted Modaraba contract because the bank agrees to finance a
particular (restricted) investment need of the customer and to share a percentage of the
project’s associated profits

5. Salam (sales contract)

Salam is a sale of a commodity whose delivery will be in a future date for a cash
price, which means, it is a financial transaction in which price is advanced in cash to the
seller, who abides to deliver a commodity of determined specification on a definite due
date. The deferred is the commodity sold and described (on liability) and the immediate
is the price. In other words, a Salam sale contract is a futures contract.
The practical steps in the Salam sale are as follows. The bank: pays the price in
the contract to the seller so that he can have the immediate use of funds to cover his
financial needs. The seller abides by the contract to make a delivery of the commodity
on the specific due date. At the time of delivery on the specific due date the bank has
several options to choose from: the bank receives the commodity on due date, and sells
it either for cash or on credit; or it can authorize the seller to sell the commodity on its
behalf against fees (or without fees); or it can direct the seller to deliver the commodity
to a third party (the buyer) according to a previous promise of purchase, where the
promise is that the buyer will purchase from the bank. Once the delivery has been
arranged by any of the above mentioned options, the commodity is sold through a sale
contract between the bank and the buyer. In this contract, the bank agrees to sell the
commodity for cash or a deferred price higher than the Salam purchase price paid by
the bank to the seller. The buyer agrees to purchase and to pay the price according to
the agreement.
The Salam sale can be used to meet the capital requirements as well as cost of
operations of farmers, industrialists, contractors or traders as well as craftsmen and
small producers.
The bank benefits from entering into a Salam contract with a seller because
usually a Salam purchase by the bank is cheaper than a cash purchase. Due to this
reason the bank is secured against price fluctuations, barring those extreme
circumstances of a price deflation or a market crash when post Salam prices could dip
lower than currently contracted Salam sale prices.

6. Ijara (leasing contract)

As is well known, leasing is designed for sale of vehicles, equipment or property
for conducting business. Unlike traditional banking where the bank allows the customer
(buyer) to lease goods at fixed interest rates, the Islamic leasing facility has two sub
contracts. First, the bank signs a purchasing contract with the seller for the commodity
which the buyer wishes to lease. The bank pays the seller and then gets the commodity
delivered to the buyer from the seller. Second, the bank signs a lease contract with the
buyer in which commodity is leased to the customer allowing him the ownership (or
simply the use) of the asset after payment of lease installments and residual charges.
The lease option is commonly used for transactions in real estate, cars, computers,
machinery and equipment.

7. Qard-e-Hasna (benevolent loan or interest free loan)

Islamic banks provide such a facility on a limited scale to poorer sections of
society such as needy students or small rural farmers. Such loans would have negative
NPVs for the banks. Traditional banks do not have any such benevolent loan structures.
Any benevolence is only manifested through charities and grants or scholarships, but
not through non-returnable zero interest loans. The next section outlines the risks
associated with various Islamic modes of financing discussed above.

Islamic Muamalat
After taking out the types of muamalat (transactions) that are prohibited, those
that are permitted can be divided in three broad categories that are being practiced in
Islamic Banks all over the world.
1. Trading Contracts
2. Contracts of Profit Sharing
3. Supporting Contracts

Trading Contracts
Some of the most wisely used transactions are;
Cash Sales
(i) Normal cash sales
(ii) Sarf (foreign currency exchanges)
 (iii) Exchanges between ribawi materials of different kinds and of the same basis
(gold with money or wheat with palm oil)
(iv) Bai Al-Dayn (debt trading as in Bills of Exchange)

Deferred payment sales (debt financing)

(i) Bai Murabahah (cost plus)
(ii) Bai Tawliyah (novation)
(iii) Bai Wadhiah
(iv) Bai Salam
(v) Bai Istisna’a (sale by order)
(vi) Bai Bithaman Ajil (deferred payment sale)
(vii) Bai Istijrar (supply or whole sale financing)
(viii) Bai Inah
(ix) Ijarah (leasing)
(x) Kiraa’ Waqtinaa’ (leasing then procurement)

Contracts of Participation
Contracts of participation (equity financing/ profit sharing) are:
(i) Musharakah (joint venture profit sharing)
(ii) Mudharabah (trustee profit sharing)
(iii) Muzaraah (leasing of land for agriculture)
(iv) Musaqat (watering of orchard)

Supporting Contracts
The Shariah also permits contracts to support and facilitate trading and
mobilization of capital. These contracts are:
(i) Rahnu (mortgage)
(ii) Kafalah (guarantee)
(iii) Wakalah (agency)
(iv) Wadiah (safe custody)
(v) Qardh Hasan (benevolent loan)
(vi) Hiwalah (transfer of debt)
(vii) Tabarru’u (donation)
(viii) Hibah (gift)
(ix) Wakf (endowment)
(x) Ibraa’ (rebate)
(xi) Muqasah (set-off)

Banking Contracts
 - In Islamic banking the following contracts may be applied in mobilization of
deposits:
(i) Musharakah for shareholder’s fund
(ii) Mudharabah for customers’ investments
(iii) Wadiah for safe custody and
(iv) Qardh Hasan
- For uses of funds all the contracts of debt financing and equity financing may be
applied.

Different Features of Contracts

Bai Bithaman Ajil
A sale with the payment of the selling price deferred to an agreed later date.
- The merchandise exists at the time of contract.
- The Shariah does not require that the cost price be known to the buyer.

Ijarah
A sale of the use of another’s property.
- The property rented belongs to the lessor.
- The lessor has the right to repossess the property on default of the lessee.

Ownership of Assets
The purpose of contracts is to obtain ownership of asset or the ownership of
benefits of the assets. Where there are two contracts, one immediately following the
other proper sequence in their executions must be followed.
This sequence applies-
- in refinancing (Bai Inah)

- in Ijarah facility where the asset must be purchased for the Ijarah or the asset must be
leased for secondary lease

Real Sale and Purchase

In contracts of exchange there must be real buying and selling to make them
valid:
- there must be mal (assets) being exchange with assets.
To make contracts real and valid they must have essential elements with their
necessary conditions.

1. Contract of Sale
2. Contract of Leasing
3. Bai Inah
Bai Inah must meet the following requirements:
1. There must be two separate contracts properly executed. 1st the contract of sale
by bank to customer on deferred payment terms. 2nd the contract of repurchase
by bank from customer on cash terms.
2. The merchandise or the asset must not be a ribawi material in the medium of
exchange category (gold, silver or currency) because all payments for purchases
are made in money.
3. Each of the two contracts must have the essential elements and each of the
essential element must meet the necessary conditions.

Bai Dayn
The requirements of Shariah concerning Bai Dayn are:
1. A debt must have been created through a contract of deferred payment sale of
goods or service.
2. The goods must have been delivered or the service must have been rendered.
3. The trading of the debt must be on cash terms.

Musharkah and Mudarabah

Musharakah is a general partnership whereby two or more parties into a
contract to exploit their labor and capital jointly and to share the profits and losses of
the partnership.
Mudharabah is a contract where the owner of capital entrusts his funds to an
entrepreneur who contributes skills in a business and the profits generated is to be
shared between them.

Wadiah
There are two forms of Wadiah:
1. Wadiah Yad Amanah (Trustee Safe Custody)
2. Wadiah Yad Dhamanah (Guaranteed Safe Custody)
Originally Wadiah is of Yad Amanah where the custodian has the duty to protect the
property by:
1. Not mixing or pooling the properties (money) under his custody.
2. Not using the properties.
3. Not charging any fees for safe custody.
If he failed in any of the above Wadiah changes to Yad Dhamanah where:
- he has to return (replace) the properties to the owners if they were lost or destroyed.

Qardh Hasan
In giving Qardh Hasan the two following matters must be observed:
1. The lender must not impose any extra payment in the contract.
2. The borrower must not promise in the contract to pay anything extra.

Ibraa’
Ibraa’ is where a creditor lets go of his right to a debt. Normally it is given for
early settlement of debt.
Two of the most important characteristics of Ibraa’ are:
1. The amount of Ibraa’ must be known and specified, and
2. When the Ibraa’ is given and accepted it is forbidden and invalid for the party
who gives to withdraw it.