ISLAMIC BANKING

2ND HOURLY
SYLLABUS
 Diminishing Musharika  Istisna
 Ijara  Wakala Wada Kafala
 Murabaha  Islamic authorities
 Salam

DIMINISHING MUSHARIKA

Definition:
A financier and his client participate either in the joint ownership of a property or an equipment pr in a joint
commercial enterprise.

Modus Operandi
The share of the financier is further divided into a number of units and it is understood that the client will purchase
the units of the share of the financier one by one periodically, thus increasing his own share till all the units of the
financier are purchased by him so as to make him to sole owner of the property, commercial enterprise as the case
may be.

1. Create joint ownership in the property (Shirkat-al-Milk)

2. Giving share of the financier to the client on rent
3. Promise to purchase the units of share of the financier
4. Actual purchase of the units at different stages
5. Adjustment of rent according to the ownership proportions at given stages.

Shariah Justification
 Hadith: “When two people enter into a partnership the third partner is Allah”.

Utilization in the market

1. House financing – client wants to buy a house for which he lacks adequate funds
 20% of the house price is paid by the client and 80% is paid by the financier.
 Financier owns 80% of the house and client owns 20% but the client uses the house for his residential
purpose and pays rent to the financier for using his part of the house.
 The financier’s 80% share is divided into 8 units of 10% each. The client promises to buy 1 unit after 3
months.
 After 3 months he buys 10% (one unit) of the financier’s share reducing the financier’s ownership to 70%
and increasing his to 30%. The rent payable after that is also reduced to that extent.
 This process continues for two years (8 terms – 3months each) after which the client has purchased all
the units and is therefore liable to no rent henceforth.

2. Carrying business of services - Purchase a taxi for offering transport service but short of funds (person A)
 A & B purchase a taxi jointly where 20% of the price is paid by A and 80% is paid by B.
 The taxi earns 1000Rs daily divided according to the investment proportion – 200Rs to A and 800Rs to B
daily
 Again, the share of B is divided into 8 units that A intends to buy in installments of 1 unit per 3 months.
 After 3 months A purchases one unit becoming 30% owner of the taxi and entitling himself to 300Rs daily.
 This process continues until 2 years at the end of which the whole taxi is owned by A. B gets his whole
investment back along with the income distributed to him during the two years.
Note: The taxi will depreciate over time – therefore depreciation in the value of the taxi must be kept in mind
while determining the price of different units of the share of the financier.
3. Trade- Start a business but short of funds (person A)
 B agrees to participate in the business for 2 years – 40% investment is contributed by A and 60% by B.
 The proportion of profit allocated to each is agreed in the start.
 Again, B’s 60% share is divided into 6 units and A will keep on purchasing them until the end of two years.
 B earns periodic profits and the price of the units of his share which cover his initial investment.

Other Notes:
 Mostly banks use Shrikat-ul-Milk for the benefit of the customer
 The customer does not want the price to be on market rate
 They want the price to be locked for their own benefit
 The price can be re-discussed if the agreement mentions it
 In Shirkat-ul-Milk the price is locked.

IJARAH

Definition:
Two types of ijarah –
1. To employ the services of a person on wages given to him as a consideration for this hired services. (Teacher)
2. To transfer the usufructs of a particular property to another person in exchange of a rent claimed from him.
(generally used as a form of investment or mode of financing)

Main features
1. Subject matter – should be shariah compliant and usufruct. For example a barren piece of land cant be leased
since it does not provide benefit to the lessee.
2. Lease rent – rent is paid in periods. After every lease period the rent can be renewed (floating rates) if both
parties agree on it mutually.
3. Every lease payment will have components of profit and principal. Lease payments can be amortized
4. Sukook- only profit is paid. Principal at the end
5. The lessee is obligated to make lease payments after the asset is delivered to him by the lessor
6. In case of late payment by the lessee extra charges will be paid.

Modus Operandi
 Assets can be sub-leased if mentioned in the agreement.
 The asset is leased out to the lessee. Here the lessor (bank) bears the capital expenses and the lessee
(customer) bears operational expenses.
 Major maintenance is borne by the lessor and the minor maintenance is borne by the lessee.
 The lessor does not have a share in the profit or the losses of assets leased out for the purpose of revenue
making.
 The lessee can is responsible for any loss caused to the assets by his misuse or negligence. He can also be
made liable to the wear and tear that happens to asset during his use.
 Lessee cannot be made liable to a loss caused by factors beyond his control.

Questions:
If there is land sliding who is liable? The loss is divided as per capital.
Customer said ‘ I will live here’ and then put up a factory. The factory caught fire. Now who pays? The customer
pays.
Gari li – if break kharab hogaya tu customer pays – operational expense but if engine kharab hai then the bank will
pay – capital expense.
Aag lag gaye ghar main- the bank wont take rent until ghar set nahe hojata.

Shariah Justification:
  Chapter 6 Ayah 65 – If you hire someone to breastfeed your children to can pay them
 Chapter 7 Ayah 26-28
 Hadith: “Mazdoor ko uski mazdoori uska paseena khushk honay se pehle dou” translated to Give the
worker his wages before his sweat dries.
 Holy Prophet (PBUH) cursed a person who does not work honestly for an employer
Termination
 On the basis of death
 Family members can continue the ijarah by discussing with the bank

Conclusion of Ijarah:
 The rentals will start after the asset has been delivered.

Penalty Charges
 Penalty charges are allowed. They however are not an income of the bank and must be given in charity.
 Bank can also forgive.

Notes:
 Islamic banks are criticized for asking for too much documentation
 A sukook will have 300-700 pages of documentation
 Islamic banks can be hesitant in providing financing new businesses.
 Ijarah is not a sood because money is still a medium of exchange and there is ownership of the assets.
 Insurance is done by the bank and when ownership is completely transferred insurance is given to the
customer as hiba.
 Bank should be informed of any subleasing
 At the end of the lease period bank can give as hiba or sell on nominal value or residual value.

MUSHARIKA VS IJARAH

In diminishing musharika both parties are owners. In ijarah the asset is leased therefore only one party owns the
asset. They can happen together by should be independent of each other and unconditional.

Diminishing Musharika cum Ijarah

1. Buy the house jointly with undivided ownership (first contract)
2. Bank leasing out their owned part
3. Bank starts selling their units

The benefit of having a diminishing musharika cum ijarah is to ensure that the customer also has a stake in the
asset. The ultimate goal is that the customer will become the sole owner.

Notes:
 You cannot mix one contract with another
 You cannot make one depend on the other
 Both are separate and independent contracts
 The bank cannot force the customers to buy the units of the assets
 Contracts are not valid in case of duress.

Summary/Explanation:
Diminishing Musharika is two parties jointly owning an asset with one party purchasing the units to eventually
becoming sole owner – thereby reducing ‘partnership’.
Ijarah is leasing out an asset
Combining them both – one of the parties lends his share becoming a lessor and receives rent in exchange.
Shariah Non-Compliance Risk (SNCR)
 Generally the risk for Islamic banking and conventional banking are the same but in Islamic banking a
major risk is SNCR.
 If this happens then:
1. Amount will go in charity
2. SBP inspection – there could be penalty
3. Internal control etc (Internal and External audits)
 If a bank gets involved in SNCR repetitively it damages the reputation
 Reputational risk can be linked to operational risk
 If a bank gives charity to an NGO that the bank manages – conflict of interest.

MURABAHA

Definition
Murabaha is a particular kind of sale where the seller expressly mentions the cost of the commodity he has
incurred, and then sells it to another person by adding some profit or markup.
Cost plus profit
Lafzi matlab – increase in capital/ profit main izafa

Modus Operandi
 Customer goes to the seller and demands x number of goods. If the seller does not have it the customer
can come back in a few days. The payment can be in cash or through deferred payments (Bai Muajjal). It
can be lump sum or in installments.
 When the payment is deferred the price is pre-determined.
 The profit in murabaha can be determined by mutual consent – either in lump sum or through an agreed
ratio of profit to be charged over cost.
 All the expenses incurred by the seller in acquiring the commodity (freight, custom) shall be included in
the cost. Markup will then be applied to aggregate cost.
 Recurring expenses of the business (salaries of staff/rent) is not included in the cost of an individual
transaction. The profit takes care of this.
 Only valid where the exact cost of the commodity can be ascertained.
Example: A purchases pair of shoes for 100Rs. Wants to sell for 10% markup. Cost in known. Murabaha is valid.
Example 2: A purchases shoes + suit for 500rs. Murabaha is valid for the entire package. A cannot sell the shoes
separately because the cost of it alone is unknown.

Procedure: MPO Murabaha purchase order

1. Client and institution sign an overall agreement. Institution promises to sell and the client promises to buy the
commodities on an agreed ratio of profit added to the cost. (relationship of a promiser and promisee)
2. Institute will buy the asset.
2.1 Bank directly buys it from a wholesaler
2.2 Bank appoints the client as his agent for purchasing the commodity on his behalf – an agreement of
agency is signed by both parties (relationship of a principal and agent)
3. The client purchases the commodity on behalf of the institution and takes possession as an agent of the
institute. (relationship between institute and supplier is of buyer and seller)
4. The client informs the institute that the purchase has been made. Offers to purchase it from the institution.
5. The institution accepts the offer and the sale is concluded. Ownership as well as risk of commodity is
transferred to the client. (relationship between institute and client is of buyer and seller)

Note: If the instituition directly purchases the commodity from a supplier – an agency contract is not needed. (this
is recommended). In this case the third stage institution itself will purchase from the supplier. Fourth phase will be
restricted to making an offer by the client.
Important:
 The commodity must remain in the risk of the institution during the 3-5th stage. It distinguishes murabaha
from interest based transaction. Otherwise murabaha will be invalid.
 Commodity is purchased from a third party. The purchase of commodity from the client himself on a ‘buy
back’ agreement will make it invalid

Basic Features
 Not a loan given on interest. Sale of commodity for a deferred price which includes a profit added on cost.
 Should fulfil all conditions necessary for a sale
 Requires a real sale of commodities and not advancing a loan.
 Financier must have owned the commodity before he sales it to the client.
 Commodity must come into the financier’s possession – physical or constructive

Shariah Justification
Chapter 2 Ayat 282: “when you contract (i.e. when you have or contract a debt) a debt one upon another for a
stated term, then write it down.” Trade is permissible, riba is unlawful.
Surah Muzammil Verse 20

Issues/Risks
 The financier cannot enter into an actual sale at the time the client seeks murabahah financing from him
because the required commodity is not owned at that point. If the asset is sold without ownership – wont
be shariah compliant.(1)
 He is therefore bound to first purchase the commodity from a supplier and then sell to it the client after
having constructive or physical possession.
 If the client is not bound until after the commodity has been purchased the financier faces a risk of the
client refusing to buy it.(2)
 Solution= client signs a promise to purchase the commodity. It is a unilateral promise which binds the
clients and not the financier.
 This solution is subjected to an objection – unilateral promise create a moral obligation but it cannot be
enforced as per shariah.
 Imam Abu Hanifah/ Imam Shafai – fulfilling a promise’s violation is reproachable but it is not mandatory
or enforceable by law
 Other jurists say that a moral is mandatory – promisor is under moral + legal obligation

With the unilateral promise a deposit (token money) is taken. Bank’s loss will be cut from that and the rest will
be returned. Loss includes the actual monetary loss and not any opportunity cost
The client can be an agent and sell the asset to someone else.

Notes:
 If a person sells a commodity for a lump sum price without any reference to the cost this is not a
murabaha even though he is earning some profit on his cost. Why? Because it is not based on a
cost plus” concept. This sale is called musawamah
 The institution may ask the client to furnish a security to its satisfaction for the prompt payment of the
deferred price. He may ask him to sign a promissory note or a bill of exchange but it must be after the
actual sale takes place (Stage 5) – it is signed by a debtor in favor of his creditor and that relation begins
after stage 5.

Questions:
Securitization of Murabaha: Murabaha is a transaction, which cannot be securitized for creating a negotiable
instrument to be sold and purchased in the secondary market. It cannot be sold or purchased at a lower or a
higher price. You cannot make money on money.
Difference between Murabaha and Musawamah
What is meant by undivided ownership of an asset? When two people jointly own an asset but cannot do
divisions or demarcations in an asset. (A & B buy a car. A has two seats B has two seats. A & B buy a house. A gets
bathroom B gets bedroom)
Can interest rates be used as benchmarks? Many institutions determine their markup on the basis of the current
interest rate (mostly LIBOR). If libor is 6%, their markup will be equal to or some percentage above LIBOR. It is not
considered desireable due to its apparent resemblance to interest based financing. However the since the deal
itself does not contain interest the murabaha is considered valid.

SALAM

Background:
 One of the conditions of a valid sale in Shariah- ownership of the commodity intended to be sold.
 This condition has 3 parts 1)commodity must be existing 2)seller should have ownership 3) constructive or
physical possession
 2 exceptions to this general principle are Salam and Istisna

Definition:
Salam is a sale whereby the seller undertakes to supply some specific goods to the buyer at a future date in
exchange of an advanced price fully paid at spot.

Modus Operandi
 Price is cash but supply is deferred
 Buyer is called rab-us-salam and seller is called Muslam ilahi
 The cash price is called ras-ul-mal
 There is sales contract where the buyer makes the full payment. They specify all details regarding date,
quantity, place, and quality. The date of delivery is in the future.

Shariah Justification
 Allowed by Holy Prophet (PBUH) subject to certain conditions. Basic purpose was to meet the needs of
small farmers who needed the money to grow their crops and feed their families upto the time of harvest.
After prohibition of riba they could not take usurious loan. They were then allowed to sell their
agricultural products in advance.
 Traders of Arabia used to export their goods to other places and imports good to their homeland. They
needed money to undertake the business and could not borrow from usurers. They were also allowed to
sell the goods and advance and with the cash price they could undertake the business.
 Hadith: “Whoever wishes to enter into a contract of salam, he must effect the salam according to the
specified measure and the specified weight and the specified date of delivery”.
 Holy Prophet said that in the case of Salam we need to make 100% payment.

Salam Conditions
1. Buyer pays the price in full to the seller at the time of effecting the sale
2. Effected only in commodities where the quality and quantity can be specified exactly (precious stones not
allowed- different in size weight quality)
3. Not effected on a particular commodity or a product of a particular farm (You can say A quality chaunsa
but not specify the fruit from a particular tree)
4. Quality of the commodity should be fully specified leaving no ambiguity that may lead to dispute.
5. Quantity of the commodity should be agreed upon. (what is normally weighed cannot be quantified in
measure and vice versa)
6. The exact date and place of delivery should be specified.
7. Cannot be effected in respect of things which must be delivered at spot. (if gold purchased in exchanged
of silver according to shariah delivery of both must be simultaneous)
Some conditions have a point of difference in different schools of thoughts:
8. Availability of Commodity
8.1 Hanafi says that salam can be effected for the commodity that remains available in the market
from the day of the contract up to the date of delivery.
8.2 Shafi, Maliki and Hanbali say that the commodity must only be available at the time of delivery.
9. Time of delivery
9.1 Hanafi and Hanbali say the time of delivery is at least one month from the date of agreement. (Sellers
need the time of acquire the commodity and concession in price may also be justified only when
commodities are delivered after a period which has some bearing on the prices).
9.2 Imam Malik says the minimum period should be not less than 15 days because the rates of the
market may change within a fortnight.
9.3 Shafi and Hanafi say no minimum time should be specified – parties to fix the date on mutual
consent.

Notes
 Salam beneficial to the seller because he received price in advance
 It was beneficial to the buyer because the price was normally lower than the price in spot sales
 If the salam product is not upto the standard then:
i. Since you have already paid, you can force the seller to buy the products from the market
ii. Contract cancel
iii. Enter into a new contract with the same seller
 Risk management: If the customer does not bring the products can he be sued? Yes he can

Penalty
A penalty can be liable on the seller if there is delay in delivery, which can be calculated as a percentage per day of
delay but needs to be donated to charity

Termination
Salam contract cannot be revoked unilaterally, but only with mutual consent.

Parallel Salam
 The bank enters into two different contracts
 In one the bank is the buyer and in the second bank is the seller
 Each of these contracts must be independent of the other
 Each contract should have its own force and its performance should not be contingent on the other.
 Parallel salam is allowed with a third part only. The seller in the first contract cannot be a purchaser in the
second – becomes a buy back contract – not permissible in Shariah.

Example:
 A purchased 1000 bags of wheat from B through salam – to be delivered on December 31
 A can contract a parallel salam with C to deliver 1000 bags of wheat on Dec 31.
  While contracting parallel salam with C, the delivery of wheat to C cannot be conditioned with taking
delivery from B.
 Even if B did not deliver wheat by Dec 31, A has a duty to deliver wheat to C
 He cannot red himself from the liability to deliver wheat to C
 If B has delivered defective good which do not conform to agreed specifications – A is still obligated to
deliver goods to C according their specifications.

ISTINA

Definition:
Istisna is the second kind of sale where a commodity is transacted before it comes into existence. It means to order
a manufacturer to manufacture a specific commodity for the purchase. If the manufacture undertakes to
manufacture the goods for him – istisna comes into existence.

Condition:
 Price is fixed with the consent of the parties
 Necessary specifications of the commodity intended to be manufactured is fully settled between them

Shariah Justification:
 Prophet (PBUH)’s mimbar and anghooti was made on the basis of istisna

Termination:
 The contract of istisna creates a moral obligation on the manufacturer to manufacture the goods
 Any one of the parties may cancel the contract after giving a notice to the other IF the manufacturer
hasn’t started the work
 If the manufacturer has started the work the contract cannot be cancelled unilaterally.

Parallel Istisna
1) Customer wants a product to be manufactured – specifies all details. Bank approaches a manufacturer
with the same details and gets a quoted price. The bank will add its own profit to the price and quote it to
the customer.
2) If customer accepts the quoted price and delivery time, then enters Istisna contract with the
bank, customer is buyer and bank is the seller.
3) After Istisna contract is completed, bank enters Parallel Istisna with the manufacturer, bank is
buyer and manufacturer is the seller.
4) Delivery time for both contracts usually are the same, bank takes title only from manufacturer,
delivery directly to the customer

DIFFERENCE BETWEEN SALAM AND ISTISNA

 1) The subject of istisna is always a thing that needs to be manufactured – salam can be on anything no
matter it needs manufacturing or not
2) Necessary in salam that the price is paid in full in advance- this is not necessary in istisna ( can be paid in
advance or in tranches)
3) Salam once in effect cannot be unilaterally cancelled. Istisna can be cancelled before the manufacturer
starts work
4) Time of delivery is an essential part of sale is salam – it is not necessary that the time of delivery is fixed in
istisna (2 months extension is very common – the purchaser may fix a maximum time of delivery after the
appointed date after which he is not bound to accept the goods or pay)
5) In salam you cannot change the price (charge a penalty) if there is a delay. In istisna you can say if there is
a delay then price will go down 1%. This amount does not go to charity.

DIFFERENCE BETWEEN ISTISNA AND IJARAH

In istisna the manufacturer is required to make the goods with his own material. If the material is not with him, he
shall obtain the material and undertake the work required to make the ordered goods with it.
If the raw material is provided by the customer and the manufacturer is using his labor and skill only – the
transaction is no longer istisna but becomes ijarah. Here the services of a person are hired for a specific fee paid to
him.

Darzi ko kapre dekar silwana is Ijarah. Jab darzi khud se kapre lekar banaye tu woh istisna hoga.

Supporting Contracts

Wakala – Agency

Shariah Justification : The prophet made a sahabi his agent who bought goods on his behalf
“so send one of you with this silver coin of yours to the city and let him look to which is the best of food and bring
you provision from it ….” (Surah AlKahf, verse 19)

Wakala

Specified General

Free Fee-based

Examples:
Specified: Pani leao Aquafina ka |General : Pani leao
Specified: ye item x rupees main y jaga pe becho |General : ye item bechdo

Notes:
 Can be fee-based (Bank has goods, he can ask a textile person to sell them for a fee)
 If it is fee-based it becomes binding
 Can be either life long or time-bound
 The agent cannot provide any type of guarantee – just representing the principal
 Anything that is beyond the control of the agent – he cannot give the guarantee of
 For example: The agent cannot say im investing in a project and that will surely provide a profit of x%.
Kafala – Guarantee

 The guarantor is obligated to pay the payment if the debtor fails.

 Guarantee cannot be given in a trust based transaction. In a waqalah a waqeel cannot be a guarantor – in
a mudarabah the mudarib cannot be a guarantor.
 This is a third party guarantee
 According to AAIOFI charging a fee for guaranteeing is not allowed. Some shariah scholars have allowed
the guarantor to charge a fee because they have to do somethings, put in effort, do documentation etc
 Kafalah can be seen in the Sunnah of the Prophet Muhammad S.A.W., where Abu Qatadah asked the
Prophet to pray for a man to whom he (Abu Qatadah) had been a guarantor for a debt

Wa’ad – Unilateral Promise

 It is a unilateral promise made by one party in favor of another party
 For example party 1 who is a lessee in a transaction undertakes to purchase the underlying asset on the
maturity if the lease period.
 Binding only on one party only – cannot be bilateral in nature or contractual in nature