Introduction to Islamic Finance

Islamic banking is interest free banking, in which there is no fixed rate of return. Islamic
banking is the banking system which is run in accordance with the Islamic laws and the Shari
a` board; that guides the institutions. This Shari a` board authorizes the products that
whether these are Shari a` compliant or not. Islamic banking is the banking that is guided by
Islamic law ( Shari a`) principles and guided by Islamic economics. In particular, Islamic law
prohibits usury, the collection and payment of interest.

Riba: Islamic banking also finds its roots in Islamic finance and all type of transactions are
interest free and of risk sharing. The interest is prohibited in Islamic ways of banking as it is
also obvious from Quran.
In Quran, in Sura Al-Imran, Allah said that; “O you who believe! Do not devour Riba
multiplying it over and keep your duty to Allah that you may prosper” (3:130). Same kind
of prohibition regard fixed interest is also lead in Sura Al-Rum(39) , Al-Nisa(160-161) and Al-
Baqarah(275-281) of Quran.

Riba and Gharar are illegal under Islamic law. Riba refers to fixed rate of interest. Gharar
refers to speculation. Islamic banking shows dramatic improvements and developments in
Pakistan. Islamic banking is taken as national policy and it is supported but there exist dual
banking structure in the Muslim countries. Mostly the banks of conventional system are also
opening their separate Islamic banking divisions and branches

The expectation of increase in growth of networking of Islamic banking system is increasing.

The Islamic banking has increased in terms of branches, deposits, capital funds, sources. The
ratio of income to expenses is high which indicates increasing profitability of the sector.

Riba literally means increase, addition, expansion or growth. It is however not every
increase or growth, which is prohibited by Islam. In shariah, Riba technically refers to the
premium that must be paid without any consideration. 

Equity Based Financing:

Under Islamic Banking there are two main fields of financing. One is Equity Based Financing and the
second is Debt Based Financing. These modes of financing primarily differ from conventional
financing due to their voidance of interest.

Equity Based Financing –

 profit-and-loss sharing (PLS)Musharaka (Sharing, Equity/Business partnership, Joint Venture)

 Mudaraba (Trustee/Limited/Investment Partnership)

1.  Musharaka (Sharing, Equity/Business partnership, Joint Venture)

Two or more parties come together and contribute funds in a partnership. Partners share in
the profit or loss of a joint venture.The profit-ratio is determined according to the
agreement of the partners and not necessarily according to their capital contribution. This
could depend on how much each partner contributes to the partnership beyond their capital
share. However, the losses must be determined according to the percentage of one’s share
in the investment. Scholars agree (Ijma’) on the equal division of loss i n accordance with the
ratio of each investor. The profit returned to each partner should reflect the actual profits
made by the enterprise as opposed to a set income. Partners may contribute cash or assets
towards the partnership. Their contribution ratio should be determined according to the
value of the assets.
1.1 Home purchase/Diminishing Musharaka – This method can be used in purchasing property or
assets such as machinery for a factory. For example, under a diminishing Musharakah contract, the
bank (or financier) and the client become partners.The client must provide a significant amount of
funds e.g. 20% to purchase the house with the bank. The bank in this case owns the other 80% which
the client will pay over time in installments. Since the client will be living in the house, they will pay
(on top of the installments) a certain percentage (e.g. 8%) in rent (ijarah) to the bank for the share
the bank owns.Over time, the client will own more equity in the house until it is completely bought,
while the rent will decrease as the bank’s share diminishes.

2. Mudaraba (Trustee or Investment Partnership)

Such a contract requires one partner with the funds, known as Rabb-ul-Mal (Owner of
Wealth), and one partner is the Mudarib (Entrepreneur, Fund Manager). There can be more
than one Mudarib to work together as partners with the Rabb-ul-Mal.If the business or
project is a success, the profit is shared according to a pre-agreed ratio. Typically, the Rabb-
ul-Mal bears the risk of losing money, while the Mudarib loses time and effort if the project
does not bear fruit.The Rabb-ul-Mal may specify where they want the Mudarib to invest
their money (Al-Mudaraba Al-Muqayyada – specific or restricted Mudaraba, eg. Specific type
of business of place). Otherwise, the Mudarib is free to invest where they best see fit (Al-
Mudaraba Al-Mutlaqa – unrestricted or general investment (Mudaraba), unrestricted by
time, place, activity and so on).
Debt-Based Financing or non-PLS Modes:

The following instruments are the most commonly used within IBF. They are the Shari’ah compliant
alternatives to interest based modes of financing.

1. Murabaha (Cost Plus Sale)Implies a mark-up in price. The merchandise is purchased, the buyer
marks up the price and sells it to the customer and thus benefits from the profit.Bai’ bithaman ajil
(BBA)- Murabaha (deferred payment) In the case of financing, Murabaha is the useful alternative to
conventional loans when it is combined with Bai’ bithaman ajil (BBA). Bai’ bithaman ajil (BBA) means
sale with deferred payment and can also be known as Bai’ Al-Mu’ajjal, which carries the same
meaning.

BBA and Murabaha are similar concepts and are often used interchangeably, where Murabaha is
used for short term and BBA represents long term credit sale.When a customer seeks to purchase a
product and is unable to pay up-front, the customer may require the bank (or financier) to purchase
the product. Thereafter, the bank (or financier) sells the product to the customer who will pay at a
later date, in full or by installments (BBA), with a mark-up in price. The profit is a fixed amount
agreed upon at the commencement of the contract. Under a Murabaha contract, both parties are
aware of the original price as well as the mark up price. This is different from a typical everyday sale
(Musawama) where costs and profit are not disclosed (like buying from the shop).
2. Ijarah (Leasing)Leasing entails that ownership remains that of the lessor and is to be transferred
to the lessee by way of usufruct (i.e. the right to use it). The lessee pays the lessor for the duration of
the contract at an agreed amount.

Upon the close of an ijarah contract: The lessee may return the assets to the owner. The lessee
may sign another contract to continue leasing.The lessor may offer to sell the assets to the lessee
under another contract. This is known as Al-Ijarah Thumma Al-Bai’ (AITAB).The lessor may give the
asset as a gift to the lessee. This is referred to as Al-Ijarah Muntahia Bittamleek (a contract of leasing
ending with ownership).Ijarah cannot be applied to money, or perishables (food), or other things
that can be consumed (such as fuel).Ijarah can also be used in reference to the services given by a
person (such as a lawyer) who is paid by the hour for their services.