Islamic Economics and Finance

Philosophical Foundation & Shari’ah compliant Business Shariah compliant Insurance Contemporary Subjects &
Islamic Financial Market
Basic Rules & Financial Contracts (Takaful) Shariah Compliance

Foundation & Basic

Concepts Murabahah Islamic Equity Market (Overview)

Islamic Economic System Salam & Istisna’a Money Market – Islamic Perspective

Sources of Shari'ah Ijarah Capital Market – Islamic Perspective

Key Prohibitions Mudarabah Shariah Compliant Stocks

Islamic Law of Contracts Screening of Shariah Compliant stocks

and Sale Musharakah
MURABAHA – Salam – ISTISNA’A
CHAPTER 6
 Contents

 Introduction
 Shari’ah compliant modes of transaction (Trade based – Deferred Sale)
a) Murabahah
b) Salam
c) Istisna’a
 Introduction

 Contracts based on future execution (deferment) of transaction are generally not accepted in Islamic
commercial law.

However, there are three exemptions to this ruling:

1. Murabahah

2. Salam

3. Istisna’a
 COST + PROFIT
Contract Type 1
(MURABAHAH - ‫)مرابحة‬
 Introduction

 Islamic finance requires each financial transaction to be linked to a real asset.

 When commodities are traded for credit, an excess can be charged according to the majority of Muslim
scholars.

 Thus, the seller can charge a different price for a cash sale or a credit sale, where the credit sale price
would be higher.
 Cont ….

In Islamic commerce, sales can be classified according to delivery and payment as:

1. Immediate delivery with spot payment.

2. Immediate delivery with deferred payment.

3. Immediate payment with deferred delivery.

 Types of Sales

Sales can also be classified based on disclosure of cost to the customer as:

1. Musawamah or bargain sale (‫اومة‬.‫ع المس‬.‫)بي‬: In this sale, the seller and buyer agree upon a price without
any reference to the cost, because a seller is not obliged to reveal it. When we buy something from a
shop we are aware of the price but do not know the cost. We either decide to buy at the given price or
try to bargain on the price.

2. Murabahah or trust sale: It is the sale of a commodity at the price the seller has purchased it, with the
addition of a stated profit known to both the seller and buyer. In short, it is a cost-plus-profit sale in
which the seller expressly discloses the profit.
 Murabahah

 Murabahah is a term derived from the Arabic word ‘Ribh - ‫ ’ربح‬meaning profit or gain acquired from
trading.

 Murabahah is also called trust sales, since the distinguishing feature of Murabahah from regular sales is
that the seller discloses the cost to the buyer and a known profit is added; the buyer puts their trust in
the seller to buy the required item and to disclose to the client the quality or specification of the item and
the actual cost as well as the markup added.
 Murabahah

There are two types of Murabahah.

a) Ordinary Murabahah: The client asks the bank to acquire an asset that they would like to purchase
without making any promise to buy it.

b) Murabahah sale with a promise (Murabahah to the purchase orderer): The client makes a promise
to buy the item once the bank acquires it. This type is more common as Islamic banks want to
guarantee that the client will buy what they asked the bank to acquire for them.
General Conditions

Primary Condition
 Must posses the elements of valid sale.
 Goods must be existing and in either constructive of physical possession of the seller.
Goods Subject to Murabaha Sale
 Tangible Items
 Intangible Items
Costs related to Murabaha
 All direct and indirect costs must be in knowledge of both parties
 Both parties must agree on the price.
Mark-up or Profit
 Fixed or percentage of the cost of the Murabaha item.
 Must be clearly stated (cost and profit)
The seller of the Good
 The seller must be a third party.
Defect
 The defects must be disclosed by the seller
 Risk of loss or any concealed defect in the asset is borne by the Bank.
Ownership
 Bank is the owner of the assets
 Ownership risk belongs to the bank unless the ownership is transferred to the client
Advance payment
 Advance payment made by the client becomes the part of the total price of the asset.
Delivery of the item
 Delivered to the client immediately and the ownership is transferred

Repayment
 Spot or deferred

Security
 Asset of the murabaha contract can be treated as security
 Lien on the basis of hypothecation or mortgage.
 Third party guarantee (fee issue)
 Promissory note

Rollover
 Rollover is possible however the price cannot be revised.

Delay in Payment
 No extra amount could be charged.
 If a solvent client fails to pay  legal action
 If insolvent  leniency
Application of Murabaha

 1. Retail finance.
 2. Working capital financing.
 3. Business medium and long-term financing
 4. Syndicated loans.
 5. Trade finance.
 Murabahah Process

(1a) Buy/Sell Agreement

Customer of (6) Deferred Payments (Murabahah Price = Cost + Profit) in lump Islamic Bank
Goods sum or instalments.

(1b) Agency Contract

(2a) Deal of Goods by the (5) Physical Delivery (4) Title of Goods
customer as agent of of Goods Passes to Bank
Islamic Bank

(3) Full Payment against

purchase of Goods
Supplier of Goods
(Vendor)
 Issues in Murabahah

1. Interest alike, Use of Interest Rate as Benchmark and 6. Penalty of Default

uncertainty in using benchmark
7. Absence of Rollover in Murabahah (rollover
2. Promise to Purchase (one cannot sell a commodity
without any change in price)
not owned by him nor can he effect a forward sale.)
3. Ownership risk remains with the bank until 8. Rebate on early payment (voluntary)
Murabaha agreement Is signed.
9. Rescheduling of Payments in Murabahah
4. Securities against Murabahah Price (seller/financier (without change in price or currency)
may ask the client to furnish a security to make sure
that price will be paid on the due date. Mortgage, 10. Tax Implications
pledge or hypothecation)
11. Securitization
5. Guaranteeing the Murabahah (bank asks the client a
guarantee from a third party. However, 1) The
Guarantor cannot charge a fee from original client. 2) The
Guarantor can charge for expenses related to
Documentation.)
12. The cost of Murabaha
 Must be Money 1  Money 1
 However due to international trade the situation may be different.
 First, buy in dollars and sell in dollars
 Second, convert the foreign currency into local at the time of the sale.
 If the bank purchase commodity from foreign country on deferred payment and sell it to the
customer. There can be fluctuation in dollar rate how to fix the price?
 Bank should pay in full OR
 Sell to the client in Dollars OR
 Use bai al muajjal for such contracts
 Murabahah, Tawarruq, Bai’ Inah

 In case of Murabahah the customer owns the assets at the end of the tenure.

 In case of Tawarruq a customer sells the commodity under transaction to a third party immediately after its
possession to create required cash.

 Bai' al-'Inah (Sale with Immediate Repurchase) - A Shariah principle involving the sale and buy-back transaction
of assets by a seller. A seller sells an asset to a buyer on a cash basis and later buys it back on a deferred payment
basis where the price is higher than the cash price.
Murabahah, Tawarruq, Bai’ Inah

Bai’ Inah Process

 Difference between Murabahah, Tawarruq & Bai’ Inah

Elements Murabahah Tawarruq Bai’ Inah

May or may not be the To get money rather than
Objective To buy a commodity
commodity commodity

Contracting Parties Two parties involved Three parties involved Two parties involved

Commodity Kept by the buyer Sold to third party Sold to its original seller

Contract Sale arrangement Financing arrangement Financing arrangement

Shariah approval Approved Disliked Majority (disapprove)

 Practical Applications of Murabahah

1. Raw Material
2. Inventory
3. Equipment
4. Asset Financing
5. Import Financing
6. Export Financing (Pre-Shipment)
7. Consumer Goods Financing
8. House/Vehicle/Land/Shop Financing
9. Tour Packages
10. Education Packages
11. Securitization
 DEFERRED SALE
Contract Type 2
(SALAM - ‫)بيع سلم‬
 Introduction

According to Shariah rule, a sales contract can be executed only when

a) the item already exists,

b) it is owned by the seller at the time of sale, and

c) is in the physical or constructive possession of the seller.

 Two exceptions to this rule are the contracts of Salam and Istisna’a.
 Salam

According to Shafi’i school

 A sale of well-defined commodity to be delivered by the seller in the future.
Hanbalis define it as
 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.
Malikis school
 A sale in which the capital sum price is paid in advance, and the object of sale is deferred to a specified term.
AAOIFI (Shariah Standard No.10)
A Salam is the purchase of a commodity for deferred delivery in exchange for immediate payment.
 General Ruling of Salam

1. Price of Salam Contract

 It is necessary for the validity of Salam that the buyer pays the price in full to the seller at the time of effecting the sale.
 All the Muslim jurists are unanimous on the point that full payment of the price is necessary in Salam.
 Imam Malik is of the view that the seller may give a concession of two or three days to the buyers, but this concession should not form part
of the agreement.

2. Goods of Salam Contract

 Salam can be effected in those commodities only the quality and quantity of which can be specified exactly.
 Salam cannot be effected on a particular commodity or on a product of a particular field or farm.
 It is necessary that the quality of the commodity (intended to be purchased through Salam) is fully specified leaving no ambiguity
which may lead to a dispute.
 It is also necessary that the quantity of the commodity is agreed upon in unequivocal terms. i.e. quantified in weight or measures.
 Salam cannot be effected in respect of ribawi Items.
 Salam commodity (al musalam fihi) can not be sold before it is received from the seller.
 General Ruling of Salam

3. Delivery Date and Place

 The exact date (with some relaxation of period) and place of delivery must be specified in the contract.
 The date and place can be changed by mutual consent.
4. Buy-Back Condition
 The Buyer cannot demand a buy-back condition from the seller.
 This would require the seller to buy back the goods delivered.
 However, it is possible once the goods are delivered, a separate contract may be executed for such sale.
5. Security & Guarantee
 Mortgage, Hypothecation, performance bond, guarantee.
 In case of failure to deliver goods according to the T&Cs, the security or guarantee may be claimed.
 Claim up to the value of the goods.
6. Penalty
 Delayed in the delivery by the seller.
 Calculated as a percentage per day of delay.
 The penalty needs to be donated to charity.

 Salam Financing Process

Seller AGENT
Ultimate Buyer
(Al-Muslam Illeihi)

Cash Delivery of commodity (Al-

Full Price muslam fihi)
Cash
(on due date)

Islamic Bank
(Al-Muslam)

Buyer Seller
 Practical Applications of Salam

The scope of Salam has been extended from agricultural commodities to manufactured fungibles and trade.
 Risks in Salam

 The seller may default in delivering the commodity at the delivery date. (Credit Risk)

 The price of the commodity may change at the time of delivery. (Market Risk)

 The quality of the commodity can be different from the contract specifications.

 The second party (the second purchaser) may default.

If the seller fails to perform his obligation, the purchaser shall have the following options:

 to wait until commodity is available.

 to cancel the contract and recover the paid capital.

 to replace the commodity by other goods.

 Hedging the Salam Risks

 To minimize risks related to market price, the purchaser may enter into a contract with a third party
through a Parallel Salam who promises to purchase the commodity after delivery at a certain price.

 In a parallel Salam contract two conditions need to meet:

a) Both contracts must be independent of each other.
b) The seller in the parallel Salam must be a third party.
Parallel Salam
 DEFERRED SALE
Contract Type 3
(ISTISNA’A - ‫)استصناع‬
 Introduction

 Istisna’a is a deferred sale contract.

 It is a second exception to the valid sale contract (i.e. the general condition of a sale that states the
goods intended to be sold must be in the physical or constructive possession of the seller.)
 Istisna’a

 The word Istisna’a is derived from the Arabic word Sina’a - ‫َص ْنَع‬, which means to manufacture a
specific commodity.

 It is a contract of sale of specified items to be manufactured or constructed with an obligation on the

part of the manufacturer or contractor to deliver them to the customer upon completion.
 Shari’ah Rules in Istisna’a

 Buy contracts with seller to produce, construct, fabricate, assemble or process any asset in accordance with given:
 Specification
 Quality
 Quantity
 The seller’s raw material, labour and efforts would be utilized.
 All conditions and details must be finalized with mutual consent of both parties.
 Material sourcing – responsibility of the manufacturer
 Price – mutually agreed, any changes can be made with mutual agreement.
 Delivery date and place – as per agreement
 Payment option – multiple options (full in advance, part payments, work in progress payments etc.)
 Cancellation of Istisna’a contract – cannot be unilateral (after the inception of work)
 Shariah Rules in Istisna’a

 Default – can be in four ways

1. Default at the delivery by the seller
 Cannot complete the manufacturing
 Goods manufactured are not meeting the specifications or damaged.
 Buyer can claim the payments made and the damages, if any.

2. Default at delivery by the buyer

 If the buyer defaults in making payments, or refuse to take delivery then the seller has the right to recover the cost
 If the installment paid by the buyer is greater than damages than the seller should deduct the damages and return the surplus
 If the instalment is lower than the damages then the buyer has to pay the rest of amount.

3. Default after delivery by the seller

 When the seller is unable to provide post-construction or after-sale service in such a manner that the asset cannot be used by the buyer as was intended
 The buyer can return the product, claim the contract price and damages.

4. Default after delivery by the buyer

 If buyer fails to pay the due amount.
 In such case the seller cannot recover the asset because the title is passed to the buyer.
 However, damages and dues can be recovered through collateral or security or through court procedure.
 Shariah Rules in Istisna’a

 Penalty
 If the seller fails to deliver on due date then the price of the item can be reduced by the specific amount each day.
 If the buyer make delay in payment, a percentage per day on the delayed payment would be charged.
 Penalty will be donated to charity.
 Security or collateral
 The bank as a seller may ask the buyer to provide security or collateral.
 In case of delay or non-payment the security can be sold by the seller.
 Insurance
 In parallel istisna the manufacturer is responsible for insurance during manufacturing phase.
 After delivery to the client, the bank is responsible insuring the asset.
 Independence of istisna and parallel istisna contracts.
Istisna’a Process
 Parallel Istisna’a

 Parallel phased Istisna’a (PPI). This technique was first introduced by the ABC International Bank, based in the
UK and a subsidiary of the Arab Banking Corporation of Bahrain. Construction projects with Istisna’a can be
risky and expensive, as they are often drawn out over an extended period and subject to various kinds of delay. To
reduce this risk ABC broke the construction period into multiple Istisna’a contracts, each linked to staggered
financing, conditional on the completion of the previous phase.
 Buy, operate, transfer (BOT). Istisna’a can also be used for projects in BOT mode. For example, a government
may contract a manufacturer to build a bridge. Once the bridge is completed, the builder operates it, collecting
toll, which in turn pays off the builder. Once the toll money repays the builder completely, it hands over the
bridge.
 Difference between Salam & Istisna’a

Features Salam Contract Istisna’a Contract

Applied to homogenous goods. May need

Type of Asset Applied to goods that need manufacturing.
manufacturing or not.

Can be sourced from any supplier.

Buyer can recommend a specific
Manufacturer The buyer cannot dictate a specific
manufacturer and supplier of raw material.
manufacturer.

Payment Method Full in advance Various payment options

Can be terminated unilaterally till

Cancellation Cannot be unilateral
manufacturer starts performance.
 Issues in Istisna’a

1. The obligation of the manufacturer is fully dependent upon the specification of the commodity.

2. It is prohibited that the subject matter be already in existence at the time of the contract, or identified by designation
(the subject matter must be identified by specifications only to be manufactured in future).

3. The price should not be changed on account of the normal change in commodity prices or the cost of labour (to
avoid the element of gharar).

4. The raw material of the subject matter should not be supplied by the buyer otherwise the contract becomes an ijarah
and not an istisna’a.

5. In the case of parallel istisna’a two contracts must be independently concluded.

 Practical Application of Istisna’a

Suitable for construction and project financing related to building or manufacturing capital goods such as machinery, vehicle
etc.