Transcript 6. Islamic Modes Of Financing

Islamic modes of Financing
Essentials of Islamic Banking and Finance
IQRA University Gulshan Campus
IRSHAD AHMAD AIJAZ
[email protected]
Essentials of Islamic Finance – IU Gulshan Campus, Slide # 1
Contents of the lecture
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Mode of financing;
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Islamic modes;
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Trade based modes of Financing;
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Rental based mode of financing;
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Participatory mode of financing;
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Q & A;
Essentials of Islamic Finance – IU Gulshan Campus, Slide # 2
Mode of financing
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Mode of financing:
– Mode of financing means way of supplying funds to those who need
funds;
– Supply of fund from a financial institution to a company is called
financing;
– Conventional banks supply funds under one and only mode of financing
that is LENDING of money;
– Every banking product, whether it is a car loan, industry loan,
investment loan, personal loan or a governmental loan, is offered under
this mode;
Essentials of Islamic Finance – IU Gulshan Campus, Slide # 3
Islamic mode of financing
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Islamic mode of financing:
– Islamic modes of financing mean the way of supplying funds that is
acceptable to Islam;
– As we have learned Islamic mode of financing could not be based on
lending of money as lending of money is not a remunerative way of
financing;
– Prohibition of interest does not allow utilization of loan/lending as mode
of earning;
– Therefore, there must be a way of funding that does not contain element
of interest;
– There are three type of financing available under Islamic concept of funds
supply:
 Trade-based
modes of financing;
 Rental-based mode of financing; and
 Participation-based of financing;
Essentials of Islamic Finance – IU Gulshan Campus, Slide # 4
Financial activities
Capital provisioning
Exchange of goods or services
Murabahah (cost disclosed
sale)
Ijarah (services rendering)
Non-remunerative
Remunerative (partnership based financing)
Partnership
Loan
Salam (future sale)
Gift
Permanent
Musawamah (simple bargain
sale)
Temprory
Istisnaa' (Manufacturing Sale)
Essentials of Islamic Finance – IU Gulshan Campus, Slide # 5
Trade-based modes of financing
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Trade-based mode of Financing means a way of financing in which
Islamic banks provide financing through sale and purchase of
commodities and assets;
Trade-based modes are secure modes because they create debt and
payables upon debtors/customers;
Islamic banks buy a commodity/asset (directly or through its
agent) from the market and sells it to customers on deferred
payment basis (instalments);
The agent may be a an employee on Islamic bank, a third party or
the customer himself as well;
All conditions should be observed carefully in sale financing.
Essentials of Islamic Finance – IU Gulshan Campus, Slide # 6
Trade based modes of Financing
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There are four kinds of Trade-based modes of financing which are
very common:
– MURABAHAHA;
 Cost+profit
transaction in which both are disclosed to the buyer;
– MUSAWAMAH;
A
simple sale transaction in which a price is quoted to customer without any
disclosure to the buyer;
– SALAM;
A
kind of sale in which price is paid in advance for a specific commodity to
be delivered in future;
– ISTISNAA';
A
sale transaction for assets that require manufacturing.
Essentials of Islamic Finance – IU Gulshan Campus, Slide # 7
Trade based modes of financing
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The customer expresses its wish to buy a certain thing from the
bank and the bank buys it from market and sells it on instalments;
All modes follow laws and rules of Islamic Sale contract with little
or no modifications;
Each mode has separate set of additional rules which needs to be
followed strictly;
Any error may lead to make the transaction a void sale;
Credit Risk is lower in this kind of financing therefore Islamic
Banks prefers it;
The rate once fixed in these modes could not be changed;
The concept of credit sale applies here in these modes;
Islamic banks earn money through cash purchase and credit sale;
Profit is difference between cash purchase and credit sale;
Essentials of Islamic Finance – IU Gulshan Campus, Slide # 8
Trade based modes of financing
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Sometimes it is argued that the time has effects on calculation of
profit in case of credit sale;
We will analyze this question in following slides;
Essentials of Islamic Finance – IU Gulshan Campus, Slide # 9
Price difference in Credit and Cash sale
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A common question to Islamic banks: Why the price is high
in case of credit sale? This excess is as good as charging of
interest;
But the question is too simple to reply;
The main concept is that: is there any room for time in
pricing?
Meaning can a seller consider 'time' as one of the decisive
factor for pricing a commodity or asset?
The answer is yes, the is one of the main factors that play role
in determining the price;
The difference of price between whole sale and retail is due
to volume which is turnover of X (quantity) in a given time;
Essentials of Islamic Finance – IU Gulshan Campus, Slide # 10
Price difference in Credit and Cash sale
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The fast moving or perishable items are not charged high
profit and return;
Slow moving and storable items are charged higher profits
and return;
The reason is 'TIME';
So the time is not something that should always be neglected
in pricing or determining the value;
The generic vale of interest is its linkage with time and not
with real assets and commodity;
If the time increases the value will follow suite.
Essentials of Islamic Finance – IU Gulshan Campus, Slide # 11
Fixation of return/profit in trade-based
modes
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Non-fixation of price in a Sale transaction means no precise
determination of price which is an essential element of
Islamic Sale Contract;
So non-fixation in sale is not allowed;
While fixation in partnership is as good as considering
something unconfirmed as confirmed which is no doubt
injustice with one of the pertners;
So non-fixation here is the acceptable way.
Essentials of Islamic Finance – IU Gulshan Campus, Slide # 12
Fixinf of return/profit in trade-based
modes
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A repeated question is that the return/profit is fixed in tradebased modes of financing while Islam prohibits fixinf of
profit;
So what about famous Islamic concept of non-fixation of the
profit rate?
The actual reason of prohibition is not FIXATION or NONFIXATION;
In fact the element of GHARAR is not acceptable in financial
transaction;
Gharar sometime appears in fixation and sometime in nonfixation.
Essentials of Islamic Finance – IU Gulshan Campus, Slide # 13
Murabahah and Musawamah
Essentials of Islamic Finance – IU Gulshan Campus, Slide # 14
Murabahah – definition and
concept
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Murabahah is one of the kinds of sales;
It comes under trade-based modes of financing;
Murabahah means selling a commodity or asset on “disclosure of
cost and profit” basis, which means the seller discloses the cost and
the added profit to buyer;
So the distinguishing feature of Murabahah from ordinary sale is
that the seller is bound to discloses the cost and profit both to the
buyer.
If he does not disclose the cost the sale will not be a Murabahah
sale;
Essentials of Islamic Finance – IU Gulshan Campus, Slide # 15
Murabahah – definition and
concept
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The seller (bank) sells a specific commodity or asset as per the laws
and rules of Islamic sale (pertaining to Price, Subject Matter,
Wordings and Contractors);
The cost and profit are disclosed to the buyer;
The buyer shows his agreement with the price for that commodity
/asset;
Lastly the buyer takes delivery of the asset (possession, physical or
constructive) and the sale is concluded;
The payment of price should be according to the rules and laws set
for Islamic sale and purchase;
As per the rules set for sale and purchase either the price or the
delivery of the sold goods (not both) could be deferred;
Essentials of Islamic Finance – IU Gulshan Campus, Slide # 16
Murabahah – definition and
concept
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As any other sale the payment of Price in Murabahah could be in
three ways:
– Spot payment (Al-Bai' ul Muajjal - immediate delivery and payment);
– Deferred for a specific future date (Al-Bai' ul Muwajjal - full payment at a
future date);
– Deferred for a period of time (Al-bai' ul Muwajjal - sale on instalment
basis – payment in tranches, similar to purchase on instalments);
Essentials of Islamic Finance – IU Gulshan Campus, Slide # 17
Murabahah – definition and
concept
 As we have discussed Islamic bank is one of the players in financial
markets;
 Therefore product of Murabahah used in Islamic Banking as a mode
of finance is slightly different from a simple Murabahah used in normal
trade.
 Banking Murabahah is a contract wherein Islamic Bank purchases a
commodity or an asset from a third party (supplier/ vendor);
 This purchase happens upon request of the customer;
 After purchase of the required asset Islamic bank sells the same to the
customer usually against a deferred payment [Bai Muajjal] (sale on
instalments);
 The whole process is called “Murabahah to the Purchase Orderer”;
 It is a bunch of contracts completed in steps and ultimately suffices
the financial needs of the customer.
Essentials of Islamic Finance – IU Gulshan Campus, Slide # 18
Murabahah – definition and
concept
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Some important features of the Murabahah are:
– As Banking Murabahah is a kind of sale, there must be a seller (bank)
and a buyer (customer) and something that could be bought and sold;
– In such transactions the Bank is the seller, the customer is buyer and a
commodity/goods are exchanged between them;
– In case there is nothing that could be sold and purchased Murrabahah is
not possible;
– WC finance /Overheads financing etc. etc. are not possible under
Murabahah since there is no sale and purchase.
– Because it is a sale from bank to customer the Bank is required to
purchase the commodity directly or directly from the market/seller
before selling it to the customer;
Essentials of Islamic Finance – IU Gulshan Campus, Slide # 19
Process flow
Essentials of Islamic Finance – IU Gulshan Campus, Slide # 20
Murabahah – step by step
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Step # 1:
– Client and Bank sign an agreement to enter into Murabahah.
BANK
AGREEMENT TO MURABAHAH
CLIENT
Essentials of Islamic Finance – IU Gulshan Campus, Slide # 21
Murabahah – step by step
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Step # 2:
• Client appointed as agent to purchase goods on behalf of Bank;
AGREEMENT TO MURABAHAH
BANK
CLIENT
AGENCY AGREEMENT
Essentials of Islamic Finance – IU Gulshan Campus, Slide # 22
Murabahah – step by step
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Step # 3:
• Bank gives money to directly to supplier or to the client for purchase of
goods;Client appointed as agent to purchase goods on behalf of Bank;
AGREEMENT TO MURABAHAH
BANK
CLIENT
AGENCY AGREEMENT
PAYMENT OF PRICE OF GOODS TO THE
SUPPLIER OR AGENT (COUSTOMER
OR THIRD PARTY)
SUPPLIER
Essentials of Islamic Finance – IU Gulshan Campus, Slide # 23
Murabahah – step by step
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Step # 3:
• Client pays agreed price to bank according to an agreed schedule. Usually
on a deferred payment basis (Bai Muwajjal) in tranches;
BANK
PAYMENT OF PRICE IN AN
AGREED PERIOD OF TIME
AND INSTALMENTS
CLIENT
Essentials of Islamic Finance – IU Gulshan Campus, Slide # 24
Application
Essentials of Islamic Finance – IU Gulshan Campus, Slide # 25
Murabahah – Application
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Murabahah can be used to finance the real purchase needs of
customer;
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It could be used for assets which are acceptable to Shari’ah and has
a tangible form.
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Therefore, Murabahah can be used to finance the purchase of:
– Raw Material;
– Equipment;
– Consumer Goods;
– Personal loans;
– Credit cards.
Essentials of Islamic Finance – IU Gulshan Campus, Slide # 26
Musawamah
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Musawamah is also one kind of sale;
Musawamah is also one kind of sale;
This is a simple sale we do in our daily routine life;
The difference is that the quoted price does not require any breakup of cost and profit;
All other details are same as for Murabahah;
The process flow is also same and the payment method may also be
of same nature.
Essentials of Islamic Finance – IU Gulshan Campus, Slide # 27
Questions
Essentials of Islamic Finance – IU Gulshan Campus, Slide # 28