INTRODUCTION TO ISLAMIC MODES OF FINANCE

IQRA UNIVERSITY KARACHI – 1 FEB 2016

Size of Islamic Finance

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Size of Islamic Finance

• Estimated Size is set to increase to USD 2 trillion by the end of 2014.

• Assets held by Islamic Banks and FIs continue to grow by > 15% p.a.
• London is competing with Dubai to become the global hub for Islamic
Banking and Finance.
• In January this year, UK became the first non-muslim country to issue
Islamic Bonds worth £200 million – Subscription exceeded USD 3.8
billion = more than 11 times the bonds on offer!
• Hong Kong then raised USD 1 billion through Sukuk offering in
September, followed by South Africa (USD 500 million) and Luxemborg
(USD 254 million).
• State Bank of Pakistan has announced to conduct OMOs in Ijarah Sukuk
which will not be benchmarked against T-bills.
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Legal Battle around Riba Free Finance in Pakistan

• 1991: Federal Shariat Court declared all laws allowing interest

repugnant to the injunctions of Shariah.
• The decision was challenged by the Federation and various banks.
• 1999: Shariat Appellate Bench of the Supreme Court decision;
‘.. It is hereby held that any amount, big or small, over the principal, in
a contract of loan or debt is “riba” prohibited in the Holy Quran,
regardless of whether the loan is taken for the purpose of consumption
or for some production activity.’
‘The present financial system, based on interest, is against the
injunctions of Islam as laid down by the Holy Quran and Sunnah, and in
order to bring it confomity with Shariah, it has to be subjected to radical
changes.’
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Legal Battle around Riba Free Finance in Pakistan

• 2002: In a review petition filed by the UBL and supported by the

Federal Government, the Shariat Appellant bench under Chief Justice
Riaz Ahmed set aside its 1999 judgment and remanded the case back
to the Ferderal Shariat Court.
• 21 October 2013: The case was taken up for hearing by the Federal
Shariat Court ….
• 24 March 2014: Case taken up again …

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Modes allowed under Islamic Financing

1- Musharakah
Original Modes of Finance – Ideal State
2- Mudarabah

3- Ijarah Not originally treated as modes of Finance by

4- Murabaha classic jurists. Contemporary products

5- Salam
Expressly Allowed under Sunnah as modes of
6- Istisna financing
 Asset Types in Islam

Real Monetary
- Intrinsic Utility - Currencies
- Power to satisfy real - Gold and Silver
human needs (Dirham and Dinar)
- No direct functional /
operational utility

Consumable
Non-Consumable - Food & Fuel
- Disappear after
consumption

• No separation of financing from trade and industry

MUSHARAKAH

• ‘Shirkah’ means “Sharing” and in the terminology of Islamic Fiqh ‘A

joint enterprise in which all partners share profit and loss of the joint
venture.’
• It has been divided into two kinds
 SHIRKAT-UL-MILK: joint ownership of two or more persons in a
particular property.
 SHIRKAT-UL-’AQD: a partnership effected by a mutual contract
 Shirkat-ul-amwal (‫)شرکۃ االموال‬: partnership through capital
 Shirkat-ul-A’mal (‫)شرکۃ االعمال‬: partnership through services
 Shirkat-ul-wujooh )‫)شرکۃ الوجوہ‬: partnership through goodwill
• The term ‘Musharakah’ has been introduced recently by those who
have written on the subject of Islamic modes of financing
THE BASIC RULES AND FEATURES OF
MUSHARAKAH

• The capital of Musharakah can be equal or varying among the partners.

• All conditions for a valid contract must apply.
• All assets of Musharakah are jointly owned in proportion to the capital of
each partner who has a right to take part in management.
• No partner can guarantee capital, part of capital, profit or part of profit
to another partner. Any arrangement of exit from a business. partnership
on pre agreed price, would not be permissible.
• The ratio of profit may differ from the ratio of investment. This ratio
must be decided at the time of effecting the contract.
• The share of profit for a sleeping partner cannot be more than the ratio
of his investment.

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THE BASIC RULES AND FEATURES OF
MUSHARAKAH

• The ratio of profit must be determined in proportion to the actual

profit accrued to the business, and not in proportion to the capital
invested by him. It is not allowed to fix a lump sum amount for any
one of the partners, or any rate of profit tied up with his investment.
• In the case of a loss, all the Muslim jurists are unanimous on the point
that each partner shall suffer the loss exactly according to the ratio of
investment. Therefore, if a partner have invested 40% of the capital,
he must suffer 40% of the loss, not more, not less, and any condition
to the contrary shall render the contract invalid.
• At termination, either liquidation or the price of the share of the
leaving partner must be determined by mutual consent. Securitization
is possible to form negotiable instruments after cash is converted.
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MUDARABAH

• Kind of partnership where one partner gives money to another for

investing in a commercial enterprise.
• Establishes and governs the relationship between the investor and
manager (Mudarib).
• Profits are shared on a pre-determined basis.
• Revaluation gains do not accrue to the Mudarib.
• Losses accrue only to the investors and not to the Mudarib.
• Amanah Principles apply; rule of reasonable prudence.
• Mudarib cannot charge a fixed fee / remuneration.
• Musharakah and Mudarabah can be combined – different profit % can
be agreed for both elements.
• May be used for financing a single transaction.
DIMINISHING MUSHARAKAH

• This is a type of Shirkah where one partner purchases the other

partner’s share gradually.

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DIMINISHING MUSHARAKAH

• Bank and the client jointly purchase and own a house. Therefore
according to the ratio of ownership, each one is responsible for the
loss.
• Bank divides its own part of asset into units, which is promised by the
client to purchase on pre-agreed price.
• Each unit will be purchased on the basis of Offer & Acceptance.
• After taking possession of house, bank rents out its share to the client
by execution of Ijarah Agreement.
• Rent may be fixed on prevailing market rate or with mutual consent.
• In Ijarah Agreement, a lump sum amount of rent is necessary to be
fixed for a certain period. Rent for the rest of the period, may be
linked with agreed Benchmark.

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PENALTY FOR LATE PAYMENT OF RENT

• In case of late payment, Islamic Bank cannot charge additional

amount as penalty.
IJARAH

• Transferring of usufruct, not ownership to another person for an

agreed price, at an agreed consideration (employment, leasing).
• Item of lease must be non-consumable.

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IJARAH

• Ijarah agreement does not contain a condition of sale or gift at the

end of lease period and lessor bears the responsibility of lessor and
assumes the full risk of the corpus of the leased asset.
• Unilateral promise to buy can be made, binding on the promisor only.
• The rental must be determined at the time of contract. Permissible
that different amount of rent are fixed for different phases.
• It is permissible to tie up the rental amount with a variable
benchmark, the ceiling and floor should be determined.
• Rental will be charged when the Leased asset is handed over to the
lessee and not from the day the price has been paid. Must be in use.
• The lessee is liable to compensate the lessor for every harm to the
leased asset caused by any misuse or negligence.

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MURABAHA

• Murabaha is a particular kind of sale where the seller discloses its cost
and profit charged thereon.
• It is a contract wherein the institution, upon request by the customer,
purchases a asset from the third party usually a supplier/vendor and
resells the same to the customer either against immediate payment or
on a deferred payment basis.
• The price in this sale can be both on spot and deferred.
• It is a bunch of contracts completed in steps and ultimately suffices
the financial needs of the client.
• The sequence of their execution is extremely important to make the
transaction Shariah compliant.
SALAM

• A Salam transaction is the purchase of a specified commodity for

deferred delivery in exchange for immediate payment.
• Price is fully paid at spot while the delivery of goods is deferred.
• Only those goods can be sold through a Salam contract in which the
quantity and quality can be exactly specified.
• All details in respect to quality and quantity of goods sold must be
expressly specified. The commodity of Salam contract should be in the
market at least at the date of delivery.
• The exact date and place of delivery must be specified in the contract.
• Specification of subject is mandatory and identification is impermissible.
• It is not permissible that the subject matter of Salam is increased due
to delay in its delivery.
ISTISNA

• It is an order to a producer for manufacturing a specific commodity for

the purchaser.
• The subject of Istisna’ is always a thing which needs manufacturing.
• Manufacturer uses his own material.
• Quality & Quantity should be agreed in absolute terms.
• Purchase price should be fixed with mutual consent.
• Price of Istisna’ may be spot or deferred, therefore Istisna’ is applicable
where Salam is not applicable.
• Price of Istisna’ can be paid in installments.
• Once the works starts, Istisna can not be cancelled unilaterally.
• Time of delivery does not have to be fixed
CONCLUSION & QUESTIONS

THANK YOU!