UNIVERSITY OF HARGEISA

Introduction to Islamic Banking and Finance:

Principles and Practice

Chapter 1

Introduction to Islamic Banking and Finance

Subject Aims:
The key aim of this subject is to assist students in understanding
the theory and practice of Islamic banking, based on the
contemporary situations. At the end of the course, students will be
able to:

1. Understand the theory of Islamic banking,

2. Understand the operation of Islamic banking,
3. Identify the products offered by Islamic banks,
4. Evaluate the performance of Islamic banks, and
5. Analyse current issues and problems faced by Islamic banks.
Introduction

• Islam is a way of life. A verse from the Quran states, “This

day I have perfected your religion for you, completed My
favour upon you, and have chosen Islam as your way of
life” (Qur’an 5:3). The lexical meaning of the word Islam is
‘submission’
• Actions in Islam can be categorized into two broad
categories, namely ‘Ibadaat and Mu’amalaat.
 Introduction (cont)
• ‘Ibadaat – Acts of Worship
Ibadaat are based on the individual’s direct relationship with God.
This entails that specific acts of worship must be directed solely
for Allah (God) alone with sincerity. This includes one’s Prayers,
Fasting, Pilgrimage etc.
• Mu’amalaat – Interactions with People
This refers to the conduct one has with fellow human beings. This
can refer to law, work, marriage, inheritance, business
transactions, partnerships, buying, selling etc. Islamic finance and
banking falls under this category. One must ensure their conduct is
in conformity with Shari’ah principles.
• Objective of human life is to please GOD – Almighty Allah via
Ibadaat and Mu`amalaat.
 Introduction (cont)

• Shari’ah –Islamic Law

Shari’ah is the set of rules which includes and clarifies
obligations, prohibitions, recommended duties, detested (yet not
blameworthy) actions, what is lawful and unlawful etc.
Therefore it includes ethics, manners, laws, public life, social
life, economic life, politics etc.
• Sources of the Shari’ah
The two Primary sources of the Shari’ah are the Qur’an and the
Sunnah. Other sources include Ijma’ (consensus) and Ijtihad
(juristic decision)
Basis of Islamic Banking and Finance

Figure 1.1: Shari’ah as the Basis of Islamic Banking and

Finance
The Qur’an

• The Qur’an is believed by Muslims to be the word of God

revealed to the Prophet Muhammad – peace be upon him
(PBUH). It is the final revealed scripture and remains
intact in the Arabic language. The Prophet Muhammad
was instructed with the Message of Islam when he was at
the age of forty in the year 610 CE. From then onwards, his
Prophethood lasted twenty-three years until the Message
was complete and the Prophet passed away.
• The Qur’an was therefore revealed over a period of twenty-
three years in stages and intervals. The Qur’an can be studied
closer by looking into the Sunnah, the teachings of the
Companions (who learned directly from the Prophet and
were preserved when verses were revealed concerning
specific circumstances), studies from scholars and experts in
the Arabic language.
 Basis of Islamic Banking and Finance
The Qur’an
• The first source of the Shari’ah
• General and specific rules on religious, commercial, political,
economic, legal and social norms
• Emphasis on mutual consent and consensus among consenting
parties
• Prohibits exploitative measures:
– Excessive risk or uncertaintly (gharar)
– Usary or interest (riba)

• Prohibits cheating and corrupt practices in the management of

funds
• Does not allow dealings in prohibited products
 The Sunnah
• The Sunnah refers to the authentic statements, actions and approvals
of the Prophet Muhammad. Sunnah literally means way and
therefore refers to the way of the Prophet. Another word
sometimes interchangeably used with Sunnah is Hadith (speech,
statement or saying). Therefore, books of Hadith are referred to as
the Sunnah as they are collections of the statements, actions and
approvals of the Prophet Muhammad - PBUH.
• The Sunnah is collected in many volumes of Hadith books.
Hadith can be used to help explain and elaborate on the Qur’an.
Likewise, the Sunnah contains rulings and guidance on all kinds
of issues and circumstances. There are over forty verses in the
Qur’an which command adherence to the way of the Prophet
(his Sunnah).
 Other sources for Shari’ah are Ijma’
(consensus) and Ijtihad (juristic decision).
• Ijma’ (Consensus) – This refers to teachings in Islam that have been
agreed upon by the early generations of Muslims or Muslim scholars.
These are matters that are established and leave no room for
disagreement in the Shari’ah.
• Ijtihad (Juristic decision) – Ijtihad is applied by the Mujtahid
(Muslim Jurist/Scholar) who does not find the answer clear cut
from the Qur’an or Sunnah. Therefore, they explore into the
Primary sources to find the answer based on their skills of
judgment -maintaining the aims of the Shari’ah- and trying their
best to interpret the intent of the Law Maker.
• Sometimes the word Qiyas (analogy) is used to refer to ijtihad. Qiyas
is used to figure out rulings based on similar existing rulings by way of
analogy.
 Origins and Historical Overview of
Islamic Banking and Finance

• Islamic finance is both a new and old phenomenon. The

history of Islamic finance is divided into two general
aspects:

• The early days transactions (The guiding principles of Islamic

Finance originate from the early days of Islam).

• The modern-day experiments (Experiments in Islamic

finance in Egypt, Malaysia, and Pakistan: the basis of modern Islamic
banking and finance) .
 Origins and Historical Overview of Islamic Banking and
Finance
The Era of the Prophet
The prevailing modes of transactions during this era include:
• Shirkah (partnership) based on profit-and-loss sharing (PLS)
• Al qard Al hasan (benevolent loan)
• Salam (Forward) contract
• Sarf (exchange of money), i.e. gold for gold and silver for silver at
the same sitting
• Ijarah (leasing)
• Trans-regional trade involved trade caravans from Mecca to Syria
and vice versa
 Origins and Historical Overview of slamic Banking and
Finance
Timeline of Modern-day Experiments of
Islamic Banking and Finance from 1962 to 1975
• Initial Reforms in the Banking Industry in Pakistan in 1962
• Mit Ghamr Local Savings Bank in Egypt of 1963 (“the first modern-
day trial of Islamic baking”)
• The Malaysian Pilgrims Savings Board, Tabung Haji of 1969
(managing savings of prospective pilgrims by investing in
Sharī’ah-compliant investments)
• The new birth of modern Islamic finance took place in Dubai in
1975 through Dubai Islamic Bank as the first Islamic commercial
bank in the world. At the same time, IDB established and started
Islamic Finance.
 Origins and Historical Overview of Islamic
Banking and Finance

• The functions of IDB are

• To participate in equity capital and to grant loans

• To provide financial assistance to member countries

• To establish and operate special funds for specific purposes

• To accept deposits and to mobilize financial resources through

Sharī’ah compatible modes

• To promote foreign trade, especially in capital goods, among

member countries
Origins and Historical Overview of
Islamic Banking and Finance

Dubai Islamic Bank (DIB)

The first fully-fledged Islamic world commercial bank in 1975.
Operates five main business groups:

• Retail banking

• Corporate banking

• Real estate

• Investment banking

• Proprietary trading investments

 What is Islamic Banking?
Definition:
“an Islamic bank is a financial institution whose statutes, rules and
procedures expressly state its commitment to the principle of
Shariah and to the banning of the receipt and payment of interest
on any of its operation.
Moreover, the Malaysian Islamic Banking Act 1983, defines an Islamic
bank as
“… a company which carries on Islamic business. Islamic business
means banking business whose aims and operations do not involve
any element which is not approved by the religion of Islam…”
Thus, Islamic banking is banking that complies with Shari’ah or Islamic
law.
 The Banking Business
1. Bank is an authorized deposit-taking institution (ADI)
2. Facilitates intermediation between savers and investors.
3. Transfer funds from surplus units to deficit units.
4. It manages payments and clearing systems.

Islamic and conventional banking

• The prohibition of riba (interest, usury), gharar (excessive
uncertainty) and haram (impermissible) activities.
• The implementation of profit and loss sharing (PLS) principle.
• The emphasis on productivity and real economic activity (rather
than credit worthiness).
The Banking Business: Flow of money
The Banking Business: Flow of profits
 Key 6 principles of Islamic banking
1. Prohibition of predetermined loan repayments as interest (riba)
2. Profit and loss sharing, which is at the heart of the Islamic finance
system
3. Making money out of money as being unacceptable, with all
financial transactions needing to be asset-backed
4. Prohibition of speculative behavior
5. Only Shariah approved contracts being acceptable
6. The sanctity of contracts

“The ethical principles on which Islamic finance is based may

bring banks closer to their clients and to the true spirit which
should mark every financial service,”
 Ethics in Islamic Finance and Banking
"Assist one another in righteousness and piety. And do not
assist one another in sin and transgression…" (Qur’an
5:2)
• One objective of Islamic finance and banking is to
assist in the spread of economic prosperity. The other
objective is to do this in accordance with Shari’ah
principles.
• Among the norms concerning Islamic finance are a free
market, where prices are determined by demand and
supply, freedom from manipulation, prevention of
hoarding, profit and loss sharing in partnerships,
information efficiency etc.
 Among the norms in Islamic finance that we want to
elaborate on here are the following three topics:
• 1. The Prohibition of Riba (Interest or Usury) – Money is not to
be exchanged for money with profit. As a result of this
prohibition, alternative solutions are given which encourage
trade and equity participation.
• 2. The Prohibition of Gharar (Uncertainty) – This demands
transparency in contracts as well as in buying and selling. Prices
should be specified, there should be clarity of the delivery
details, quality of goods, quantity of goods etc. The information
should be available to all parties involved and the outcomes of a
contract should be free from ambiguity etc.
• 3. Sanctity of Contract – Contracts should be fair and agreed
upon by both parties. Therefore, the contract should be free
from the elements of Gharar and reach Shari’ah approval in
their content.
 1. The Prohibition of Riba (Interest or Usury)
• Definition of Riba: ‫لربا‬GG‫ا‬
• Riba in the Arabic language literally means increase. However,
according to the specific Shari’ah definition, it means unlawful
increase ‫لمحرمة‬GG‫لزيادة ا‬GG‫ا‬. Under today’s literature and
terminologies, riba commonly refers to interest and usury.
• The Islamic Fiqh Academy which was initiated through the OIC
(Organization of the Islamic Conference), was established to
bring scholars from around the world in order to address current
issues and concerns. During the 2000 meeting, the OIC
reaffirmed the consensus of the historical prohibition of
interest. Riba is one of the core concerns in Islamic finance. In
order to avoid riba, many financial alternatives have been
adopted over the centuries. Although scholars describe
rationales as to why riba may be prohibited, the sole reason for
sincere Muslims to refrain from riba is to conform to what the
Law Maker has legislated.
 Riba ‫لربا‬EE‫( ا‬Interest or Usury)
• Riba is strongly prohibited in Islam. The many verses of
the Qur’an leave no question in this regard: “Allah has
permitted trade and forbidden riba.” (Qur’an: Surah Al-
Baqarah 2:275). The verses prohibiting riba are located in
four Surahs of the Qur’an; Surah Al-Baqarah 2:275-276,
278-280; Surah Aal Imran 3:130; Surah An-Nisaa 4:161
and; Surah Ar-Room 30:39.
• Riba is further elaborated on in the Prophet’s Sunnah.
Numerous hadiths explain the details surrounding riba. In
a hadith narrated by the Prophet’s companion Jaabir:
“Allah’s Messenger cursed the one who accepts riba, the
one who gives it, the one who records it and the two
witnesses to it, saying, ‘They are all the same.’”
(Collected By Muslim).
 Types of Riba:
• There are two major categories of riba.
• The first category is known as Riba An-Nasee’ah which relates to
riba in debt. It increases with time (e.g. interest on borrowed
money). This is the most common type of riba today and it relates
to return of money on money at any rate (fixed or floating,
compounded or simple interest).

• The other category is Riba Al-Fadl which refers to riba in

exchange. This type of riba refers to the six commodities (e.g.
Gold) mentioned in the hadith.
It increases with the transaction.
Riba An-Nasee’ah - Riba in Debt
• This form of riba was well known in jahiliyah (pre-Islamic era of
ignorance). When the date of maturity neared for one’s debt, it would
be said to him, “pay up, or pay riba (increase)”. Due to deferment in
repaying the debt, the debt would increase. It would continue to
accumulate as compounded interest until it doubles and so on.
• Another practice from the jahiliyah period included the loaning of
money with a fixed increase in the return. For example, one would
borrow, 10 gold coins (Dinars) with the condition of returning 12
gold coins at a future date.
• From the above description, we see how riba an-nasee’ah is
equivalent to interest. For example, it includes the use of credit cards
and “interest free” periods, as the date of maturity passes, interest is
incurred. Likewise it is typical of bonds, or loans from conventional
banks today which lend money with the condition to be paid back
with an increase of a certain percentage in the future, at a variable or
fixed interest rate.
 Riba Al-Fadl - Riba in Exchange

• Although gold and silver were the real currency at the time, the
Prophet described certain commodities that relate to riba. These
commodities are prohibited to exchange, same for same, unless they
are of equal amount, without increase. One hadith states, “Gold
with gold, silver with silver, wheat with wheat, barley with
barley, dates with dates, and salt with salt; same quantity for
same quantity, equal for equal; transaction being made hand to
hand (i.e. on the spot payment)” (Muslim).
• Some scholars have stated that these commodities are only limited
to the six mentioned. Other scholars, by making Qiyas (analogy),
have stated that it can also include other commodities that can be
weighed, or other food, or specific food which can be stored similar
in nature to the six.
 Riba Al-Fadl - Riba in Exchange (cont)
• However, gold and silver are the universal tenders
like cash money today. The remaining four
commodities may have been used in a similar
fashion to currency.
• Another hadith mentions, “Do not sell gold for
gold unless it is the same amount for the same
amount, and do not make one amount greater than
the other. Do not sell silver for silver unless it is
the same amount and do not make one greater
than the other.” (Bukhari and Muslim).
 Riba Al-Fadl - Riba in Exchange (cont)
• The following narration sheds light on this form of riba with the
exchange of these types of commodities. A hadith mentions, “Once
Bilal brought Barni (a kind of dates) to the Prophet and the
Prophet asked him, ‘From where have you brought these?’
Bilal replied, ‘I had some inferior type of dates and exchanged
two Sa’s (approximately 6 kilograms) of it for one Sa’
(approximately 3 kilograms) of Barni dates in order to give it to
the Prophet to eat.’ Thereupon the Prophet said, Beware!
Beware! This is definitely Riba! Don’t do so, but if you want to
buy (a superior kind of dates), sell the inferior dates for money
and then buy the superior kind of dates with the money”
(Bukhari).
• This hadith shows the prohibition of exchanging the same
commodity of a different measurement, yet it also displays the
alternative solution. That is to sell the dates, and buy the other dates
with the money.
 Riba rules - summary
• The commentator of Sahih Muslim, Imam Nawavi has summarized
these rules in the following way:
• When the underlying ‘characters of the two goods being
exchanged is different, shortfall/excess and delay both are
permissible, e.g. the exchange of gold for wheat or dollars for a
car.
• When the commodities of exchange are similar, excess and delay
both are prohibited, e.g. gold for gold or wheat for wheat,
dollars for dollars, etc.
 2. The Prohibition of Gharar (Uncertainty)

• Gharar has a broad scope and is not limited to one

simple definition. For our purposes here, it relates
to excessive uncertainty or ignorance by way of
a contract, or the goods involved in a sale, the
price, ownership, possession of goods,
deliverability, dates of exchange etc. A hadith
collected by Muslim narrated by Abu Hurairah
states,
Minor and major Gharar
Minor Gharar
• Gharar has been categorized into two categories, namely major
and minor. It is expected that minor (or trivial) accounts of gharar
will exist and for that reason it is tolerated and not given concern.
Such is the case of catching a taxi, there is an element of
uncertainty in the price as it rises with the mileage, yet this is a
minor form of uncertainty and is permissible. Another example is
buying fruit without peeling the skin to see inside.
Major Gharar
• Causes for alarm are the major or substantial forms of gharar
which are clearly condemned from a Shari’ah perspective. Major
Gharar will be simply referred to as gharar in the rest of the
lecture notes.
• Gharar can generally refer to the following:
• Lack of Transparency -The Shari’ah stipulates that transparency
must exist in order for contracts to be legitimate. For example, the
terms of the contract must be clear to both parties involved in order
to be just and fair. Under such measures, individuals are protected
from fraud, deceit and exploitation.
• Deception - Gharar can also imply deceit.
Once Prophet Mohammad came upon a heap of grain in the market
of Madinah and thrust his hand onto it. His fingers felt dampness.
On being asked, the trader replied that rain had fallen upon it. The
Prophet observed, "Why did you not then keep (the wet portion
of) it above the dry grain, so that people may see it? He who
deceives, has nothing to do with me” (Muslim). Therefore,
relevant information cannot be withheld.
• Selling what you do not have

Part of Gharar is selling what is not in one’s possession. The

common example of this is the selling of the fish in the ocean
which has not been caught yet, or selling vegetables that the seller
is yet to purchase (i.e. they are not in possession or ownership).
This can lead to settlement risk and is therefore a form of gharar.
One should therefore catch the fish and then sell it, or buy the
vegetables from a wholesaler, and then sell them to avoid the risk
of uncertainty.
An exception to this rule is a salam contract (Bai’ As-Salam) which
relates to farm produce which has not been harvested yet. Such a
contract is paid up-front and an agreed upon amount of goods (e.g.
one ton) must be delivered at a later date when the produce is
harvested.
• Ignorance - The buyer should have relevant information about the
goods they intend to buy or the contract they intend to sign. This is
why it is important to inspect the goods one is about to buy. With
regards to what the buyer is buying, the buyer should know (for
example) the quantity, the attributes, species etc. Or in the case of
a contract, both parties should have a sufficient understanding of
the details and outcome of the contract in order to remove any
doubt.
• Unspecified Price - The price of the sale should be stipulated. This
is important if the goods are purchased on credit, in order to avoid
disagreement at a later date.
• Unspecified dates - As for the delivery of goods, the price can be
delayed or the goods can be delayed in delivery, yet this should be
by mutual consent of the buyer and seller.
 3. Sanctity of Contract
Sanctity of Contract
• As excessive gharar is impermissible in Islam, the Shari’ah
emphasizes that contracts must include transparency and
honesty. Prices should be specified, there should be clarity of
the delivery details, quality of goods, quantity of goods etc. The
information should be available to all parties involved and the
outcomes of a contract should be free of ambiguity.
• When full disclosure is present, both parties eliminate or reduce
financial speculation and undue complexity in contracts (due to
gharar). This will include discloser of the risk involved by
providing as much information as possible for buyers or investors.
 3. Sanctity of Contract (cont)
• If two or more parties come together for a partnership
(e.g. musharakah), all parties should be aware of their
profit-sharing ratio, underlying assets involved, and
other conditions of the contract.
• The parties involved must mutually agree on the sale
or contract, albeit orally or preferably in written form,
without coercion (pressure).
• Contracts must be in accordance with Shari’ah
principles. Therefore, investments considered
unethical, unlawful (haram), unjust etc, would not be
considered. Although riba and gharar may not be
involved, one must make sure that other unlawful
practices are not present. For example, it is prohibited
to finance a casino or deal with alcohol etc.
Case study: Riba & Gharar today

Identify role of Riba & Gharar in:

I. Global Financial Crisis (GFC)
II. European debt crisis (EDC)
III. Other examples?
ISLAMIC BANKING - FIN5BNK
Topic 3: Equity Based Financing (PLS mode)

Equity Based Financing:

Musharaka (Sharing, Equity/Business partnership, Joint Venture)
Mudaraba (Trustee/Limited/Investment Partnership)

FACULTY OF LAW AND

MANAGEMENT
SCHOOL OF ECONOMICS AND
 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)
 Musharaka (Sharing, Equity/Business
partnership)
• 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 in
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.
Musharaka (Equity partnership, Joint Venture)

$2.5mil Profit

Investor $10mil (25%) 25%

A
Business Profit
10mil
Investor $30mil (75%) Venture
B
75%

$7.5mil Profit
Musharaka - example

Investor Contribution Outcome Outcome

1 2
Profit 200 Loss 100
A 100 (10%) 20 (10%) -10 (10%)

B 300 (30%) 60 (30%) - 30 (30%)

C 600 (60%) 120 (60%) - 60 (60%)

Profit arrangement ratio is pre-agreed at the start (10/30/60 or it

could be eg. 15/30/55) based on investors involvement in the
business management and other relevant factors (eg. experience,
skills and so on). However, loss must be shared in proportion to
contributed capital (in this case 10/30/60) and can not be changed.
 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.
Diminishing Musharaka (Musharaka Mutanaqisa)

Home Purchase
Ownership %
Bank Customer
Bank Transfer of ownership 80%↓ 20%↑
Customer 70%↓ 30%↑
Payment for piece of property (eg.
10%)
60%↓ 40%↑
50%↓ 50%↑
40%↓ 60%↑
Rent % Rent % 30%↓ 70%↑
20%↓ 80%↑
10%↓ 90%↑
Price 80% Price 20% 0%↓ 100%↑

Bank’s participation diminishes over

time until customer becomes sole
owner of the property.
 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).
 Mudaraba (Investment Partnership)

Share of profits

capital

Investor
Business
Profit
Mudarib management
Venture
(entrepreneur)

Share of profits

Profit can not be a fixed amount (for PLS financing) but must be determined
by a pre-agreed ratio. In case of loss, the investor loses capital and the
mudarib loses time and effort. In the case of proven negligence by the
mudarib, the mudarib may be liable for capital as well.
 ISLAMIC BANKING - FIN5BNK

Topic 4: Debt-Based Financing (non-PLS Modes)

Murabaha (Cost Plus Sale) - Bai’ bithaman ajil (BBA, deferred payment) - Ijarah (Leasing)
- Bai’ As-Salam (Deferred Delivery Sale) - Bai’ Al-Istisna’ (Manufacturing Sale) - Bai’
Al-Istijrar (Suply Sale) - Qard Hasan
Contentious Instruments: Bai’ Al-Einah (Back to back repurchase) - At-Tawarruq
(Tripartate Sale) - Bai’ Al-Dayn (Sale of Debt, Bill discounting)

FACULTY OF LAW AND

MANAGEMENT
SCHOOL OF ECONOMICS AND
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. 
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 (beginning) 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).
Murabaha

Financing asset purchase

Goods (immediate Goods (immediate

delivery) delivery)

Goods
Bank
Supplier
Customer
$100,000
(spot payment) $130,000
(deferred
payment,
Bank must own including profit
the asset before mark up)
selling it.
Question

Debt Based Financing:

Why it is called debt based?
Why is it Shariah complaint?
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.
Bai’ As-Salam (Deferred Delivery Sale, pre-paid sale)
• When the Prophet came to Madina, the inhabitants use to pay in
advance for dates to be delivered a year or two later. The Prophet
told the people, “Whoever pays in advance for dates (to be delivered
later) should pay it for a known specified weight and measure (of
the dates).” Another hadith mentions, “…for a specific
period”(Collected by Bukhari). The other items that were sold in the
lifetime of the Prophet under a Salam sale included wheat, barley
• Selling agricultural produce in advance is permissible providing
certain conditions are fulfilled. Some may refer to a Salam contract
as a forward contract, however, a forward contract involves a
deferred payment as well as deferred delivery. Among the
conditions of a Salam contract is the up-front spot payment. This
may help the farmer with the means of sustenance or for the finance
needed to harvest the crops. As the hadiths above mention, the
Salam contract must stipulate a specified measure for a specific time
period.
• Bai’ Al-Istisna’ (Manufacturing Sale) – This sale requires
the manufacture, assembly, construction etc of a specified
item or items. This could be used for the production of
electrical goods, machinery, a construction of a house,
plane etc. Unlike a Salam sale, an Istisna’ sale may consist
of a deferred payment, lump sum or installments,
depending on the agreement.
• Bai’ Al-Istijrar (Suply Sale) – This involves the delivery of
certain goods periodically over time. Likewise the price can
be paid periodically according to the agreement of both
parties.
• Qard Hasan (Benevolent Loan) – This is a loan that involves
no interest. The principle is paid at a later date without any
increase. If one borrows $1000, they will repay $1000 at a
later date.
Bai’ Al-Einah (Back to back repurchase)
• One contract that comes under scrutiny is Bai’ Al-Einah.
When someone requires money, they sell a product to the
bank in receipt of cash. The seller then agrees to buy back
the product from the bank at a higher price to be paid in
the future, commonly through installments (BBA).
Therefore, it includes a spot sale and a credit sale. Most
scholars criticize this sale as a form of ‘riba through the
back door’. The sale is artificial in order to receive cash.
Likewise the bank buys the goods momentarily for which
it has no use. Likewise, Al-Einah involves two sales in
one contract. The Prophet forbade “two sales in one”
(Ahmad, An-Nasaa’i, Al-Tirmithi).
Bai-al-Einah (Repurchase)

In Bai-al-Einah, identity
of the customer &
supplier is the same.
Goods
Customer ends up with
$100 Bank $100 (cash) and
Customer (spot payment) deferred debt of $110
is created.

Repurchase Profit in this case is not

of goods result of a genuine sale
$110 and is therefore
(deferred indistinguishable from
payment)
riba.
This mechanism is used
in some countries for
At-Tawarruq (Tripartate Sale)
• Tawarruq has been criticized as being related to Al-Eenah in the
sense that it is seen as a means to by-pass Riba. Others may see it
as a legitimate sale, some scholars do not. Those who tolerate this
sale may do so based on the individual’s need for instant cash,
providing certain conditions are met. Unlike Al-Eenah which
involves only two parties, three parties are involved in Tawarruq.
For example, the customer seeking cash approaches the bank. The
bank buys a product from a vendor, then sells it to the customer
BBA-Murabaha (Mark-up sale with deferred payments). The
customer agrees and then requires the bank (now as an agent) to
sell it to a vendor on their behalf in order to receive cash. The
customer gains liquidity, yet now they have a higher debt to pay at
a later date.
Tawarruq (Tripartate Sale)

Goods (immediate Goods (immediate

delivery) delivery)

Goods
Bank Customer A
Supplier $100,000
(spot payment) $130,000
(deferred
payment)

Spot sale for $100,000

In Bai-al-Einah identity of the customer A &
supplier is the same, while in Tawarruq it is not.
Customer A ends up with cash that is result of a
genuine sale to customer B.
This mechanism is used in some countries for Customer B
credit card arrangements. However, organised
tawarruk where goods supplier and customer B
have same identity may resemble Bai-al-Einah
Bai’ Al-Dayn (Sale of Debt, Bill discounting)
• The Shariah promotes investment in tangible assets as
opposed to investment in debts. The only exception put
forward (by the Shafi’ee School) for the sale of debt is
when the debt is sold off (or passed on) at par value
without any discount. This condition is necessary in order
to prevent any form of riba (interest).
• In the following weeks we will look at how some of these
mechanisms have been applied in the Islamic banking
industry.
Questions?
ISLAMIC BANKING - FIN5BNK

Topic 5: Deposit products

Main Deposit accounts: Current (Wadiah/Qard) account - Savings (Wadiah/Mudaraba) account - Investment (Mudaraba) account - Debit and Charge cards

FACULTY OF LAW AND

MANAGEMENT
SCHOOL OF ECONOMICS AND
 Deposit products

• In order to facilitate intermediation between savers and investor, the bank

mobilizes funds via a range of deposit products with different risk/return
characteristics.
• Main Deposit accounts:
1. Current (Wadiah/Qard) account
2. Savings (Wadiah/Mudaraba) account
3. Investment (Mudaraba) account

Deposit Financi
accounts: Deposits
1.
Bank ng Equity-
Produc Based
Current (Financial ts Debt-
(PLS)
account Based
Intermedia (Non-PLS)
Deposit products (cont)
• Deposit accounts play a key role, not just for banks, but
for the economy in general. Much of the wealth kept
within the trust of a bank is utilized in investments,
financing businesses etc. This in turn helps the
workforce and stimulates productivity via a number of
PLS and debt-based modes of financing. Islamic banks
therefore, with deposits from customers, utilize these
modes of financing to provide a sustainable service to
the community.
• While mobilizing in a Shari’ah compliant manner, other
issues such as risk, return, liquidity, maturity, safety,
and stability are considered before offering the right
deposit account that would satisfy customers’ needs.
 Current accounts
• It is attractive for customers to leave their deposits in
banks for safe-keeping and to have easy access to
liquidity. These accounts allow money to be withdrawn
by card access to automated teller machines (ATM). The
deposits are held with the bank as an Amanah (Trust).

• Current account deposit may be structured on various

mechanisms. Two of the most common are:
1. Wadiah-wad-Dhamanah (Guaranteed deposits)
2. Qard (benevolent loan)
 Current accounts (cont)
• Wadi’ah (Safekeeping) – Customers deposit money in Islamic
banks under the principle of Wadi’ah wad Damanah. ‫ة‬EEE‫ع‬EE‫ودي‬
Wadi’ah means Deposit or Trust. ‫مانة‬EE‫ض‬ Damanah means
Guarantee. Wadi’ah is like an Amanah (trust), yet under a trust there
is no total guarantee (due to theft, catastrophe etc). Therefore the
word Damanah is added. Under such an account the customer is
able to safely deposit their money on the basis of trust, knowing that
they can withdraw all or part of their funds when they desire.
• Since there are no conditions for deposits and withdrawals, funds
kept by the bank as a trust may be utilized at the banks own risk.
Depositors do not share any risk, so, any profit or loss is passed only
to the bank.
 Current accounts (cont)

• Qard Hasan (Benevolent Loan) – Another way current accounts may

be described is with the use of Qard Hasan. The deposit by the
customer is seen as an interest free loan given to the bank. The
account bears no profit for the customer.
• As was the case with a Wadiah account, the bank may utilize the
funds at its own risk. Any benefit to the lender under this
mechanism is seen as riba and against the spirit of the qard
account.
• The main motive for a customer to have a current account is to keep
excess liquidity available in demand. The objective to earn profit is
not the priority. These accounts are operated for the safe custody of
deposits, and for the convenience of customers.
 Saving accounts
• Deposit products that are modeled on Wadiah/Mudaraba
mechanisms, are known as savings deposits. Their
function is to safeguard deposits whilst providing a modest
return on the capital. In that sense it is similar to the
savings account with a conventional bank.
• This form of deposits is very popular in almost islam
countries, as customers have a degree of convenience in
using and accessing their funds. Banks must request the
permission of depositors before utilizing the funds for
investment. The bank however claims ownership over the
profits and at times rewards the customers. Withdrawal
facilities are provided by the banks to the customer, such
as passbook, ATM cards and so on.
 Investment Accounts

• Investment accounts follow the principle of Mudaraba

(investment partnership). The investor is the Rabb-ul-
Mal who deposits money in the bank under an
investment account. The bank in this case acts as the
Mudarib who will manage the funds. The bank will find
Shari’ah compliant investments such as projects, sukuk
(certificates), financing transactions, property etc. The
profit will be according to a pre-determined ratio
agreed upon by both parties. As it is based on the
success of investments, the rate of return cannot be
fixed.
 Investment Accounts (cont)
• The investor will receive weightages which are
profit ratios according to each investment.
Inevitably, the depositor (Rabb-ul-Mal) risks the
loss of funds if the investments fail. Although
bearing loss is not common, this is how a
Mudaraba contract works. However, some banks
may guarantee the principle of the deposit if
investments fail.
 Debit and Credit Facilities

Debit Cards
• As offered by conventional banks, the debit card is a useful
alternative to credit cards. The card is merely a prepaid card
and therefore does not assist users by falling into debt and
most importantly, paying interest. Debit cards fulfill the
same purposes of credit cards like online purchases (such as
airline tickets). The major difference is that customers must
upload their own money to use the debit card. Likewise,
debit cards also allow cash withdrawals from ATMs
worldwide. Some banks charge a monthly or annual access
fee, while some banks charge no fees.
• Some banks promote Shari’ah compliant credit
cards. These are advertised as bearing no interest
and no hidden costs. The customer pays an annual
fixed fee which can be paid monthly. This fee is
seen as ijarah for the services provided (or Ujrah).
There is a grace period like a conventional credit
card contract, thereafter penalties apply for late
payments.
ISLAMIC BANKING - FIN5BNK

Topic 6: Financial management

Risk and Liquidity management

Systematic risk (Macroeconomic factors)
Unsystematic risk (Unique to a firm or an industry)
Risk Management
Liquidity management
The differences in managing risk: IB and CB
 Financial management
• The objective of financial management is to maximize the value of
the firm.
• The value of the firm can be measured through its profitability
and risk level.
• In reality one of the key aspects of financial management is risk
management because every decision or process will have a risk.
• Risk arises when there is a possibility of more than one outcome
and the ultimate outcome is unknown.
 The Elements of risk and Liquidity in
Islamic banks
• Risk is the variability or volatility of unexpected outcome.
• Risk can be divided into two types: systematic risk and
unsystematic risk.

• Systematic risk is a risk that arises from the

macroeconomic factors such as changes in economy, political and
social issues, business environment, interest rates, inflation, war and
international incidents.
• As such it can be hedged, but cannot be diversified completely
away. Systematic risk includes: interest rates risk, foreign
exchanges risk, commodity prices risk and industry concentration
risk.
• Unsystematic risk is a risk that is
unique to a firm or an industry.
• It is associated with random causes that can
be eliminated through diversification and it
can be controlled through good governance.
The examples of unsystematic risk are
regulatory action, mismanagement of a
firm, labour difficulties, consumer
preferences, loss of key accounts and
labour strikes.
 Risk Management

• The nature of financial institution operations

exposes them to different types of risks. Both
depositary and non-depositary financial institutions
are a risky business. According to Saunders and
Cornett (2006), there are five common risks faced
by financial institutions: credit or default risk,
interest rates risk, liquidity risk, underwriting risk
and operating risk.
 Risk Management (cont)

• Largest source of serious banking problems is credit risk, the risk

of counter party default. Credit Risk is defined as a risk that the
value of portfolio may change due to the unexpected changes in
the credit quality of issuer or trading partner (McNeil, Frey, &
Embrechts, 2005).
• Note:Islamic finance is also vulnerable if care is not taken - not
in terms of its product structuring, but in relation to non-
performing financing due to its credit policies.
 Risk Management (cont)

• Islamic banking is involved in risk taking by its very

nature, with the risk minimized by way of valid risk
management tools, but never totally avoided or
eliminated.
• In Islamic banking there has to be real business conducted
as a result of which profit or loss can be incurred and
hence Islamic Banks take on risk. The additional risk
that IFI have to face, compared to conventional
finance, is asset risk, market risk, Shariah non-
compliance risk, greater rate of return risk, and
greater legal risk.
 Risk Management (cont)
• Asset risk is involved in all modes, particularly
in Murabaha (onward sale to the client with mark-
up price), Salam (after taking delivery from the
seller) and Ijarah as all the ownership-related risk
belongs to the bank as long as the asset is in its
ownership.
• If the asset is damaged without any fault on the
part of the lessee and it is not deliverable, the
bank’s right to receive rent will cease.
• Shirkah-based risk (PLS) is borne as per the share
in the ownership market risk.
 Risk Management (cont)

• The bank might not be able to market the goods

purchased on the basis of salam, Istisna etc at a
profitable price.
• Rate of return risk is involved as the price (once
fixed) in Murabaha /Salam cannot be increased.
• Remaining within Shariah principles, Islamic banks
are allowed to take risk mitigation/management
measures, but transfer of risk to anyone else without
transferring related rewards is not permissible.
Risk Management (cont)

• In addition to effective management and

supervision, other factors necessary to ensure the
safety of the banking institution and the stability
of the financial system and the market include;
sound and sustainable macroeconomics policies;
well developed and consistent legal
framework; adequate financial sector
infrastructure; effective market discipline; and
a sufficient banking sector safety net.
 Risk Management (cont)
• Credit risk is simply defined as the potential that a borrower
or counterparty will fail to meet their obligation in
accordance with the agreed term. It is the risk of failure of the
counter party to honour their commitment and also refer to
default risk.
• This arises from the inability of the counterparty to service
the debt on the agreed term. It can also arise when the
solvency or the credit rating of the counterparty changes
adversely.
• In Islamic banking there is limited availability of credit rating
defined from external agencies.
 Risk Management (cont)

• The risk of non-compliance with Shariah rules is

referred to as Shariah risk. This can be included in
operational risk as non-compliance can lead to reputational
damages which can trigger an exodus of findings from the
Islamic investor, causing failure and system risk.
• If Islamic financing found a product that does not fully
comply with Shariah rules, then it would be subject to
Shariah scrutiny and thus be considered to be an adaptation
based on current market needs.
• These products pose special risks in terms of being rejected
under the scrutiny of Shariah rules. As interpretation can
differ, the utmost precaution is needed before entering into
any contract, with approval from the Shariah council .
 Risk Management (cont)

• There are four elements that should be well defined

and considered in financial risk analysis for Islamic
products, which are:
1. The construction of the financial contract
2. Identification of the markets
3. Identification of the behavior of counterparties
4. Interaction of the above two within a time period
mapped into the financial contract.
 Risk Management (cont)

• The role of information in the risk management

of the Islamic financial institution can be more
critically compared to conventional finance, with
the nature of contracts in Islamic banking more
integrated with the activities of the entrepreneur.
• The PLS contract is heavily biased towards the
availability of information for managing risks. In
the case of musharakah and mudarabah contracts,
there is a heavy bias towards the availability of
information for risk management.
• There is special emphasis on transparency in the conduct
of activities, calculation of profit and loss, as well as the
nature of activities. This includes a focus on social
responsibilities, with efficient information management
requiring special dimensions in Islamic finance institutions
which are more than merely statutory .
• Profit has to be earned by sharing risk and reward of
ownership through the pricing of good services.
• Investment both by bank depositors and the financial
institution will be considered only if it is part of real
activity, or is itself a real activity. This is because money
has the potential for growth when joined with
entrepreneurship, as in itself, it is recognized as capital and
therefore it cannot earn a return.
 Risk Management (cont)
• The business risk involved in shirkah (PLS) based modes
where loss has to be borne by the capital provider, whilst
the manager or entrepreneur loses the labour in the case of
joint business venture.
• For the depositor in Islamic banking, risk stems from the
failure of business and uncertainty in the level of profit
to be shared.
• Depositor should not be burdened on the account of
negligence.
• Mitigation of that risk would require special expertise and
sound knowledge of Shariah rules, lest it may lead to non-
Shariah compliance.
• Risk of default by clients can be mitigated, in some
cases, by putting a penalty clause in the contract to serve
as a deterrent, the amount of penalty would go to a
Charity account.
• This is in all modes except Istisna, when the bank can
insert a clause for decrease in the price if asset in case of
delay in delivery.
• The logic behind the provision in the case of Istisna is
that manufacturing/construction of any asset depends, to
a large extent, on personal effort, commitment and hard
work by the Manufacturer who may start work on the
contract with other people. While in the case of
Murabahah and Salam one has to pay the deferred
liability that has been defined and stipulated in the
Liquidity Management

• Liquidity management means ensuring that

the bank has sufficient liquid funds
available for a smooth running of its
operation in order to meet short term
financial obligations as and when due.
 Liquidity Management (cont)

• Liquidity can be managed by dealing in the Islamic

interbank fund market. The most useful instrument
for the transaction is the mudaraba ratio that could
be negotiated according to market conditions.
• Liquidity management in Islamic banks can also be
done through securitization of the pool of income
generating assets. If the bank requires liquidity it
may sell sukuk in the secondary market to another
bank to generate cash. If it is in surplus, it can
purchase sukuk from the market.
 The differences in managing risk:
• Risk management is a process that protects assets and profit of
an organization by; reducing the potential for loss before it
occurs; mitigating the impact of the loss if it occurs; and
executing a swift recovery after the loss occurs (Coffin, 2009).
• Financial institutions are a business entity owned by their
shareholders and the objective of the business entity is to
maximize the shareholders’ wealth. One way to achieve this
objective is that the management should efficiently diversify
the unsystematic risk and reduce or transfer the systematic risk.
In the financial sector, risk management is an area of high
interest due to the financial crises of the last two decades
(Galindo & Tamayo, 2000).
Basic Concept of Risk Management Process and
System
1. Establishing Appropriate Risk Management
Environment and Sound Policies and Procedures
2. Maintaining an Appropriate Risk Measurement,
Mitigating and Monitoring Process
3. Adequate Internal Control
 The differences in managing risk: IB & CB (cont)
• Islamic financial institutions can be riskier than
conventional financial institutions due to several reasons
including the specific nature of risk and the unlimited
number of ways to finance a project using either profit loss
sharing or non-profit loss sharing contracts.
• Scarcity of hedging instruments, undeveloped inter-bank
money markets and a market for government securities
which are Shariah compliant. Therefore, Islamic financial
institutions may be more vulnerable to unfavourable
events than conventional financial institutions.
The differences in managing risk: IB & CB (cont)
• Inability to utilize money markets makes Islamic
financial institutions more susceptible to liquidity risk.
• For Islamic financial institutions, liquidity risk can be
considered as one of the most critical risks due to certain
factor such as:
(1)limited liability of Shariah compatible money market and inter-
bank market,
(2) the problem of the lender as a last resort from central bank.
 The differences in managing risk: IB & CB (cont)
• The last group of risks faced by Islamic financial
institutions are governance risks. Governance risk
refers to the risk arising from: a failure in
governing the institutions; negligence in
conducting a business and meeting contractual
obligations; and from a weak internal and external
institutional environment, including legal risk,
whereby financial institutions are unable to
enforce their contracts.
Any Questions?