the action of deploying funds with the intention and expectation that they will
earn a positive return for the owner (Brokington 1986, p.68). Funds may be
invested in either real assets or financial assets. When resources are used for
purchasing fixed and current assets in a
process or for a trading purpose, then it can be termed as real investment. The
establishment of a factory or the purchase of raw materials and machinery for
production purposes are examples in point. On the other hand, the purchase of a
legal right to receive income in the form of capital gains or dividends would be
indicative of financial investments. Specific examples of financial investments
are: deposits of money in a bank account, the purchase of Mudaraba
Savings Bonds or stock in a company. Ultimately, the savings of investors in
financial assets are invested by the respective company into real assets in the
form of the expansion of plant and equipment. Since Islam condemns hoarding
savings and a 2.5 percent annual tax (Zakat) is imposed on savings, the
owner of excess savings, if he is unable to invest in real assets, has no option
but to invest his savings in financial assets.
When money is
deposited with an Islamic Bank, the bank, in turn, makes investments in
different forms approved by the Islamic Shariah with the intent to earn a
profit. Not only a bank, but also an individual or organization can use Islamic
modes of investment to earn profits for wealth maximization. Some popular modes
of Islamic Investment are discussed below. A comparison is also attempted
between the Islamic Modes of Finance and these of conventional
At the beginning
it is better to give a clear definition of "Islamic Modes of
Finance". The word "Modes" literally means "methods", or in other words, it
refers to systematic and detailed rules, stipulations and steps to be followed
for accomplishing a specific thing. The thing that needs to be accomplished in
this context is, however, the subject matter of each of the said modes, i.e. any
of the different types of investment activities (trade, leasing, real estate,
manufacturing, agriculture, agriculture production etc., or, using
Shariah expressions Murabaha, Mudaraba, Musharaka, Ijarah, Istisna,
etc.). The word "Finance" in one of its different meanings refers to the
supply of money capital or credit, provided by either a person (household), or
an organization (private or public - financial or non financial). The word
"Islamic" is inserted in the above expression to restrict the type of rules that
can govern different modes of finance to the Shariah rules. A complete
definition for the term "Islamic Modes of Finance"' may be given as
systematic and detailed Shariah rules that govern the
contractual relationship of an investment activity that can be applied for
attracting money capital" (Fahmy & Sarkar).
1.1 Meaning of
"Bai-Murabaha" have been derived from Arabic words Bai and
Ribhun. The word 'Bai' means purchase and sale and the word
'Ribhun' means an agreed upon profit. "Bai-Murabaha" means sale
for an agreed upon profit. Bai-Murabaha may be defined as a contract
between a buyer and a seller under which the seller sells certain specific goods
permissible under Islamic Shariah and the Law of the land to the buyer at
a cost plus an agreed upon profit payable today or on some date in the future in
lump-sum or by installments. The profit may be either a fixed sum or based on a
percentage of the price of the goods.
Types of Murabaha
In respect of
dealing parties Bai-Murabaha may be of two types (IBBL 1986,
order on and
Bai-Murabaha is a direct
transaction between a buyer and a seller. Here, the seller is an ordinary
trader who purchases goods from the market in the hope of selling these goods to
another party for a profit. In this case, the seller undertakes the entire
risk of his capital investment in the goods purchased. Whether or not he earns a
profit depends on his ability to find a buyer for the merchandise he has
order on and
three parties -
the buyer, the seller and the bank. Under this arrangement, the bank acts as an
intermediary trader between the buyer and the seller. In other words, upon
receipt of an order and agreement to purchase a certain product from the
buyer, the bank will purchase the product from the seller to fulfill the order.
should be noted here that the Islamic Bank acts as a financier in this
transaction. This is the case, not in the sense that the bank finances the
purchase of goods by the consumers; rather it is a financier by deferring
payment to the seller of the product. Thus, there is a chance that this
transaction could resemble nothing more than a loan for which interest
(Riba) is earned, which is contrary to Islamic beliefs.
avoid this potential misuse of the Bai-Murabaha relationship, the bank
should purchase the goods on behalf of the bank from the seller and sell the
goods to the buyer, receiving payment on behalf of the bank as well. In this
way, the profits generated by the transaction to each of the parties involved
cannot be misconstrued as interest or (Riba) profits.
There are some
important features of Bai-Murabaha as given below.
Features of Murabaha
A client can
make an offer to purchase particular goods from the bank for a specified
agreed upon price, including the cost of the goods plus a profit.
A client can
make the promise to purchase from the bank, that is, he is either to satisfy
the promise or to indemnify any losses incurred from the breaking the
promise without excuse.
permissible to take cash/collateral security to guarantee the implementation
of the promise or to indemnify any losses that may result.
of the debt resulting from Bai-Murabaha by a Guarantor, or a mortgage, or
both like any other debt is permissible. Mortgage/Guarantee/Cash Security
may be obtained prior to the signing of the Agreement or at the time of
signing the Agreement.
availability of goods is a basic condition for signing a Bai-Murabaha
Agreement. Therefore, the bank must purchase the goods in accordance with
the specifications of the client, thereby taking ownership of the goods
before signing the Bai-Murabaha agreement with the client.
acquiring the goods, the bank assumes the risk of ownership. In other words,
the bank is responsible for damages, defects, and /or spoilage to the
merchandise until such time that it is actually delivered to the buyer.
must deliver the goods to the client at the date, time, and place specified
in the contract.
sells the goods at a price above the cost to obtain a profit. The sale
price that is charged by the bank is agreed upon in the Bai-Murabaha.
The profit can be stated in terms of a flat dollar amount or on a percentage
of the purchase price. If a percentage is used, the percentage shall
never be expressed in terms of time, in order to avoid confusion that the
price is a form of interest (Riba), which is not allowed.
agreed to in the agreement is binding on both parties.
permissible for the bank to contract with a third party to buy and receive
the goods on its behalf. This agreement must be a separate contract.
make Bai-Murabaha distinctive from all other modes of Islamic Investment.
There are certain steps to accomplish a deal of Bai-Murabaha as shown
below (ABIIB 1995, p.12).
1.4 Steps of
submits a proposal regarding his requirements of the bank. The
sends a proposal
with the specifications of the commodity to be acquired from the bank. The
proposal also indicates details regarding the date, time and place of delivery
as well as price and form of payment information. The bank responds by sending a
counter proposal either accepting the buyer's price or stipulating a different
The client promises to buy
the commodity from the bank on a Bai-Murabaha basis, for
the stipulated price. The bank accepts the order and establishes the terms and
conditions of the transaction.
bank informs the
client (ultimate buyer) of its approval of the agreement to
purchase. The bank may pay for the goods immediately or in accordance with
approval to the sale and sends the invoice(s).
The two parties
(the bank and the client) sign the Bai-Murabaha Sale contract
according to the agreement to purchase.
Bank authorizes the
client or its nominee to receive the commodity
sends the commodity to the place of delivery agreed upon. The client
undertakes the receipt of the commodity in its capacity as legal
representative and notifies the bank of the execution of the proxy.
Bai-Murabaha has some legal rules. These rules are mentioned below (Ibid,
1.5 Rules of
permissible for the client to offer to purchase a particular commodity,
deciding its specifications and committing itself to buy it on Murabaha for
the cost plus the agreed upon profit.
permissible that the mutual agreement shall contain various conditions
agreed upon by the two parties, especially with respect to the place of
delivery, the payment of a cash security to guarantee the implementation of
the operation and the method of payment.
permissible to stipulate the binding nature of the promise to
purchase. Thus, the agreement can only be satisfied by either
fulfilling the promise to purchase or by indemnifying the bank for any
losses incurred if the promise to purchase is not fulfilled.
It is a
condition that the bank purchases the requested commodity (first purchase
contract) before selling it on Murabaha to the buyer. The contract in the
first purchase must be settled, in principle, between the source seller and
permissible for the bank to authorize a second party including the buyer to
receive the commodity on its behalf. This authorization must be in a
separate contract, particularly if the buyer is going to receive the goods
on behalf of the bank. This is necessary to avoid any conflicts with the
ensuing Murabaha sale.
bank takes ownership of the goods, it is responsible for any damages or
defects. Thus, if the goods are damaged, the bank is liable and must repair
the damage prior to delivering the goods to the purchaser.
It is a
condition that the Bai-Murabaha contract be drawn at the last phase. That is
after the promise to purchase and the purchase of the commodity in the name
of the bank and receipt of the commodity directly by the bank or through an
rules of Bai-Murabaha must be observed in drawing the contract of the
Murabaha sale connected with a promise to purchase. Particularly
concerning the issue of the transparency of the cost of the first purchase
and the amount of profit because discrepancies lead to disputes, which may
invalidate the contract.
permissible to document the debt resulting from Bai-Murabaha by a guarantor
or a mortgage, like any other sale on credit. Further, it is permissible
that the mortgage accompanies the contract, because it is possible to take a
mortgage on actual debt as well as promised debt before it is
realized. However, the mortgage shall only be in effect if the debt is
The areas of
application of Bai-Murabaha are discussed below.
Murabaha is the most
frequently used form of finance in Islamic banking throughout the world. It is
suitable for financing the different investment activities of customers with
regard to the manufacturing of finished goods, procurement of raw materials,
machinery, and other required plant and equipment purchases.
Musharaka is derived from the Arabic word Sharikah meaning partnership. Islamic
jurists point out that the legality and permissibility of Musharaka is based on
the injunctions of the Qura'n, Sunnah, and Ijma (consensus) of the
scholars. It may be noted that Islamic banks are inclined to use various
forms of Shariakt-al-Inan because of its built-in flexibility. At an Islamic
bank, a typical Musharaka transaction may be conducted in the following
One, two or more
entrepreneurs approach an Islamic bank to request the financing required for a
project. The bank, along with other partners, provides the necessary
capital for the project. All partners, including the bank, have the right to
participate in the project. They can also waive this right. The profits are to
be distributed according to an agreed ratio, which need not be the same as the
capital proportion. However, losses are shared in exactly the same proportion in
which the different partners have provided the finance for the project (Hussain
Musharaka may take two forms:
discussed below (ABIIB 1995).
In this case,
the bank participates in the equity of a company and receives an annual share of
the profits on a pre-rate basis. The period of termination of the contract is
not specified. This financing technique is also referred to as continued
contributions of the partners under this mode may be equal or unequal
percentages of capital for the purpose of establishing a new income-generating
project or to participate in an existing one. In this arrangement, each
participant owns a permanent share in the capital structure and receives his
share of the profits accordingly. This type of a partnership is intended to
continue until the company is dissolved. However, one can exit the
partnership by selling his share of the capital to another investor.
Musharaka is used by Islamic Banks in many income generating projects.
They can provide financing to their customers, in exchange for ownership and
profit sharing in the proportion agreed upon by both parties. In addition,
the bank may leave the responsibility of management to the customer-partner and
retain the right of supervision and follow up.
The three steps
to establishing Permanent Musharaka are discussed below.
Partnership in Capital: The bank tenders part of the capital required in its
capacity as a partner and authorizes the customer/partner to manage the project.
Partner tenders part of the capital required for the project and is entrusted
with what he holds from the bank funds.
Two - Results of the
intent of the project is growth. However, the project may be profitable or it
may loss money.
Three - The Distribution of
wealth accrued from the Project: In
event a loss is incurred, each partner bears part of the loss proportionate to
his share in capital. In the event the venture is profitable, earnings are
divided between the two parties (the bank and the partner) in accordance with
The following is
a discussion of those legal rules that apply to the Musharaka
It is a condition that the
capital provided by each partner is specific, existent and easily
accessible. It is inappropriate to establish a company with borrowed
money, for the purpose of profit.
It is permissible for partners to
have unequal ownership in the project. The percent of ownership is set forth
in the agreement.
It is a condition that the
capital of the company is money and valuables. Some of the jurists permit
contributing merchandise as invested capital. However, the merchandise must be
evaluated, and the value agreed upon by all parties. Once the value has
been established, it is counted as capital and stipulated in the contract as
It is impermissible to impose
conditions forbidding one of the partners from work. The company is
built on honor and each partner implicitly permits and gives power of attorney
to the other partner(s) to dispose of and work with capital as is deemed
necessary to conduct business. However, it is permissible for one partner to
have full responsibility for the operations of the company, provided he is
granted this authority by the other partners.
A partner is a trustee of company
funds in his possession and is held responsible for their proper use. It is
permissible to take a mortgage or a guarantee against company assets, but it
is impermissible to take security for profit or capital.
It is a condition that each
partners' share of the profits be known to avoid uncertainty. Also, it
is required that the ownership interest be in percentage terms and not a fixed
sum, because this would violate the requirements of a
In principle, profit must be
divided among partners in ratios proportionate to their shares in capital but
some of the jurists permit variation in profit shares, so long as it is agreed
to by all of the partners. This may be the case when one of the partners is
more dexterous and more diligent and does not agree to parity, so variation in
the sharing of profits becomes necessary.
In principle, a partnership is a
permissible and non-binding contract. Thus, if a partner wishes, he
could rescind the agreement provided that this occurs with the knowledge of
the other partner or partners. Rescinding the agreement without the
knowledge of the other partners' prejudices the rescinding partner's interest.
On the other hand, some of the jurists take the view that the partnership
contract is binding up to the liquidation of capital or the accomplishment of
the job accepted at the contract.
Musharaka is helpful in providing financing for large investments in
modern economic activities. Islamic banks can engage in Musharaka
partnerships for new or established companies and activities. Islamic
banks may become active partners in determining the methods of production cost
control, marketing, and other day-to-day operations of a company to ensure the
objectives of the company are met. On the other hand, they can also choose
to either directly supervise or simply follow up on the overall activities of
the firm. As part of the agreement, Islamic banks will share in both profits and
losses with its partners or clients in operations of the business.
Digressive Musharaka is a special form of Musharaka, which
ultimately culminates in the ownership of the asset or the project by the
client. It operates in the following manner.
participates as a financial partner, in full or in part, in a project with a
given income forecast. An agreement is signed by the partner and the bank, which
stipulates each party's share of the profits. However, the agreement
also provides payment of a portion of the net income of the project as repayment
of the principal financed by the bank. The partner is entitled to keep the rest.
In this way, the bank's share of the equity is progressively reduced and the
partner eventually becomes the full owner.
When the bank
enters into a Diminishing Musharaka its intention is not to stay in the
partnership until the company is dissolved. In this type of partnership, the
bank agrees to accept payment on an installment basis or in one lump sum, an
amount necessary to buy the bank's partnership interest. In
this way, as the bank receives payments over and above it's share in partnership
profits, it's partnership interest reduces until it is completely bought out of
discharge, the bank withdraws it claims from the firm and it becomes the
property of the partner. The decreasing partnership arrangement is an
Islamic bank innovation. It differs from the permanent partnership only in
continuity. It appears that there are four
steps of the diminishing partnership. Those are mentioned
in Capital: The bank -
tenders part of the capital required for the project in its capacity as a
participant and agrees with the customer/partner on a specific method of
gradually selling its share in capital back to the partner.
The partner -
tenders part of the capital required for the project and agrees to pay the
agreed upon amount in return for the ultimate full ownership of the
Results of the
Projects: The intent
of the project is capital growth. The project may be profitable or lose
distribution of the Wealth accrued from the Projects: In the event
of loss each partner bears his share in the loss in his exact proportionate
share of capital. In the event that the project is successful, profits
are distributed between the two partners (the bank and the customer) in
accordance with the agreement.
The bank sells
its Share of Capital: The bank
expresses its readiness, in accordance with the agreement, to sell a specific
percentage of its share of capital.
partner pays the
price of that percentage of capital to the bank and the ownership is
transferred to the partner.
continues until the bank has been fully compensated for it's capital share of
the business. In this way the bank has its principal returned plus the profit
earned during the partnership and vice versa.
In the first
Conference of the Islamic Banks in Dubai, the conferees studied the topic of
partnership ending with ownership (decreasing partnership) and they decided that
this type of business relationship may take one of the following
this form, the bank agrees with the customer on the share of capital and the
conditions of partnership. The Conference decided that the bank should sell its
shares to the customer after the completion of the partnership. Furthermore,
they determined that the selling of the banks interest to the partner should be
done under an independent contract.
Form: In this
form, the bank participates in financing all or part of the capital requirements
in exchange for sharing in the prospective earnings. In addition, the bank gains
the right to retain the remainder of the income for the purpose of applying it
towards the capital provided by the bank.
Form: In this
form, the bank and partner's ownership is determined by stocks comprising the
total value of the asset (real estate). Each partner, (the bank and the
customer) gets its proportionate share of the earnings accrued from the real
property. On an annual basis , the partner may purchase a prescribed
number of the bank's shares until such time that the partner becomes the sole
owner of the real property.
There are some
legal rules for diminishing Musharaka as given below.
In addition to
all the legal rules that apply to the permanent partnership which also apply to
the decreasing partnership, the following rules also must be observed.
It is a
condition in the decreasing partnership that it shall not be a mere loan
financing operation. In other words there must be shared ownership and all the
parties must share in the profits or losses during the period of the
It is a
condition that the bank must completely own its share in the partnership and
all rights of ownership with regard to management of the business. In the
event that bank authorizes its partner to manage the business, the bank shall
have the right of oversight supervision and follow up.
impermissible to include in the contract of decreasing partnership a condition
that adjudges the partner to return to the bank the total of its shares in
capital in addition to profits accruing from that share, because of
resemblance to Riba (usury).
permissible for the bank to offer a promise to sell its shares in the company
to the partner, if the partner pays the value of the shares. The sale must be
concluded as a separate deal with no connection to the contract of the
of Diminishing Musharaka
Musharaka is suitable for the financing of industrial businesses that have
regular income. It can be considered to be the appropriate mode to finance
collective investment. In this arrangement, the bank earns periodic profits
throughout the year and it encourages the partner to participate in the joint
investment. In addition it fosters individual ownership by allowing the partner
to gradually buy the bank's ownership interest. In terms of society as a whole
it corrects the course of the economy by developing a mode of positive
partnership instead of the negative relationship of indebtedness. In addition,
it assists in the equitable distribution of societies wealth.
through a Musharaka partnership is investment-based. The capital provider has
full control in the management of the business. In addition, he shares
proportionately in both the profits and losses of the business. Therefore, the
rate of return is uncertain and can be either positive or negative. The cost of
capital is also uncertain and there exists perfect correlation between the
relationship of cost of capital and rate of return on capital.
3.1 Definition of
Mudaraba refers to a contract between two parties in which one party supplies
capital to the other party for the purpose of engaging in a business activity
with the understanding that any profits will be shared in a mutually agreed
upon. Losses, on the other hand, are the sole responsibility of the provider of
the capital. Mudaraba is also known a Qirad and Muqaradah (Shirazi 1990,
Mudaraba is a contract
of those who have capital with those who have expertise, where the first party
provides capital and the other party provides the expertise with the purpose of
earning Halal (lawful) profit which will be shared in a mutually agreed upon
proportion. This type of business venture serves the interest of the
capital owner and the Mudarib (agent).
owner may not have the ability or the experience to run a profitable business.
On the other hand, the agent (the Mudarib) may not have adequate capital to
invest in a business or project. Therefore, by entering into a contract of
Mudaraba each party compliments one another, allowing a business venture to be
financed. The following are the steps of the Mudaraba contrac (ABIIB,
3.2 Steps of
provides the capital as a capital owner. The Mudarib provides the effort and
expertise for the investment of capital in exchange for a share in profit that
is agreed upon by both parties.
The Results of
Mudaraba: The two
parties calculate the earnings and divide the profits at the end of Mudaraba.
This can be done periodically in accordance with the terms of the agreement,
subject to the legal rules that apply.
Mudaraba Capital: The bank
recovers the Mudaraba capital it contributed before dividing the profits
between the two parties because the profit is considered collateral for the
of wealth resulting from Mudaraba: In the event
a loss occurs, the capital owner (the bank) is responsible for the entire
loss. In the event of profits, they are divided between the two parties
in accordance with the agreement between them, subject to the capital being
3.3 Rules of
There are some
legal rules that govern the business relationship Mudaraba which are as
It is a
condition in Mudaraba that the capital be specific in nature. In other words,
the amount of capital must be known at the inception of the contract. The
purpose of this rule is to ensure that there is no uncertainty about the
amount of capital and, thus, no uncertainty about the division of
It is a
condition that capital must be in the form of currency in circulation.
However, merchandise can be contributed, so long as both parties to the
business arrangement agree upon its value.
It is a
condition that the capital cannot be subject to indebtedness.
permissible for a Mudarib to mix his private capital with the capital of the
Mudaraba, thus becoming a partner. In addition, it is also permissible for the
Mudarib to dispose of capital on behalf of the Mudaraba.
It is a
condition that the capital of the Mudaraba is delivered to the Mudarib. Some
of the jurists permit the capital owner to withhold capital and release it
gradually according to the needs of the Mudarib since the Mudaraba adjudges
permissible for the capital owner to deliver capital to two Mudharibs in a
single contract. It is permissible for the capital owner to vary the in
profit sharing agreement between the two Mudharib based upon differences in
the services provided
permissible to impose restrictions on the Mudarib as long as the restriction
is beneficial and does not hinder the agent's ability to make a profit.
permissible for the Mudarib to hire an assistant to perform difficult work
that he is unable to perform on his own.
of capital by the Mudarib is restricted to reasons that are conducive to the
Mudaraba. The Mudarib must not lend or donate any of the Mudaraba capital.
Further, he is not allowed to enter into indebtedness nor enter into another
partnership agreement with the Mudaraba capital. However, these activities are
permissible if the capital owner consents and authorizes the agent to use his
The Mudarib is
not required to contribute any capital to the Mudaraba contract except when he
is found to be negligent in the way the funds are handled. It is permissible
to take a surety or mortgage from the Mudarib to guarantee payment in the
event of negligence violation of the contract conditions. However, it is
impermissible to take a mortgage as a guarantee of capital or profit.
It is a
condition that profits be carefully and properly accounted for to avoid
confusion by the parties to the contract. The contracting parties should
stipulate how profits are to be shared on a percentage basis. It is
impermissible to stipulate a fixed lump sum as profit.
Profits in a
Mudaraba relationship are distributed according to the agreement of the two
contracting parties. It is a condition that the capital owner be solely
responsible for any losses.
shall collect his share of the profit only after obtaining the permission of
the capital owner. In addition, the Mudarib can not collect his share of
profit until after capital outlay is recouped. In the event the
profits are split prior to the closing of the Mudaraba, any losses incurred
shall be reimbursed by the distributed profits.
does not receive his share of the profits until the final settlement of the
Mudaraba. Once the Mudaraba has been settled, neither party is liable to the
other without a new agreement being made.
agreement may be terminated if one of the two parties decides to rescind the
agreement. This is possible because the Mudaraba is an optional non-binding
agreement. Some of the jurists hold the view that Mudaraba is binding and it
cannot be rescinded if the Mudarib commences work.
It is an
investment-based form of financing. The provider of capital in Mudaraba
has no role in the management of the capital. However, he has to bear the risk
of capital loss as well as the opportunity cost of capital for the entire period
of the contract. The rate of return is quite uncertain and the cost of capital
is also uncertain. Hence, there is a perfect correlation between cost of capital
and rare of return on capital.
4.1 Meaning of
Bai-Salam is a term used
to define a sale in which the buyer makes advance payment, but the delivery is
delayed until some time in the future. Usually the seller is an individual or
business and the buyer is the bank.
Bai-Salam sales serve the interests of both parties
receives advance payment in exchange for the obligation to deliver the
commodity at some later date. He benefits from the Salam sale by locking in a
price for his commodity, thereby allowing him to cover his financial needs
whether they are personal expenses, family expenses or business
benefits because he receives delivery of the commodity when it is needed to
fulfill some other agreement, without incurring storage costs. Second, a
Bai-Salam sale is usually less expensive than a cash sale. Finally a Bai-Salam
agreement allows the purchase to lock in a price, thus protecting him from
4.2 Steps of
Cash sale or
Sale on Credit - The bank pays
the agreed upon price at the time of the contracts inception. The seller
agrees to the delivery of the commodity some specified date in the
Receipt of the Commodity on the Specific due Date: There are
several options for delivery available to the bank
The bank may
receive the commodity and resell it to another party for cash or
The bank may
authorize the seller to find another buyer for the commodity.
The bank may
direct the seller to deliver the commodity directly to a third party with whom
the bank has entered into another agreement.
Contract: The bank
agrees to sell the commodity for cash or a deferred price, which is higher
than the Salam purchase price. The buyer agrees to purchase and to pay
the price according to the agreement.
There are some
rules for Bai-Salam as given below.
4.3 Rules of
It is a
condition that the commodity known by both parties to the agreement.
Misunderstandings about the commodity may lead to disputes, which could void
It is a
condition that the quality of the commodity be monitored closely, as very
little variation from specifications in the contract are allowable. If the
commodity cannot be monitored for quality standards, a Salam transaction is
It is a
condition that the commodity be deliverable on the due date. If there is
uncertainty about the ability to deliver the commodity at the due date, a
Salam transaction is impermissible.
permissible to draw a Salam sale contract for a total to be delivered
increments on different specified future dates.
It is a
condition that the commodity is a liability debt. The seller is obliged to
deliver the commodity when it is due, according to the specifications
stipulated in the contract, whether or not his firm produces the commodity or
obtained from other firms.
Salam sales are
impermissible on existing commodities because damage and deterioration cannot
be assured before delivery on the due date.
impermissible on Land lots and real estates.
permissible on a commodity of a specific locality if it is assured that it is
almost always available in that locality and it rarely becomes
It is a
condition that the purchase price in Salam is specified and advanced to the
seller at the time of signing of contract.
It is a
condition in a Salam sale that the due date is known to avoid confusion, which
may lead to a dispute.
It is a
condition that the place of delivery be stated in the contract if the
commodity requires special handling and delivery arrangements.
permissible to take a mortgage on Salam debt to guarantee that the seller
satisfies his obligation by delivering the commodity on the due date.
impermissible for the buyer of a Salam commodity to sell the commodity before
receiving it. It is known that the Salam commodity is a liability debt to the
seller and not a commodity that exists. However, it is permissible for the
buyer to draw a parallel Salam contract without connecting it to the first
Bai-Salam transactions are discussed below:
Salam sales are
frequently used to finance the agricultural industry. Banks advance cash to
farmers today for delivery of the crop during the harvest season. Thus banks
provide farmers with the capital necessary to finance the cost of producing a
Salam sale are also
used to finance commercial and industrial activities. Once again the bank
advances cash to businesses necessary to finance the cost of production,
operations and expenses in exchange for future delivery of the end product. In
the meantime, the bank is able to market the product to other customers at
In addition, the
Salam sale is used by banks to finance craftsmen and small producers, by
supplying them with the capital necessary to finance the inputs to production in
exchange for the future delivery of products at some future date.
Thus as has been
demonstrated, the Salam sale is useful in providing financing for a variety of
clients, including farmers, industrialists, contractors and traders. The
proceeds in a Salam sale may be used to cover the finance of operation costs and
The Bai Salam
agreement is a combination of debt and trading. The capital provider has no
control over the management of capital provided. However the capital provider
takes all of the risk as profits cannot be determined until the commodity is
delivered and the final sale price is determined. In addition the capital
provider incurs the opportunity cost associated with the capital outlay. Like
the other three previously discussed modes of finance there is no certain rate
of return. In addition the cost of capital is uncertain ex-ante. Also, there is
no correlation in the relationship of cost of capital and rate of return on
Definition of Istisna'a
sale is a contract in which the price is paid in advance at the time of the
contract and the object of sale is manufactured and delivered later (IDB 1992,
p.28). The majority of the jurists consider Istisna'a as one of the divisions of
Salam, Therefore, it is subsumed under the definition of Salam. But the Hanafie
school of Jurisprudence classifies Istisna'a as an independent and distinct
contract. The jurists of the Hanafie school have given various definitions to
Istisna'a some of which are: "That it is a contract with a manufacturer to make
something" and "It is a contract on a commodity on liability with the provision
of work". The Purchaser is called 'Mustasnia' contractor and the seller is
called 'Sania' maker or manufacturer and the thing is called 'Masnooa',
manufactured, built, made (ABIIB). Islamic banks can utilize Istisna'a in two
permissible for the bank to buy a commodity on Istisna'a contract then sell it
after receipt for cash or deferred payment.
It is also
permissible for the bank to enter into a Istisna'a contract in the capacity of
seller to those who demand a purchase of a particular commodity and then draw
a parallel Istisna'a contract in the capacity of a buyer with another party to
manufacture the commodity agreed upon in the first contract.
is deemed a separate contract with payment being made in cash either immediately
or on a deferred basis. Any disagreements that may arise are settled under each
contract separately according to the provisions therein. The steps of the
Istisna'a sale and the parallel Istisna'a have been discussed below.
Steps of Istisna'a Sale
Contract: The Buyer
expresses his desire to buy a commodity and brings a request to purchase the
commodity to the bank. The method of payment, whether cash or deferred is set
forth in the agreement. The bank agrees to deliver the commodity to the buyer at
some agreed upon time in the future.
Istisna'a Contract: In order that
the bank is able to deliver said commodity in the Istisna'a agreement, the bank
enters into a parallel Istisna'a agreement with a third party to either
manufacture or otherwise deliver-said commodity. Obviously, the bank stipulates
a price that is lower than that agreed to in the original agreement and requires
delivery on or before the date stipulated in the original contract.
The seller, in
the parallel agreement, agrees to manufacture the specific commodity and to
deliver it on the due date agreed upon.
Receipt of the Commodity: The seller in
the parallel Istisna'a agreement, delivers the commodity to the bank on the
agreed upon date. The bank, in turn, delivers the product to the buyer of the
original Istisna'a contract, in accordance with the original agreement. In this
way, all parties fulfill their obligations to the contract.
Rules of Istisna'a Sale
It is a
condition in the Istisna'a contract to clearly define dimensions and
specifications of the product being purchased. This is important to ensure
that there is no room for dispute over what is required.
contract is only used for objects that can be manufactured. It can not be used
to purchase corn, wheat, barley, fruit or any natural product.
sold in a Istisna'a contract is a fixed liability debt and it is permissible
for the object to be a custom manufactured product, made in accordance with
should supply the materials. If they are supplied by the buyer, the contract
is Ijara and not Istisna'a.
contract is drawn the ownership of the asset is confirmed to the buyer and the
purchase price is confirmed to the manufacturer.
It is not a
condition in the Istisna'a contract to advance the price. Usually part of the
price is paid in advance and the remainder is withheld until the time of
It is a
condition that the time of delivery be specified in the agreement to avoid
confusion that may lead to a dispute over the transaction.
It is a
condition that the place of delivery be stated in the contract if the
commodity requires special handling and delivering arrangements.
The buyer may
stipulate in the Istisna'a contract that the commodity shall be manufactured
or produced by a specific manufacturer, or manufactured with specific
materials. This is not permitted in a case of Salam Sale.
Application of Istisna'a Sale
contract allows Islamic banks to finance the public needs and the vital
interests of the society to develop the Islamic economy in accordance with
Islamic teachings. For example Istisna'a contracts are used to finance high
technology industries such as the aviation, locomotive and ship building
industries. In addition, this type of business transaction is also used in the
production of large machinery and equipment manufactured in factories and
workshops. Finally, the Istisna'a contract is also applied in the construction
industry such as apartment buildings, hospitals, schools, and universities to
whatever that makes the network for modern life. One final note, the Istisna'a
contract is best used in those transactions in which the product being purchased
can easily be measured in terms of the specified criteria of the
QARD HASAN (Benevolent loans)
Qard Hasan is a
contract in which one of the parties (the lender) places into the ownership of
the other party (the borrower) a definite parcel of his property, in exchange
nothing more than the eventual return of something in the same value of the
(1998, p.49) mentioned that since interest on all kinds of loans is prohibited
in Islam, a loan that is to be given in accordance with the Islamic principle,
has to be, by definition, a benevolent loan (Qard Hasan) i.e. a loan without
interest. It has to be granted on the grounds of compassion, i.e. to remove the
financial distress caused by the absence of sufficient money in the face of dire
need. Since banks are profit driven organizations, it would seem that there is
not much opportunity for the application of this technique. However, Islamic
banks also play a socially useful role. Hence they make provisions to provide
Qard Hasan besides engaging in income generating activities.
There may be
slight variations among different Islamic banks in the use of this technique.
The Faisal Islamic Bank of Egypt provides interest-free benevolent loans to the
holders of investment and current accounts, in accordance with the conditions
set forth by its board of directors. The bank also grants benevolent loans to
other individuals under conditions decreed by its Board. On the other hand, the
Jordan Islamic Bank Law authorizes it to give "benevolent loans (Qard Hasan) for
productive purposes in various fields to enable the beneficiaries to start
independent lives or to raise their incomes and standard of living (Ibid,
pp.49-50). Iranian banks are required to set aside a portion of their resources
out of which interest free loans (Qard Hasan) can be given to small producers,
entrepreneurs and farmers who are not able to secure financing for investment or
working capital from other alternative sources, and needy customers. It should
also be noted that Iranian banks are permitted to charge a minimum service fee
to cover the cost of administering these funds.
Pakistan, Qard Hasan is part of the bank's normal financing activities. Qard
Hasan loans are granted compassionate basis and no service charges are imposed
on the borrower. While these loans are considered loans of compassion, they are
expected to be repaid when it is possible for the borrower to do so. Furthermore
in Pakistan, Qard Hasan operations are concentrated in the head office of each
bank. Branch offices are not permitted to extend these loans.
BAI-MUAJJAL (Deferred Sale)
Meaning of Bai-Muajjal
The terms "Bai"
and "Muajjal" are derived from the Arabic words 'Bai' and 'Ajal'. The word 'Bai'
means purchase and sale and the word 'Ajal' means a fixed time or a fixed
period. "Bai-Muajjal" is a sale for which payment is made at a future fixed date
or within a fixed period. In short, it is a sale on credit.
may be defined as a contract between a buyer and a seller under which the seller
sells certain specific goods, permissible under Shariah and law of the country,
to the buyer at an agreed fixed price payable at a certain fixed future date in
lump sum or in fixed installments.
There are some
important features of Bai-Muajjal as given below (ABIIB).
Important Features of Bai-Muajjal
permissible and in most cases, the client will approach the bank with an offer
to purchase a specific good through a Bai-Muajjal agreement.
permissible to make the promise binding upon the client to purchase the goods
from the bank. In other words, the client is required to either satisfy the
promise or to indemnify the bank for damages caused by breaking the promise
permissible to take cash/collateral security to guarantee the implementation
of the promise or to indemnify the bank for damages caused by non-payment.
It is also
permissible to document the debt resulting from Bai-Muajjal by a Guarantor, or
a mortgage or both, like any other debt. Mortgage/Guarantee/Cash security may
be obtained prior to the signing of the Agreement or at the time of signing
availability of goods is a basic condition for signing a Bai-Muajjal
Agreement. Therefore, the bank must purchase the goods in accordance with the
specifications of the client, prior to signing the Bai-Muajjal Agreement with
purchased on behalf of a Bai-Muajjal agreement are the responsibility of the
bank until they are delivered to the client.
The bank must
deliver the goods to the client at the time and place specified in the
The bank may
sell the goods at a higher price than the purchase price to earn
The price is
fixed at the time of the agreement and cannot be altered.
The bank is
not required to disclose the profit made on the transaction.
This type of
financing by the bank is considered to be more risky than the other Islamic
modes of investment previously discussed. Therefore, the
application/proposal for Bai-Muajjal investment must be reviewed very carefully
to ensure the client can ultimately make payment. . The following steps may be
taken to ensure the Bai-Muajjal Investment is a good proposition for the
The bank may
meet with the prospective client regarding his investment needs and business
experience prior to an application /proposal is submitted.
The bank may
review the client's past performance and other financing arrangements he may
have had with the bank in the past.
The bank may
review its current investment policy regarding this type of financing
arrangement to ensure the proposal meets bank guidelines.
It should be
remembered that if the Bai-Muajjal investment is not secured by first class
collateral securities, it becomes more risky than investments under other modes
of Islamic banking.
points should receive attention before making any investment decision under
goods that the client intends to purchase are marketable and have steady
demand in the market.
price of the goods is subject to frequent and violent changes.
goods are perishable in short or in long-term duration.
quality and other specifications of the goods as desired by the client can be
goods are available in the market and the bank will be in a position to
purchase the Goods in time and at the negotiated price.
sale price of the goods is payable by the client at the specified future date
in lump sum or in Installments as per the agreement.
Definition of Ijarah
Fuqaha (jurists) have
defined Ijaraha as ownership of a benefit for consideration. This is also known
as lease or Hire contract. Al-Ijarah is an Arabic term. This has been derived
from the Arabic term "Ujr" or "Ujrat" which means 'consideration' or 'return' or
Islamic Shariah (jurisprudence), Ijarah is a contract between two parties - the
lessor and the lessee, where the lessees (Hirer or Mustajir) have the right to
enjoy/reap a specific benefit against a specified consideration/rent/wages from
the lessor - the owner (Muajjir).
majority of Fuqaha, there are three general and six detailed elements of
This includes offer and acceptance
parties: This includes a lessor, the owner of the property, and a lessee, the
party that benefits from the use of the property.
of the contract: This includes the rent and the
(Mujjir) - The individual or organization who leases out/rents out the property
or service is called the lessor.
(Mustajir) - The individual or organization who hires/takes the lease of the
property or service against the consideration rent/wages/remuneration is called
the lessee (Mustajir).
(Maajur) - The benefit that is leased/rented out is called the benefit
The rent (Aj'r
or Ujrat) - The consideration either in monetary terms or in quantity of goods
fixed to be paid against the benefit of the goods or service is called the rent
or Ujrat or Aj'r.
Rules for Ijarah
It is condition
that the subject (benefit/service) of the contract and the asset (object) should
be known comprehensively.
It is a
condition that the assets to be leased must not be a fungible one (perishable
or consumable) which can not be used more that once, or in other words the
asset(s) must be a non-fungible one which can be utilized more than once, or
the use/benefit/service of which can be separated from the assets
It is a
condition that the subject (benefit/service) or the contract must actually and
legally be attainable/derivable. It is not permissible to lease something, the
handing-over of the possession of which is impossible. If the asset is a
jointly owned property, any partner, according to be majority of the jurists,
may let his portion of the asset(s) to co-owner(s) or the person(s) other than
the co-owners. However, it is also permissible for a partner to lease his
share to the other partner(s),
It is a
condition that the lessee shall ensure that he will make use of the asset(s)
as per provisions of the Agreement or as per customs/norms/practice, if there
is no expressed provision.
contract is permissible only when the assets and the benefit/service derived
from it are within the category of 'Halal' or at least 'Mobah' as per Islamic
The lessor is
under obligation to enable the lessee to the benefit from the assets by
putting the possession of the asset(s) at his disposal in useable condition at
the commencement of the lease period.
In a lease
contract, the period of lease and the rental to be paid in terms of time,
place or distance should be clearly stated.
that is suitable to be considered a price, in a sale, can be suitable to be
considered as rental in a lease contract.
It is a
condition that the rental falls due from the date of handing over the asset to
lessee and not from the date of contract or use of the assets.
permissible to advance, defer or install the rental in accordance with the
permissible to review the lease period or the rental or the both, if the
lessor and the lessee mutually agree to do so.
asset is a trust in the hands of the lessee. He will maintain the asset(s)
with due prudence and shall not be held responsible for the damage or
destruction of the asset without transgression, default or negligence,
otherwise he must be responsible for the same.
lessor/owner bears all the costs of legally binding basic repairs and
maintenance including the cost of the replacement of durable parts on which
the permanence and suitability of the leased assets depends.
permissible to make the lessee bear the cost of ordinary routine maintenance,
because this cost is normally known and can be considered as part of the
permissible for the lessee to let the asset to a third party during the lease
period whether for the same rental or more as long as the asset is not
affected by the change of user and not barred/restricted by the Lease
Agreement/customs to do so.
permissible to purchase an Asset bearing a lease contract. The lease contract
may continue since the purchased agrees to its continuity up to the end of the
lease term. All rights and liabilities emanating from the lease contract will
transfer to the new owner. But if the sale-contract is drawn and the purchaser
is oblivious of the lease contract, he has the right to rescind the purchase
contract and the lease continues.
As soon as the
lease period terminates the lessee is under obligation to return the Asset to
the owner or if the lessor agrees he may enter into a fresh lease contract or
purchase if from the lessor on payment of agreed upon price as per market
contract is binding and no one party shall unilaterally rescind except reasons
that abrogate binding contracts such as damage or destruction.
If the leased
asset is damaged or destructed by the act of Allah and if the lessor offers a
substitute with the same specifications agreed upon in the lease contract, the
contract does not terminate.
permissible to sell the leased Asset by the lessor to the lessee during the
tenure of the lease period either part by part or in full at a time. As soon
as any part or in full the Asset is sold during the tenure of the Lease
Agreement, the lease contract for that part or for the full Asset as the case
may be, be lapsed and the rental ceased to apply.
permissible for the lessee to promise or to give undertaking to purchase the
leased asset during the tenure of the lease period, either part by part or in
full or at the end of the lease period in full. It is also permissible for the
lessor to give similar promise to sell the Asset.
The lease with
promise to purchase and sale is different from the memorandum of sale. The
rent paid by the lessee cannot, in any way, be considered as part of the price
of the Asset, rather it is the price of the service of the Asset.
permissible to divide the cost price of the Asset and ownership of the lessor
to the Asset into several parts and to sell each part of ownership on payment
of proportionate price/equity of the lessor under a separate sale
HIRE-PURCHASE UNDER SHIRKATUL MELK or IJARAH MUNTAHIB BIL
under Shirkatul Melk has been developed through practice. Actually, it is a
synthesis of three contracts: (a) Shirkat; (b) Ijarah, and (c) Sale. These may
be defined as follows:
Shirkatul Melk: 'Shrkat' means
partnership. Shirkatul Melk means share in ownership. When two or more persons
supply equity, purchase an asset and own the same jointly and share the benefit
as per agreement and loss in proportion to their respective equity, the contact
is called Shirkatul Melk. In the case of Hire Purchase under Shirkatul Melk,
Islamic banks purchase assets to be leased out, jointly with client under equity
participation, own the same and share benefit jointly till the full ownership is
transferred to the client.
Ijara: The term 'Ijara' has been defined as a contract between two parties, the
lessor and the lessee, where the lessee enjoys or reaps a specific service or
benefit against a specified consideration or rent from the asset owned by the
lessor. It is a lease agreement under which a certain asset is leased out by the
lessor or to a lessee against specific rent or rental for a fixed
Sale contract: This is a contract between a buyer and a seller under which the
onwnership of certain goods or asset is transferred by the seller to the buyer
against agreed upon price paid by the buyer. In the case of Hire Purchase under
Melk, the lessor
bank sells or transfers its title to the asset under a sale contract on payment
of sale price.
Thus in Hire
Purchase under Shirkatul Melk mode, both the bank and the client supply equity
in equal or unequal proportion for purchase of an asset like land, building,
machinery, transports, etc., purchase the asset with that money, own the same
jointly, share benefit as per agreement and bear the loss in proportion to their
respective equity. The share/part or portion of the asset owned by the bank is
leased out to the client partner for a fixed rent per unit of time for a fixed
period. Lastly, the bank sells and transfers the ownership of its
share/part/portion to the client against payment of price fixed for that part
either gradually part by part or as a whole within the lease period or on expiry
of the lease agreement. Hire-Purchase under Shirkatul Melk contract is to a
great extent similar to the contract of Ijarah Montahia Bil Tamlek as termed by
Accounting and Auditing Standards Board of the Account and Auditing Organization
of Islamic Financial Institutions (AAOIFI).
Stages of Hire Purchase under Shirkatul Melk
under Shirkatul Melk Agreement has got three stages:
asset under joint ownership of the lessor and the lessee.
transfer of ownership by the lessor to the other partner -
In case of
Hire Purchase under Shirkatul Melk transaction the asset/property involved is
jointly purchased by the lessor (bank) and the lessee (client) with specified
equity participation under a Shirkatul Melk contract in which the amount of
equity and share in ownership of the asset of each partner (lessor bank and
lessee client) are clearly mentioned. Under this agreement the lessor and the
lessee become co-owners of the asset under transaction in proportion to their
Purchase under Shirkatul Melk Agreement the exact ownership of both the lessor
(bank) and lessee (client) must be recognized. However, if the partners
wish and agree the asset purchased may be registered in the name of any one of
them or in the name of any third party clearly mentioning the same in the Hire
Purchase Shirkatul Melk Agreement.
of the purchased asset owned by the lessor (bank) is put at the disposal
possession of the lessee (clients) keeping the ownership with him for a fixed
period under a hire agreement in which the amount of rent per unit of time and
the benefit for which rent to be paid along with all other agreed upon
stipulations are clearly stated. Under this agreement the lessee (client)
becomes the owner of the benefit of the asset not of the asset itself, in
accordance with the specific provisions of the contract that entitles the
lessor (bank) the rentals.
ownership of leased portion of asset lies with the lessor (bank) and rent is
paid by the lessee against the specific benefit, the rent is not considered as
price or part of price of the asset.
In the Hire
Purchase under Shirkatul Melk agreement the Lessor (bank) does not sell or the
lessee (client) does not purchase the asset but the lessor (bank) promise to
sell the asset to the lessee only if the lessee only if the lessee pays the
cost price/equity price of the asset as fixed and as per stipulations on which
the lessee also gives undertakings.
The promise to
transfer legal title by the lessor and undertakings given by the lessee to
purchase the ownership of leased asset upon payment part by part as per
stipulations are affected only when it is actually done by a separate sale
As soon as any
part of lesssor's (bank's) ownership of asset is transferred to the lessee
(client), that becomes the property of the lessee and hire contract for that
share/part and entitlement for rent thereof lapses.
Purchase under Shirkatul Melk Agreement, the Shirkatul Melk contract is
effected from the day the equit7y of both parties deposited and the asset is
purchase and continues up to the day on which the full title of lessor is
transferred to the lessee.
contract becomes effective from the day on which the lessor transfers the
possession of the leased asset in good order and usable condition, so that the
lessee may make use of the same as per provisions of the agreement.
of the sale contract depends on the actual sale and transfer of ownership of
the asset by the lessor to the lessee. It is sold and transferred part by part
it will become effective part by part and with the sale and transfer of
ownership of every share/part, the hire contract for the share/part will lapse
and rent will be reduced proportionately. At the end of the lease, the period
when the full title of the asset will be sold and transferred to the lessee,
the lessee will become the owner of both the benefit and asset, hire contract
will fully end.
under Shirkatul Melk are binding contracts, and the parties to it - the bank
and the client - are committed to meet their obligations in accordance with
the relevant agreement.
agreement, the bank acts as a partner, as a lessor and at last as a seller; on
the other hand the client acts as partner, as a lessee and lastly as
is borne both by the lessor and lessee in proportion to their ownership
agreement the role of lessee is one of a trustee, the leased asset being a
trust in his hands: he will manage, in favor of the interest of thee lessor at
his own cost the exact subject of lessee, except in cases of emergencies and
acts of Allah.
The lessee is
responsible for keeping the leased asset (s) in good condition throughout the
whole period of lease, and if the asset is damaged or defrayed due to
transgressions default or negligence of the lessee, he shall be responsible to
compensate for that.
cannot without obtaining prior written permission of the bank make changes in
the exact item of lease, and or remove it from its place of installation, and
transfer it to another location.
In a hire
purchase under Shirkatul Melk agreement, any stipulation may be made, provided
it is not against the nature and requirements of the contract itself, nor does
it violate the Lessee laws of Islam, and is also acceptable to both parties.
under Shirkatul Melk facileties may be for medium-term and long-term period,
which may be utilized for the expansion of production and services. as well as
housing activities. The duration of hire purchase under Shirkatul Melk
contract shall not exceed the useful life of the subject asset of the
transaction. The bank should not normally enter into a Hire Purchase under
Shirkatul Melk transaction for items with useful life of less than two years.
under Shirkatul Melk transaction facilitates the client (lessee) to get
benefit from the lease asset in exchange of rental and also to become full
owner of the asset by purchasing it.
under Shirkatul Melk Mode is a combination of three contacts. All rules
governing the lease contract should be applicable in this mode also. Moreover,
the rules for Musharakah and sale contracts will also apply to this. In
addition, the following should also be followed:
Purchase Shirkatul Melk Agreement, both the lessor and the lessee must pay
their respective equity as agreed upon to purchase the desired asset under
the asset of both the lessor and the lessee should be recognized as per law of
SOME ISLAMIC FINANCIAL INSTRUMENTS
financial instrument can be defined as "an instrument representing a share in a
joint capital collected for investment with the aim of realizing profit, issued
by the investing party in his capacity as Mudarib (agent-manager) or by a third
party on his behalf; such certificate is negotiable and capable of being turned
into liquid money".
Participation Term Certificates (PTCs)
Participation Term Certificates (PTCs) have replaced debentures. PTCs are
transferable corporate instruments based on the principle of profit and loss
sharing to replace debentures for providing medium and long-term funds for
industrial and other financing. Instead of receiving interest, as in the case of
debentures, the holders of PTCs share in the profit or loss of companies raising
finance through this device. The PTCs have the following features:
Certificates are issued for a specific period not exceeding
10 (Ten) years, excluding the grace period.
principles governing the legal aspects of Participation Term Certificates
(PTCs) are prescribed by the Government by making suitable amendments in the
statutes governing the operations of corporate entities (the Company
As PTC finance
is provided for a specific period, it is secured by a legal mortgage on the
fixed assets of the company. It also enjoys a floating charge on the current
purpose of allocation of profit to PTC holders, the investments rank Pari
Passu with equity, and share in profit on a basis to be determined by mutual
the purpose of determining return to the PTC holders are taken to be pre-tax
profit before appropriations.
to PTC is treated as deductible expense for income-tax purpose.
The share of
PTC holders in the profit is deducted prior to the claim of shareholders in
the profits of the company in any given year.
In case of
loss, the first recourse is made to the free reserves, including the credit
balance in the profit-and-loss accounts of the issues, and the balance of the
loss (if any) is shared between the PTC holders and other providers of funds
in proportion to their funds.
of PTCs are used exclusively for the project or the business concerned, and
the sponsors are required to give an undertaking to conduct the business with
diligence and efficiency, in accordance with sound engineering, financial and
business practices and such other terms as may be agreed between the
In order to
provide protection to the purchasers of PTCs, a trustee is appointed who is
responsible, inter alia, for the appraisal of the business or the project. The
trustee has the right to call for any information from the company, visit
premises where the business or the plant and machinery of companies are
located and have access to their records.
An option is
also given to the PTC holders to convert a certain portion of outstanding PTCs
into ordinary shares.
A right option
is also given to the existing ordinary stockholders to subscribe to the fresh
issues of PTC.
issue PTC's can be obtained from the Controller of Capital Issues in the case
of non-banking companies and from the State Bank of Pakistan in the case of
are being used by Islamic Investment Companies to mobilize funds for investment
in a variety of ways. Mudaraba Certificates are usually of two types: Specific
purpose Mudaraba Certificates and General purpose Mudaraba Certificates.
Specific purposes Mudaraba Certificates are related to financing of specific
projects and mature only on the completion of the project. General purpose
Mudaraba Certificates can have a specific or an indefinite duration. Both types
of certificates can be issued in negotiable form, either registered or bearer.
Mudaraba Certificates can be distributed in an underwriting or sales effort of a
fixed term, or be continuously available or be available on a periodic
special law called the Mudaraba Companies and Mudaraba (Floatation and Control)
Ordinance 1980 governs the floatation and operations of Mudaraba. The Mudaraba
Companies and Mudaraba Rules-1981 subsequently supplemented the Law. The
Mudaraba Law provides the necessary legal framework for the flotation of
Mudaraba in Pakistan. Under this law, management companies, banks and financial
institutions can register themselves as Mudaraba Companies and float a Mudaraba
for a specific or general purpose. The objects of any Mudaraba will be
restricted to only such business as are permitted under the Islamic Shariah.
In order to
ensure that Mudaraba are not used in any activity that is repugnant to the
tenets of Islam, the prospectus of each Mudaraba will need a prior clearance
from a Religious Board. Furthermore, after the Mudaraba goes into operation, the
Law imposes additional responsibility on the auditors to certify that all
business conducted, investments made and expenditure incurred are in accordance
with the objects, terms and conditions of the Mudaraba. To safeguard the
interest of the Mudaraba Certificate-holders, a number of protective clauses
have been provided, including quicker and simpler adjudication by a tribunal. In
order to promote the growth of Mudaraba and keeping in view the larger interest
of Mudaraba Certificate - holders, the entire income of the Mudaraba funds has
been exempted from income take, provided that 90 percent of the income is
distributed to the Mudaraba Certificate-holders. The salient provisions of the
Mudaraba Law are described below:
Registration - Only
companies that are registered as "Mudaraba Companies" can float a Mudaraba to be
eligible for registration as a Mudaraba Company, the following conditions must
It should be a
company in the private or public sector registered under the Companies Act or
any other Law in force.
engaged in floatation and management of Mudaraba, its paid-up capital should
not be less than Rs. 5.00 million.
engaged in business other than floatation and management of Mudaraba, the
company must have capital of such amount and nature as may be
Types: A Mudaraba can
be multipurpose or specific purpose:
multi-purpose Mudaraba is one, which has more that on specific purpose or
purpose Mudaraba is one, which is set up for a specific purpose or
Both types of
Mudaraba can be either for a limited period or for
A Mudarib shall
be a legal person capable of suing or being sued in its own name through the
Floatation - Floatation of
Mudaraba may be authorized on fulfilling the under-noted
requesting for permission is registered as a Mudaraba Company.
containing name, type of Mudaraba, amount, conditions, business prospects,
mode of distribution of profit, and proof of Management Company's own
contribution is filed with the Registrar.
The consent of
the Controller of Capital Issues has been obtained.
of the Mudaraba is not opposed to any injunction of Islam.
Conditions for Mudaraba are as follows:
The assets and
liabilities of each Mudaraba shall be separate for each Mudaraba and also
distinct from those of the Mudaraba Company.
accounts shall be maintained for each Mudaraba.
received with application shall be kept in separate accounts until either
refunded or certified by the Registrar that Mudaraba Certificates have been
If the minimum
amount is not subscribed by the specified date, money received shall be
refunded within 15 (fifteen) days of the specified date.
shall be transferable in the manner prescribed in the
must be issued within 30 (Thirty) days of allotment.
Mudaraba Companies - Conditions to be fulfilled by Mudaraba Companies are as
Company shall not engage in any business of the same nature in competition
with the Mudaraba floated by it.
Company shall subscribe in each Mudaraba floated by it not less than 10
percent of the total amount offered for subscription.
and officers of the Mudaraba Company or their relatives shall not obtain
loans, advances or credit from Mudaraba fund or against its
loss account and the balance sheet along with the Auditors and the Company's
report shall be circulated to Mudaraba Certificate-holders within 6(six)
months of the close of accounting period.
Government Investment Certificates
of Malaysia introduced Investment Certificates in 1983. The Government
Investment Certificates are liquid short-term government certificates introduced
by the Malaysian Government through an Act of Parliament (The Government
Investment Act-275 of 1983). These certificates enable the Islamic bank and
other institutions as well as individuals to lend short-term funds to the
Government without interest but on the Shariah principle of Qard Hasan. Under
this principle, while the repayment of the principle amount of the loan is
obligatory, the payment and magnitude of reward for the loan is at the absolute
discretion of the borrower - the government.
features and provisions of the Malaysian Government Investment Act-275 and the
relevant Investment Certificates are as under:
of Finance is authorized to receive, on behalf of the Government of Malaysia,
at such times and upto such maximum amounts as he may from time to time
specify, investment of moneys from any person - of a sum of ten thousand
ringgit (Malaysian dollar) or a multiple of ten thousand ringgit.
received as above shall be applied and be appropriated to the following
moneys so received, to such extent as the Minister of Finance may determine,
with the prior approval of the Dewan Rakyat (Parliament) into the
Development Fund (of the Government).
making an investment shall declare the period for which the investment is
made, which shall be one full year or more; and at the end of that period the
money invested shall be repaid.
shall issue a receipt in the form of an Investment Certificate.
Certificates shall be transferable by endorsement and delivery.
shall be paid on investments in the Government Investment Certificates but
there shall instead be paid dividends.
of Finance shall from time to time, by order published in the Gazette, declare
the rates of dividends to be paid on investments in the Certificates.
each investment shall become due annually on the anniversary of the date of
its making and shall be paid at the Federal Treasury to the holder of the
Investment Certificate relating to the investment on presentation of the
shall be due or payable on any investment after the period for which the
investment was made.
shall be repaid on maturity to the holder of the Investment Certificate
relating to the investment on his tendering the certificate.
shall be repaid except upon surrender of the Investment Certificate relating
thereto for cancellation.
represented by investment Certificates, and the dividends thereon, are charged
upon and shall be payable out of the consolidated Fund.
No stamp duty
shall be leviable or payable on any Investment Certificate or on the transfer
of Finance may, be notification in the Gazette, delegate to the Accountant
General or the Central Bank of Malaysia any or all of the powers or duties
conferred upon him by this Act.
Any person who
forges or alters any Investment Certificate or any word, figure, marks, sign,
signature, or facsimile upon or attached to any investment certificate, or who
offers or utters or disposes of any Investment Certificate knowing the same to
be forged or altered shall on conviction be liable to imprisonment for a term
not exceeding fifteen years.
Investment Certificates having similar features have also been introduced in
Egypt and Yemen.
10.4 IDC, IIC and
instruments proposed in the Seminar on Developing a System of Financial
Instruments, jointly sponsored by the Islamic Development Bank and the
Government of Malaysia, held in Kuala Lumpur 1986, were Islamic Deposit
Certificates (IDCs), Islamic Investment Certificates (IICs) and Muqarada Bonds
(MBs). These appeared promising the IDC proceeds are meant to be used by the
issuing bank for general purposes, while IIC proceeds are meant for investment
in a specific project or activity by the issuing bank. The MBs proceeds are
meant to be used for income-yielding public utility projects, such as
electricity and telecommunications, and infrastructure development projects such
as construction of roads and bridges.
denominator for all the above three instruments is that they are all based on
the principle of profit sharing. The holders of IDC and IIC will also share in
the losses, if any, but not the holders of MBs, as the nominal value of MBs
would be guaranteed by the Government, which is a third party independent from
the other two. It is of interest to note that Muqarada Bonds have already been
adopted as a financial instrument in Jordan, though with a limited
It may be
pointed out that the financial instruments certificates described above may
serve well in an integrated Islamic Financial System. In countries where Islamic
banks co-exist with interest-based banks, the role of Islamic banks would be
quite different. They would have not only to generate incremental savings, but
also to divert savings from non-Islamic financial institutions. Therefore, the
rates of return offered by Islamic banks in a mixed system will have to be
competitive with those offered by rival institutions. A project that appears
good on paper may well turn out to be a failure if people behind it as dishonest
or incompetent. The Islamic banks will, therefore, have to evaluate not only the
project but also the persons selling the project for purpose of financing.
Needless to mention, the necessary legal framework should also be
Muslim theoreticians and practitioners have helped in evolving new Shariah-based
financial instruments. These have proved to be effective instruments for
mobilization of savings, and have proved their usefulness in meeting the
corporate requirements in a modern Islamic economy. Nevertheless, the newly
evolved instruments of finance need to be further refined and developed to
incorporate necessary sophistication so as to meet the changing environment of
financial markets. Moreover, further research is needed for developing
methodology for equitable sharing of profit and loss among the suppliers and the
users of funds. It is imperative to develop a cadre of Islamic bankers and
financial analysts, risk management, project appraisal and monitoring, and
equity financing. Finally, a transformation of the thinking and the approach of
the Muslim society as a whole would be essential for the widespread and
successive operation of the Islamic Shariah-based financial Instruments.
COMPARISON OF ISLAMIC AND CONVENTIONAL MODES OF FINANCING
Before we go on
make a comparison between the modes of finance of Islamic banks and those of
conventional banks, let us very briefly state the financial arrangements of the
MODES OF ADVANCE OF THE CONVENTIONAL BANKS
banks engage in the following types of financing
The most obvious
form of financing by a conventional bank is the loan arrangement. The bank
advances (loans) a lump sum to an individual (the borrower) for a set length of
time at either a fixed or viable rate of interest. The borrower repays the loan
with equal installments over the prescribed term or in one lump sum at the end
of the term. There are no checks issued in this type of relationship.
of financing through overdrafts can only occur when there is an existing
demand deposit account. An overdraft occurs when the amount of a check
presented for payment to the bank exceeds the clients deposit balance. The
banks may choose to pay on the item, thereby causing a negative balance in the
client's account. This negative balance is effectively an extension of
financing and can be a prior arrangement with the bank. In addition, overdraft
facilities may be extended against deposit certificates and/or government
Cash credit is a
popular mode of borrowing by traders, industrialists and agriculturalists. It is
a separate account by itself and does not require having any other account with
the bank. It resembles the use of overdrafts on a checking account. It is an
arrangement whereby the borrower may withdraw funds as needed for day-to-day
operations without the delay associated with making a loan. The borrower may not
exceed a predetermined limit and must deposit cash back into the account as
funds become available from daily operations. Interest is charged on the daily
balance in the account.
This type of
loan is advanced to industries and agriculture for fixed capital requirements.
These loans are also granted to traders for purchase of fixed assets, to
transport operators for purchase of vehicles, and to self-employed persons for
purchase of equipment. These loans are usually extended for a term of 3 to 7
years and in special cases up to 10 years and are generally repayable by
instalments. Since it will take a year or two to derive the full benefits of
expansion or renovation, instalments for repayment may commence after one or two
years of the disbursement of the loan. Interest is charged on annual basis.
arrangement, conventional banks grant advances to its clients engaged in
hire-purchase business relating to transports, refrigerators, and televisions,
for example. This type of financing is usually repaid with instalments including
principal and interest. The bank generally requires immovable property as
collateral against this type of financing.
businesses are performed through opening of L/Cs with Bank. The client,
while opening the L/C, comes to an agreement with the bank that the latter will
repay the bill received on the farmer's behalf on a certain date onward in
exchange for a specific rate of interest determined at the time of agreement. If
the bill happens to reach well ahead of the date mentioned, the bank may
purchase the bill, if requested, with a discount. In this case, the bank makes
the return twice: first, by charging interest and then by discounting the bill.
COMPARISON OF FINANCIAL MODES
For an effective
comparison between the modes used by the two systems of banking, the following
categorizations common to both may be adopted:
to project financing,
to financing trade and commerce, and
or system specific modes.
In line with the
above categorization, medium and long-term loans under conventional banking, and
Mudaraba and Musharaka of PLS-banking come under category (a). Under category
(b), loans, cash credits, Hire Purchase and bills purchased/discounted of
conventional banking and Murabaha, Bai-Salam and Bai-Muajjal of PLS-Banking may
be listed. Loans and cash credits of conventional banks may be categorized
under (c) to satisfy the working capital needs of the borrower. For Islamic
banks, there are no similar modes like its conventional counterpart to meet
working capital needs. Though the "Qard Hasan" is customarily grouped under this
category, it is not widely practiced by PLS-banks since this mode, by its very
nature, does not earn a return. Qard Hasan is benevolent loans, made on an
interest free basis.
Keeping in mind
the above categorizations, one may analyze the similarities or differences
between the modes of conventional and those of the PLS-banking. As far as the
first category is concerned, unlike PLS banks, conventional banks advance money
in exchange for a predetermined fixed rate of interest. That is, under the
conventional banking system, every advance made by a bank is a contract between
the bank and the client with the following essential features: (i) a
creditor-borrower relationship is established; (ii) the lending or borrowing is
time bounded qualifying specific date(s) on which a certain percentage of
interest on borrowed capital becomes due for payment along with the principal;
and (iii) the income of the bank is known and prefixed and not in any way
related to or variable with the income of the borrower generated from the
On the other
hand, the financing arrangements under the PLS system of Islamic banks, have the
following features: (a) it is a contract between two partners - the bank and the
client-providing a partner-partner relationship; (b) the contract is time
bounded in the sense that the client has to return the capital on/within
specific date(s). However, the return of the bank is not fixed either from the
standpoint of time or that of the rate; and (c) bank shares a prefixed ratio of
profit expressed in percentage terms. This is not a prefixed rate of return
calculated on capital advanced. Thus, income (profit) for a PLS-bank, unlike the
practice of its conventional counterpart, fluctuates with the profits of the
In summary, in
conventional banking, the bank is simply a financier and is not directly
concerned about the success or failure of the project for which the loan was
made, as long as it receives its payments. This is so because the bank's income
(interest income) does not fluctuate with the fluctuations in the profit
generated from the specific project. In other words, conventional banks advance
financing in return for a guaranteed fixed return. On the other hand, a PLS-bank
has a high interest in the performance of each project it finances because its
income is directly related to the returns from each project it finances.
Thus, with regard to the first grouping of financing methods, the conventional
bank is a risk-avatar, whereas the PLS-bank is a risk-taker.
With regard to
the second class of financing methods, those that are generally used for
financing trade and commerce, the only comparison worth mentioning is that in
Conventional banking, fixed interest payments are made to the bank, whereas in
the Islamic counterpart, the bank earns a profit margin. The Murabaha, Bai-Salam
and Bai-Muajjal arrangements have often been accused of being 'Riba'
practices. However, the accusation is countered by the argument that the
PLS-banks, unlike its conventional counterparts, are obliged to buy the goods
and establish the bank's ownership, prior to selling the goods for a
concerning the third class of investment types, these modes are very much system
specific and hence no meaningful comparison is possible.