You are on page 1of 68


Trade Finance in Islamic Banks
Muhammad Faisal Shaikh
BankIslami Pakistan Ltd Shaban 03 , 1426 September 08, 2005

Trade Finance in Islamic Banks Famous quote in Conventional Banking ¨BANKS DEAL IN DOCUMENTS NOT GOODS¨ .

Trade Finance in Islamic Banks The quote needs to be modified as follows: ¨ISLAMIC BANKS DEALS IN GOODS AND DOCUMENTS¨ .

. We will now look at different options to finance imports and exports in Islamic Banking.Trade Finance in Islamic Banks Trade Finance Operations of Banks play an important role in overall economic development of the country through facilitating Imports and Exports. conversion of trade finance operation is relatively easier. Since they usually involve assets.

Trade Finance in Islamic Banks Following modes can be applied in financing trade Musharakah/Mudarabah Murabahah .

Musharakah/Mudarabah can be applied in Trade Finance without complexities generally faced in such financing arrangements. Islamic Banks can use Musharakah/Mudarabah in trade finance to build a profitable and secure portfolio. Export Finance through Musharakah/Mudarab ah . Since the chances of fraud. negligence and others problems are relatively lower.

The exporter receives an order from abroad to export a specific commodity/good at a known price. The Bank can provide financing on the basis of Musharakah or Mudarabah.Export Finance through Musharakah/Mudarab Banks can use Musharakah and Mudarabah in trade finance ah in the following manner. Exporter can estimate its expected profit. Exporter needs financing for manufacturing/procurement of the goods. .

. being a partner of the exporter. ah the exporter The Bank can secure itself from any negligence on the part of However.Export Finance through Musharakah/Mudarab Profit would be shared on a pre-agreed percentage. the bank will be liable to bear any loss which may be caused due to any reason other than the negligence of the exporter.

. in order to undertake such operation Banks need to ah A practical application of a similar transaction of import finance is discussed next. Export Finance through Musharakah/Mudarab However.understand the nature of exporter´s business and other requirements.

. ABC & Co was interested in financing the transaction through a Musharakah arrangement.Import Finance through Musharakah/Mudarab A government departmentah awarded a contract to a local supplier (ABC & Co) for supply of an Imported Equipment.

. In a Shirkat-ul-Wujooh arrangement the partners have no investment at all.Import Finance through Musharakah/Mudarab The structure of the product was developed on a special kind ah of Musharakah i. They purchase goods on deferred price.e. and sell them at spot. Shirkat-ul-Wujooh. The profit so earned is distributed between them at an agreed ratio.

.Import Finance through Musharakah/Mudarab The process of the transaction consisted of following steps ah ABC & Co opened a Usance LC of Rs. 10 million which was issued by Islamic Bank (Islamic Bank participation) in favor of M/s XYZ Machines Italy.

Equipments were shipped to Karachi through Air Cargo due to sensitiveness of the equipment. . XYZ Machines agreed to give credit period of 180 days. 2. 3.Import Finance through Musharakah/Mudarab ah 1. ABC & Co inspected the goods and confirmed their satisfaction to the bank upon which Islamic Bank conveyed its acceptance of documents to the negotiating bank.

After the installation. ABC & Co took around 50 days to install the equipment. government inspected and tested the equipment for its performance. 6. . As soon as the satisfaction certificate was issued system. bill was lodged for payment.Import Finance through Musharakah/Mudarab 4. Pakistan Custom’s took 30 days for the clearing of ah equipment. 5. 7.

.Import Finance through Musharakah/Mudarab 8. 10. ah 9. Payment was received within 150 days of shipment. Islamic Bank settled the LC on the due date. Profit was distributed among the partners as per the agreed ratio.

However. . a detailed study should be undertaken before the execution of transaction. Close relationship with the customer during the currency of the transaction is necessary.Import Finance through Musharakah/Mudarab On the same lines other transaction may also be ah undertaken.

Trade Finance through Murabahas .

As explained before since assets are involved in trade finance structured Murabahah facility can be used.Trade Finance through Murabahah Murabahah is widely used as mode of finance in trade finance. .

. A step by step process is explained next.Murabahah Financing for Exports Murabaha is simply a sale transaction Which is being used by Islamic Financial institutions as a mode of financing by routing the transaction through Bai Mujjal. The mode can be used to provide financing to exporter for purchase of raw materials.

Murabahah Financing for Exports Step by step Murabahah financing 1. Bank Agreement to Murabaha Exporter . Exporter and bank sign an agreement to enter into Murabahah.

Exporter appointed as agent to purchase goods on bank’s behalf Bank Agreement to Murabaha Agency Agreement Exporter .Murabahah Financing for Exports Step by step Murabahah financing 2.

Murabahah Financing for Exports Step by step Murabahah financing 3. Bank Agreement to Murabaha Agency Agreement Exporter Disbursement to the supplier or agent Supplier . Bank gives money to exporter for purchase of goods.

Exporter purchases goods on bank’s behalf and takes their possession.Murabahah Financing for Exports Step by step Murabahah financing 4. Delivery of goods Transfer of Risk Vendor Bank Agent .

Exporter makes an offer to purchase the goods from bank. Bank Exporter Offer to purchase .Murabahah Financing for Exports Step by step Murabahah financing 5.

Murabahah Financing for Exports Step by step Murabahah financing 6. Bank Exporter Murabaha Agreement . Bank accepts the offer and sale is concluded.

Murabahah Financing for Exports Step by step Murabahah financing 7. Bank Payment of Price Exporter . Exporter pays agreed price to bank according to an agreed schedule.

. Murabahah alone cannot fulfill their requirements. since their main raw material also include labor and overhead expenses. In Pakistan textile composite units purchase cotton to manufacture finished cloth.Murabahah-Istisna Financing for Exports Exporters some times needs financing for processing of raw material. these unit cannot rely on Murabahah Finance.

Murabahah-Istisna Financing for Exports These exporters can be financed using the following Islamic Financing instruments: Istisna Murabahah Wakalah A step by step process in discussed next .

the exporter primarily needs funds to Purchase raw material To manufacture the finished product The Bank fulfills the need of the exporter by providing funding .Murabahah-Istisna Financing for Exports Having the LC in hand.

Murabahah-Istisna Financing for Exports This funding is provided under the following two agreements: Murabahah Istisna Murabahah is provided for purchase of Raw Material Istisna is provided to manufacture the required goods .

the Istisna transaction is effected.Murabahah-Istisna Financing for Exports Istisna is an exception where a sale is allowed without delivery of the goods sold It relates to goods that require manufacturing If the manufacturer undertakes to manufacture goods with material available with the manufacturer. It is necessary for the Istisna transaction that price is fixed and necessary specifications of the product are clearly defined .

3.Murabahah-Istisna Financing for Exports The process will consist of the following steps 1. The bank will finance the purchase of Raw Material through a Murabahah transaction. Once the goods are manufactured they will become the property of the bank. It will also give funds to the customer under a separate Istisna agreement to manufacture and deliver the goods to the bank as per the LC. . 2.

Murabahah-Istisna Financing for Exports 4. 6. . The exporter will now export the goods. The bank will appoint the exporter as its agent to export the goods on its behalf under a Wakalah agreement. 5. acting as the bank’s agent. The Wakalah agreement is required because under Istisna the customer is liable to deliver goods to the bank.

. Which will deduct from the proceeds The cost of goods ( Istisna price) And profit 9. Graphical flow of the new process is explained next. The export proceeds will be remitted to the bank 8. Client will pay Murabahah price to the Bank.Murabahah-Istisna Financing for Exports 7.

Exporter Request for financing Islamic Bank .

Exporter Murabahah Facility for purchase of Raw Material Islamic Bank .

Exporter Istisna Facility to manufacture goods Islamic Bank .

Exporter Agreement to Wakalah Islamic Bank .

Exporter Delivery of Goods manufactured under Istisna Islamic Bank .

Exporter Wakalah Agreement Islamic Bank .

Exporter Islamic Bank Goods Exported Importer .

Exporter Islamic Bank Remittance of Export Price Importer .

Islamic Bank Islamic Bank will deduct the cost of goods from the export proceeds and will pay the balance as bonus to the exporter .

Exporter Payment of Murabahah Price Islamic Bank .

Islamic Banks cannot provide the facility of Purchase/Discounting.Post-Shipment Financing to Exporters Exporters some time needs Post-Shipment financing in the form of Bill Purchas/Discounting. Murabahah can be used to partially help the exporters in this regard. Bill However. .

50/US$.000/.to be realized after 55days (February 25. . the transaction would be executed in the following manner. 2005 Client would approach Islamic Bank with a bill of US $ 200. 2005) for discounting.Post-Shipment Financing to Exporters 1. Spot rate of dollar is Rs.75/US$ 3. Islamic Bank agrees to quote rate of Rs. On January 1. 57. 2. It is understood that MMFA is executed between the client and the Islamic Bank. 57. However.

000/.to the client under the Agency Agreement for the purchase of agreed commodities. . 2005.Post-Shipment Financing to Exporters be paid on February 25. 5. 5. Client will make the purchasing of the equivalent amount and would sent Declaration to the Bank to purchase the stocks held by it as agent.000/. The Under the arrangement. Islamic Bank would disburse funds of Rs.750. at US$ 200.

2005. As per the authority given by the client. . Islamic Bank would accept the offer and sale would be concluded.000/. 8.Post-Shipment Financing to Exporters 6. the Islamic Bank would deduct US$ the client’s account maintained with Islamic Bank.from the client account and transaction would be completed. Foreign Bank would remit US$ 200.000/. 7. On February 20.

Import Finance through Murabahah Islamic Banks are using Murabahah in import financing very effectively all over the world. Details of the procedure being followed is discussed next. .

Import Finance through Murabahah Process Flow: Step 1: Islamic Bank and the customer will sign a Master Murabahah Finance Agreement and an Agency Agreement to finance Lcs of the Customer. . As per the Agency Arrangement the customer would purchase goods from foreign suppliers on Bank’s behalf by opening LCs with the Bank.

.Import Finance through Murabahah Process Flow: Step 1: The difference between a general Murabahah agreement and LC Murabahah agreement lies in the fact that it is possible in LC Murabahah that a good may be sold at cost price in case of a spot Murabahah. In order to accommodate such transaction agreement need to mention that such transactions would be regarded as Muswamah.

Import Finance through Murabahah
Process Flow:

Step 2:
The customer will negotiate a deal with some foreign supplier (exporter) for the purchase of assets as agent of the bank. It should be ensured that such deal should be finalized only after execution of Agency Agreement.

Import Finance through Murabahah
Process Flow:

Step 3:
Importer will request the Bank to open LC by submitting all relevant documents. Insurance to be arranged by the importer on behalf of the bank and relevant policy to be forwarded along with the LC application form.

Import Finance through Murabahah
Process Flow:

Step 4:
The Bank will record LC opening and other charges due from the customer and issue an LC in the favor of the beneficiary(exporter).

Import Finance through Murabahah Process Flow: Step 5: On receipt of LC exporter will ship the goods and deliver the related shipping documents to the negotiating bank for the payment of bill amount. . If the documents are found in order the negotiating bank will send documents to Islamic Bank.

Islamic Bank will discuss the payment terms with the customer and settle the bill .Import Finance through Murabahah Process Flow: Step 6: On receipt of documents Islamic Bank will contact the customer and inform him of the availability of the documents. The customer will negotiate the FX rate for the required foreign currency amount.

it will issue a Musawamah Declaration to the Customer. . Bank's risk on the goods will end only after the assets delivery to the customer.Process Flow: Import Finance through Murabahah Settlement: Normal Payment: Islamic Bank will discuss the payment date with customer and if the customer wishes to settle the transaction. Through Musawamah Declaration Bank would sell the assets at the following price of the customer: LC Cost+All Charges+Insurance After receiving payment Bank will release the shipping documents to the customer. However.

Profit will be charged from the day bank’s nostro was debited to the Murabahah settlement date according to the agreed profit rate. The Bank will release the shipping documents to the customer and record a Murabahah receivable. . Issuance of Sub-Murabahah means signing of declaration by the customer and the acceptance of its offer to purchase by the Islamic Bank.Import Finance through Murabahah Process Flow: Settlement: Normal Payment: Islamic Bank will discuss the payment date with customer and if the customer require financing it will issue a Sub-Murabahah.

. The price will included profit from the day Bank’s Nostro account was debited till the Sub-Murabahah settlement date.Import Finance through Murabahah Process Flow: Settlement: Payment Against Documents(PAD): Sub-Murabaha will be booked on the day the customer can arrange funds and shipping documents will be released on the same day.

The only difference is that the financing by the Bank is done for a longer period such as 60.Import Finance through Murabahah Process Flow: Settlement: Trust Receipt (TR) Murabahas TR Murabahas are the same as the case normal payment. 90 or 120 days. .

. The selling price will be fixed at that stage.Import Finance through Murabahah Process Flow: Shipping Guarantees or Delivery Order(DO): If the goods have arrived prior to the shipping documents the customer may request Islamic Bank to issue a shipping guarantee or delivery order. In such cases the Bank will take 110% margin from the customer and execute a Sub-Murabahah based on the FX rate prevailing on that date.

upon arrival of the documents the cost of the goods comes out to be higher or lower than the cost price of the SubMurabahah. the Bank will settle the difference with the customer by paying or receiving the differential amount. However. . This adjustment in price after the execution of Murabahah is possible because Murabahah is a cost plus profit transaction and if after the execution of the Murabahah the seller discovers that the cost was higher or lower he can settle the difference with the buyer. only cost portion may be adjusted.Import Finance through Murabahah Process Flow: Shipping Guarantees or Delivery Order(DO): If however. profit portion would not be adjusted.

Alternate to the need of forward cover has been developed by Shariah Scholars on the basis of promise.Import Finance Forward Cover Conventional Forward Rate hedging is not allowed in Shariah. A unilateral request from customer can be entertained for obtaining cover on behalf of the customer. .

On the basis of Unilateral promise. customer would be liable to compensate for actual loss to the bank. In case of default of purchase of foreign exchange. Import Finance Forward Cover .No forward contract shall be signed for booking of forward cover. the customer is bound to purchase the foreign exchange at the booking rate.

Conclusion .

Trade Finance Experts and Shariah Scholars needs to collaborate more to develop mutual understanding. . There is a need to further research on the topic.Conclusion Several other options may also developed.