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Islamic modes of Financing

Contents of the
lecture
Mode

of financing;

Islamic

Trade

modes;

based modes of Financing;

Rental

based mode of financing;

Participatory

mode of financing;

Mode of financing

Mode of financing:
Mode of financing means way of supplying funds to those who need
funds;
Supply of fund from a financial institution to a company is called
financing;
Conventional banks supply funds under one and only mode of financing
that is LENDING of money;
Every banking product, whether it is a car loan, industry loan,
investment loan, personal loan or a governmental loan, is offered under
this mode;

Islamic mode of financing

Islamic mode of financing:


Islamic modes of financing mean the way of supplying funds that is
acceptable to Islam;
As we have learned Islamic mode of financing could not be based on
lending of money as lending of money is not a remunerative way of
financing;
Prohibition of interest does not allow utilization of loan/lending as mode
of earning;
Therefore, there must be a way of funding that does not contain
element of interest;
There are three type of financing available under Islamic concept of
funds supply:
Trade-based

modes of financing;
Rental-based mode of financing; and
Participation-based of financing;

Financial activities
Capital provisioning

Exchange of goods or services

Ijarah (services rendering)

Non-remunerative

Remunerative (partnership based financing)


Partnership

Loan

Musawamah (simple bargain


sale)

Salam (future sale)

Gift

Permanent

Murabahah (cost disclosed


sale)

Temprory

Istisnaa' (Manufacturing Sale)

Trade-based modes of
financing
Trade-based

mode of Financing means a way of


financing in which Islamic banks provide financing
through sale and purchase of commodities and assets;
Trade-based modes are secure modes because they
create debt and payables upon debtors/customers;
Islamic banks buy a commodity/asset (directly or
through its agent) from the market and sells it to
customers on deferred payment basis (instalments);
The agent may be a an employee on Islamic bank, a
third party or the customer himself as well;
All conditions should be observed carefully in sale
financing.

Trade based modes of


Financing
There

are four kinds of Trade-based modes of financing


which are very common:
MURABAHAHA;
Cost+profit transaction in

which both are disclosed to the buyer;

MUSAWAMAH;
A

simple sale transaction in which a price is quoted to customer without


any disclosure to the buyer;

SALAM;
A

kind of sale in which price is paid in advance for a specific commodity to


be delivered in future;

ISTISNAA';
A

sale transaction for assets that require manufacturing.

Trade based modes of


financing

The customer expresses its wish to buy a certain thing from the
bank and the bank buys it from market and sells it on instalments;
All modes follow laws and rules of Islamic Sale contract with little
or no modifications;
Each mode has separate set of additional rules which needs to be
followed strictly;
Any error may lead to make the transaction a void sale;
Credit Risk is lower in this kind of financing therefore Islamic
Banks prefers it;
The rate once fixed in these modes could not be changed;
The concept of credit sale applies here in these modes;
Islamic banks earn money through cash purchase and credit sale;
Profit is difference between cash purchase and credit sale;

Trade based modes of


financing
Sometimes

it is argued that the time has effects on


calculation of profit in case of credit sale;
We will analyze this question in following slides;

Price difference in Credit


and Cash sale

A common question to Islamic banks: Why the price is high


in case of credit sale? This excess is as good as charging of
interest;
But the question is too simple to reply;
The main concept is that: is there any room for time in
pricing?
Meaning can a seller consider 'time' as one of the decisive
factor for pricing a commodity or asset?
The answer is yes, the is one of the main factors that play role
in determining the price;
The difference of price between whole sale and retail is due
to volume which is turnover of X (quantity) in a given time;

Price difference in Credit and Cash sale


The fast moving or perishable items are not charged high
profit and return;
Slow moving and storable items are charged higher profits
and return;
The reason is 'TIME';
So the time is not something that should always be neglected
in pricing or determining the value;
The generic vale of interest is its linkage with time and not
with real assets and commodity;
If the time increases the value will follow suite.

Fixation of return/profit in
trade-based modes

Non-fixation of price in a Sale transaction means no precise


determination of price which is an essential element of
Islamic Sale Contract;
So non-fixation in sale is not allowed;
While fixation in partnership is as good as considering
something unconfirmed as confirmed which is no doubt
injustice with one of the pertners;
So non-fixation here is the acceptable way.

Fixinf of return/profit in trade-based


modes

A repeated question is that the return/profit is fixed in tradebased modes of financing while Islam prohibits fixinf of
profit;
So what about famous Islamic concept of non-fixation of the
profit rate?
The actual reason of prohibition is not FIXATION or NONFIXATION;
In fact the element of GHARAR is not acceptable in financial
transaction;
Gharar sometime appears in fixation and sometime in nonfixation.

Murabahah and Musawamah

Murabahah
definition and
concept

Murabaha is a kind of sale;

It comes under trade-based modes of financing;

Murabaha means selling a commodity or asset on


disclosure of cost and profit basis, which means the
seller discloses the cost and the added profit to buyer;

So the distinguishing feature of Murabaha from


ordinary sale is that the seller is bound to discloses the
cost and profit both to the buyer.

If he does not disclose the cost the sale will not be a


Murabaha sale;

Murabahah
definition and
concept
The seller (bank) sells a specific commodity or asset as per
the laws and rules of Islamic sale (pertaining to Price,
Subject Matter, Wordings and Contractors);
The cost and profit are disclosed to the buyer;
The buyer shows his agreement with the price for that
commodity /asset;
Lastly the buyer takes delivery of the asset (possession,
physical or constructive) and the sale is concluded;
The payment of price should be according to the rules and
laws set for Islamic sale and purchase;
As per the rules set for sale and purchase either the price
or the delivery of the sold goods (not both) could be
deferred;

Murabahah
definition and
concept

As any other sale the payment of Price in Murabahah


could be in three ways:
Spot payment (Al-Bai' ul Muajjal - immediate delivery and
payment);
Deferred for a specific future date (Al-Bai' ul Muwajjal - full
payment at a future date);
Deferred for a period of time (Al-bai' ul Muwajjal - sale on
instalment basis payment in tranches, similar to purchase on
instalments);

Murabahah definition and concept


As we have discussed Islamic bank is one of the players in financial
markets;
Therefore product of Murabahah used in Islamic Banking as a mode
of finance is slightly different from a simple Murabahah used in normal
trade.
Banking Murabahah is a contract wherein Islamic Bank purchases a
commodity or an asset from a third party (supplier/ vendor);
This purchase happens upon request of the customer;
After purchase of the required asset Islamic bank sells the same to the
customer usually against a deferred payment [Bai Muajjal] (sale on
instalments);
The whole process is called Murabahah to the Purchase Orderer;
It is a bunch of contracts completed in steps and ultimately suffices
the financial needs of the customer.

Murabahah
definition and
concept

Some important features of the Murabahah are:


As Banking Murabahah is a kind of sale, there must be a seller
(bank) and a buyer (customer) and something that could be
bought and sold;
In such transactions the Bank is the seller, the customer is
buyer and a commodity/goods are exchanged between them;
In case there is nothing that could be sold and purchased
Murrabahah is not possible;
WC finance /Overheads financing etc. etc. are not possible
under Murabahah since there is no sale and purchase.
Because it is a sale from bank to customer the Bank is required
to purchase the commodity directly or directly from the
market/seller before selling it to the customer;

Process flow

Murabahah step by
step

Step # 1:
Client and Bank sign an agreement to enter into Murabahah.

BANK

AGREEMENT TO MURABAHAH

CLIENT

Murabahah step by step

Step # 2:
Client appointed as agent to purchase goods on behalf of Bank;

AGREEMENT TO MURABAHAH

BANK

CLIENT
AGENCY AGREEMENT

Murabahah step by step

Step # 3:
Bank gives money to directly to supplier or to the client for purchase of
goods;Client appointed as agent to purchase goods on behalf of Bank;

AGREEMENT TO MURABAHAH

BANK

CLIENT
AGENCY AGREEMENT

PAYMENT OF PRICE OF GOODS TO THE


SUPPLIER OR AGENT (COUSTOMER
OR THIRD PARTY)

SUPPLIER

Murabahah step by step

Step # 3:
Client pays agreed price to bank according to an agreed schedule. Usually
on a deferred payment basis (Bai Muwajjal) in tranches;

BANK

PAYMENT OF PRICE IN AN
AGREED PERIOD OF TIME
AND INSTALMENTS

CLIENT

Application

Murabahah Application

Murabahah can be used to finance the real purchase needs of


customer;

It could be used for assets which are acceptable to Shariah and has a
tangible form.

Therefore, Murabahah can be used to finance the purchase of:


Raw Material;
Equipment;
Consumer Goods;
Personal loans;
Credit cards.

Musawamah

Musawamah is also one kind of sale;

This is a simple sale we do in our daily routine life;

The difference is that the quoted price does not require


any break-up of cost and profit;

All other details are same as for Murabahah;

The process flow is also same and the payment method


may also be of same nature.

Questions