Islamic modes of Financing

Essentials of Islamic Banking and Finance

IQRA University Gulshan Campus
Talha Saleem Kapadia

talhasaleemkapadia@gmail.com

Contents of the lecture

Mode

of financing;
Islamic modes;
Trade based modes of Financing;
Rental based mode of financing;
Participatory mode of financing;
Q & A;

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 modes of financing

Islamic modes 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)

Nonremunerative

Remunerative (partnership based

financing)
Partnership

Loan

Gift

Permanent

Temprory

Murabahah (cost
disclosed sale)

Musawamah (simple
bargain sale)

Salam (future sale)

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 analyse 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, time is one of the main factor 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;

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 partners;
So non-fixation here is the acceptable way.

Fixing of return/profit in trade-based modes

A repeated question is that the return/profit is fixed in

trade-based modes of financing while Islam prohibits
fixing of profit;
So what about famous Islamic concept of non-fixation
of the profit rate?
The actual reason of prohibition is not FIXATION or
NON-FIXATION;
In fact the element of GHARAR is not acceptable in
financial transaction;
Gharar sometime appears in fixation and sometime in
non-fixation.

Murabahah and Musawamah

Murabahah definition and concept

Murabahah is one of the kinds of sales;

It comes under trade-based modes of financing;
Murabahah 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 Murabahah 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
Murabahah 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 indirectly
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
BANK

AGREEMENT TO MURABAHAH

CLIENT
CLIENT

Murabahah step by step

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

AGREEMENT TO MURABAHAH

BANK
BANK

CLIENT
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
BANK

CLIENT
CLIENT
AGENCY AGREEMENT

PAYMENT OF PRICE OF GOODS TO THE

SUPPLIER OR AGENT (COUSTOMER
OR THIRD PARTY)

SUPPLIER
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
BANK

PAYMENT OF PRICE IN AN
AGREED PERIOD OF TIME
AND INSTALMENTS

CLIENT
CLIENT

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
BANK

PAYMENT OF PRICE IN AN
AGREED PERIOD OF TIME
AND INSTALMENTS

CLIENT
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;

Murabahah cannot be used to finance:

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