ISF 1101 Foundation of Islamic Finance TOPIC 3

ISF 1101 Foundation of Islamic Finance TOPIC 3. SPECIFIC CHARACTERISTICS OF ISLAMIC FINANCE

TOPIC CONTENT 1)Salient Features of Islamic Finance 2)Debt Versus Equity

1. Philosophy and Features of Islamic Finance

1. BASIC PROHIBITIONS • Avoiding interests • Avoiding gharar • Avoiding gambling

2. ALTERNATIVE FINANCING PRINCIPLES • IB transaction is not just merely advancing money. It involves certain trade arrangement • Major forms or business contracts of Islamic finance 1. Contract of Profit-Sharing: Mudharabah; Musharakah 2. Contract of Sale: Murabahah; Ijarah; Bay as-Salam; Istisna’a; Qard ul hasanah; BBA; Bay as-sarf; Ju’alah 3. Contract of Deposits: Al-wadiah 4. Contract of Agency: Wakalah 5. Contract of Hibah 6. Contract of Security: Al-Rahn; Kafalah; Hiwalah

1. Basics of Mudarabah • Definition: An arrangement whereby owner of property (rabbal mal) provides a specified amount of capital to another person who is to act as entrepreneur to trade with the capital (mudarib) • Profit sharing is justified: one on basis of capital, another on basis of labor • A form of trustee partnership; a contract of fidelity • An investor/group provides capital to agent/manager to trade with it. Example: – Bank (rabbal-mal) = owner of capital – Entrepreneur/Customer (mudarib) = responsible for management of business; provide expertise to initiate and operate business • 2 types of mudarabah: – Restricted: financier may specify particular business to be invested in – Unrestricted: financier does not specify; mudarib invests in business he deems fit 6/2 9

1. Basics of Mudarabah • Profits – Shared between the two parties according to a mutually pre-agreed ratio – Profit sharing must be a percentage of actual profit – Cannot be a fixed amount or a fixed percentage of capital contribution - Both parties at liberty to agree on the ratio - Must be decided at the conclusion of contract - Different proportions can be agreed for diff situation (eg: deal in wheat vs cloth) – Loss means erosion in capital, loss can be compensated by future profit – Financier can award/donate bonus • Losses – Investor/financier: bears financial loss; Entirely absorbed by capital provider; A shortfall in capital – Agent/mudarib: bears loss of time and efforts; Will not be compensated except if mudarib negligent or dishonest, he has to bear financial losses 7/2 9

2. Basics of Musharakah Definition n An arrangement whereby two/more persons contribute capital for purpose of trading with the joint capital, profit of which, shall be shared among the partners Forms of musharakah: depending on economic activity: n - muzara’a (agriculture) musaqat (gardening) musharakah (trading) Salient features of musharakah n – – Profit to be shared according to mutually agreed ratio Losses to be borne strictly according to ratio of capital contribution All partners have right to participate in business Difference of opinion amongst fiqh schools on what constitutes acceptable 8/29 capital: money vs physical commodities

2. Basics of Musharakah Basic principles n – Cannot entail mere advancing of money: Must involve equity or participation in business – Financier must share any losses incurred by business, according to proportion of capital investment – Profits can be distributed in any mutually agreed ratio 9/29

Musharakah-Mudarabah Compared Characteristics Musharakah Mudarabah 1. Investment/ Capital Comes from all partners Comes from rabbul mal, not mudarib 2. Right to participate All partners Rabbul mal has no right to participate 3. Loss sharing All partners, according to capital contribution Absorbed fully by rabbul mal 4. Liability Normally unlimited Liability of rabbul mal limited to his investment 5. Distribution of profit Can be distributed on any interval by valuation of the assets (annual, quarterly, monthly) Final distribution takes place only after liquidation of mudarabah business 6. Ownership of assets All assets become jointly owned by all partners according to the proportion of their investment All asset owned by rabbul mal 10/29

3. Murabahah Contract § Definition: a contract of sale between buyer and seller where seller discloses the actual cost of commodity and profit margin added to buyer § Purpose: to protect innocent consumers lacking in trade expertise from tricks of cunning traders § Different from musawwamah: commodity is sold for a lump sum price without any reference to cost (based on bargaining from both sides) § Payments for murabahah -Can be cash basis or deferred payment terms -Commonly deferred payment (murabahah-muajjal)

Shari’ah Basic Rules of Sale Since murabahah is a sale contract, its validity is based on the conditions pertaining to sale as prescribed by the shari’ah 1. On matters pertaining to object of sale: 1. 2. 3. 4. 5. 6. 2. Must be existing at time of sale Must be owned by seller at time of sale Must be in physical/constructive possession of seller at time of sale Must be of value Must be specifically known and identified Cannot be for haram use On matters pertaining to the sale transaction: 1. 2. Sale must be instant and absolute Sale must be unconditional -Certainty of delivery -Certainty of price

Murabahah as a Mode of Financing § Concept of murabahah is highly used by IBs § § § Debt-based, no sharing of risks A means of circumventing prohibition of riba Caution: a murabahah transaction does not become valid simply by replacing the term “interest” with “profit” or “mark-up” -All conditions stipulated by Shari’ah in relation to a murabahah transaction must be observed to ensure Shari’ah validity

Mechanisms of Murabahah Financing 1. Customer identifies commodity Supplier of commodity Customer 2. Customer approaches bank, promises to buy commodity from bank 4. Customer buys commodity via murabahah on deferred payment terms Bank 3. Bank buys commodity on cash basis

4. Ijarah Definition o § § § ‘ajr; ujrah: consideration, return, wages, rent A form of exchange value/consideration/rent of service of an asset contract between 2 parties: Lessor (mu’jir) leases property to lessee (musta’jir) in exchange for lease or rental payment (‘ujrah) Basis for ijarah o § § Al-Quran: “If you had wished, surely you could have exacted some recompense for it” (Surah al. Kahf, verse 77) Sunnah: “Whoever hired a worker must inform him of his wages and give a worker his wages before his sweat dries” Sale of usufruct (bay’ al manfa’ah) o § Usufruct : Right to use and enjoy profits/advantages/benefits of property belonging to others as long as it is not damaged or altered in any way

Basics of Ijarah Types of usufruct o § § q Property - capital assets (manfa’ah al-’ayn) Labour - employment and service (manfa’ah al-’amal) In ijarah-based financing, ijarah ‘ayn is applied o Major difference between ijarah and al-bay’ (sale) contracts § Ownership of property is NOT transferred § Risks and responsibilities remained with the owner (lessor) o Comparable (but not identical) to conventional leasing contract

AL- IJARAH PROPERTY BANK (Lessor) (1) Bank buys property (3) Customer pays rental (2) Bank leases property CUSTOMER (Lessee)

Salient Features 1. Asset must have valuable use 2. Asset must not be consumable • • Ownership of asset 3. • • Remains with lessor Only usufruct is transferred to lessee Liabilities and risks 4. • • Incidental to ownership: reside with lessor Associated with usage: reside with lessee Lease contract is a bilateral contract 5. • 6. Must be returned to lessor in its original form at end of leasing period Normal wear and tear accepted/expected Termination must be mutually agreed Upon loss or non-existence of usufruct, ijarah contract is terminated

Terms and Conditions 1. Period of ijarah arrangement must be clearly specified 2. Purpose and mode of usage should be agreed upfront 3. Leased asset is a trust in hands of lessee • • 4. Lessee liable for damage only due to negligence Lessee does not guarantee safeguarding of leased asset nor indemnifies lessor of damages Rental payment must commence after delivery of leased asset either actually or constructively (e. g. give keys to house)

5. Salam Contract 1. Definition Sale whereby seller undertakes to supply specific goods to buyer at a future date in exchange for advanced payment made at spot Price paid in advance (at conclusion of the contract) for goods to be delivered later Sale by advance payment l l l 2. Permissibility of salam • Being practiced during time of the Prophet • People used to pay in advance for dates to be delivered in 1, 2 or 3 months • Application of salam subject to the strict observance of certain conditions: quality, measure, weight, price and quantity to be specified • Prophet ordered: “Whoever who wishes to enter into a contract of salam, he must effect the salam according to the specified measure and the specified weight and the specified date of delivery” 20

Features of Salam 1. Subject matter • • • 2. Consensus: Any commodity that can precisely be determined in quality and quantity Not particularized (with specified origin: e. g. product of a particular farm or field) – might not be able to produce Cannot be for exchange of identical items and subjective assessments, like antiquities, diamond Payment • • • Majority view: buyer should give full price/payment at the time of making contract • • Shafi’e: on the spot, before separation of the parties Maliki: allows voluntarily concession of 2 or 3 days Contemporary jurists: 3 days, provided before delivery of goods Normally in legal tender 21

Features of Salam 3. Period & place of delivery • • 4. Necessary to fix period/time & place to deliver goods (part of the condition) Hadith: 1 -3 years for delivery, later jurists: shorten the period, some to 1 day for transporting goods Penalty for non-performance • • AAOIFI Standard: not permitted to impose penalty for late delivery As deterrent, penalty can be agreed in contract and be channeled to charity account – not part of bank profit 22

Benefits of Salam l Seller • • l Price received in advance – able to cover cash/liquidity needs for personal/productive/trading activities • Better way of taking financing rather than loan with interest No risk/hardship in marketing produce • Ready demand, no oversupply Buyer • • • Gain cheap price - salam price is typically lower than cash/market/spot price Get commodity at the time he needed No risk of product non-availability • No excess demand • Secured against price fluctuations - effective price stabilizer 23

Salam as Mode of Financing Suitability of salam l Agricultural financing l Source of bank profit l Difference between salam price and market/cash/spot price l l Problems/Issues • • Banks would receive commodities, not money Banks are accustomed to dealing with only money, not equipped with competency to trade in commodities To earn halal profit, banks have to deal with commodities in one way or the other Paradigm shift required 24

1. Parallel Salam with Third Party Second salam (Apr’ 05) Commodity Buyer Deliver goods in 3 months (July 2005) Pay $11, 000 immediately (Apr’ 05) Commodity Producer Pay $10, 000 immediately (Jan 2005) Deliver goods in 6 months (July 2005) First salam (Jan’ 05) Bank

Parallel Salam with Third Party Source of bank profit • • Price differences between first and second salam Period of second salam is shorter, thus price of second salam is typically higher than price of first salam Bank engages in two salam contracts l l As buyer and seller These contracts must be independent of each other -In second salam, bank bear risk and liability as the owner of commodity -If commodity producer does not deliver goods as per first salam contract, bank must still deliver goods to commodity buyer as per second salam contract 26

6. Basics of Istisna’ Contract l Definition l Contract whereby purchaser orders a manufacturer to manufacture a specific commodity • l Cancellation • • l Price and necessary specifications of commodity are determined and agreed upfront Before work starts, any party may cancel contract (although there is moral obligation on manufacturer to manufacture the commodity) After work has started, contract cannot be cancelled unilaterally Payment • • Mode is flexible as long as mutually agreed Can be in advance, progressive with stages of work completed, upon delivery or deferred for periods after delivery 27

Basics of Istisna’ Contract Required materials l Sourced by manufacturer (otherwise becomes contract of ijarah) Purchaser can specify quality of materials Manufacturer arranges both raw materials and labour l l Not necessary for seller himself to manufacture unless specified in the contract l Time of delivery need not be fixed • However, purchaser may fix maximum time for delivery, beyond which • Purchaser not bound to accept goods and pay the price • Financial penalty imposed for late delivery 28

Istisna’ as Mode of Financing l Istisna’ can be used for financing of assets that require construction • • l Applied in financing purchase of real estate from property developers on concept of “sell and build” Unfortunately, much of Islamic home financing have inappropriately used contracts like BBA and murabahah when istisna’ should have been used A parallel istisna’ arrangement is used given that the bank has no competencies to build houses • • Bank engages a third party (contractor) The two istisna’ contracts are independent of each other In the event that the contractor fails to deliver or delivers but with defects, bank must be liable to customer Bank has contracted to deliver the house to the customer as per stipulated and agreed specifications and must do so regardless of whether the contractor delivers 29

Parallel Istisna’ with Third Party Second istisna’ Developer/ Contractor Progressive payment To deliver house as per specifications Bank Customer To deliver house as per specifications Deferred payment schedule First istisna’ Bank

Comparison of Salam and Istisna’ Features Salam Istisna’ 1. Delivery of goods In the future 2. Payment of price Spot Flexible (spot, progressive, on delivery, in installments after delivery, or some combination) 3. Type of goods Homogenous commodities with a ready market Assets requiring construction or tailormade manufacturing 4. Suitable sector Agriculture Construction, small batch manufacturing

7. Wadi’ah (Safe-keeping) Literal definition: Leave, i. e. things left with a person (not the owner) for purpose of safe-keeping Legal definition -Authorization of a person to keep the property of another in his safe custody by explicit or implicit terms -Basis: “and if one of you deposits a thing on trust with another, let the trustee (faithfully) discharge his trust, and let him fear his Lord” [Al-Baqarah: 238] Types 1. Wadi’ah yad amanah (like current account) Gives no return on deposits, allow depositors to withdraw funds anytime 2. Wadi’ah yad dhamanah (like saving account) o Bank may at its own discretion pay depositors positive return in form of hibah (gift), depending on banks profitability o No pre-determined/priori guarantee of benefits

Wadi’ah Contracts (2) Wadi’ah yad amanah Wadi’ah yad dhamanah Pure safe custody Guaranteed safe custody Original contract of wadi’ah Modification of original contract: combines wadi’ah with contract of guarantee (kafalah or dhaman) No liability on custodian in case of loss or damage (except if negligent) Custodian liable for any loss or damage Custodian not allowed to use or benefit from Deposited property can be used for trade deposited item Not entitled to any profit gained Profit gained from use of deposited property exclusively right of custodian Deposited property must be kept separately, no pooling of funds Deposit properties need not be segregated Owner of asset (depositor) can take back deposited asset at any time Custodian is allowed to charge a fee for custodianship but traditionally wadi’ah has been a charitable act

Wadi’ah yad Dhamanah o o In contemporary Islamic banking, wadi’ah yad dhamanah contract is used to emulate conventional savings account Salient features of its use n Bank guarantees deposited monies n Depositor can withdraw monies at any time n Bank can use deposited monies to generate profit n Depositor is not entitled to profits generated by bank n n Bank typically gives a return to depositor in form of discretionary and voluntary hibah (gift or token of appreciation) In Malaysia, hibah rates used to calculate profit allocated for wadiah saving accounts is determined by bank at end of each month

8. Al-Rahnu 1. Parties in contract: n 2. Pledger (rahin), pawn broker (murtahin), pledged asset (rahn) Three contracts in operation n Al-rahn – pledged property taken as collateral for debt Qard hasan – benevolent loan = interest free loan Wadi'ah yad amanah – custodianship of property 3. Source of profit for bank: Storage cost: custodial fee levied as part of wadi’ah amanah contract 4. If pledger does not repay qard hasan loan within agreed period, pawn broker can auction off pledged asset n Murtahin takes loan amount plus storage fee due to him and returns any surplus to rahin 35/34

Mechanisms of Al-Rahnu 2. Qard hasan loan Customer 1. Pledge asset 3. Custodial fee under wadi'ah amanah Repay qard hasan loan Return pledged asset Islamic pawn broker

9. Bay’ Bithaman Ajil (BBA) p Meaning: -Bay (sale), thaman (price), ajil (deferment) -A sale where payment of price is deferred p A payment facility to complement a murabahah sale p Thus, BBA facility refers to a murabahah sale where payment of goods sold is deferred over a period of time p Terms BBA, bay’ muajjal and murabahah are used interchangeably Most common instrument for Islamic home financing in Malaysia p

BBA Home Financing (Malaysian Practice) Property Developer / Original Home Owner Sales & Purchase Agreement (S&P) 5. Balance 90% Property Sale Agreement (PSA) 1. Beneficial ownership 1. 10% down payment 3. BBA price (deferred payment) 3. House sell back Bank 2. House 2. Cash price (90% balance) Property Purchase Agreement (PPA) 4. Deeds of Assignment / Charge Customer Seeking Financing

Bay’ al-’inah 1. Pay cash $X 1. Sell Asset A Customer Bank 2. Sell back Asset A 2. Deferred Payment $X + y (bank profit margin)

Musharakah Mutanaqisah p Based on concept of diminishing partnership in ownership p Mechanisms 1. 2. 3. 4. 5. 6. 7. Home buyer and bank jointly acquire and own property Bank leases its share of property to home buyer on basis of ijarah Home buyer, as owner-tenant, promises to acquire, periodically, bank’s share of property Home buyer pays rental to bank under ijarah, which partially contributes towards increasing home buyer’s share in property Risks and costs of ownership to be shared equally between home buyer and bank At end of ijarah/lease term and upon payment of all ijarah/lease rentals, customer would have acquired all of bank’s shares and partnership will ceased Customer becomes sole owner of house

Mechanisms of Musharakah Mutanaqisah Bank leases its 90% share of property to customer Bank 90% Jointly Purchased Property 10% Customer pays rent for usage of Bank’s 90% share of property Customer gradually buys share of property from Bank Customer’s monthly installment payments

Musharakah Mutanaqisah Islamic Bank of Britain (IBB): An Example of Monthly Installments under Home Purchase Plan Date Acquisition Payment (£) Rent (£) Total Monthly Payment (£) July 333. 33 615. 85 949. 18 August 335. 26 613. 92 949. 18 September 337. 69 611. 99 949. 18 October 339. 12 610. 06 949. 18 November 341. 05 608. 13 949. 18 December 342. 98 606. 20 949. 18 Calculations are based on property purchase price of £ 150, 000; the customer contribute 30, 000 (20%) towards the property purchase price; the financing period is 30 years; and the rent rate is 6. 95% (and assuming rent rate is fixed).

Comparison between BBA Home Financing and Diminishing Partnership (MMP) BBA Home Financing Diminishing Musharakah (MMP) 1. Contract Buyer and Seller (Debt) Partnership (Equity) 2. Ownership risk Customer Jointly customer and financier 3. Pricing Fixed profit rate Variable rental rates (review) 4. Contracted amount Fixed based on Selling Price Flexible market rental rates 5. Monthly installment Repayment of Profit/Principal Repayment of rental and share redemption portion 6. Treatment on profit Profit is capitalized in installment sum Profit is shared between customer and financier based on ratios 7. Early settlement Banks decides on profit rebate Customer redeem more shares 8. Changes in economic cycle Fixed rates cannot be varied thus mismatch of funds Variable rental rates can address mismatch of funds Issues

8. Other Arrangements § Tawarruq: buy on credit, then sell at spot to third party for cash: murabahah financing with tawarruq § Wakalah: a contract of agency – contract between two parties in which one party appoint another to act on his behalf. Delegating duty to another party for specific purposes and under specific conditions § Hibah: gift; discretionary

Original Form of Tawarruq 1 Person A B buys asset RM 120 Deferred Person B (needs financing) RM 100 Cash B sells 2 asset Person C

2. DEBT VERSUS EQUITY

Debt versus Equity �Basic differences between debt and equity financing � Debt financing: where investor is just capital provider, fixed return no matter what the outcome of business venture � Equity financing: reflecting share of ownership; sharing of profit & loss, return depending on outcome of business venture �In Islam, equity financing is most desirable � Asset-based, entail real economic activity � Undertaking responsibility and liability: Risk and liability sharing � Direct participation/contribution of parties involved � Shirkah-based participatory mode of business �Shirkatul milk: partnership by ownership-profit motive may not necessarily exist �Shirkatul aqd: partnership by contract – partnership to do joint business with objective to earn profit 47/29

Role of Equity in Islamic Economics Earliest financing instrument being proposed in IB literature n – – Mudarabah is an ideal instrument to achieve objectives of IE n – – 48/ 29 Principle alternative for replacing interest-bearing transactions Murabahah, ijarah and BBA are derivatives and complements -should be limited to cases where mudarabah and musharakah are not applicable To alleviate concentration of wealth Reduce income disparities via equitable allocation of capital-promotes distributive justice Productive uses of resources: labor and capital Islamic concept of development includes moral, spiritual and material aspects -Money and property are social tools to achieve social goals; promote brotherhood -Bank’s objective should be maximization of social benefit, not solely profit maximization

References 1. Ayub (2007)