What is Islamic Finance Abdul Samad Shariah Advisor

What is Islamic Finance? Abdul Samad Shariah Advisor The Bank of Khyber

Why Islamic Finance? n n n The body which is promoted by Hiram sources is bound to hellfire. On the Day of Judgment, a person will not be moved from the place where he stand until he is asked about the sources of his income and they way he spent it. Purifying of the needs of life (food, drink, clothes house etc) is one of the most important reason for the acceptance of prayers by Allah.

Rulings In Islam n n n These 5 primary objectives follow by Shariah can be observed though the Al Ahkam (rulings) upon which Fiqh (Islamic Jurisprudence) rotate around. The rulings are categorized as follows: a. Wajib (obligatory) e. Haram (unlawful) b. Mustahab (recommended) (Sunnat) c. Mubah (permissible) d. Makruh (disliked)

Rulings n n n Wajib- An obligatory action or something that shall be performed. Anyone who leave it is liable to gain the punishment of Allah s. w. t. in the Here after as well as a legal punishment in this world. Haram- An unlawful action or the one that shall not be performed and is strictly prohibited. Anyone who engages in it is liable to gain the punishment of Allah s. w. t. in the Here after as well as a legal punishment in this world. Mustahab- A recommended action or something that should be performed. Mubah- A permissible action or something that is neither encouraged nor discouraged. Makruh- A disliked action or something which is abominable and should be avoided but not in strictly prohibitory terms.

Islam and Shariah Islam Aqidah (Faith & Belief) Shariah (Practices & Activities) IBADAT (Man to God Worship) Political Activities Akhlaq (Morality & Ethics) Muamalat (Man to Man Activities) Economic Activities Banking & Financial Activities Social Activities

Human Financial Needs Fulfillment of Financial Needs Own Capital Others’ Capital Equity Financing Debt Financing

External (Equity & Debt) Financing Equity Financing Al-Musharakah (Joint Venture Profit Sharing) Debt Financing Uqud al-Muawadhat (Deferred Contracts of Exchange) Al-Mudarabah (Trustee Profit Sharing) Al-Bai’ Bithaman (Mu)Ajil (Deferred Installment Sale) Others Bai’ al-Murabaha (Cost Plus Profit Sale) Al-Ijarah (Leasing) Bai’ al-Salam (Commodity Sale) Equity Market Bai’ al-Istisna’ (Sale on Order) Debt Market

Most Important Islamic Teaching Related To Business 1. 2. 3. 4. 5. 6. 7. 8. 9. Elimination of Interest (Raba) The prohibition of uncertainty (Gharar) The prohibition of Gambling (Qimar) The precipitation of games of chance (Maser) Honesty and Fair Trade (Ghishsh and Khilabah) Spending in the Good Cause Buy Back Two Mutually Conditional Contract Entitlement to profit depends on liability for risk

Interest n Interest, Usury, or Riba is forbidden in almost all major religions of the world e. g. n Judaism n Christianity n Islam

Riba in Quran n God has permitted trade and forbidden interest…. ” (The Cow – Sura Al-Baqara 2: 275) n O believers, fear Allah, and give up what is still due to your from the interest (usury), IF [indeed] you are true believers[!!!]. If you do not do so, then take Notice of War from Allah and his Messenger. n But, if you repent, you can have your principal. Neither should you commit injustice, nor should you be subjected to it. ” (The Cow – Sura Al-Baqara 2: 278 -9)

Riba in Quran (Related in context to 2: 278) The only reward of those Who make War upon Allah & his Messenger, and strive after corruption in the land, will be that they will be 1. Killed 2. Or, Crucified, 3. Or, have their Hands and Feet on alternate sides Cutoff, 4. Or, will be Expelled out of the land. n Such will be their degradation in the world, and n in the hereafter, theirs will be an terrible doom. ” (Quran: The Table Spread - Al-Maida Chapter 5: Verse 33)

Riba in Hadith The Prophet cursed n the receiver and n the payer of interest, n the one who records it and n the witnesses to the transaction n and said: “They are all alike (in guilt). ” (Sources: Jabir Ibn Abdullah, Muslim, Tirmidhi, Musnad Ahmed

RIBA Riba-Al-Fadl Riba-Al-Nasiyah Sarfi Sood Tijarti Sood Simple Sood Compound Sood

The prohibition of uncertainty (Gharar) n n There are strict rules in Islamic finance against transactions that are highly uncertain or may cause any injustice or dishonesty against any of the parties. The concept of Gharar has been broadly defined by the scholars in two ways. First, Gharar implies uncertainty. Second, it implies dishonesty.

Classical Examples of Gharar n n n n Selling goods that the seller is unable to deliver Selling known or unknown goods against an unknown price, such as selling the contents of a sealed box Selling goods without proper description, such as shop owner selling clothes with unspecified sizes Selling goods without specifying the price, such as selling at the 'going price' Making a contract conditional on an unknown event, such as when my friend arrives if the time is not specified Selling goods on the basis of false description Selling goods without allowing the buyer the properly examine the goods The Prophet (pbuh) prohibited the pebble sale and the Gharar sale.

Qimar n n n Qimar includes every form of gain or money, the achievement of which depends purely on luck and chance. All Lotteries and Prize schemes based purely on luck come under this prohibition. O ye who believe! Intoxicants and gambling, sacrificing to stones, and (divination by) arrows, are an abomination, of Satan’s handiwork…. . : (5: 90 -91) n He who played Qimar has disobeyed Allah and His Messenger. ” (Ibn Majah )

Honesty and Fair Trade (Ghishsh and Khilabah) n n n n Thus Manipulations and Mismanagement like Hoardings Black marketing Cheating Profiteering Short weighting Hiding the defective quality of the goods are prohibited in Islamic Financial System. The prophet (PBUH) said: the truthful honest merchants are with the prophets in the Day of Judgment.

Spending in the Good Cause n n The Islamic economic approach is one, which is directed towards the achievement and actualization of justice in human relations. The result of this effort is falah or success and salvation, and hayah tayyibah or good life in this world and the hereafter. So Islamic banks don’t permute to establish any relation with commodities, services and individuals whose moral practices are doubtful Some people spend Allah’s wealth (i. e. Muslim’s Wealth) in an unjust manner, such people will be put in the (Hell) fire on the day of resurrection” (Bukhari and Ahmad)

Buy Back n The financier sells an asset to the customer on a deferred-payment basis, and then the asset is immediately repurchased by the financier for cash at a discount.

Two Mutually Conditional Contract n n Two mutually contingent contract have been prohibited by the holy Prophet (pbuh). The sale of two item in such a way that one who intends to purchase good is obliged to purchase the other also at any given price. One sale transaction with tow prices. Combining sale and lending in one contract.

WHAT IS ISLAMIC BANKING?

WHAT IS BANK? n n The name bank derives from the Italian word banco "desk/bench. In practice, the word “Bank” means an institution which borrows money from people and lends money to people for interest or profit and provided other financial services.

BANKS ENGAGE IN THE FOLLOWINNNG ACTIVITIES. n n n Accepting money Processing of payments by way of telegraphic transfer, internet banking, or other means; Issuing bank drafts and bank cheques Lending money Providing documentary and standby letter of credit, guarantees, performance bonds, securities underwriting commitments and other forms of off balance sheet exposures Safekeeping of documents and other items in safe deposit boxes

WHAT IS ISLAMIC BANKING? Islamic banking has been defined as banking in consonance with the ethos and value system of Islam and governed, in addition to the conventional good governance and rick management rules by the principle laid down by Islamic Shariah.

Comparison of the Islamic and Conventional systems Conventional Banking n Conventional Banks take deposit on interest basis and lend on the basis on interest. A part of interest is paid to the depositors and the remaining interest is left for the bank as its income. If this residual is more than its expenses, it will have Net Income otherwise it will have Net loss. Islamic Banking n Islamic Banking accepts deposits on PLS basis and invest in Shariah based modes. Whatever is the profit, it is shared with depositors. If there is a loss it will also be shared. 26

OBJECTIVES OF ISLAMIC BANKING n n Shariah compliant banking, to enable Muslims to do their banking transaction – a Halal way. Achieving the goals and objectives of an Islamic economy.

DEPOSITS n n A deposit is an account at a banking institution that allows money to be deposited and withdrawn by the account holder. These transactions are recorded on the bank's books. All deposit appears as liability on Balance Sheet of the Bank.

CATEGORIES OF DEPOSIT IN ISLMIC BANKING The Shariah option for deposit mobilization can be worked out by respecting two principles: n n The aim of the exchange at hand must be recognizes in Shariah. The modalities to achieve the said must be Shariah Compliant.

GENERAL MOODES OF ISLAMIC BANKING USED TO RAISE DEPOSITS Depositors n 1. 2. n n n Deposit can be accepted by islamic bank on basis of: Amanah Qarid Investment Accounts Islamic banks generally use Musharakah and Mudarabah based product for obtaining investment account. These deposits are based on the Shariah principles of profit and loss sharing, and the banks use them, along with its own funds in businesses which are Shariah compliant. Wakala model can also be used for Investment Account.

Definition of Qard n n In Islamic Shariah, loans called Qard have only one concept as far as return thereon is concerned i. e. these are interest–free. These are repayable in exactly equal amounts in which these are paid.

Definition of Amanah n n To give any commodity / asset to anybody for the sake of safety is called Amanah. Anything given as Amanah is considered to be something held in trust, and the same can not be used.

Shirkah

MEANING OF SHAIRKAT n n The literal meaning of Musharakah is sharing. The root of the word "Musharakah" in Arabic is Shirkah, which means being a partner. Under Islamic jurisprudence, Musharakah means a joint enterprise formed for conducting some business in which all partners share the profit according to a specific ratio while the loss is shared according to the ratio of the contribution.

Types of Shirkah Shirkat-ul-Milk Shirkat-ul-Aaqd (Co- ownership) (Contractual Partnership)

Shirkat-ul-Milk (Joint ownership) • • Joint ownership of two or more persons in a particular property/ asset with out any business intention. This comes into being as a result of joint purchase, joint acceptance of gift or a bequest and inheritance of joint property etc.

Types of Shirkat-ul-Milk n n Shirkat-ul-Milk Optional (Ikhtiari) This comes into operation through the act of parties e. g. , purchase of asset with mutual consent. Shirkat-ul-Milk Compulsory (Ghair Ikhtiari) This comes into operation without any action on the part of parties e. g. , ownership of heirs on the inherited property.

Shirkat-ul-Aqd (Joint venture/partnership). n n Shirkat-ul-Aqd or Contract Partnership is an Agreement between two or more parties to combine their assets or to merge their services or obligations and liabilities with the aim of making profit. It can also be referred to as a joint commercial enterprise or activity

Kinds of Shirkat-ul-Aqd Shirkat-ul-Amwal (Investment /Capital Partnership) Shirkat-ul-Aamal (Work Partnership) Shirkat-ul-Wojooh (Credit Partnership)

Shirkat-ul-Amwal Where all the partners invest some capital into a commercial enterprise and share its profits according to agreement.

Shirkat-ul-Aamal n n Where all the partners jointly undertake to render some services for their customers, and the fee charged from them is distributed among them according to an agreed ratio. For example, if two persons agree to undertake tailoring services for their customers on the condition that the wages so earned will go to a joint pool which shall be distributed between them

Shirkat-ul-Wujooh Where the partners have no investment at all, they purchase commodities on deferred price by their goodwill and sell them on spot. Their capital is their credit worthiness and reputation.

Types of Shirkat-ul-Aqd All the three are further divided in to two types: Shirkat-ul-Amwal Shirkat-ul-Mufawadah Shirkat-ul-Aamal Shirkat-ul-Wojooh Shirkat-ul-Inan

Subdivision of Shirkat-ul-Aqd n n 1 -Shirkat-ul-Mufawadah: Where capital, profit, loss and management are equal among the partners. 2 -Shirkat-ul-Inan: Partners’ share capital, management, profit and risk are not equal and may differ for each partner. This is common type of partnership.

SHIRKAH Shirkatul-Aqd Shirkatul-Amwal Shirkat-ul. Mufawada h Shirkatul-Inan Shirkatul-A’mal (Shirkatul. Abdan) Shirkat-ul. Mufawadah Shirkatul-Inan Shirkatul-Milk Shirkatul. Wajooh Shirkat-ul. Mufawadah Optional Shirkatul-Inan Compulsory

Shirkat-ul-Ammwal Definition: n It is an agreement between two or more persons to invest a sum of money in a business and share its profits according to agreement. The investment of this partnership consists of capital contributed by the partners.

SHIRKAT-UL- AMWAL: Capital of Musharakah It should be known, ascertained and available at the time of contract. n n n The value should be agreed upon in case of kinds; Capital paid in different currencies should be valued into the currency of Shirkah; Capital advanced by the parties. Should be uniform (currency of partnership). Share capital in a Musharakah can be contributed either in cash or in the form of commodities In the letter case the market value of the commodities shall determine the share of the partner in the capital.

Management of Musharakah n n n Each partner has right to take part in Musharakah management. The partner may appoint a managing partner by mutual consent. One are more of the partners may decide not to work for the Musharakah and work as a sleeping partner. It is not allowed to specify a fixed remuneration to a partner Musharaka who manages funds or provides some form of other services, such as accounting; However, it is permissible to give him a greater share of profit than he would receive solely on the basis of his share in the partnership capital;

Distribution of Profit n n The ratio of profit distribution must be agreed at the time of execution of the contract. It is not necessary for sharing profit according to proportionate capital contribution; It is not allowed to defer the determination of profit until realization of profit. The ratio must be determined as a proportion on the actual profit earned by the enterprise. n n 1. 2. Not as percentage of partner’s investment. Not in lump sum amount. It is not allowed to defer the determination of profit until realization of profit. A sleeping partner cannot share in the profit more than the percentage of his capital.

Rules of Loss Determination/Distribution n Sharing of Loss: n n As a matter of principle the loss has to be shared according to the ratio of capital contribution; Partners are not allowed to adopt any other mechanism except the mechanism that ensure distribution of loss among partners on pro rata basis; Any other arrangement, even agreed upon by partners, will be invalid and void. It is not allowed to hold one partner or group of partners liable for entire loss.

MUDARABAH

Mudaraba Introduction - Definition “Mudaraba” is a kind of partnership where one partner gives money to another for investing in profitable avenues. n The investor (fund supplier) is called “Rabb-ul-Mal” ( ) ﺭﺏ ﺍﻟﻤﺎﻞ while the person who utilizes this fund (the fund manager) is called “Mudarib” ( ) ﻣﻀﺎﺮﺐ who is exclusively responsible for management of the business.

Capacities of Mudarib has different capacities for which rules are different. Listed down are his roles: n n n Ameen (trustee): n Mudarib holds money and assets of Mudarabah as trustee; n Therefore, he is responsible for management of assets honestly; n In case of actual loss he is responsible for nothing; Wakeel (Agent): n Mudarib manages Mudarabah as an agent of owner; n Therefore his actions are considered as of Rabbul Maal; n Actual loss is born by Rabbul Maal in case it happens; Shareek (partner): n Mudarib becomes partner in the profit that Mudarabah generates;

Mudaraba Introduction - profit & loss distribution n Profit and Loss distribution: n The Mudaraba contract should mention profit sharing ratio in defined and clear terms; n The profit sharing ratio should be: n specific; n of the expected profit; Apart from the agreed proportion of the profit, the Mudarib cannot claim any periodical salary or a fee or remuneration for the work done by him for the Moradabad. The Mudarib & Rab-ul-Maal cannot allocate a lump sum amount of profit for any party nor can they determine the share of any party at a specific rate tied up with the capital.

Mudaraba Vs Musharaka. Mudaraba: 1. The contribution comes from Rabbul Maal (the investor); 2. The Rabbul Maal (investor) is not permitted to manage the business; 3. The Mudarib manages the business only; 4. The Mudarib can also invest in the capital of Mudarabah. Musharaka: 1. The contribution comes from all partners in form of cash, commodities, services or liability in case of reputation partnership; 2. The work, as a general rule, is to be done jointly by the parties; 3. A partner or some partners may be sleeping;

CATEGORIES OF DEPOSIT IN ISLMIC BANKING Investment Account Depositors Profit & Loss Sharing Saving Accounts Current Account Fixed Investment Accounts Security Deposit

DIFFERENCE IN DEPOSITS & INVESTMENT ACCOUNTS Investment Account Deposits Account These are not guaranteed. These are guaranteed. Their nature is investment It is liability of the bank Investment account holders are in It is loan to the bank. participatory modes. Return paid to the account holders is their portion in profit of the bank. Interest paid to the depositors is treated as bank expenses.

COMPONENTS OF VALID SALE CONTRACT • Offer/Acceptance • Buyer/Seller SUBJECT MATTER • Existence • Ownership • Possession PRICE • Physical • Constructive • Certain • Valuable • Halal Purpose 58 POSSESSION l l Instant and absolute Unconditional

Types of sale n A trust sale is a type of sale in which buyer and seller agree on disclosure of actual cost while General sale is a type where seller quote a price whit out disclosure of cost; In trust sales honest disclosure of cost by seller is necessary; There are three types of trust sale: Ba’y Tauolia Ba’y Wa’dia Ba’y Murabaha Cost to cost sale; Below the cost sale; Cost plus profit sale; 59/2 5

Musawamah is a general kind of sale in which price of the commodity to be traded is stipulated between seller and the buyer without any reference to the price paid or cost incurred by the former. Thus it is different from Murabaha in respect of pricing formula. Unlike Murabaha, seller in Musawamah is not obliged to reveal his cost. 60

Murabaha n n In literary terms, Ba’y Murabaha ( )ﺑﻴﻊ ﻣﺮﺍﺑﺤﻪ means “sale on profit”. In Arabic, its origin is Rabah ( )ﺭﺑﺢ which means profit. Technically, it is a contract of sale in which the seller declares his cost and profit. It may be on spot basis, or on deferred payment basis.

FEATURES OF BANKING MURABAHA Murabaha finance is not a loan given on interest, it is a sale of Asset(s) for cash/deferred price. It is the obligation of the Seller to disclose the Cost and Profit to the Buyer. 62

FEATURES OF BANKING MURABAHA Murabaha Transaction can either be a cash sale (Spot Payment Murabaha) or a credit sale (Deferred Payment Murabaha) or a combination of both. Payment of Murabaha Price can be made in lump sum or in installments. 63

FEATURES OF BANKING MURABAHA Murabaha Finance can only be used for the purchase of fresh Asset(s) only. Buy-Back arrangement is prohibited. This means that Murabaha transaction cannot be executed for the Asset(s) already purchased by the Customer. 64

Scope of Murabaha • Murabaha is a fixed price sale and is normally used for short term financing; • Murabaha cannot be used as a substitute for cash advancing or pure cash based running finance facility; • The transaction can be used in order to meet the working capital requirements however it cannot be used to meet liquidity requirements; • Murabaha can be used for long term as well but it such a case it would be a fixed rate transaction and will not accept flexibility in rate of financing; financing 65/2 5

VARIOUS MODELS OF MURABAHA FINANCE 66

MODEL - I TWO PARTY REALTIONSHIP n Bank – Customer MODEL - II THREE PARTY RELATIONSHIP n (Bank-Vendor) and Customer MODEL - III THREE PARTY RELATIONSHIP n Bank and (Vendor-Customer) 67

MODEL - I n n n The simplest possible Model emerges when the transaction involves two parties only, i. e Bank and the Customer. The Bank is also vendor and sells the Asset(s) to its Customers on deferred payment basis. From Shari’ah perspective it is an ideal Model and its profits are fully justified because Bank assumes all risks as Vendor/Trader. 68

MODEL I – GRAPHICAL PRESENTATION 2 Customer 1 3 69 Bank/Vendor

MODEL I - PHASES Phase 1: The customer approaches Bank (Vendor) and identifies Asset(s) and collects relevant information including cost and profit. Phase 2: Bank sells Asset(s) to the Customer, transfer risk and ownership to the Customer at certain Murabaha Price. Phase 3: Customer pays Murabaha Price in lump sum or in installments on agreed dates. 70

MODEL - II n In most cases Murabaha Transaction involves a third party (i. e. Vendor) because Bank is not expected to engage in sale of variety of products required for variety of Customers. n The Bank directly deals with the Vendor and purchases the Asset(s). 71

MODEL II n The Bank sells the purchased Asset(s) to the customer on cost plus basis. n There are two distinct sale contracts at different point of times. First between Bank and Vendor and second between Bank and the Customer. 72

MODEL II – GRAPHICAL PRESENTATION 1 Customer 73 Vendor 5 2 6 3 4 Bank

MODEL II - PHASES Phase 1: Customer identifies and approaches the Vendor or Supplier of the Asset(s) and collects all relevant information. Phase 2: Customer approaches the Bank for Murabaha Financing and promises to buy the Asset(s). Phase 3: The Bank makes payment to vendor directly. 74

MODEL II – PHASES Phase 4: Vendor delivers the Asset(s) & transfers the ownership of Asset(s) to the Bank. Phase 5: Bank sells the Asset(s) to Customer on cost plus basis and transfers ownership. Phase 6: Customer pays Murabaha Price in lump sum or in installments on agreed dates. 75

MODEL III – BANKING MURABAHA n n 76 This Murabaha Model is mostly practiced model in Banking now a days and therefore we will look at it in more detail. We will also look at the documentation required at different stages of the transaction. It is also a three-party structure but it is bit complicated than previous ones.

MODEL III – BANKING MURABAHA n The product of Murabaha that is being used in Islamic Banking as a mode of finance is something different from the Murabaha used in normal trade. n It is called Murabaha to the Purchase Orderer. 77

MODEL III – BANKING MURABAHA n It is a bunch of contracts completed in steps and ultimately suffices the financial needs of the client. n THE SEQUENCE OF THEIR EXECUTION IS EXTREMELY IMPORTANT TO MAKE THE TRANSACTION SHARIA’H COMPLIANT. 78

MODEL III – GRAPHICAL PRESENTAION 3 Vendor 4 5 5 2 Bank Customer 6 Offer Acceptance 1 79 7

How Murabaha works in Islamic finance? Facility requested & credit approvals Master agreemen ts signed Customer identifies supplier & obtains quotation Customer promises to buy the goods at cost + profit Bank appoints customer as agent to purchase goods

How Murabaha works in Islamic finance? Bank pays the price of goods to supplier Agent purchases goods & obtains possession Agent informs bank about purchase of goods and possession Bank sells the goods to customer on credit at cost + profit Customer makes payment when it is due

Steps Of Banking Murabaha MOU Order Form Agency Agreement Purchase Payment of Purchase Price Possession Offer and Acceptance (Declaration) Payment of Murabaha Price

Ijarah n n n Lexically, Ijarah means “to give something on rent or to provide some service for consideration”. In Islamic jurisprudence, there are two different types of Ijarah; The first one is an employment or service contract by virtue of which a person provides services to employer and against those services he gets Ujrah i. e. remuneration of services.

Ijarah n The second type of Ijarah which is more common in Islamic finance, is a contract in which: fifty n n n the owner of an asset (other than consumables) transfers its usufructs to another person for an agreed period against an agreed consideration. In this case, the term Ijarah is synonym to the English term ‘leasing’.

Basic Rules of Ijara n n n Ø It is necessary for valid lease that the corpus of the leases property remains in the ownership of the lessor. ØThe period of lease must be determined in clear terms. Ø The lease period shall start from the date on which the leased asset has been delivered. 85

Liabilities of Parties n n Lessor Responsibilities: Ø Since corpus of leased property remains in the ownership of the lessor therefore all liabilities of ownership are borne by lessor. Expenses: Ø As the lessor is the owner of the asset he is liable to pay all the expenses incurred in the process of its purchase and its import to the country of the lessor example expenses of shipment and customs duty etc. 86

Lessee Responsibilities: n n n Ø Being user of the lease asset lessee can be made liable to any normally occurring wear and tear. Ø The lessee cannot use the leased asset for any purpose other then the purpose specified in the lease agreement. Ø If no such purpose is not specified in the agreement, the lessee can use it for whatever purpose it is use in normal course. 87

Lessee as Ameen: n Ø The lessee is liable to compensate the lessor for every harm caused to the leased asset by his misuse or negligence. 88

Rental n n n Ø The rental must be determined at the time of contract for the whole period of lease. Ø It is permissible that different amount of rent are fixed for different phases provided that the amount of rent for each phase is specifically agreed upon at the time of affecting a lease. ØThe lessor cannot increase the rent unilaterally and any agreement to this effect is vied. 89

Rental n n Ø A lease contract can have a condition that the rent shall be increased according to a specified proportion (e. g. 5%) after a specified period (like one year). Ø The rent or any part thereof may be payable in advance before the delivery of the asset to the lessee, but that amount so collected by the lessor shall remain with him as Amana and shall be adjusted towards the rent after its being due. 90

In Case of Late Payment n n Ø The lessor cannot charge an additional amount in case the lessee delays payment of the rent. ØPenalty of late payment is given to charity by lessee. 91

Termination: contractual n n n Ø Lease is binding contract. ØIt cane be terminated by mutual consent. ØThe lessor may terminate it when the lessee doesn’t pay the rent or fails to pay it on time or because of violation of any other term and condition of the agreement. 92

Termination: contractual n n n Ø With total destruction of the leased asset Ø Upon the expiry of term. Ø Two parties may terminate it before it begins to run. 93

Procedure of Banking Ijarah Undertaking to Ijarah Agency Agreement Purchase Payment of Purchase Price Lease Agreement

Finance Lease (Ijarah) Features: 1. Customer buys the property as Bank’s agent. Cost: $100 Manufacturer / Supplier Customer 2. Execution of Ijara Agreement Lease Bank • Floating rate financing 3. Disbursement of the Facility Amount: $100 possible • Can be used for refinancing Uses: • Financing Capital Expenditure 4. Bank • Financing Big Ticket items like Aircraft, VLCCs, LNG appoints the Customer as its Carriers, etc. Tenor: agent to buy the property. • 5 -7 years 5. Under the Ijara Agreement the Bank will lease the property immediately. Risks: • Credit Risk • Performance Risk • Cost Overruns • Ownership Risk

Diminishing Musharakah (DM is a type of Shirkah where one partner purchases the other partner’s share gradually

FEATURES OF DIMINISHING MUSHARAKAH IN SHIRKAT-UL-MILK (JOINT OWNERSHIP) Two partners purchase any asset (machinery/property) and their intention is that one or both partners will use this asset or they rent out their share and one Shareek undertakes to purchase the share of other gradually.

Diminishing Musharakah in Shirkat ul Milk – with Ijarah n n A and B invest their capital and purchase a joint asset e. g. a house. A separate Musharaka agreement is executed. B promises to sell his shares to A gradually or A promises to buy B’s shares in the jointly owned property. A and B enjoy their rights as partners as they share the risks and rewards in the ratio of their joint investment.

Diminishing Musharakah in Shirkat ul Milk – with Ijarah n n n A uses the asset while he pays rent to B in proportion of B’s ownership in the joint property according to the pre-agreed benchmark. Expenses incidental to ownership are shared in proportion of ownership, while expenses relating to use are borne by A who uses the property. A will keep buying B’s shares until he acquires the complete ownership.

Diminishing Musharaka Ownership Transfer

Diminishing Musharaka Monthly Rentals Rs

Procedure of DM D M Agreement (Bank +Client) Undertaking to Ijarah (from the client) Sale Agreement (Client + owner of the house) Payment of Purchase Price (to the owner of the house) Lease Agreement (Bank + client)

Diminishing Musharakah n Bank enters into a participation (Shirkat-ul-Milk) arrangement with the Customer n Bank provides the larger share of the purchase price of the vehicle n Bank rents out its share of the vehicle to the customer n n n The customer makes regular scheduled investments to increase its equity in the property over the life of the transaction The monthly/ periodic payments are structured to reflect a portion of rent and a portion of purchase price i. e. EMI = Rent + Purchase of Share Once the customer has purchased all of the Bank’s share the ownership will transfer to the customer with free and clear title to the vehicle

Salam & Istisna 104

Elements of Sale n A valid sale has 4 big elements: 1. Offer & acceptance (Ijab-o-Qobool): 2. Sold good or subject matter (Mube’e) 1. Valuable 2. Seller must have title & risk 3. Existable 4. Capable of ownership/title 3. Price (Thaman) 1. Quantified (Maloom) 2. Specified & certain (Muta’aiyan) 4. Delivery or possession (Qabza) 1. Physical (Haqiqi) 2. Constructive (Hukmi) 105

Sold good or subject matter (Mube’e) n n The purchased commodity must be existing but it is not necessary to be presented at the place of offer and acceptance. In such case commodity can be sold through descriptions. In sale through description, purchaser gets following rights: n n n Khiyar-e-Aib Khiyar-e-Wasf Khiyar-e-Roiyyat 106

Basic Conditions About the Subject Matter There are three basic conditions about the subject matter for the validity of a sale in Shariah. n The purchased commodity must be existing n The seller should have acquired the ownership of that commodity, n The commodity must be in the physical or constructive possession of the seller. There is one exception to this principle in Shariah n Salam n Istisna 107

Meaning of Salam is a sale whereby the seller undertakes to supply some specific goods to the buyer at a future date in exchange of an advanced price fully paid at spot. n Here the price is cash, but the supply of the purchased goods is deferred. n The buyer is called “rabb-us-salam”, the seller “muslam ilaih”, n the cash priceis “ra’s-ul-mal” and the purchased commodity is termed as “muslam fih”, 108

FROM WHERE SALAM STARTED n n Before prohibition of interest farmers used to get interest based loans for growing crops and harvesting. After prohibition of interest, they were allowed to do Salam transactions. This helped them to get money in advance for their needs. During the days of our prophet (SAAWS), the merchants going with caravans used to get interest based loans for purchasing the commodities. After prohibition of interest, they were allowed to do Salam. 109

Benefits of the Salam n Salam was beneficial to the seller, because he received the price in advance, and it was beneficial to the buyer also, because normally, the price in salam used to be lower than the price in spot sales. 110

BASIC RULES 111

CAPITAL OF SALAM n n The capital of Salam should be known to all the parties. Generally it should be fixed in terms of cash. Purchase price in Salam must be fully advanced to the seller at the commencement of the contract. 112

SPECIFICATION OF COMMODITY n n The commodity (Al-Muslam fihi) should be known. It must be monitored by specifications to the maximum possible degree, only negligible variation is tolerated. It must also be ensured that the commodity is possible to be delivered when it is due. 113

SPECIFICATION OF COMMODITY n n n Only those goods can be sold through Salam contract in which the quality and quantity can be exactly specified. In other words it can be done only in such items which can be weighed, measured or counted. Salam can only be carried out in the items in which variations in numbers make no difference. Salam is not allowed in Sarf transactions i. e. in gold, silver and currencies. 114

DELIVERY CONDITIONS n n Due date of delivery must be agreed at the commencement of the contract. The place of delivery should also be known. If it is not known, the place where the contract took place shall be considered to be the place of delivery, unless it is impracticable. In such a case, the place of delivery shall be decided according to customary practices. 115

DELIVERY CONDITIONS n n Before delivery, goods will remain at the risk of seller. After delivery, risk will be transferred to the purchaser. Possession of goods can be physical or constructive. Transferring of risk and authority of use and utilization / consumption are the basic ingredients of constructive possession. 116

REVOKING SALAM CONTRACT n n Once agreed upon, a Salam contract cannot be revoked unilaterally by any party. It can be cancelled or partially cancelled with mutual consent by returning the actual or proportionate amount of price paid. 117

SALE BEFORE POSSESSION n n Commodity purchased under Salam can not be sold earlier than taking possession thereof. However, a very small school of though is of the view that this restriction should apply to the food commodities only. These commodities can, however, be sold under parallel Salam or may be promised to be sold at a future date. 118

PARALLEL SALAM n n n The Bank being the purchaser of Salam commodity can further sell on Parallel Salam in a similar manner as it has previously purchased on first Salam without making one contract dependent on the other. There must be two separate and independent contracts, one where the Bank acts as buyer and other in which it is a seller. The two contracts cannot be tied up and performance of one should not be contingent on other. 119

AGENCY CONTRACT n n If the bank has no expertise to sell the commodities received under Salam contract, then the bank can appoint the customer as its agent to sell the commodity in the market / third party, subject to Salam agreement and Agency agreement are separate from each other. A price must be determined in agency agreement on which the agent will sell the commodity but if the price is increased, the benefit can be given to the agent. 120

BUY BACK n n Salam arrangement cannot be used as a buy back facility where the seller in the first contract is also the purchaser in the second. Even if the purchaser in the second contract is a separate legal entity but owned by the seller in the first contract, it would not tantamount to a valid Parallel Salam agreement. 121

SECURITY IN SALAM n Delivery of the commodity can secured through a pledge or guarantee or any other means securing payment. be a of 122

Farmer Rs. 100 Million Amount –Spot Commodity - Deferred BANK Commodity for Rs. 110 M Sold 1. Parallel Salam 2. Agency with Farmer/3 rd person 3. Prior promise to purchase 4. Murabaha 123

Istisna

Definition n Istisna is a sale transaction where a commodity is transacted before it is manufactured. It is an order to a manufacturer to manufacture a specific commodity for a purchaser. The manufacturer uses his own material to manufacture the required goods. In Istisna price must be fixed with consent of all parties involved.

Istisna based financial products n n Financing high technology industries such as aircraft industry, locomotive and ship building industries. Working capital and export financing. To finance construction industry such as apartment buildings, hospitals, schools and universities. Housing finance schemes.

Difference between Istisna & Salam ISTISNA n n The subject of Istisna is always a thing which needs manufacturing. The price in Istisna does not necessarily need to be paid in full in advance. SALAM n n The subject can be any thing that can be weighed, counted or measured except for heterogeneous things and those goods whose exchange may give rise to Riba al Fadl. The price has to be paid in full in advance.

Difference between Istisna & Ijarah (Ujrah) Istisna n The manufacturer uses his own materials and the sales price is fixed. Ijarah / Ujrah n The manufacturer uses the material provided by the buyer and he is paid the agreed wages.

Separate contracts for parallel Istisna n A clear Istisna contract shall be entered into between the Bank and the customer, whereby on the other hand the Bank may enter into a Parallel Istisna with the third party (Contractor), but this contract shall not be tied up with the first contract.

Agency Agreement To Arrange Contractor To Monitor the project BANK Istisna of 7. 5 M Rs. 7 M (ISTISNA) Payment to Constructor as per schedule CUSTOMER CONTRACTOR Payment to the bank as per schedule 130

BUILDER Rs. 120 M BANK Deferred Rs 100 M CONTRACTOR Spot Sale of Building (Flats or Offices) Receivables assigned for Rs. 120 M to Bank Plus Profit 131

ISLAMIC BANKING MODEL Bank Equity Operational Expenses POOL OF FUNDS PLS Depositors Investment Income/ Loss from Investment SBP Current Deposit Income from non fund business Idle fund Distributable Income Depositors PLS Reserves Equity

Comparison of the Islamic and Conventional systems Conventional Banking Equation of Banks Failure Admn Exp + Interest Exp > Total Income + Reserves n Equation of Banking System Failure Admn Exp + Interest Exp > Total Income + Reserves + Equity n Islamic Banking Equation of Banks Failure Operational Losses > Reserves + PLS Deposits n Equation of Banking System Failure Operational Losses > Reserves + PLS Deposits + Equity n Operational Losses = Income (Losses) from Invest ± Admn Exp n

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