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Home > Financing Best Practice > Islamic Modes of Finance and the Role of Sukuk

Financing Best Practice

Islamic Modes of Finance and the Role of Sukuk

by Abdel-Rahman Yousri Ahmad

Modes of Finance

Musharaka

Musharaka (partnership) is practiced by Islamic banks either on a “permanent” or on a “diminishing” basis. In both cases capital is provided by the bank in return for a share in the realized profit (or the loss, if a loss occurred). In diminishing musharaka, which is a new Islamic product, the bank is entitled to receive, in addition to its share in realized profits, an extra payment that is specifically assigned for the purpose of reducing its share in the company’s capital until this is fully paid off by the partner. Diminishing musharaka has mostly been used to finance small and medium-size enterprises, but it has also been employed in the financing of several big projects in some Arab Gulf countries (Kuwait, Bahrain, and Emirates).

Murabaha

Among all the modes of Islamic finance, murabaha has played the most important role. Banks’ annual reports reveal that since the 1970s murabaha has been steadily responsible for the employment of about 80–90% of Islamic banks’ resources. Murabaha in traditional fiqh (Islamic jurisprudence) is a spot sale contract where the price is based on a cost plus profit margin formula. The contract has been modified to include bai ajil (deferred payment sale) and renamed as “Murabaha to the Order of the Purchaser.” According to the new contract, the bank’s customer orders the purchase of a prescribed commodity that is available in the domestic or the foreign market. If the customer’s creditability is satisfactory, the bank buys the commodity, adding its markup to the market price. The bank accepts payment for the commodity in installments, which normally stretch over one year or more. When murabaha purchase is made by means of importation from foreign markets, letters of credit and foreign conventional banks are involved, and necessary shariah precautions are taken to avoid payment of “interest” at any step.

Murabaha, which has established a flexible mechanism for extending interest-free trade credit on short- and medium-term bases to households and firms, has also played a significant role in financing small and microenterprises (for example Faisal Bank’s Um Dorman branch in Sudan). Banking risk involved in murabaha operations is significantly reduced by customers undertaking to fulfill the contract once the commodity is purchased and by collaterals in the form of mortgage rights given to the bank over the purchased commodity until its price is fully paid.

The practice of murabaha has been the subject of criticism. It is held against Islamic banks that they are frequently guided by prevailing interest rates in determining their profit margin (markup) when they should instead consider market conditions for deferred payment sale, as intended in shariah. Also, (for instance in Pakistan) banks have sometimes not acted as purchasers and have merely financed customers in equivalent cash to the ordered commodity price plus markup. In this case the markup charged by the bank above the commodity price is no different from interest, which is prohibited.

Salam

Salam is the sale of a prescribed commodity for deferred delivery in exchange for immediate and full payment of its price. Salam is permissible in shariah to meet the instant cash needs of a seller who undertakes the future delivery of the commodity. Salam sale is absolutely forbidden in currencies, gold, silver, and all quasi-money assets, since gain in this exchange is riba. The objects of salam are commodities (or services) that are normally available in the market and can be specifically defined in terms of quantity, and quality. The exact date and place of delivery must be specified in the contract to avoid any problem. Thus, banking finance is extended to firms or individuals against their commitment to deliver commodities at future dates.

To hedge the salam operation banks also practice parallel salam. This involves making counter deals with other parties whereby they obtain immediate cash payments against a commitment to deliver commodities of similar quantity and quality to those in the salam contracts at some future date. Islamic banks in Pakistan, Sudan, and in some Arab Gulf countries have practiced salam transactions.

Istisna

Istisna is a manufacturing contract, treated in traditional fiqh as a special sale contract. A household that wishes to build a house, or a firm that needs to construct a building, or to manufacture equipment with particular specifications, would approach the bank for this purpose. The bank has to estimate the economic viability of the operation and the creditability of the customer. If the response is favorable, an istisna contract will be signed between the two parties. The customer submits a down payment and undertakes to pay the remaining part of the manufacturing price, as mutually agreed with the bank, in installments over a given period of time. The Islamic bank would then sign a parallel istisna contract whereby it extends finance to a firm that agrees to manufacture the requested object according to specification and to deliver it at an agreed future date. Islamic banks in the Arab Gulf countries have used this type of contract successfully to finance big operations, particularly in the construction sector and infrequently in the industrial sector.

Ijara Muntahia Bittamleek

Ijara muntahia bittamleek (lease ending with ownership) ranks next in importance after murabaha as an employment mode. The Islamic bank purchases real assets for leasing as requested and specified by its customers. The bank (lessor) and the client (lessee) will mutually agree on the leasing period, rent, and terms of payment. Maintenance and insurance of the leased asset are the bank’s responsibility, whereas the lessee has to bear the running costs as well as any repair costs in the case of misuse. As shariah does not allow for the combination of leasing and ownership in one single contract, ijara muntahia bittamleek implies a promise on the part of one party—namely the bank—to gift or to sell the leased asset at a nominal price to the lessee by the end of the leasing term. Ijara muntahia bittamleek has opened the door for successful leasing activities by the Islamic banks, particularly in the housing sector. Ijara of houses gives the bank the advantage of keeping the title of property until the end of the leasing period, and gives the lessee the benefit of subleasing rights.

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Further reading

Books:

  • Hassan, M. Kabir, and Mervyn K. Lewis (eds). Islamic Finance: The International Library of Critical Writings in Economics. Cheltenham, UK: Edward Elgar Publishing, 2007.
  • Iqbal, Munawar, and Tariqullah Khan (eds). Financial Engineering and Islamic Contracts. New York: Palgrave Macmillan, 2005.
  • Karim, Rifaat Ahmed Abdel, and Simon Archer (eds). Islamic Finance: Innovation and Growth. London: Euromoney Books, 2002.
  • Warde, Ibrahim. Islamic Finance in the Global Economy. Edinburgh, UK: Edinburgh University Press, 2007.
  • Yousri Ahmad, Abdel-Rahman. “Islamic banking modes of finance: Proposals for further evolution.” In Munawar Iqbal and Rodney Wilson (eds). Islamic Perspectives on Wealth Creation. Edinburgh, UK: Edinburgh University Press, 2005.

Articles:

  • Yousri Ahmad, Abdel-Rahman. “Islamic securities in Muslim countries’ stock markets and an assessment of the need for an Islamic secondary market.” Islamic Economic Studies 3:1 (December 1995): 1–37. Online at: tinyurl.com/cx6qtgy [PDF].

Reports:

  • Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI). “Shari’a standards.” Listed online at: tinyurl.com/c7hqjkl
  • Ali, Salman Syed. “Islamic capital market products: Developments and challenges.” Occasional paper no. 9. Jeddah: IRTI, Islamic Development Bank, 2005. Online at: www.irtipms.org/PubDetE.asp?pub=213
  • Islamic Fiqh Academy of the Organization of Islamic Countries. “Resolutions and recommendations of the council of the Islamic Fiqh Academy 1985–2000.” IRTI, Islamic Development Bank, 2000. Online at: www.irtipms.org/PubDetE.asp?pub=73

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