Islamic Banking Principles

 Prohibition of Riba in all forms. Only Qard al hasan is allowed.

 There is Equity participation, which means that the suppliers of funds act as investors and
not just creditors. Because they are partners in the investment, they try to maximize the
return of investment along with the banks and the entrepreneurs. They share the risks of
profit and loss. There can be no gain without liability or effort.
 Money is treated as ‘potential capital’. It only acts as capital when it combines with other
resources to undertake economic activity. It is a medium of exchange and cannot be used to
generate more money. A mere postponement of consumption is not a justification for a
reward. Hoarding of money is ‘haram’.
 There is prohibition of Gharar (uncertainty) and Maysir (gambling), which means that you
cannot speculate. You have to have knowledge about the investment that you are making.
Risky transactions are not allowed, although a little bit of risk is permissible. This means that
products such as options and futures are not allowed. The seller cannot sell an item that he
currently does not possess.
 Sanctity of contracts – This means that contractual obligations are to be upheld and there
should be full disclosure of the contract and the product of investment. There cannot be any
predetermined ratio for profit, because the principle of ‘uncertain gains’ is applied.
 Shariah approved activities are permissible only. This means that investments in haram
products like alcohol, gambling and casinos are not allowed. A Shariah Board is usually
established which consists of Islamic jurists that oversee the Shariah compliance of the
investments.

Sources of Shariah

Primary – Quran & Sunnah

Secondary – 1. Ijma (consensus of scholars and jurisprudents) 2. Qiyas (deduction by analogy) or

Ijtihad (deduction by reasoning)

An individual act of reasoning is called an opinion, ra’ay, and when it is directed towards the
achievement of a systematic consistency it becomes qiyas or ijtihad.

Shi’ite school of thought differs from Sunni , in that it treats ‘aql’ (logical reasoning) as the
replacement for Qiyas.

 e.g Ijma on one decision can be based on Ijtihad carried out on such a decision earlier.
(Hazrat Ali example where he talked of canning man for drinking CP Pg 76)
 Shariah Supervisory Board and Shariah Advisory Council are the same thing

Mudarabah – The investor bears all the loss, but both the investor and entrepreneur share the
profits according to a predetermined ration. The entrepreneur will only return funds to the investor
if negligence and mismanagement is proved.
Musharakah – The investor gives some funds to a company/entrepreneur that already has some
funds for investment. Both the parties share in the profit according to a predetermined ration, but
the losses are shared in the proportion of the capital invested. Both the parties maybe spending
different amounts of time and effort managing the business, therefore the profit is shared according
to a predetermined and fixed ratio, and not just in the proportion of capital invested.

 Both Mudarabah and Musharakah are Profit-Loss-Sharing (PLS). PLS ensures that the bank
undertakes those projects that are potentially high profit making, safest and most socially
beneficial. These kinds of projects will be selected according to their profit making potential
and not the credit worthiness of the borrower. The relationship between the finance and
business is transformed with both parties working jointly to create more wealth.
 All Islamic schools of thought consider Musharaka to be a valid contract.
 Diminishing Musharaka can be used for house financing also.

The PLS scheme is something that is more attractive to Islamic economists rather than Islamic Banks
because it does serve a socio-economic cause but it entails risk on an investment for a bank. The
bank is not guaranteed a profit share on an investment as opposed to fixed returns offered via
interest to conventional banks. The Islamic Bank also has to spend considerable time and effort in
evaluating a project for its profitability and protect itself against manipulation of the profits that are
shared. So Islamic Banks have looked for other ways to employ funds that do not involve risk sharing
and are economically profitable. Therefore the majority of investments by Isl Banks are in trade
financing whereby mark up and similar arrangements assure the banks of a more or less fixed rate of
return.

Ijarah

The service that the asset performs must be clearly known to both lessor and lesse. The lesse pays
lease at a fixed rate to the lessor which is decided at the beginning of the contract. The sale price of
the asset at the time of contract expiration to the lesse can only be decided once the contract
expires and not beforehand. The leasing contract ends as soon as the asset stops performing the
service that it is required to do. While the lease is being paid the ownership of the asset belongs with
the lessor (banks) and it is responsible for the asset’s maintenance.

 In Ijarah, there is no transfer of ownership, the asset is a usufruct.

 The lessee is charged 1 percent of Islamic money market rate on the outstanding instalment
and it is to cover the cost incurred by the lessor on admin due to late payment for penalty.

Al-Ijarah Thumma AL-Bai (AITAB) Financing

It is lease or hire ending with purchase by the lessee. It is composed of Al-ijarah and al-bai in one
contract. The customer pays back additional money at the end of instalments payment to own to
asset, this price is predetermined at the time of contract.

Ijarah wal – Iqtina (Hire purchase)

The bank agrees to buy a property/equipment for its client and the client agrees to make
incremental payments into an account. At the end of each year, profits are added to the instalments
paid such time as the investment account contains the identical amount the bank paid to purchase
the building equipment and facility. The client then becomes the owner of the financed object.

Savings Instruments

Three basic type of accounts: Current, Savings and Investment accounts that are offered to
depositors. The bank insures safe withdrawal of the money by the depositor from Currents and
Savings at all time, therefore it must maintain a certain level of liquidity. The bank at its discretion
decides to give profit (hibah) from financial activities to a depositor on savings accounts which
makes it a current account.

The investment accounts are the ones that are used by banks to finance profit making ventures. As
such they entail risks and the depositor partakes in that risk, he may lose everything he has put in an
investment account. But he may gain profit on that account according to a pre agreed profit sharing
ratio with the bank.

Murabahah

Murabahah or murabaha (Arabic ‫مرابحة‬, more accurately transliterated as murābahah) is a particular

kind of sale, compliant with shariah, where the seller expressly mentions the cost he has incurred on
the commodities for sale and sells it to another person by adding some profit or mark-up thereon
which is known to the buyer. As the requirement includes an "honest declaration of cost",
murabahah is one of three types of bayu-al-amanah (fiduciary sale). The other two types of bayu-al-
amanah are tawliyah (sale at cost) and wadiah (sale at specified loss).

It is one of the most popular modes used by banks in Islamic countries to promote riba-free

transactions. Different banks use this instrument in varying ratios. Typically, banks use murabahah in
asset financing, property, microfinance and commodity import-export.[1]

The seller may not use murabahah if mudarabah or musharakah is practicable. Since those profit-
sharing modes of financing involve risks, they cannot guarantee banks any income. Murabahah, with
its fixed margin, offers the seller (i.e. the bank) a more predictable income stream. A profit-sharing
instrument, conversely, is preferable as it shares the risks more equitably between seller and buyer.

There are, however, practical guidelines in place which aim to ensure that the
murabahah transaction between the bank and the customer is one based on trade and not merely a
financing transaction. For instance, the bank must take constructive or actual possession of the good
before selling it to the customer. Whilst it can be justified to charge an additional margin to the
customer to reflect the time value of money in terms of actual payment not being received from the
customer at time zero, the bank can only impose penalties for late payment by agreeing
to purify them by donating them to charity.

The accounting treatment of murabahah, and its disclosure and presentation in financial statements,
vary from bank to bank.
  The markup charged to the client is not like interest because it is compensation for the
services that the bank performs like locating the goods, negotiating a price and taking a risk
(client may not accept quality of goods). Unlike interest, the markup is not related to time
and it is predetermined. It does not increase due to delay in payment by the client. Although
the markup is fixed, it doesn’t necessarily mean that the finance provider will end up earning
a profit at the end of the deal because his client might reject the goods, or money he spends
in locating goods might be higher than predetermined money.
 Time value attached to trading is permissible and time value to financial transactions is not
permitted.
 Cost of goods to financier and profit charged is explicitly mentioned in contract. Payments
can be made on an instalment basis.

Istisna (sale contract)

Istisna is a Sharia mode of financing widely used by Islamic banks and financial institutions to finance
the construction of buildings, residential towers, villas and related products, and manufacturing of
aircrafts, ships, machines and equipment, etc.

The Arabic word "Istisna" means "asking someone to manufacture". It may be further defined and
elaborated as a sale contract between the seller and the buyer for the sale of an asset described in
the sale contract and transacted before it comes into existence. To fulfil its obligation, the seller can
either manufacture/construct it by itself or can get it manufactured/constructed by someone else to
deliver it to the buyer on the date described in the sale contract. The buyer can pay the sale price in
lump sum at the time of signing the contract or later in different stages as the
manufacturing/construction process proceeds.

We adopt Istisna mode of financing to fulfil your financing requirements in relation to properties,
buildings, and villas, etc. Following is a brief outline of this mechanism. If you own, or have a
usufruct of, a plot of land and want to construct a property on it and need financing for this purpose,
we will sign an Istisna agreement with you to sell the property and then construct the building as per
your specifications at our own cost and will get the sale price from you on a deferred payment basis.

 Istisna is being used for short term working capital financing, and may replace Murabahah as
the preferred choice for Short term financing. Opens up many opportunities in futures
contract trading of processed commodities.
 Istisna financing is employed in high technology industries like aircraft, locomotive and ship
manufacturing, in addition to other capital goods. Also applied in the construction industry.
 Settlement price not necessarily paid on the spot, but paid in instalments and the time of
delivery is not necessarily fixed.

Bai Bithaman Ajil (BBA) (sale contract)

Sale of goods with deferred payments, not a spot sale. Used for property financing usually, but can
also be used for consumer goods. Since the deal is a sale contract, and not a loan contract, the bank
is allowed to charge a profit on the deal. Customer can make instalment payments. But the selling
price is fixed throughout the tenure of the transaction. This is different from conventional banks
because the selling price in that is similar to nominal value of loan plus the total interest payment
and interest rates vary from time to time. Principle of aqad requires only price in one sale.

 Difference between Murabaha and BBA is that Murbabah is for short term financing with
lump sum repayment usually, while BBA is for long term financing with deferred instalment
payments.

Bai Salam

 It is a deferred delivery contract, whereby the seller supplies the goods at a later date
against a payment that is made on the spot. Used for agricultural financing usually. The bank
then sells on the goods and the difference between its selling price and purchase price is the
profit. The permissibility of salam is a general exception to rule of forward’s sale and is
therefore subject to stricter conditions.

Qard Al Hasan

 Beneficial or benevolent loan.

 The debtor at his discretion may or may not pay an extra amount beyond the principal
amount to the lender.
 The charging of service cost for a loan is allowed under AAOFI, but it must strictly be an
actual cost. Formula for cost calculation must be stated clearly.
 Usually offered to small producers, farmers and entrepreneurs that are not able to get the
loan from other sources.