Level 3 Certificate in Islamic Finance

Islamic Finance
Qualification
(IFQ)
Edition 10, February 2022

This learning manual relates to syllabus

version 10.0 and will cover examinations from
1 June 2022 to 30 June 2025
Welcome to the Chartered Institute for Securities & Investment’s Islamic Finance Qualification study
material.

This workbook has been written to prepare you for the Chartered Institute for Securities & Investment’s
Islamic Finance Qualification examination.

Published by:
Chartered Institute for Securities & Investment
© Chartered Institute for Securities & Investment 2022
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Supérieure des Affaires accept no responsibility for persons undertaking trading or investments in
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Candidates should be aware that the laws mentioned in this workbook may not always apply to Scotland.

A learning map, which contains the full syllabus, appears at the end of this manual. The syllabus
can also be viewed on cisi.org and is also available by contacting the Customer Support Centre on +44
20 7645 0777. Please note that the examination is based upon the syllabus.

The questions contained in this manual are designed as an aid to revision of different areas of the syllabus
and to help you consolidate your learning chapter by chapter. They should not be seen as a mock
examination or necessarily indicative of the level of the questions in the corresponding examination.

Please note that, as part of exam security, hand-held calculators are not allowed in CISI exam venues.
Candidates must use the onscreen calculator for all CISI CBT exams in all languages in the UK and
internationally.

Learning manual version: 10.4 (September 2023)

Important – Keep Informed on Changes to this Workbook and Examination Dates
Changes in industry practice, economic conditions, legislation/regulations, technology and various other
factors mean that practitioners must ensure that their knowledge is up to date.

At the time of publication, the content of this workbook is approved as suitable for examinations taken
during the period specified. However, changes affecting the industry may either prompt or postpone the
publication of an updated version.

It should be noted that the current version of a workbook will always supersede the content of those
issued previously.

Keep informed on the publication of new workbooks and any changes to examination dates by regularly
checking the CISI’s website: cisi.org/candidateupdate

Foreword by Shariah Scholar Mufti Muhammad Nurullah Shikder

Islamic finance continues to grow at a high rate, with an increasing number of people interested in
this area of innovative finance. Some people see this as an excellent opportunity to diversify their
business into this area of finance, whereas others are looking to do business in accordance with Islamic
law because of their religious convictions. Whatever the motive may be, the fundamental rules and
principles relating to Islamic finance apply to all. As such, all market participants, particularly the new
entrants, need to have solid and accurate knowledge of Islamic financial products and services, and
of the Shariah principles that govern them. In this regard, this latest edition of the Islamic Finance
Qualification manual provides an excellent platform at an introductory level, which should allow the
reader to grasp the fundamentals of Islamic banking and finance.

This manual will provide a stepping stone for those who are interested in Islamic finance to familiarise
themselves with the basic concepts and structures that are generally used by Islamic banks and financial
institutions, and to enhance their understanding.

(Mufti) Muhammad Nurullah Shikder

Managing Director
Alhuda Shariah Advisory Services Limited
Foreword

The IFQ represents a positive step towards the global recognition of Islamic finance and the role it has to
play in global finance, and the Chartered Institute for Securities & Investment (CISI) would like to thank all
of the contributors to the workbook and to the IFQ examination.

The IFQ continues to underpin the development of the Islamic finance profession and the content of this
edition is fully Shariah-compliant, having been reviewed by Mufti Muhammad Nurullah Shikder. The IFQ
official workbook ensures that candidates gain a comprehensive understanding of examination content,
as well as being a valuable reference for practitioners.

Chartered Institute for Securities & Investment

Workbook Contributors:

Dr Abdel-Maoula Chaar

Raed H Charafeddine

Firas Hamdan

Dr Natalie Schoon

Mansoor Shakil
Mufti Muhammad Nurullah Shikder

Dr Anwar Misbah Soubra

Dr Sami Suwailem

Editor:

Dr Natalie Schoon

Advisory Council for Islamic Finance (ACIF) Members:

Raed H Charafeddine (Chairman April 2009)

Dr Abdul Sattar Abu Ghuddah

Firas Hamdan

Jean-Marc Riegel

Samir Salameh

Dr Natalie Schoon

Mansoor Shakil

Dr Sami Suwailem (March 2009)

UK Technical Group for the Islamic Finance Qualification:

Sultan Choudhury
Mahmood Faruqui
Usman Hayat
David Kemp
Mansur Mannan
Waheed Qaiser
Mufti Muhammad Nurullah Shikder
The Basis of Islamic Banking and Finance . . . . . . . . . . . . . . . . . . . . 1

1
An Introduction to Islamic Banking and Finance . . . . . . . . . . . . . . . . 13

2
Islamic Principles of Exchange . . . . . . . . . . . . . . . . . . . . . . . . . . . 31

3
Basic Contracts and their Treatment . . . . . . . . . . . . . . . . . . . . . . . 57

4
Financial Contracts and Techniques Applied by Islamic Banks . . . . . . . 89

5
Islamic Asset Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 135

6
Sukuk Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 151

7
Islamic Insurance – Takaful . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 175

8
Islamic Corporate Governance . . . . . . . . . . . . . . . . . . . . . . . . . . . 195

9
Glossary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 217

List of Arabic Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 225

Multiple Choice Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 229

References and Websites . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 261

Syllabus Learning Map . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 267

It is estimated that this manual will require approximately 130 hours of study time
 1
Chapter One

The Basis of Islamic

Banking and Finance
1. Introduction 3

2. Islamic Banking and Finance: Conceptual Framework 3

3. Islamic Fundamentals 5

This syllabus area will provide approximately 2 of the 100 examination questions
2
 The Basis of Islamic Banking and Finance

1. Introduction

1
Islamic finance has been growing steadily at a compound annual growth rate of 10.8% per year since
2006. As of 2020, worldwide Shariah compliant assets stood at US$1.7 trillion1. As such, it has become an
increasingly attractive sector within the financial industry.

To be able to understand Islamic finance, it is necessary to understand the underlying principles

(outlined in this chapter) and recognise that Shariah governs all aspects of life.

The term ‘conventional bank’ is used throughout this workbook, reflecting the fact that, within the
Islamic financial industry, a conventional bank is understood to be a bank that is not based on Islamic
principles.

It is important to bear in mind that the workbook does not advocate any particular stream of the Islamic
jurisprudence. The views on Islamic instruments presented throughout this workbook represent a
generally accepted view of the financial instruments in the marketplace.

2. Islamic Banking and Finance: Conceptual

Framework

Learning Objective
1.1.1 Understand the ethical underpinning of Islamic finance: Islamic moral guidance governing
property and wealth given through the Quran and Sunnah; to make charitable distributions:
Zakat (obligatory) and Sadaqah (voluntary); the role of trade and investment in wealth creation;
prohibition of Riba, gambling and Gharar

Islamic commercial and financial ethics stem from the principles and rules of the Islamic faith and
Shariah. Therefore, Islamic finance has a strong ethical underpinning as it is imbued with the concepts
of efficiency (avoiding waste and resource misallocation), fairness (equitable distribution and non-
monopolisation) and Ihsan (pursuing perfection and giving more than is due) which is clearly stated in
some verses of the Quran:

Allah commands justice (fairness), and (the pursuit of) virtue. (Surat Al Nahl, 16:90)

2.1 Islamic Commercial Ethics

Islamic commercial and financial ethics are based on five main principles:

1. The Principle of Stewardship of Humanity on Earth

The Quran designates human beings as Allah’s stewards in the created world.

I will create a steward on earth. (Surat Al Baqara, 2:30)

1 https://www.thebanker.com/Markets/Top-Islamic-Financial-Institutions-2020

3
This verse affirms that man is responsible for developing the earth and the implementation of Allah’s
(SWT) directives. SWT stands for Subhanahu wa Ta’ala, which has the meaning of ‘Blessed be His name’.
It is placed after the name of Allah as a sign of reverence. Although private ownership is permitted, any
personal wealth or property should be regarded by the individual as entrusted property from Allah
(SWT). Ownership of assets is a means to provide a decent life for the owner, his family and society as a
whole and not an end in itself. Fairness, justice and transparency in economic transactions are important
characteristics and, in addition, the public and environmental good should be considered equally when
using wealth or property in order to achieve fairness and perfection relating to society and nature.

2. Integrity
Integrity is valued highly and should govern all acts.

3. Sincerity
A person must always act with sincerity and should be fair and just.

4. Piety
Piety implies that people have to be devout both in private and in public and that the values, norms and
rules of Shariah will be implemented in all circumstances.

5. Righteousness and Perfection at Work

A person must have the ability to perform his duties, but should not just confine himself to performing
his occupational and professional duties. All people should strive to reach righteousness and perfection
in all their religious, social and economic obligations.

2.2 Charitable Distribution

Zakat, one of the five pillars of Islam, is mandatory almsgiving and is levied on anyone who has in excess
of a minimum level of wealth (Nisab). For the calculation of Zakat, see chapter 4.

The Quran also encourages Muslims to make voluntary charitable donations (Sadaqaat), the amount
of which is dependent on the goodwill of the donor. Individuals are encouraged to prioritise the
distribution of their charity as follows:

They ask you about what they should spend (in charity), say, ‘whatever you spend on good
(let it be first) on your parents, and (then) your close relatives, the orphans, the poor and
the traveller and, whatever good you do, surely Allah knows’. (Surat Al Baqara, Verse 215)

2.3 Wealth Creation

One of the major objectives of Shariah is the preservation of wealth. Preservation of wealth requires
avoiding waste or improper use, but also entails the creation of wealth via appropriate means. Wealth
creation is, therefore, in principle, an objective of Islamic economics, provided that it is directly linked to
economic activity and production (see chapter 3).

Making money purely from money (ie, lending on interest), gambling and deceptive uncertainty are
prohibited for Shariah-compliant investors. This does not mean, however, that wealth creation as such

4
 The Basis of Islamic Banking and Finance

is prohibited. On the contrary, investments in trade and enterprises with a view to making a fair and

1
acceptable level of profit are encouraged.

The challenge in Islamic finance is how to apply the basic principles of Shariah in such a way that
individuals and organisations are able to finance their needs without violating the underlying principles.

2.4 Enterprise and Asset Bias

As a result of the adherence to Shariah principles and its associated precepts, the modes of financing
that can be applied differ from conventional banks. Conventional banking is largely based on lending
and borrowing against interest, a practice that is prohibited in Islamic finance due to the prohibition
of Riba (see chapter 3). In addition, within Shariah, deceptive uncertainty (Gharar – see chapter 3) is
prohibited, which results in a situation where many derivative-type transactions that are common in
conventional finance cannot be applied.

The Islamic ban on interest does not mean that capital is costless in the Islamic system. Islam recognises
capital as a factor of production. However, Islam regards finance as a means to undertake business
activities: trade and production.

The value of time is acknowledged in relation to economic value and wealth creation. Wealth and
returns cannot be generated by pure lending and can only be created by means of real economic
transactions. Legitimate transactions either involve ownership of goods and services, or represent
an ownership stake in an enterprise. Both Riba and Gharar are forbidden as they decouple financial
activities from the underlying real transactions, thus potentially creating an imbalance in the economy
resulting in instabilities and crises.

3. Islamic Fundamentals

Learning Objective
1.1.2 Understand the role and purposes of Shariah

3.1 Shariah and its Role

Shariah is a comprehensive system of values, norms and rules governing all aspects of life. In Arabic, the
word Shariah refers to a path, or to a water spring in which water is abundant and easily accessible. In
early Islamic literature, Shariah refers to guidance and instructions concerning all Islamic teachings. In
late Islamic literature, however, the meaning changed and mostly referred to rulings related to practical
matters excluding matters of belief (Aqidah).

Fiqh literally means ‘deep understanding’ and is often defined as jurisprudence. It represents the
interpretations of Shariah scholars. Fiqh al Muamalat, ie, Fiqh related to worldly transactions, has
developed over time from the Quran and the Sunnah, as well as the secondary sources (see section 3.2).

5
3.1.1 Morality of Shariah
Although Shariah is often referred to as Islamic law, scholars clearly stipulate that it is a code of both
moral and civil behaviour, simultaneously governing matters relating to this life and the hereafter.2

The relationship between the ethical and legal dimensions of Shariah is clear as Shariah rulings are
categorised into two classes:

1. Religious verdicts (ahkam al-diyanah) – rulings on matters between a person and Allah (SWT).
2. Judicial verdicts (ahkam al-qadha) – rulings concerning actions before a judge or human court.

However, despite the best efforts of a human judge, a court ruling cannot overrule a divine ruling.
It is acknowledged that the world we live in is imperfect and that a human judge may not be in full
possession of all relevant information. The moral dimension makes up for these imperfections which
distinguishes Shariah from worldly legal systems.

Example
Although the Quran clearly forbids Israf (extravagant spending), a sale contract through which
extravagant spending is conducted is legally valid. The contract is, however, not Shariah compliant.

The sale of grapes for the purpose of making wine, or the sale of weapons for the purpose of killing
innocents, is prohibited. The underlying sale contract is legally valid since the use of the asset is not
stated in the contract. The contract is, however, not Shariah compliant.

In either of these cases, a court is unlikely to invalidate the sale contract. It is the moral obligation of the
seller not to conduct the sale if he has reason to believe the goods are intended to be used in a non-
compliant manner.

3.1.2 Individual versus Collective Responsibility

Shariah balances the responsibilities of the individual versus those of society. In this respect, the
following two categories of obligation are identified:

1. Individual obligations (Fardh ‘ayn): to be fulfilled by each individual irrespective of other members
of the society. The paying of Zakat is an example of an individual obligation.
2. Collective obligations (Fardh Kifayah): to be fulfilled individually or collectively. In the event they are
not fulfilled, this will be the responsibility of every individual. For example, saving a drowning person
is an obligation on all those nearby, but once some individuals start to rescue the person, there is no
longer any obligation on the others unless called for by the rescuers. However, if no one volunteers
to rescue the drowning person, each of them becomes accountable, both legally and morally. The
same applies to, for example, taking care of orphans, the elderly and other philanthropic non-profit
activities.

Collective obligations also include building institutions vital for society, such as schools, hospitals,
various markets and industries. Usually, governments are responsible for such institutions, but if the
government fails to perform these responsibilities, every member of society becomes accountable until
those institutions are established.

2 Al Zarqa, M Al Madkhal Al Fiqhi, Vol. 1, pp. 67-69, 277-280

6
 The Basis of Islamic Banking and Finance

3.2 The Sources of Shariah

1
Learning Objective
1.1.3 Know the sources of Shariah: primary sources (Quran and Sunnah) and secondary sources
(Ijma’ Qiyas, Ijtihad)

There are a number of sources of Shariah, which can be roughly divided into primary and secondary,
each of which is described further in this section.

3.2.1 Primary Sources

There are two primary sources of Shariah: the Quran and the Sunnah.

The Quran (Book of Allah (SWT))

The Quran contains the word of Allah (SWT) as it was dictated to the Prophet Muhammad (PBUH) by the
angel Gabriel and communicated by him to others. In respect of the Quran, the Prophet Muhammad
(PBUH) is an intermediary communicating the word of Allah (SWT) to man.

The Quran is the primary reference for all Muslims and should be consulted before any of the other
sources.

The Sunnah (Words, Acts and (Tacit) Approvals of the Prophet)

During the life of the Prophet Muhammad (PBUH), the Muslims sought his clarification and guidance
on various parts of the Quran and observed his behaviour so they could follow what Allah (SWT) had
described to him to be the model of a proper Islamic life.

Each of the sayings, words, acts and (tacit) approvals of the Prophet Muhammad (PBUH) is represented
by a Hadith which together form the Sunnah.

• The sayings of the Prophet Muhammad (PBUH) were used to outline the laws and provide moral
guidance. For example, the principle of Al-Kharaju bi-dhaman states that the right to the revenue of
an operation is linked to the responsibility to take on the possible loss of the same operation.
• The acts of the Prophet Muhammad (PBUH) refer to actions of the Prophet Muhammad (PBUH) that
are used as a reference and followed. For example, the way of praying or the manner of performing
the pilgrimage (Hajj).
• Tacit approval is the absence of a reaction of the Prophet Muhammad (PBUH) to an action carried
out by one of his companions in his presence or to an action he was aware of. The lack of reaction
is considered to be an approval, since the Prophet Muhammad (PBUH) was under an obligation to
correct any undesirable action.

7
3.2.2 Secondary Sources
Secondary sources are those that are referred to in the event that the Quran and Sunnah do not provide
a direct answer to the issue at hand. There are three secondary sources: Ijma’ (consensus), Qiyas
(analogy) and Ijtihad (interpretation), which are applied in this order.

Collective Interpretation
Ijma’ (Consensus)
Ijma’ literally means ‘agreement on a matter’ or consensus, and is the consensus of the Mujtahidin
(independent jurists) from the Ummah (the Muslim community) of the Prophet Muhammad (PBUH),
concerning a specific issue. Ijma’ is of the utmost importance as the rulings adopted are integrated
within Shariah and are considered to be a third source of Islamic law. The process of Ijma’ allows for
contemporary issues to be addressed in light of the principles, values and rules of the Quran and the
Sunnah.

Example
Jurists have reached a consensus (Ijma’) on the prohibition of forward sales, whereby the good sold is a
debt obligation on the seller and the price is a debt obligation on the purchaser, each of which is to be
delivered at a certain point of time in the future.3

Example
Jurists have reached a consensus (Ijma’) that philanthropic activities, other than Zakat, are collective
obligation of the society (Fardh Kifayah).4

Qiyas (Analogy)
Qiyas (analogy) is one of the main interpretation techniques used by Islamic scholars and refers to the
assignment of an existing legal rule to a new scenario. Qiyas is applied when there is no legal rule found
in the Quran or Sunnah but there is a previous ruling for a similar case. Literally, Qiyas means measuring
or estimating one situation in relation to another. It is technically defined as ‘the application of the legal
rule of an existing case found in the texts of the Quran, the Sunnah, or Ijma’ to a new case whose legal rule is
not found in these sources’. This transposition is made on the basis of the similarity of the attribute called
the ‘illah’ (underlying rationale) of both legal rules.

Example
The prohibition of Khamr (grape wine) is laid down in the Quran. The Arabic word ‘Khamr’ means cover
or veil. From this, it has been deduced by jurists that the underlying rationale (illah) for the prohibition
of wine is intoxication, as this is against the objective of Shariah to preserve the intellect. Accordingly,
scholars would look at other substances that intoxicate and extend the prohibition to include these.

3 Bidayah al-Mujtahid, Ibn Rushd, Vol. i, p. 480.

4 Al Istithkar, Ibn Abdul-Barr, Vol. 15, p. 358.

8
 The Basis of Islamic Banking and Finance

Ijtihad (Scholarly Interpretation)

1
Following the death of the Prophet Muhammad (PBUH), and with the expansion of Islam, religious
leaders at the time were confronted with requests for guidance on new issues. Their recourse was first
to the Quran to determine a course of action. If they were unable to find a solution to their problem in
the Quran, they would turn to the Sunnah. Once it is established that an issue is not dealt with within
the Quran, Sunnah or Ijma’, scholars come to their own judgement on the basis of an exhaustive
examination of textual evidence (Ijtihad).

There are two kinds of Ijtihad: individual Ijtihad interpretations performed by individual scholars and
collective Ijtihad.

Individual Interpretation
Islamic scholars may refer to other Shariah sources to resolve an issue. In doing so, they might take into
consideration public welfare (Istislah), common plight (Umoom Balwa) and/or the traditions (Urf) of the
geographical location. They may also base their decision upon consideration of Shariah objectives and
ultimate wisdom (Istihsan).

Collective Interpretation
Collective interpretation occurs when a group of scholars interpret a specific issue together.

3.2.3 Schools of Jurisprudence

The scholars involved in Ijtihad follow the methodology of one of the five Islamic schools of
jurisprudence. There are four Sunni schools of jurisprudence (Hanbali, Maliki, Shafi’i and Hanafi) and
one Shi’a (Ja’afari). All schools use the Quran and the Sunnah as the primary sources of their legal
opinions (Fatwa/plural Fatawa) but differ in their interpretation of the texts. The Sunni schools can be
classified along a continuum, with the Hanbali school mainly promoting a literal reading of the sacred
texts on the one hand and the Hanafi school primarily supporting logical reasoning on the other side
of the spectrum. In between lie the Maliki school, which gives particular importance to the tradition of
Medina, and the Shafi’i school, which is an important influence as its founder ordered the practice of
Ijtihad.

• Hanbali – the Hanbali school originates from Damascus and is currently largely associated with
Saudi Arabia. The Hanbali school is particularly influential in the Arabian Gulf region.
• Maliki – the Maliki school originates from Medina. This school ruled heavily in favour of the practice
(Sunnah) of the local community of Medina because the town was the territory of the Prophet
(PBUH) and, as such, the traditions of the town are directly in line with the Quranic message.
• Shafi’i – the founder of the school, Al Shafi’i, was the first to standardise the activity of Ijtihad. In a
book defining Usul al-Fiqh (Principles of Islamic Jurisprudence), he advocates the use of the sources
of Islamic law in the following hierarchical order: the Quran, the Sunnah, Ijma’ (consensus) and Qiyas
(analogy). Al Shafi’i also mentioned the possible use of Istihsan (juristic preference). Its approach to
Islamic jurisprudence has become a standard reference and is used by all the schools.
• Hanafi – the Hanafi school was created in Kufa in Iraq. It is distinctively renowned for using Ra’y,
which is the logical deduction of scholars (using primary and secondary sources), comparatively
more than the other schools. The Hanafi school has a strong influence on many modern practices in
Islamic finance.
• Ja’afari – the Ja’afari school also originated in Iraq and, although it is a Shi’a school, it has many
similarities with the Hanafi school.

9
3.2.4 Bodies of Interpretation

Learning Objective
1.1.4 Know the authorities that are able to interpret the Quran and Sunnah and their role: the
scholars within the schools of jurisprudence; the Islamic Fiqh Academy; the Shariah supervisory
boards of regulatory or industry institutions

The examination (Ijtihad) of the text of the Quran and the Sunnah can be performed by individual
scholars of requisite competence, Islamic financial institutions, Shariah supervisory boards (SSBs) of
regulatory bodies and the Islamic Fiqh Academy.

Shariah Supervisory Board (SSB)

Islamic Financial Institutions use the services of their SSB to ensure their practices are in line with
Shariah. Part of the task of the SSB is to issue informed legal opinions allowing institutions to provide
financial services in a Shariah-compliant way. The SSB, which often generally includes three or more
Shariah scholars, adheres to the following process when determining whether a financial instrument is
Shariah compliant or not:

• reviewing the product concept description created by the product development team
• reviewing the market conditions identified by the product development team
• reviewing the product development team’s views on the Islamic principles on which the transactions
will be based
• reviewing the product development team’s proposals and issuing the proper legal opinions
(Fatawa).

The resulting opinion of the scholars is then reviewed by the product development team and can
be followed by a discussion between the scholars and the product development team to finalise the
product.

The need for a constant dialogue between the product development team and the scholars throughout
this process should be stressed.

In the majority of countries where Shariah-compliant financial services are offered, each institution has
its own SSB making individual decisions for the institution. In some countries, however, such as Malaysia
and Sudan, Shariah compliance is centralised in the central bank.

Centralised Shariah Supervisory Boards

Originally pioneered by the Malaysian Central Bank (Bank Negara Malaysia), other central banks, such
as those in Dubai, Oman, Nigeria and Pakistan, have more recently established a centralised SSB within
the central bank or financial regulator. The central SSB is responsible for the approval of all Shariah-
compliant financial transaction types in the country. The responsibility of the SSB of the individual
financial institutions is to ensure the transactions undertaken by the institution are compliant with
these rules. Any amendments requested by individual institutions must be presented to the central SSB
for ratification.

10
 The Basis of Islamic Banking and Finance

In addition to a centralised SSB, Bank Negara Malaysia also maintains a register of approved scholars.

1
Scholars cannot be a member of more than one board per type of financial institution. As a result, a
scholar could, for example, be a member of the SSB of a retail and an investment bank, but not of two
retail banks.

The Islamic Fiqh Academy

The Islamic Fiqh Academy was created in Jeddah, Saudi Arabia, following a decision of the Organisation
for Islamic Cooperation, founded in 1981. The Academy includes members from most Islamic countries
which are represented by scholars and knowledgeable people in many scientific, economic and social
domains. The Academy meets periodically to debate contemporary matters relating to Islam and issues
resolutions (jurisprudence) which originate from the Islamic tradition and Islamic thinking. Note 1

Chapter Notes
Note 1: This explanation is based on the translation of the Arabic website of the Islamic Fiqh Academy
(www.fiqhacademy.org.sa).

11
 End of Chapter Questions

1. Name the five main principles of Islamic and commercial ethics.

Answer reference: Section 2.1

2. In relation to the creation of wealth, what is one of the challenges within Islamic finance?
Answer reference: Section 2.3

3. What is the relationship between Shariah and Fiqh?

Answer reference: Section 3.1

4. What are the two classes of Shariah rulings?

Answer reference: Section 3.1.1

5. What are the primary reference sources of Shariah used by all Muslims?
Answer reference: Section 3.2.1

6. What is the definition of Sunnah?

Answer reference: Section 3.2.1

7. What are the three secondary sources of Shariah?

Answer reference: Section 3.2.2

8. What are the two forms of Ijtihad and how do they differ?
Answer reference: Section 3.2.2

9. How would a jurist apply Qiyas?

Answer reference: Section 3.2.2

10. Name the three bodies engaged in the interpretation of Shariah.

Answer reference: Section 3.2.4

12
Chapter Two

2
An Introduction to Islamic
Banking and Finance
1. The History of Islamic Finance 15

2. The Structure and Scope of the Islamic Finance Industry 20

This syllabus area will provide approximately 3 of the 100 examination questions
14
 An Introduction to Islamic Banking and Finance

1. The History of Islamic Finance

Learning Objective

2
2.1.1 Know the development of Islamic finance and banking: the beginnings of Islamic banking;
Islamic banking in the Gulf Cooperation Council (GCC), Africa and the Middle East countries;
Islamic banking in Southeast and South Asia and Australasia; Islamic banking in Europe and the
Americas

The history of Islamic finance is long and varied and its current development is subject to constant and
rapid change. It is important for candidates to understand historic and current developments, so that
they have a better idea of the background.

1.1 The Early History of Islamic Finance

Islamic finance dates back to the 7th century CE and the beginning of Islam, when the Prophet
Muhammad (PBUH) approved the usage of one of the main contracts of Islamic finance – the Mudaraba,
a participation type contract (covered in chapter 5) – and his companions continued its practice after he
departed. From the 7th century onwards, Islamic merchants traded over long distances and the means of
financing their trades and investments in line with Shariah were introduced. By the 11th century, many
of the commercial practices used by Islamic merchants had been adopted across Southern Europe, Asia
and the Middle East.

The concepts and practices of Islamic finance were revived in the 1960s.

1.2 The Contemporary History of Islamic Finance

The contemporary history of Islamic finance can be divided into three stages: a founding period,
that took place during the 1960s; a formative period, which began with the creation of the Islamic
Development Bank (IsDB) in 1975 and ended in 1990; and a development period, which began in 1990.

The timeline can be depicted as follows:

Founding Period Formative Period Development Period

1963–1975 1975–1990 1990–Now

1963 Mit Ghamr, Egypt, Formation of IsDB and Regulation and

based on profit sharing commercial banks standardisation
and concepts of mutual First attempts to turn Islamic windows
credit union conventional finance into
Increasing sophistication
an Islamic format, some
new product development

15
1.2.1 The Founding Period (1963–75)
Contemporary Islamic finance emerged in the 1960s with the creation in Egypt of the Mit Ghamr Saving
Project in 1963. Set up by Dr Ahmad el Najjar, its aim was to assist the people of the region of Mit Ghamr
with the financing of the development of their land in line with Islamic finance principles. All finance
was free of Riba and based on profit sharing.

Around the same time, the Muslim Pilgrims’ Saving Corporation in Malaysia offered to manage Muslim
pilgrims’ savings according to Islamic rules. This programme was specifically developed to assist people
in their efforts to save money so as to be able to fulfil one of the important elements of Islam – to go on
pilgrimage (Hajj).

1.2.2 The Formative Period (1975–90)

The second landmark in the history of Islamic finance was the inauguration of the IsDB in 1975. The IsDB
is a multilateral bank with the objective of fostering the economic development and social progress of
member countries and Muslim communities, using techniques that respect the principles of Shariah.
This event was particularly important because it gave institutional recognition to the developing Islamic
finance industry. A few months after the inauguration of the IsDB, the Dubai Islamic Bank, the first
modern Islamic commercial bank, opened its doors, followed by the Kuwait Finance House, the Faisal
Islamic Bank of Sudan and the Faisal Islamic Bank of Egypt. The Jordan Islamic Bank was incorporated
in 1978 and, a year later, was followed by the Bahrain Islamic Bank. As it was only regarded of being of
interest to a minority of customers, the development of Islamic finance during this period was still slow.

Initially, the focus of the banks was on providing an alternative to conventional commercial banking
functions in a Shariah-compliant manner, and services were predominantly retail and trade finance-
oriented. Since the 1980s, Islamic banks have expanded into countries with a Muslim minority.
Simultaneously, Iran, Sudan and Pakistan sought to impose Islamic banking solutions, while Malaysia
made significant progress in establishing a dual-banking system.

1.2.3 The Development Period (1990 onwards)

The development period began in 1990 with the incorporation of the Accounting and Auditing
Organisation for Islamic Financial Institutions (AAOIFI). The establishment of AAOIFI was a clear
statement that Islamic finance was becoming an integral part of the finance industry and this was
reinforced further with the incorporation of the Islamic Financial Services Board (IFSB) in 2003. Both
AAOIFI and the IFSB are detailed further in section 2. The result of the establishment of these two
institutions was that Islamic finance started to offer a credible alternative to conventional finance. In
addition to the regulatory frameworks provided by AAOIFI and the IFSB, Citibank, one of the largest full
service conventional banks in the world, launched its Islamic finance operations under the name Citi-
Islamic in Bahrain in 1996 and was the first conventional financial institution to offer Islamic financial
services. More recently, some Western countries, such as the UK, have amended their regulation to
facilitate the offering of Islamic financial services within the framework of their financial regulations.

Since the 1990s, Islamic finance has become increasingly sophisticated and Islamic financial products
have developed to match almost every demand from capital markets, consumer banking and wealth
management. During this period, the number of Islamic banks has expanded significantly around the
world.

16
 An Introduction to Islamic Banking and Finance

1.3 The Geographical Development of Islamic Finance

The Islamic financial industry has grown, irrespective of any government support. Initially mainly
limited to Middle Eastern countries, it expanded into Asia in the 1980s and into Europe from around
2002. Bahrain, Malaysia and the UK have played important roles in their respective regional Islamic

2
finance markets and the developments in each of these jurisdictions have been beneficial to the global
development of the industry.

1.3.1 The Countries of the Gulf Cooperation Council (GCC), Middle East
and Africa
Bahrain was the first country of the Gulf Cooperation Council (GCC) to develop a comprehensive
approach to Islamic banking and finance and is considered as one of the key players in the field. It was
among the first countries to recognise the importance of the industry and contribute to its growth.
AAOIFI is based in Bahrain and the Central Bank of Bahrain (CBB) is playing an active role in the
development of the Islamic financial industry. The CBB has established the necessary supervisory and
regulatory framework to promote the growth of the sector. The CBB has, for example, implemented the
IFSB standards for regulations, requires Islamic financial institutions under its supervision to adhere to
AAOIFI standards and has designed an Islamic paper (Sukuk) issuance programme to provide a liquidity
instrument for the Islamic financial institutions in Bahrain.

The Kingdom of Saudi Arabia started a process to formalise a robust regulatory structure for Islamic
banking and finance in 2000 and this has encouraged the rapid adoption of Islamic banking and
insurance in the Kingdom. As the largest market in the GCC, robust growth is projected for institutions
based in Saudi Arabia.

All GCC countries now formally support Islamic banking and investment. More recently, Dubai formed
the Dubai International Financial Centre (DIFC), Qatar formed the Qatar Financial Centre (QFC) and
Kuwait has begun to examine how it may offer more robust financial services in the region. Although
these centres aim to service their domestic economies, they are well positioned to service Iraq, Iran, the
Indian subcontinent, and East Africa.

All the GCC countries are applying a dual-banking system in which Islamic and conventional financial
institutions are operating side by side.

In Lebanon, Islamic banks and financial institutions have been authorised by the Central Bank (Banque
du Liban) since February 2004 and are governed under the same legal and regulatory provisions as
non-Islamic banks. An additional provision is included in the law which requires the banks to appoint a
consultative body, consisting of three experts in Islamic law and banking and financial operations. This
body is appointed for a renewable three-year period. Jordan has made it mandatory for Islamic banks in
its jurisdiction to follow AAOIFI standards for accounting and reporting.

Islamic banks have been incorporated in Sudan for many years and also, more recently, in Syria, where
banking supervisors have made AAOIFI standards mandatory.

Throughout the African countries, and currently in South Africa particularly, Islamic finance is gaining
traction. In other countries, Islamic financial services are slowly being introduced.

17
1.3.2 South and Southeast Asia and Australasia
Bank Islam Malaysia Berhad (BIMB) was incorporated in Malaysia in 1983 as part of a national strategy
to establish a dual-banking system. The primary driver for this strategy was that Muslims were
disproportionately not using the formal financial system and required a viable alternative. Currently,
Malaysia has one of the most developed Shariah-compliant financial systems in the world and is
committed to the international development of Islamic finance. The IFSB is based in Malaysia and
is considered to be one of the main hubs of Islamic finance. The Malaysian Islamic banking sector is
regulated by the Malaysian Central Bank and Bank Negara Malaysia under a dual-supervision regime.

Pakistan originally had limited success in converting its financial infrastructure to be Shariah compliant
and introduced a dual-banking system in 2004. Since the introduction of dual regulation, the Pakistani
Islamic banking sector has rapidly expanded.

Singapore, Hong Kong, Indonesia and Australia are all making progress on the introduction of Islamic
finance. Australia mainly focuses on managing funds containing Asian-based investments and Indonesia
issued its first government Sukuk in 2009. In each of these countries, the Islamic banking and finance
industry is regulated using the same framework as that in place for conventional banks.

1.3.3 Europe and the Americas

The US and the UK have been exploring the way to regulate domestic and cross-border Islamic financial
services since the mid-1990s.

In 2002, the Financial Services Authority (FSA) (the UK regulator at the time) and the Bank of England
(BoE) adopted a series of measures to encourage the development of Islamic finance. Since then,
several Islamic banks have been licensed to operate in the UK under the supervision of the UK regulator
and, in 2014, the UK was the first country outside the Muslim world to issue a government Sukuk. The
importance of London as an international financial hub is likely to lead to more institutions seeking
authorisation and other European countries are exploring the possibilities of the Islamic financial
industry.

In the US, the Office of the Comptroller of the Currency (OCC) has issued a series of public and private
interpretive letters on the subject, and the Federal Deposit Insurance Corporation (FDIC) and various
other agencies at state level have created a flexible framework to allow limited Islamic banking
activities to take place onshore (notably in New York, Michigan and Illinois). In addition, US banks are
allowed to engage in Islamic financial services activities offshore (for example, Citibank operates an
Islamic subsidiary in Bahrain). The Federal Reserve Bank has initiated a study group to research the
opportunities associated with Islamic finance and its implementation in the US, and the Securities
and Exchange Commission (SEC) is regulating a growing number of Islamic mutual funds aimed at US
domestic investors. In addition, Freddie Mac and Fannie Mae, the US government-sponsored mortgage
securitisation companies, have supported the development of Islamic alternatives to conventional
mortgages since 2002.

18
 An Introduction to Islamic Banking and Finance

1.4 The Future of the Islamic Finance Industry

Learning Objective

2
2.1.2 Know the constraints and challenges on the development of the Islamic banking and finance
industry

1.4.1 The Interaction of Shariah with Local Law and Regulation

In some countries, local regulations do not permit the use of financial instruments that conform
perfectly to each requirement of Shariah. Therefore, some concessions may have to be made in order
to meet local regulatory requirements, for example, capital protection for retail customers. Shariah
scholars approve financial instruments containing concessions in the event there is no other choice,
since these products enable the Islamic finance industry to develop and may be used to advocate
gradual change in local regulations in order to accommodate Shariah requirements. After all, something
less than perfect is better than nothing at all. In addition, once the instrument is accepted, efforts can be
made to improve them. In Muslim countries, these differences are less likely to be encountered.

1.4.2 The Constraints of Islamic Banking

Even though some of its instruments have been applied for centuries, the contemporary Islamic
financial services industry is relatively young and is still developing new Shariah-compliant ways to
provide a balanced, full offering of financial products and services. The ways in which Shariah-compliant
products are structured vary by region, within regions, and by school of jurisprudence. This workbook
attempts to follow the mainstream view on the various structures based primarily on the Fiqh Academy
of the Organisation of Islamic Cooperation, the international body officially representing Muslim
nations worldwide, as well as the Shariah Council of AAOIFI. It needs to be taken into consideration that
this generally might be more conservative than what is advocated by some regional Shariah bodies. This
workbook does not make a judgement on the various schools of jurisprudence, or attempt to include
different views, as this would be outside its scope.

19
 2. The Structure and Scope of the Islamic Finance
Industry

2.1 The Functions of Islamic Banks

Learning Objective
2.1.3 Know the main functions of Islamic banks

From an economic perspective, the functions of an Islamic bank are similar to those of the conventional
financial industry and include the following:

• Investment and investment management – Islamic banks invest funds that have been placed or
deposited with them (ie, their own capital funds and funds in their customers’ investment accounts)
through investment mechanisms that are consistent with Shariah.
• Generic banking services – Islamic banks offer a variety of financial services similar to conventional
banks, including current accounts, fund transfers, credit cards, consumer goods finance, home
finance and small- to medium-sized business facilities, through Shariah-compliant arrangements. It
is important to note that not all of these are offered uniformly by all institutions.

In addition to these generic functions, Islamic banks carry out direct social services since they have an
explicit responsibility for the development of their staff and their local communities. They also carry out
indirect social services via the charities to which they have donated Zakat or other gifts.

Besides commercial banks, the Islamic finance industry also encompasses investment banks, investment
funds, Takaful (insurance) companies and multilateral and development banks, such as the IsDB.

2.2 The Operating Structures of Islamic Banks

Learning Objective
2.1.4 Know the operating structures and organisational forms adopted by the Islamic financial
services industry: the window model; branches; subsidiaries; fully-fledged banks

Islamic financial services are offered via different structures, depending on whether or not the
institution also offers conventional financial services. Institutions that provide conventional, as well as
Islamic financial services, have three main organisational structures available to them.

Although in some countries, such as Iran and Sudan, the financial system is fully Shariah compliant, in
the majority of countries, Shariah-compliant and conventional banks exist side by side.

In some countries such as Qatar, Kuwait and Lebanon, for example, it is not allowed for conventional
banks to offer both Islamic and conventional financial services. In these countries, Islamic financial
services can only be offered by fully fledged Islamic banks. In most countries, however, conventional

20
 An Introduction to Islamic Banking and Finance

banks are also allowed to offer Islamic financial services, but segregation of these services from the
conventional financial services offering must be in place in order to ensure Shariah compliance.

Contrary to some other countries, Malaysia has made the choice to be an early introducer of new

2
products and services and to enhance their Shariah compliance over time or replace them with new,
more favourable options as they develop. Although not all schools of jurisprudence agree with some of
the instruments available in Malaysia (namely, Bai al ‘inah), they are considered to be Shariah compliant
by Shariah scholars in Malaysia who, in principle, follow the Shafi’i school of jurisprudence, which
is predominant in Malaysia. The approach has made it possible for the Malaysian market to display
significant growth and become one of the largest markets in the Islamic financial industry. It must be
noted, however, that Bank Negara Malaysia, the central bank of Malaysia, issued a circular in December
2012 that strongly restricted Bai al ‘inah transactions, aligning them closer to the principles of Shariah as
considered by the majority of schools of jurisprudence.

There are four main organisational forms in which Islamic financial services can be offered and these are
outlined below.

Islamic Financial Services Offerings by Conventional Banks

When conventional banks offer Islamic financial services, this is typically done using one of the following
organisational models:

• The Windows Model – in this model, a conventional bank offers Islamic financial services via the
same delivery channels it uses for its conventional financial services. For example, Lloyds in the UK
offers Islamic financial products via the same branch network it uses to offer other financial services.
• Branches – contrary to the windows model, the Islamic financial services offered by a conventional
bank are not distributed via the same channel, but instead via dedicated branches. For example,
Standard Chartered Bank provides Islamic financial services in Pakistan via a dedicated branch
network under the name Standard Chartered Saadiq. Similarly, HSBC offers Islamic financial services
via the Amanah branch network in Malaysia.
• Subsidiaries – a subsidiary is a separate legal entity owned by a conventional bank or some other
financial institution (a parent), which is set up specifically to provide Islamic financial services. The
subsidiary can either have its own dedicated service delivery channels or utilise the parent’s service
delivery channels which also offer conventional financial services. Being a separate legal entity, the
subsidiary usually formulates and manages its own policies on Islamic financial services, but within
the parent’s overall business strategies, eg, Citi-Islamic (a subsidiary of Citi) and Badr al-Islami (a
subsidiary of Mashreqbank).

It is important to bear in mind that, in each of these structures, the operations and accounting of
the Islamic financial services offering are segregated from the conventional part of the bank, and
although the services are offered by a conventional bank, the offering is generally managed separately.
Disregarding the operating model, Islamic financial services are subject to the review and controls of
a SSB. BNP Paribas, for example, which operates a windows model, has an Islamic banking unit which
manages its Islamic financial services offering.

21
Fully-Fledged Islamic Banks
Unlike any of the above, fully-fledged Islamic banks are stand-alone institutions and do not form part
of conventional financial institutions. These banks are set up solely to provide Islamic financial services
offered through their own service delivery channels. As they have fully independent management and
operating structures, they draw up their own business strategies and policies. Most Islamic banks fall
into this category. The following are among the largest Islamic banks (by total assets):

• Al Rajhi Bank
• Kuwait Finance House
• Dubai Islamic Bank
• Abu Dhabi Islamic Bank
• Qatar Islamic Bank
• Maybank Islamic.

2.3 The Regulators

Learning Objective
2.1.5 Know the bodies overseeing and/or supporting Islamic banking and finance: the regulators
(central banks or other authorities); the standard-setters (AAOIFI and IFSB); other institutions
supporting the development of Islamic finance and banking (IIFM, CIBAFI, IIRA, IILM, and IsDB
Group)

AAOIFI REGULATORS IFSB

IIFM Islamic Finance IRTI

Institutions

IIRA CIBAFI
REGULATORS

Figure 1: Islamic banking infrastructure

Islamic financial institutions are, like other financial institutions, authorised and supervised by the
regulatory authority in their country of incorporation. In addition, two standard-setting bodies have
been established: the AAOIFI and the IFSB. Their main aim is to ensure the integrity and stability of
the Islamic financial industry within the global financial system and to protect the interests of the
stakeholders (especially the customers) of financial institutions. These and other supporting institutions
are detailed in the remainder of this chapter.

22
 An Introduction to Islamic Banking and Finance

2.3.1 The Accounting and Auditing Organisation for Islamic Financial

Institutions (AAOIFI)
AAOIFI, whose headquarters are in Bahrain, is an autonomous body established in 1990 by Islamic
banks, and is responsible for the formulation and issuance of accounting, auditing, ethics, governance

2
and Shariah standards for the international Islamic banking and finance industry. The standards have
been developed to encourage the harmonisation of Islamic banking and finance practices, and to
ensure transparency and uniformity of financial reporting by Islamic banks and financial institutions.

AAOIFI’s role is similar to that of the International Accounting Standards Board (IASB) of which it
is a member. AAOIFI’s accounting standards build heavily on the International Financial Reporting
Standards (IFRS) and are designed to provide best practice on how to handle financial reporting issues
specific to Islamic institutions.

Although the standards are international, they are not mandatory in every country. The standards are
mandatory for Islamic financial institutions in countries such as Bahrain, Jordan, Syria and Sudan but are
only used as guidance in, for example, Saudi Arabia.

AAOIFI has issued standards for the following:

• Shariah Standards – these standards identify contractual issues with different instruments, such
as trading in currencies, how to deal with a default in payment by a debtor, guarantees, Murabaha
to the purchase orderer and any of the other instruments detailed in chapter 5. AAOIFI Shariah
Standard No. 11, for example, deals with the requirements of Istisn’a (project finance) and Parallel
Istisn’a.
• Accounting Standards – the accounting standards use the IFRS as a basis and provide additional
standards that cater for the specific accounting requirements associated with Islamic financial
instruments. Financial Accounting Standard (FAS) No. 9, for example, sets out the accounting rules
for the treatments related to the determination of the Zakat base, and how it needs to be accounted
for in the financial statements of the Islamic financial institution.
• Auditing Standards – these standards outline guidance on the objectives and general principles
governing the audit of financial statements of Islamic financial institutions. Auditing Standard for
Islamic Financial Institutions No. 2, for example, provides an overview of the elements that need to
be contained in the auditor’s report.
• Governance Standards – these standards outline the additional governance required for Islamic
financial institutions. Governance Standard for Islamic Financial Institutions No. 2, for example,
outlines the requirements for Shariah review.
• Ethics Standards – the ethics standards defined by AAOIFI are applicable to internal accountants
and internal auditors of Islamic financial institutions and deal with, for example, integrity, sincerity,
trustworthiness and objectivity.

2.3.2 The Islamic Financial Services Board (IFSB)

The IFSB, headquartered in Malaysia, is an international standard-setting organisation founded by
central banks of member countries in 2003. IFSB aims to promote and enhance the soundness and
stability of the Islamic financial services industry by issuing global prudential standards and guiding
principles for the industry, broadly defined to include banking, capital markets and insurance sectors.

23
The IFSB also conducts research and coordinates initiatives on industry-related issues, as well as
organising roundtables, seminars and conferences for regulators and industry stakeholders.

The IFSB standards are based mainly on the identification, management and disclosure of risks
relevant to Islamic products and operations. The role of the IFSB is comparable with that of the Bank
for International Settlements (BIS) with whom it cooperates closely. Members of the IFSB include
the Organisation of the Islamic Cooperation (OIC), member state central banks, multilateral banking
regulators and a diverse group of central banks from non-OIC countries, including China and Singapore.

IFSB standards are currently optional. However, there is an expectation that, as the Islamic financial
industry becomes more mainstream, IFSB standards will be adopted by member countries and other
jurisdictions to provide a stable and regulated environment.

The IFSB has, for example, issued the following standards:

• IFSB-7 – Capital Adequacy Requirements for Sukuk, Securitisations and Real Estate Investment
• IFSB-8 – Guiding Principles on Governance for Takaful (Islamic Insurance) Undertakings.

In addition, the IFSB issues technical notes, such as:

• TN-1 – technical note on issues in strengthening liquidity management of institutions offering

Islamic financial services: the development of Islamic money markets and other documents such as
the IFSB-IRTI-IsDB Islamic Finance and Global Stability Report.

2.3.3 Supporting Institutions

The international Islamic banking and finance industry is also supported by several other institutions.

International Islamic Financial Market (IIFM)

The IIFM is the global standard-setting body for the Islamic capital and money market segment of
the Islamic financial services industry. Its primary focus is the standardisation of Islamic products,
documentation and related processes. The IIFM has issued a master agreement for treasury placement,
which provides a standard for interbank Commodity Murabaha and has issued a standard for hedging
under the name ISDA/IIFM Tahawutt Master Agreement, which includes a master agreement to use
for profit rate swaps. The IIFM works closely together with the International Swaps and Derivatives
Association (ISDA). ISDA is a global trade association and develops and maintains industry-standard
conventional documentation and the IIFM’s role is comparable to that of ISDA.

Islamic International Rating Agency (IIRA)

The IIRA is an Islamic rating agency, playing a role similar to Moody’s, S&P and Fitch Ratings. The
difference with the conventional rating agencies is that the IIRA focuses specifically on the Islamic
financial services industry. The IIRA issues ratings based on an independent assessment and opinion on
the likelihood of timely payment of financial obligations by sovereigns, corporates, banks and financial
institutions; and securities issued by governments, corporates, banks and financial institutions. The
assessment process includes an independent opinion on the level of compliance with Shariah principles.

24
 An Introduction to Islamic Banking and Finance

Other Supporting Institutions

In addition to the above, there are other institutions supporting the Islamic financial services industry
which include:

2
• The General Council for Islamic Banks and Financial Institutions (CIBAFI), whose mission is to
promote Islamic financial institutions and disseminate rules and concepts related to Islamic finance.
The CIBAFI, an industry group, is also responsible for providing information relating to Islamic
finance institutions and strengthening cooperation among Islamic finance players. The CIBAFI is
comparable to the British Bankers Association (BBA) in the UK.
• The International Islamic Liquidity Management Corporation (IILM) is an international institution
established by central banks, monetary authorities and multilateral organisations. Its objective is
to create and issue short-term Shariah-compliant financial instruments to facilitate effective cross-
border Islamic liquidity management.
• The Islamic Development Bank (IsDB) is a multilateral bank with the objective of fostering the
economic development and social progress of member countries and Muslim communities using
techniques that respect the principles of Shariah. One of the important members of the IsDB Group
is the Islamic Research and Training Institute (IRTI), a specialised entity with a mission to promote
Islamic research and training in Islamic finance and economics. IRTI has a comparable role to, for
example, the World Bank Institute (WBI).

2.3.4 Conventional Institutions

The following table shows the institutions described in the above sections and their conventional
counterparts:

Islamic Financial Industry Body Conventional Financial Industry Body

AAOIFI IASB
Accounting and Auditing Organisation for Islamic International Accounting Standards Board
Financial Institutions

IFSB BIS
Islamic Financial Services Board Bank for International Settlements

IIFM ISDA
International Islamic Financial Market International Swaps and Derivatives
Association

IIRA Credit rating agencies such as Moody’s, S&P

Islamic International Rating Agency and Fitch Ratings

CIBAFI BBA
General Council for Islamic Banks and Financial British Bankers Association (UK) and other
Institutions comparable bodies

IRTI WBI
Islamic Research and Training Institute World Bank Institute

25
2.4 Other Components of the Islamic Finance Industry

Learning Objective
2.1.6 Know other components of the Islamic finance industry: the Shariah-compliant equity markets;
the market for Sukuk (Islamic capital market instrument); Islamic investment funds; Islamic
insurance companies – Takaful; the Waqf properties (Islamic charitable trust); Zakat funds (funds
constituted of charitable obligatory tax); Islamic microfinance; purification of non-permissible
income (Haram)

2.4.1 The Equity and Capital Markets

Islamic equity markets allow individual and institutional investors to buy and sell shares in Shariah-
compliant companies. As with the conventional equity market, the Islamic equity market encompasses
both listed and private equity. Like any other instruments, equity investments have to be Shariah
compliant, which means that the activities and financial ratios of the company, as well as the inherent
structure and documentation in connection with the equity investment, need to be compliant with
Shariah.

The establishment of a modern limited liability company and the buying and selling of its shares was
accepted as permissible in Resolution No. 63/1/7, 7th Session of the Islamic Fiqh Academy, in Jeddah, in
May 1992. During the same session, a resolution to permit Shariah-compliant investment funds was also
accepted.

Islamic capital markets have a similar function to conventional capital markets and provide short-term
and long-term liquidity on an interbank basis. Contrary to conventional capital markets, Islamic capital
markets solely use Shariah-compliant instruments, such as Sukuk (covered in detail in chapter 7).

2.4.2 Islamic Investment Funds

The market for Islamic asset management (see chapter 6) has grown significantly over the years and
there are currently close to 700 funds listed in the major databases, with estimated funds under
management of around US$70 billion. The type of funds offered are varied and include fixed-income
funds, lease funds, commodity funds, real estate funds, private and public equity funds, equity tracker
funds, exchange-traded funds and hedge funds. The operations of these funds are fairly similar to those
of a conventional fund, save for the fact that the fund structure, the underlying documentation, and all
investments made by the fund, need to be Shariah compliant.

2.4.3 Takaful
Takaful (covered in detail in chapter 8) is Shariah-compliant insurance and works on a mutual or
cooperative basis.

In Takaful, the participants jointly contribute funds (known as Tabarru) to a pool for the purpose of
providing mutual indemnity and protection to the participants exposed to defined risk(s) under the
Takaful policy. The pool is typically managed by an independent third party, the Takaful operator, on

26
 An Introduction to Islamic Banking and Finance

behalf of all participants against unexpected loss or damages which are covered under the terms of the
insurance within the agreed period and terms of the policy.

2.4.4 Waqf and Zakat

2
Waqf and Zakat are both associated with benevolent giving but have different forms and imperatives:
Zakat is obligatory whereas Waqf is recommended. Waqf represents charitable giving in a form
comparable with a charitable trust. Waqf properties are those preserved for certain philanthropic
purposes which cannot be overridden. They make up a considerable proportion of the societal
wealth in all Muslim populations. Islamic institutions and financial markets are becoming increasingly
sophisticated about the management of Waqf funds.

Zakat is a mandatory religious duty paid by Muslims according to Shariah that can be donated to any
one of the nominated recipients at the discretion of the donor. As detailed in chapter 4, Islamic financial
institutions can pay this on behalf of their shareholders or leave the responsibility for the payment of
Zakat to the shareholders. In the event that the Zakat payment is delegated to the shareholders, the
institution remains responsible for informing them of the amount of Zakat per share.

2.4.5 Islamic Microfinance

By its nature, Islamic finance is very suitable for microfinancing-type projects. The investments are
typically in a tangible business venue and have a high level of social responsibility attached to them.

There are a wide range of structures in Islamic finance that lend themselves to microfinance initiatives,
with joint venture contracts, such as Musharaka and Mudaraba, potentially the most suitable.
Microfinanciers tend to have a very close relationship with their clients, which makes a joint venture
ultimately viable. The microfinance institution (MFI) will not only supply money, but also expertise
related to the setting up and successful running of a company. It is highly likely that the client will
initially only put in expertise, while the MFI contributes in cash and will take its profit share as agreed in
Mudaraba. However, from experience with conventional microfinance, it appears that the entrepreneurs
are likely to want to obtain full ownership over their business, which could become a feature of the
contract.

Looking at a $100 investment using a Mudaraba agreement, a suggested structure could be as follows:

• The bank invests $100 and receives 40% of the profit for their input of both capital and expertise.
• 20% of the profit is held by the bank in a reserve account, which can be used as a buffer for
unforeseen circumstances or for the client to purchase units in the partnership from the bank with
its share of the profit.
• 40% of the profit is paid directly to the entrepreneur.

The advantage of this is that it provides a form of security to the entrepreneur and encourages savings
to be built up. The entrepreneur should, however, be free to use other funds (eg, excess profits) to
repurchase units.

In the Middle East and Asia, entrepreneurial funding on this scale is often granted on an informal basis
by small groups of friends, neighbours and family. The intensive nature of microfinance, in combination

27
with the fact that clients typically are not deemed creditworthy and the subsequent additional capital
charge, does not necessarily make microfinance a viable business proposition to large banks. On the
other hand, it should be recognised that the peer pressure on financiers, as well as their motivation, is
extremely high, and the default rates are negligible, which makes it an attractive proposition, despite
small ticket sizes.

2.4.6 Crowd Funding and Peer-to-Peer Lending

Crowdfunding is a way in which individuals, charities and businesses (including start-ups) can raise
money from the public to support a project, campaign or person. It usually takes place via websites that
allow businesses or individuals to raise money, and investors to provide that money. The business or
individual often explains their project in a pitch to attract loans or investment from as many people as
possible1.

Similarly, peer-to-peer lending provides alternative investment opportunities for individuals to lend
directly to other people or businesses without using a bank. It operates on a ‘many to many’ lending
model through internet-based lending platforms who arrange and manage the loans2.

Although originally started with interest-bearing loans, there are a growing number of Shariah
compliant crowdfunding and peer-to-peer financing platforms available.

2.4.7 Purification of Non-permissible (Haram) Income

Globalisation and the interrelationship between Islamic and conventional financial institutions
means that, for a number of reasons, a Shariah-compliant investor or financial institution may receive
non-permissible (Haram) (prohibited) income, eg, when investing in large multinational companies,
when the financial institution levies penalty interest charges or when a transaction that was deemed
compliant has been processed incorrectly. Any transaction subject to non-permissible income is not
automatically null and void. Instead, the financial institution will need to assess the amount of income
attributable to the non-permissible activity and purify this income by donating it to charity. The charity
and the size of the donation is usually approved by the SSB.

2.4.8 The Impact of Technology in Islamic Finance

Learning Objective
2.1.7 Know the impact of fintech in Islamic finance

Islamic finance institutions, as with conventional counterparts, are highly reliant on technology, and
embracing change is critical to the survival of most of the Institutions. The introduction of fintech,
particularly disruptive technologies and processes in the finance sector by the use of blockchain,
artificial intelligence and cryptocurrencies, presents Islamic finance with new challenges but also new
opportunities within the sector.

1 https://www.fca.org.uk/consumers/crowdfunding
2 https://www.gov.uk/guidance/peer-to-peer-lending

28
 An Introduction to Islamic Banking and Finance

With the rapid growth and uptake of emerging technologies in the global financial sector, Islamic
finance is embracing some of these new technologies. Governments are even encouraging hubs
to be set up around the main global Islamic finance centres in order to focus on developing fintech
specialising in Islamic finance.

2
The scholars, in principle, have no real issue with most of the new developments, but they do have
concerns as to how emerging technologies are being applied or used, ie, ensuring that new technology
is applied and used in a Shariah-compliant manner. Some areas of technology are relatively clear (for
example, the use of blockchain in smart contracts) and relatively straightforward to understand and
implement, but scholars have differing views as to their usage and their level of Shariah compliance
with other technologies, such as cryptocurrencies (eg, bitcoin).

In the coming years, the use of these emerging technologies within the financial sector will become
the norm and the Islamic finance sector will have implemented and embedded a number of these
technologies within the operations of its institutions and products (depending on the jurisdiction of
implementation and its own scholars’ interpretation). The use of these new technologies will vary, but
it is inevitable that technological change will have an impact on Islamic finance, in areas ranging from
operations, payments, transactions and customer communication to the introduction of new products.

29
 End of Chapter Questions

1. Outside of the Muslim world, what was the first country to issue a Government Sukuk and when did
this occur?
Answer reference: Section 1.3.3

2. Name the four methods by which Islamic financial services can be offered.
Answer reference: Section 2.2

3. When conventional banks offer Islamic financial services, what is the key difference between the
windows model and branches?
Answer reference: Section 2.2

4. What is the main aim of the two bodies engaged in regulating the Islamic finance industry?
Answer reference: Section 2.3

5. Which body issues Shariah standards?

Answer reference: Section 2.3.1

6. What is the primary focus of the IIFM?

Answer reference: Section 2.3.3

7. How do Islamic capital markets differ from conventional capital markets?

Answer reference: Section 2.4.1

8. What is the role of the Takaful operator?

Answer reference: Section 2.4.3

9. How do Waqf and Zakat differ?

Answer reference: Section 2.4.4

10. How is non-permissible income purified?

Answer reference: Section 2.4.7

30
Chapter Three

Islamic Principles of

3
Exchange
1. Introduction 33

2. Islamic Teachings Relating to Business 33

3. Principles of Islamic Contracting 35

4. Major Prohibitions: Riba 38

5. Major Prohibitions: Gharar 43

6. Rules of Exchange 46

7. Concluding Remarks 54

This syllabus area will provide approximately 13 of the 100 examination questions
32
 Islamic Principles of Exchange

1. Introduction
The Islamic principles of exchange are crucial to an understanding of Islamic finance, as they form the
basis of all Islamic finance transactions. Fiqh al Muamalat is a comprehensive body of principles and
rules, designed to promote harmonious relations between contracting parties and the avoidance of
the kinds of problems in contracting that can result in a falling-out of the contracting parties, leading

3
to costly litigation and other misfortunes. Transactions in Islamic finance which do not comply with
these principles and rules of contracting are not Shariah compliant and, apart from the fact that they
transgress moral principles, may have negative consequences, such as non-enforceability of contracts or
non-recognition of any resultant income.

Section 2 of this chapter introduces Islamic teachings relating to business and, in particular, certain
prohibitions which, if not observed, impair the legitimacy as well as the enforceability of contracts.
Section 3 provides an introduction to the major principles of Islamic contracting and sections 4 and 5
cover the major prohibitions in Islamic finance, namely Riba and Gharar. Section 6 is concerned with
detailed rules of exchange and section 7 contains some concluding remarks.

2. Islamic Teachings Relating to Business

Learning Objective
3.1.1 Know the ethical precepts relating to Islamic business

2.1 Values to be Observed by Market Participants

Chapter 1 introduced the five main principles on which Islamic commercial and financial ethics are
based. The Islamic ethical principles consist of a set of rules that should be respected by every Muslim
and every institution claiming to be Shariah compliant. Hence, the objectives of Islamic financial
services must be in line with the teachings of the Quran and Sunnah. The Prophet Muhammad (PBUH)
emphasises the importance of ethical behaviour in commercial and financial dealing by identifying
some ethical guidelines that a Muslim must follow:

• Do not lie to sell your products (principles of honesty and sincerity).

• Honour your pledges and trustee obligations.
• Do not deceive or defraud others.
• Do not offer or solicit bribes.
• Do not boast about your products.
• Do not sell products that have a negative influence on the society (principle of stewardship).
• Uphold justice in all your dealings and transactions with both friends and enemies. This implies that
all customers must be treated fairly, for example, when imposing charges and fixing profit-sharing
ratios (principle of sincerity).
• Do not value your trade higher than your Lord (SWT) or allow it to distract you from the call to prayer.

The above mentioned ethical behaviours apply to individuals as well as to institutions, commercial or
otherwise.

33
2.2 Islamic Teachings Relating to Business

Learning Objective
3.1.2 Know the Islamic teachings relating to business

Based on the principles and foundation laid down by Shariah, the Islamic teachings relating to business
are primarily structured by ten rules:

1. Avoidance of Riba – Riba is often translated by the term ‘interest’, but its literal meaning is ‘excess’.
In Shariah, it is defined as ‘any excess compensation without due consideration’ and is banned. Any
business agreement which includes an element of Riba is invalid from the Shariah point of view,
even if the parties agree on the terms of the contract. To be lawful, any profit or benefit should be
linked to the performance of a real asset and to its associated risk. The concept is explained in detail
later in this section.
2. Avoidance of Gharar – the prohibition of Gharar is also a major tenet of Shariah. The term ‘Gharar’
means danger or hazard; it is related to the concept of harmful uncertainty or ambiguity. In a
commercial transaction, Gharar normally relates to deceptive uncertainty, ignorance and lack of
transparency that inadvertently lead to deceit, as well as outright fraud. An agreement that includes
a significant element of Gharar is invalid from the Shariah point of view, irrespective of whether the
parties agree upon such a contract or not. Gharar is explained in detail later in this section.
3. Honesty and Fair Trade – trade manipulation and malpractices (hoarding, using illegal markets,
profiteering, cheating, taking advantage of a person in distress, manipulating numbers) are
prohibited. The Quran stresses the importance of fairness in business: ‘And, O my people, give full
measure and weight justly, and defraud not people of their things, and act not corruptly in the land
making mischief. What remains with Allah (SWT) is better for you, if you are believers’ (Surat Hud, 11:85).
4. Disclosure and Transparency – it is the duty of the seller to disclose all known faults in his goods
to the buyer. The Prophet (PBUH) states: ‘It is illegitimate for a Muslim to sell to his brother something
with a defect without disclosing it to him.’ He also states: ‘The parties of a sale have the right to cancel
unless they depart each other; so if they tell the truth and disclose, their trade will be blessed. If they lie
and conceal, the blessing of their deal will be lost.’
5. Avoid Misrepresentation – a Muslim businessman should not make false declarations concerning
his goods.
6. Do Not Sell Over and Above the Sale of Another Person (Bai Alal Bai) – a person cannot interfere
in a transaction that has been concluded. When person X has sold goods to another (Y), a third party
(Z) cannot interfere and try to reverse the trade by offering his own goods at a better price or by
undermining the goods already sold by X. Bargaining is permitted in Islam, but all offers should be
made before the deal is closed. The Prophet (PBUH) said: ‘A person should not enter into a transaction
when his brother is already concluding the transaction.’
7. Non-permissible (Haram) Items – a Muslim can only trade goods and services which have been
declared permissible (Halal) (lawful). Non-permissible (unlawful) items, such as wine and pork, are
banned from any transaction. See chapter 6 for more detail on non-permissible items.
8. Hoarding – the Quran condemns hoarding and excessive affection for material wealth, particularly
where it is not applied to helping the poor and supporting the needy. ‘And those who hoard gold and
silver and do not spend it for the cause of Allah (SWT) give them tidings of a painful punishment’ (Surat
Taubah, 9:34).

34
 Islamic Principles of Exchange

9. Sale of Goods and Services in the Open Market – goods and services should be sold in the
open market and parties – buyer and seller – must be aware of the state of the market before any
transaction is concluded. Buyer and seller should not take advantage of each other’s ignorance of
the conditions and prices prevailing in the market. The Prophet (PBUH) said: ‘Do not go out to meet
the merchant in the way and enter into business transaction with him, and whoever meets him and
buys from him when the owner of (merchandise) comes into the market he has the option (to cancel the
transaction null and void if he finds that he has been paid less than the market price).’

3
10. Avoid Taking Advantage of a Seller’s Helplessness (Bai’ al-Mudtar): Islam judges that it is
unacceptable to take advantage of the hardship of an individual who is forced, under duress or false
pretences, to sell an item. Instead of purchasing this item and taking undue advantage of the seller’s
helplessness, the buyer should offer to help him.

The above rules prove that Islam links business and wealth creation to social values. The prohibition of
interest (Riba), speculation (Gharar), non-permissible (Haram) items and hoarding can be related to the
principle of stewardship, while honesty and fair trade, full disclosure, misrepresentation, Bai Alal Bai and
the sale of goods and assets in the open market are based on the principles of integrity and sincerity.
As for Bai Al-Mudtar, it is indirectly linked to the Islamic obligation to distribute obligatory charity and
encourage voluntary charitable giving.

3. Principles of Islamic Contracting

Learning Objective
3.1.3 Understand the general principles governing contracts in Islamic law

There are a large number of principles governing contracts in Islamic finance. The most important ones
are detailed in this section.1

3.1 Freedom of Contracting

In accordance with the principle of permissibility, all economic activities are permissible unless
otherwise stated by Shariah. This results in the situation that the set of acceptable activities in daily and
economic life (‘aadat) is unlimited, although there are a limited number of prohibited activities.

It is, therefore, unnecessary to obtain proof that a particular transaction is acceptable; instead, special
proof is required to establish that a transaction is not permissible. In the event two parties have
contradicting opinions (one asserts a transaction is permissible and the other asserts it is not), the
burden of proof is on the party asserting impermissibility, since permissibility is the default state.

1 Further detail on the most important principles governing contracting are available in Al Madkhal Al Fiqhi, by Sh.
Mustafa Zarqa. A list of the most important 100 maxims of Shariah of the Majalla can be found at: www.iium.edu.
my/deed/lawbase/al_majalle

35
3.1.1 Permissible Transaction Types
The principle of permissibility means that permissible transactions are not limited to those that are
stated in classical texts of Fiqh, thus leaving room to create, innovate or design new instruments and
arrangements as needed, as long as they avoid the incorporation of any prohibited elements. Although
there are no special rituals associated with contracts, a fundamental component of all transactions is
that they need to be undertaken by mutual consent, ie, all parties need to be in agreement. Consent
is derived from the intention of the contract and can be expressed through words, deeds or any other
means. This is emphasised in the Quran and Sunnah:

O you who believe, do not usurp your wealth among yourselves

unjustly but as trade by your mutual consent. (Surat Al Nissa, 4: 29)

3.2 Actions are Judged by Objectives

All actions are judged by the objectives of the parties involved, not just their words. For example, if
a person says, ‘this item is yours for 10 dinars’, and the other accepts, this is considered to be a sales
contract, despite the fact that the word ‘sale’ is not specifically mentioned. Equally, if a person was to
say, ‘this is a gift to you for 10 dinars’, the objective is to sell something for 10 dinars, even though the
word ‘gift’ is included. In both cases, the substance of the transaction is that of a sale.

Example
A creditor asks a debtor to provide a guarantor (Kafeel). The debtor agrees on the condition that the
creditor shall no longer pursue him for the debt, but the guarantor. The substance of this condition is a
transfer of debt (Hawala) instead of a guarantee (Kafala) since, effectively, the debt has been transferred
from the debtor to the guarantor despite the lack of the word ‘transfer’ in the arrangement.

In a Mudaraba transaction, the investor (Rab al Mal), as the principal, provides capital to the manager
(Mudarib) as his agent to undertake a specific business activity. The two parties share the profits in
accordance with a pre-agreed profit ratio and losses are born by the investor as the capital provider. The
business manager is not responsible for any losses unless he is guilty of negligence. In the event that the
investor stipulates that the agent needs to guarantee the capital, he will have to repay the capital under
any circumstance and the transaction will need to be classified as a loan instead of a Mudaraba.

In an agency agreement (Wakala), the principal appoints another person as his agent (Wakil) to
undertake a particular activity on his behalf. If, for example, the Wakil is appointed to purchase a specific
asset and he buys the asset with the intention to keep it for himself, the Wakil, and not the principal, is
the owner of the asset. If the asset is subsequently damaged or stolen, it is the agent’s responsibility.
However, if the agent intended to buy the asset for the principal, and it is subsequently damaged or
stolen without negligence or malpractice on the side of the agent, the agent is not responsible for the
damage. To avoid disputes, the agent has to indicate at the time of purchase (by any means) whether
the good is purchased for the principal or for himself.

3.3 Do No Harm
As a general rule, causing harm to people, property, and the environment in general is prohibited.

36
 Islamic Principles of Exchange

3.4 Flexibility in the Case of Hardship

Although it is prohibited to use Islam as an excuse to dishonour contracts or to reject or deny obligations,
Shariah provides the flexibility to avoid hardship.

Allah wants ease for you rather than hardship. (Surat Al Baqara, 2:185)

This principle can be applied to Islamic financial services in several ways. When converting a conventional

3
(ie, interest-based) bank into an Islamic bank, a gradual approach could be taken since interest-based
assets and liabilities cannot be repaid or called in immediately without incurring significant penalty
charges. Instead, the transactions will be converted at maturity. The interest collected during the period
can be used for non-profit activities or charitable donations.

Equally, when a debtor is in hardship and has difficulties paying, the creditor should assist the debtor in
any way he can, and charging additional penalties is not permitted. A solvent debtor, however, has the
obligation to pay.

3.5 Incorporation of Custom and Convention

Custom (‘urf) plays an important role in the execution of a contract or transaction. Any accepted custom
is implicitly included in the transaction, even if it is not specifically mentioned.

Example
An item on the shelf in a shop in Malaysia has a price tag of 10. This is understood to mean 10 Malaysian
Ringgit since that is the commonly accepted currency. A price tag of 10 in Afghanistan, on the contrary,
cannot be assumed to be Afghani since, in Afghanistan, it is customary to pay either in Afghani or in US
Dollars.

If it is commonly expected that the delivery of a purchased good is the responsibility of the seller, the
buyer has the right to claim for compensation if the seller refuses to do so, even if this was not explicitly
stated at the time of purchase.

If it is common practice for borrowers to regularly pay an additional amount of money to a lender in
addition to the principal, this is equivalent to an explicit stipulation of interest and thus becomes Riba.

In other words, custom or common practice is considered to be equivalent to explicit stipulation of a

term.

3.6 Liability Justifies Return

The benefit, yield, or return on an asset is rightfully owned by those who bear the physical risk of
damage and loss.

This principle imposes a certain degree of symmetry and balance between rights and obligations.
Liability cannot be separated from benefits or, in other words, risk cannot be separated from return.
One cannot (or should not) bear the risk associated with an asset without being entitled to its benefits.
Separating the two, therefore, is not acceptable.

37
 4. Major Prohibitions: Riba

Learning Objective
3.2.1 Know the nature of Riba
3.2.2 Know the rationale for the prohibition of Riba
3.2.3 Understand the different types of Riba

As highlighted in section 3 of this chapter, the Principle of Permissibility implies that economic activities
are acceptable unless otherwise stated by Shariah. This section focuses on the major prohibitions.

4.1 Nature of Riba

One of the most important rules of Islamic finance is the prohibition of Riba which is absolute and
unqualified. The lexical meaning of the word Riba is excess, and is most commonly interpreted to mean
interest in which case any addition over and above the loan amount is Riba. The prohibition of Riba is not
unique to Islam but is common across Judaism and Christianity as well. Other faiths, such as Buddhism
and Hinduism, as well as many philosophers (such as Aristotle), also have a negative disposition against
usury.

One of the major underlying issues is that usury disassociates finance from the real economy and
decouples debt creation from wealth creation. The divergence between debt and wealth allows debt to
grow at a higher pace than wealth, resulting in what is often referred to as an ‘inverted debt pyramid’ –
the situation in which increasing amounts of debt need to be serviced by a shrinking base of wealth and
income. The income required to pay the debt does not grow at the same rate as the debt and thus the
system becomes unsustainable. A correction must take place to balance income with the cost of debt
servicing. These corrections most commonly take place via recessions during which excessive debt is
written off. As a result, debt levels are restored to acceptable levels relative to real wealth and income.

In Islam, finance and real economic activity cannot be disconnected, and wealth creation and debt
creation must take place simultaneously and at the same pace. As a consequence, Islamic financial
instruments need to be associated with the exchange of goods and services. With the exception of non-
profit, interest-free loans, all modes of Islamic finance must involve an aspect of ownership of an asset
or service.

4.1.1 Riba versus Trade

A loan involves the exchange of two items identical in quality and nature but with a potentially unequal
value or quantity. For example, money now for money in the future. A sale, on the contrary, is an
exchange of two items that are different in quality and nature, eg, money for food. The defining feature
of a loan, therefore, is the quality of the two sides of the exchange. In the event the quality is identical,
then the transaction is characterised as a loan; in the event that they differ, then the transaction is
characterised as a trade.

38
 Islamic Principles of Exchange

The difference between a loan and a trade is illustrated in figure 1.

Exchange

3
Different Items Identical Items

Unequal
Equal Quantity
Quantities

Trade Riba Qard Hassan

Figure 1: Loan versus trade

In other words, an exchange transaction is a:

• trade when the underlying items are of a different nature or quality;

• loan when the underlying items are identical in quality and nature. By nature, a loan is extended for
a period of time since, as the parties exchange the same asset, there is no value in exchanging at the
same time. Riba is associated with a loan where the borrower pays more than he has received (either
goods or money). Qard Hassan (benevolent loan) is associated with a loan where the borrower
repays the exact same value (either goods or money).

4.1.2 Trade and Wealth Creation

Trade fosters economic growth and encourages specialisation which is essential for wealth creation.
Different people have different tastes, abilities, gifts, skills and experience. By allowing all participants to
focus on their speciality, they can provide high quality goods or services which they can sell to others.
With the income generated by their sales, they can purchase other goods and services. Specialisation
enables each person to produce better quality and larger quantities of their product or service. However,
the economy and individuals only benefit in the form of increasing wealth and prosperity if there is a
market to trade the products and services.

39
A loan contract, on the contrary, involves the exchange of identical items and does not directly provide
an incentive for specialisation and does not create wealth. In the event that the main activity of the
community revolves around lending, borrowers are more likely to on-lend the funds rather than using
the loan for the production of valuable goods or services, thus resulting in a lack of production and
leading to a collapse of the economy. Although it is possible for some members of a community to live
off interest income, a whole community cannot live off mutual indebtedness.

4.1.3 Sale with a Deferred Price Payment

One of the most important instruments of Islamic finance is sale with a deferred payment (Murabaha).
It meets the requirements of a person who needs to obtain specific goods or services, with payment
deferred to a future date. The deferred price is typically higher than the current price, reflecting time
value. Shariah recognises time value in a sale and charging a higher price for deferred payment is
permitted, as long as the price is determined at the time of sale.

There are similarities between the mark-up on a sale and interest on a loan in that both represent a
premium for time value. However, Riba is prohibited due to the fact that it allows the debt to grow on its
own, thus leading to the destruction of wealth. A sale with a deferred price, on the contrary, integrates
debt creation with wealth creation. The debt cannot grow on its own, but is capped by real wealth-
creating activities. Trade, with or without financing, is beneficial to all parties.

4.1.4 Types of Riba

There are three types of Riba:

1. Simple interest – applies to any loan of any type including money. Scholars are in agreement
that any stipulated addition on a loan, whether a loan of money or goods, is Riba. Sometimes also
referred to as loan-Riba.
2. Compound interest – compound interest is interest on unpaid interest and occurs when a loan is
extended beyond its original maturity date without any repayment. For example, a borrower has
a loan of $1,000 at interest of 5% for one year. At maturity, he does not pay the debt of $1,050 but
agrees with the lender to reschedule the payment for one year at an additional 5%. Effectively, the
lender is lending the borrower a loan of $1,050 at 5% to pay off his previous debt. The result is a new
payment at maturity of $1,050 + 5% = $1,102.50. Simple interest thus leads to compound interest.
Compound interest is sometimes also referred to as debt-Riba.
3. Sale-based Riba – this type of Riba is associated with what are known as the Ribawi commodities
(gold, silver, wheat, barley, dates and salt). In this case, both sides of an exchange are similar, but
not identical. For example, gold and silver are similar since both can be considered to be a form of
money, but they are not identical. This equally applies to, for example, the dollar and the euro. In
brief, if the two sides of an exchange are similar, ie, neither identical nor sufficiently different, and
the assets are of a certain type, their exchange will be subject to restrictions.

Ribawi commodities are explicitly stated in the following Hadith:

Gold for gold, silver for silver, wheat for wheat, barley for barley, dates for dates, salt for salt, hand in hand,
like for like, in equal amounts. If these species differ, then sell as you like, as long as it is from hand to hand.

40
 Islamic Principles of Exchange

The essence of the statement ‘if these species differ, then sell as you like’ is that a sale is an exchange
contract in which the commodity on each side is different, while Riba involves the exchange of two
identical or similar items.

The rules implied by the Hadith are summarised in the table below where each cell represents the
requirements for exchange of the commodities in the row and column. For example, exchanging gold
for silver requires that both are exchanged immediately or from hand to hand, although the quantity

3
may differ. Exchanging gold for gold requires the two sides to be both spot and equal.

Gold Silver Wheat Barley Dates Salt

Gold ∆= ∆ √ √ √ √
Silver ∆ ∆= √ √ √ √
Wheat √ √ ∆= ∆ ∆ ∆
Barley √ √ ∆ ∆= ∆ ∆
Dates √ √ ∆ ∆ ∆= ∆
Salt √ √ ∆ ∆ ∆ ∆=

∆ Both sides must be spot or from hand-to-hand.

= Both sides must be equal in quantity.
√ Exchange is not subject to any restrictions beyond the general rules of trade.

Source: R. Al-Masri: Al Jame’ fi Usoul Al Riba, 1999, p. 94

Ribawi commodities can be grouped in two main groups, each with specific restrictions associated with
them:

1. Gold and silver (money).

2. Wheat, barley, dates, and salt (staple food).

Between the two groups, there are no specific restrictions other than the general rules of exchange.

It is clear from the table that, as the commodity on each side of the exchange becomes more similar,
the restrictions become stronger. Diagonal elements in the table, for example, are associated with
transactions in which the same commodity is exchanged and are subject to maximum restrictions.

Three main levels of restrictions can be distinguished:

1. Same commodity on both sides of the transaction – both sides of the exchange must be immediate
(spot) and equal.
2. Different commodities from the same group – the exchange needs to be immediate (spot) but does
not have to be equal.
3. Commodities from different groups – minimum restrictions apply as mentioned in the Hadith ‘if
these species differ, then sell as you like’.

41
These types of interest are referred to under the following Arabic names:

• Simple interest – Riba al-Naseeyah.

• Compound Interest – Riba al-Naseeyah/Riba al-Jahiliyyah.
• Sale-based Interest – Riba al-Fadl.

Scholars generally agree that Riba al-Fadl is a preventative measure against simple interest. The six
commodities mentioned in the Hadith were, at the time of the Prophet (PBUH), considered to be
necessities of strategic value and are fungible. In combination, these features ensure the Ribawi
commodities are likely to be borrowed and lent and exposed to simple and compound interest.

Example
The sale of one ounce of 21 carat gold versus deferred delivery of two ounces of 18 carat gold, for
example, is technically not a loan, as the two sides are not identical. However, the exchange involves a
non-permitted financing element on the same commodity.

The degree of similarity is represented in the following figure:

Simple
Riba and
Trade al-Fadl Compound Interest

Low similarity High similarity

From the figure above, it follows that:

• Transactions involving identical commodities are subject to the restrictions of single interest or
loan-Riba.
• If the commodities are different, the exchange is considered to be a trade and not subject to Riba.

In between these extremes, where the commodities are not identical but similar, the transaction is subject
to the restrictions of Riba al-Fadl, which are less limiting than simple interest or loan-riba transactions.

The minimal restrictions associated with trade clearly show the emphasis on trade and wealth creation
as one of the major objectives of Islamic economics.

42
 Islamic Principles of Exchange

5. Major Prohibitions: Gharar

Learning Objective
3.3.1 Understand the nature of Gharar
3.3.2 Know the rationale for the prohibition of Gharar

3
3.3.3 Understand the different types of Gharar

5.1 Nature of Gharar

The lexical meaning of the word Gharar is risk, ie, being exposed to harm or damage, but also implies
deception and delusion (Al-Dharir, pp. 50-54). Classical scholars define Gharar as follows:

• Gharar is the risk in which existence and non-existence are equally likely (Al-Kasani).
• Gharar is the indecisiveness between two states, one of which is in line with the objective, the other
is against it (Al-Dusuqi).
• Gharar involves two possibilities, the most likely of which is the most feared (undesired) (Al-Dusuqi).
• Gharar is the indecisiveness between two states: safety and damage (Ibn Taymiah).

In other words, Gharar is uncertainty that involves risk, ie, possibility of failure, damage or loss in which
the likelihood of loss or failure is substantial. Consequently, a risk with a small or insignificant probability
of uncertainty is not considered to be Gharar, cannot be avoided in practice and is often described as
‘minor Gharar’. Gharar mainly applies to sale transactions (Uqood al-Muawadat). Gharar is, however,
permitted in charitable transactions due to the fact that there is no loss associated with giving donating
funds to charity.

Example
Classical examples of Gharar include:

• Sale by means of pebbles (Bai al-Hasat) – sale transaction in which the price is determined up front,
but the good sold is determined by throwing a pebble on a collection of various goods of different
qualities and values after the price has been agreed. The item that touches the pebble becomes the
subject of sale. There is a risk of loss to one party for the benefit of the other, since the final object of
sale may be of higher or lower value than the pre-agreed price.
• Sale of a lost camel for an agreed price. The price is discounted to reflect that the camel is lost and
may not be found again. If the buyer finds the camel safe and intact, he benefits; otherwise, he loses
the amount he paid.

In a commercial transaction, Gharar may, for example, result from omissions or lack of clear descriptions
in the contract. Ambiguities or anomalies can inadvertently lead to deceit as well as outright fraud. Any
agreement subject to a significant element of Gharar is invalid from a Shariah point of view, regardless
of whether the parties have agreed the contract.

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In the context of modern-day finance, examples of Gharar include:

• buying a house for which the price will be determined in the future;
• selling a lost or stolen car;
• selling an existing car but without revealing the full specifications;
• selling equity at a fixed price for an undisclosed company.

Gharar can be avoided, however, if the affected party has the right to cancel the sale in the event the
outcome is not in his favour. Gharar does not apply where the asset sold is one of many items of the
same kind and value, such as mass-produced goods.

5.2 Types of Gharar

5.2.1 Gambling (Qimar)

The most obvious form of Gharar is gambling (Qimar), which involves profiting from luck or destruction
(harming the other party), and is not associated with productive skill or useful work. It destroys
responsibility and morale and may cultivate hatred and enmity among parties. Gambling involves
‘eating wealth for nothing’ (akl-ul mal bil batel), ie, taking the wealth of another party for no useful
consideration.

Gambling is characterised as a transaction in which each party is either a winner or a loser (Al-Dharir,
p. 621) such as, for example, a lottery. Trading financial derivatives is an example of Qimar in modern
finance since they result in the profit of one party to the loss of the other. A gamble does not benefit
both parties in the same way and has a highly uncertain outcome. One party gains at the expense of
another.

An easy way to verify whether or not a transaction is considered to be gambling is to assess whether
the outcome of the transaction is known in advance. If, in the absence of uncertainty, one of the parties
would not enter into the transaction, it does not serve the objectives of both parties, and one party
would gain at the expense of the other. Conversely, a trade benefits all parties, even when the outcome
is uncertain.

A trade can easily be distinguished from a gamble or a bet by considering whether the uncertainty has
an impact on whether it will be executed. In other words, one of the parties will:

• still execute a trade whether there is uncertainty or not

• not execute a gamble if the outcome is certain.

5.2.2 Major and Minor Gharar

Not all Gharar is gambling, however, since, in some cases, it might be possible for both parties to gain,
even though there is Gharar involved.

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 Islamic Principles of Exchange

Example
Sharecropping (Muzara’aah) – in this transaction type, a farmer agrees to farm the land of a landowner
in return for a pre-defined percentage of the crops. The farmer usually bears the cost of farming. If the
size of crop is sufficiently large, the farmer will be able to recover his costs and generate a profit after
having given the landowner his share. In this case, both the landowner and the farmer profit. However,
in the event the crop is inadvertently small, the farmer may not be able to recover his costs.

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Sale of fruit yet to be harvested – at the time of the Prophet (PBUH), it used to be common to purchase
fruit ahead of the harvest season in order to obtain a better price and to ensure purchasers could obtain
the amount of fruit required. However, it frequently occurred that the harvest did not yield the expected
crop and so the buyer would lose (part of) his purchase price. In order to avoid disputes, the Prophet
(PBUH) instructed that fruit could not be purchased before it starts to ripen.

When a transaction has the possibility of resulting in either a win-win or a win-lose, it is subject to two
kinds of Gharar:

1. Excessive or Major Gharar (Gharar Katheer) – transactions in which the win-lose outcome is either
significant or the dominant outcome. This type of Gharar is forbidden since it leads to obtaining
wealth for nothing and may be harmful to society.
2. Minor Gharar (Gharar Yaseer) – transactions in which the mutual gain (win-win) outcome is the
dominant outcome of the transaction, while the win-lose outcome is negligible or insignificant. In
other words, the objective of the two parties is to achieve mutual gain, rather than creating wealth
at the expense of the other. This type of Gharar is permissible and the transactions are acceptable.

In an Arboon transaction, the buyer makes a non-refundable down payment against the purchase price
of a specific asset. The buyer retains the right to cancel the purchase within a specified period but will
lose his down payment in the event he decides to cancel. If the buyer continues with the purchase, he
only pays the difference between the original purchase price and the amount of the down payment. The
Arboon transaction, therefore, has two possible outcomes: win-win if the purchase is concluded, and
win-lose if the purchase is cancelled by the buyer.

Some scholars question the validity of the Arboon sale due to the possibility of the win-lose outcome.
However, the general agreement among scholars is that the win-lose outcome is permissible as long as
it is not a significant possibility and the parties are better off to conclude rather than to cancel the trade.
The OIC Fiqh Academy ruled that Arboon sale is permitted.

The following table summarises the types of Gharar and how they compare with gambling.

Type Outcomes Condition Shariah Position

Gambling win-lose, lose-win no mutual gain unacceptable
win-win is not dominant;
Major Gharar win-win, win-lose unacceptable
win-lose is significant
win-win is dominant;
Minor Gharar win-win, win-lose acceptable
win-lose is insignificant

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Every transaction that has the possibility of a win-lose outcome is subject to an element of Gharar.
However, Gharar only becomes major, and thus not permitted, if the win-lose outcome is significant. In
the case of gambling, the only outcome is win-lose and it is therefore, by nature, the dominant outcome
and one of the most obvious forms of forbidden Gharar.

6. Rules of Exchange

Learning Objective
3.4.1 Understand the concept of profit and liability
3.4.2 Know the rationale for being liable for a good or service

In addition to the rules concerning Riba and Gharar, Shariah provides a set of detailed rules related to
trade and exchange. These rules aim to clearly draw the line between legitimate trade and illegitimate
Riba or Gharar. While Shariah rules are clear on Riba and Gharar, there are grey areas between Riba and
trade that need to be carefully considered in a transaction.

6.1 No Profit without Liability

The Prophet (PBUH) forbade making a profit without being liable for it (narrated by, among others,
Ahmad, Tirmithi, Nasa’ie). In this context, profit means the difference between the purchase price of
a good or service and its sale price, and liability (dhaman) refers to the responsibility for physical risks
associated with the good or service. To understand how and when a person becomes liable for the asset
or service, it is important to understand the concept of possession (qabdh).

Possession depends on the type of asset. For example, when purchasing something from a shop, it is
physically handed over from the seller to the buyer. Social media accounts are owned via a user ID and
password, and possession of a house is taken by obtaining the keys.

No matter how possession is obtained, it involves the ability to utilise the good or service. Once the
buyer has taken possession, they become liable for it.

Example
Ahmed purchases a laptop from a computer store on Monday, at 2:00pm, for $1,500. The sales
representative asks Ahmed to come to pick up the laptop the next morning at 10:00am. During this
period, from 2:00pm Monday till 10:00am Tuesday, Ahmed is unable to utilise the laptop he purchased
since he does not yet have it in his possession.

After Tuesday 10:00am Ahmed becomes liable for the laptop, irrespective of whether he has picked it
up or not. Therefore, if the laptop is damaged after that time, without negligence or wrongdoing of the
store, then he is responsible for it. Before that, however, the store is responsible.

In the event Ahmed receives an offer to sell the laptop before 10:00 am on Tuesday for $2,000, he cannot
accept the offer due to the fact that he does not possess it yet. If he accepts the offer, he is making profit
without being liable for the underlying good.

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 Islamic Principles of Exchange

The rationale for possession is that if an asset can be purchased and sold at a profit without taking
responsibility for the risk, the seller is making money without being liable for any real good or service
which, in substance, is Riba. As a consequence, it is prohibited to pay for something and then sell it at a
profit without taking responsibility (possession) for the underlying good or service.

Settlement
Settlement involves the seller receiving the money and the buyer receiving the goods or service. Until

3
the transaction is settled, the seller remains liable for the asset; once the transaction is settled the
liability moves over to the buyer.

In financial markets there is usually a two-day gap between the time a contract is executed and the
settlement. From a Shariah point of view, this means that an investor who purchases an asset at a certain
price at time ‘T’ must not sell that asset for a higher price (ie, to make profit) before the settlement date.
If he sells prior to this time, any profits will be illegitimate because the investor has not taken possession
of the asset.

Real-Time Gross Settlement (RTGS)

Real-time gross settlement (RTGS) is a system that performs settlement in real time, ie, at the same time
of execution of the trade. Due to the fact that there is no gap between the time of contracting and the
time of settlement, assets purchased through this system can be sold for a profit at any time after the
trade is executed.

Currency Exchange
As outlined in section 4.1.4, trading gold for silver requires both sides of the transaction to be exchanged
immediately. From the perspective of Shariah, spot is taken to mean instant possession and thus trading
currencies on delayed settlement systems (eg, T+2) is a violation of the requirements. However, given
the limited availability of alternatives, and the fact that businesses have a need for foreign currency this
violation is forgiven based on the maxim ‘flexibility in case of hardship’.

However, as technology improves, and given the increasing availability of RTGS in currency transactions,
Islamic banks and businesses should, where possible, perform their currency transactions through RTGS.
Not only is RTGS Shariah compliant, it is less risky and offers investors better protection.

6.2 Do Not Sell What You Do Not Have

Learning Objective
3.4.3 Understand the concept of selling what you have
3.4.4 Know the rationale prohibiting the sale of what you do not have

The concept ‘what you do not have’ refers to the combination of ownership or authority, possession and
control. In order to be able to sell an asset, the seller needs to either own the asset or be authorised to
sell it, and be in control of it (ie, be able to deliver it). An agent who acts on behalf of the owner to sell

47
an asset is able to do so since he is authorised to do so by the owner, and is in control of the asset. ‘What
you do not have’, therefore, can be distilled into the following:

1. The seller has the legal ability to sell, ie, he owns the good, or has permission of the owner to sell on
his behalf.
2. The seller has the physical ability to deliver the good, ie, he has it in his possession.
3. The seller can control the asset.

A sale is valid when point 1 (ownership or authority) is fulfilled in combination with either one of the
other two (possession or control). Solely having the asset in possession and having control over it is,
however, not sufficient.

Example
The following are examples of invalid sales:

1. Sale of a car by the owner, but the car has been stolen from him – the seller legally owns the asset
but is not able to deliver the car since it has been stolen.
2. Sale of a stolen watch by the thief – the seller does not legally own the asset, but is able to deliver it.
3. Selling an asset without authorisation – if an agent is in the possession of an asset and has control
of it but is not authorised to sell the asset by the owner, he is physically able to deliver but is legally
not entitled to sell the asset.

It should be emphasised that the ability to deliver should be judged not on the basis of subjective
expectations, but on the basis of objective indicators showing the actual ability of the seller to deliver.

Example
On the basis that not all travellers show up for a flight they have booked, airlines tend to sell more
tickets than they have seats on a flight. As a result, they are selling something they do not own since
they are no longer able to deliver the service.

There are a variety of ways to avoid the violation of this rule, such as keeping passengers wait-listed until
a seat becomes available.

6.2.1 Financial Derivatives

The global financial crisis of 2007/08 showed how deviating the financial sector from its role in serving
the real economy can be harmful to society. Many financial instruments have a claim on assets but are
not connected to these assets.

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 Islamic Principles of Exchange

Example
Credit default swaps (CDSs) are insurance contracts against loans or debts. However, the buyer of a CDS
on debts of a specific entity does not need to have any relation to or interest in that entity. In this case,
the buyer of the CDS is not insuring anything but is simply betting that the underlying asset will default,
and they will therefore be able to collect in compensation more than what they paid in premiums.

A short sale is a sale in which the seller sells shares he does not own for a delayed delivery date in the

3
expectation that the price will drop. Short sales can either be covered (the investor borrows the shares
against a fee) or naked (the investor does not own or borrow the shares). At maturity, these contracts are
typically settled in cash.

Derivatives contracts are detached from the underlying assets and are simply side bets on these assets.
Derivatives are not permitted in Shariah.

6.2.2 Islamic Instruments

Within Islam, selling what one does not have is generally not permitted. This rule does, however, not
apply to two transaction types: Salam and Istisn’a.

A Salam transaction is a sale contract in which the full price is paid in advance, while the delivery of
the good is delayed to a predetermined date in the future. Salam transactions are typically applied to
agriculture. The good does not have to be available at the time of contracting but this does not imply
the seller is selling something he does not own for two reasons:

1. The seller receives the full price upfront, which is a required condition for the Salam contract. The
price helps the seller to be able to deliver the future goods. By receiving the full price upfront, the
seller actually has the means to deliver the goods.
2. Since the future goods is a debt obligation on the seller, the terms of the contract must give the
seller sufficient room to be able to arrange for the delivery at maturity. For example, the delivery
date must be set so that the seller has enough time to manage delivering the goods.

The specifications of the goods must be sufficiently flexible so that the seller is able to obtain the goods
from alternative sources and not be restricted to a particular source.

A very short horizon for delivery or very restrictive specifications of the goods will make it highly risky
for the seller to meet his obligations, and thus make the transaction very close to the domain of ‘selling
what one does not have’.

The Istisn’a transaction is a production contract in which the seller agrees to produce or manufacture
the desired asset to be delivered to the buyer at the agreed date. The producer contributes material
and labour to produce the agreed product. Similar to Salam, the producer does not have the goods
at the time of contracting. Unlike Salam, however, the full price is not necessarily paid in advance, but
based on a payment schedule that is agreed between parties. The payment could be fully in advance,
gradually over the production period, include a balloon payment at the end, or any other schedule
agreed between parties.

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Another important difference between Salam and Istisn’a is that, in Salam, the seller does not need to be
the producer of the goods sold. Contractually, therefore, the seller in a Salam transaction is not required
to put in any work or effort to produce the goods; they can simply buy it at maturity from the market
and deliver it to the buyer.

In contrast, in Istisn’a, the seller needs to undertake the work to produce the agreed product. This means
the producer must have the skill and expertise required.

6.3 No Debt for Debt

Learning Objective
3.4.5 Understand the concept of debt for debt
3.4.6 Know the rationale prohibiting the sale of debt for debt

The exchange of a debt for a debt is prohibited. One of the main forms of debt for debt exchange is
to purchase a good in such a way that both the price and the good are debt obligations, and both the
payment and the delivery of the good are deferred to particular date(s) in the future.

Debt for debt relates to the exchange of an existing debt with a new debt, eg, by combining two debts
into one and issuing a new debt to increase an existing debt. The rationale for this restriction relates to
the link between finance and real economic activity. Debt for debt exchange creates debt obligations
without real transactions, ie, without possession of any tangible object at the time of contracting. The
restriction only applies to debt-creating transactions and not, for example, to Istisn’a transactions,
where the responsibility of the producer is not strictly a debt obligation but a conditional obligation.
If the producer is unable to produce the asset for reasons beyond his control without committing
negligence or wrongdoing, he is exempt from his obligation and the contract is dissolved. If the buyer
has paid any down payment, however, the producer is indebted only for this amount and he must repay
it to the buyer. In Salam, the seller is indebted to deliver the agreed goods and the obligation cannot be
dissolved by an inability to deliver, even if this inability does not arise from negligence or wrongdoing.
The obligation of the seller in Salam, therefore, is stronger than that of the producer in Istisn’a.

One instrument that was famous in Madinah is called ‘sale in the way of the people of Medina’. This is
similar to a modern day supply contract in which a buyer agrees regular delivery of specified goods over
a given period with a seller such as, for example, a butcher, baker or greengrocer. Both the payment
and the delivery of the goods are deferred. This is not considered to be a form of debt for debt for the
following reasons:

1. The seller in a ‘Medina’s sale’ is the dedicated seller who is in the business of providing this type of
goods and is, therefore, able to supply the goods on regular basis. Hence, the goods sold through
this arrangement are not strictly debt; they are effectively or constructively available.
2. If the seller is unable to deliver for reasons beyond his control (eg, if he dies), the contract is
automatically dissolved and obligations are exempted (unless the buyer made a down payment, in
which case the down payment will be a debt to be repaid).

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 Islamic Principles of Exchange

This is consistent with the principles governing Istisn’a and is in harmony with business operations that
meet the real needs of businesses and individuals.

Supply contracts do not fall within the range of debt for debt since they are associated with the business
the supplier is in and his obligations are conditional, not a fixed debt.

6.3.1 Islamic Instruments – an Overview

3
The diagram below provides a simple overview of Islamic instruments and how they differ from
unacceptable arrangements discussed above:

Sold good

Not in
In possession
possession

Not debt Debt obligation

Seller is not Seller is

Deferred price Spot price
‘in the business’ ‘in the business’

Istisn’a,
Don’t have* Debt for debt Salam Normal sale
supply contract

* See section 6.2 for the explanation of ‘don’t have’.

6.4 Two Sales in One

Learning Objective
3.4.7 Understand the concept of two sales in one
3.4.8 Know the rationale prohibiting two sales in one

The Prophet (PBUH) forbade combining two sales in one sale. While scholars provide a diversity of
interpretations of the Hadith, they generally agree that combining contradictory or inconsistent

51
contracts together is unacceptable. This Hadith is a cornerstone for financial engineering in Islamic
finance.

Combining this restriction with the principle of permissibility, it can be concluded that innovation
and creativity in Islamic finance should be directed towards fruitful and value-adding arrangements.
Combining two or more contracts, therefore, is restricted only to situations where combining the two
contracts does not add value. However, if the contracts are in agreement, the combination may bring in
value that could not have been achieved by treating the contracts separately. The latter combination of
contracts is not permitted.

Istisn’a can be viewed as a combination of Salam and leasing of labour. The producer sells his services
(which is the use of his skills) but also undertakes to contribute material for the produced good, which
is similar to Salam. However, the final outcome of the combination is different and results in a new
contract with unique properties that are not shared with its constituents.

Combining multiple contracts into one is allowed under the principle of necessity (Darurah) and has the
potential to effectively create an infinite number of financial contracts. The combination of contracts
needs to add value and should not violate Shariah.

6.4.1 Controversial Contract Combinations – Bai al-Inah

Example
Bai al-Inah is an arrangement in which two legitimate sales contracts are used to arrive at an illegitimate
outcome involving Riba. The structure is as follows:

1. ‘A’ buys a mobile phone for immediate delivery from ‘B’ for a deferred price of $1,000 to be paid in
six months.
2. Now that ‘A’ owns and possesses the mobile phone, he sells it back to ‘B’ for a cash price of $950.

The final outcome of these two steps combined is that ‘A’ obtains $950 cash from ‘B’ and has to pay ‘B’
$1000 in six months. So, the result is simply a loan with a stipulated addition from ‘B’ to ‘A’, which is Riba.

The majority of scholars forbid the combination of contradictory contracts such as Bai al-inah because
it is Riba in substance. Imam Al-Shafi’i however argues that people are free to trade as they wish (the
principle of freedom of contracting). Therefore, unless the two parties explicitly state that their objective
is to exchange money now for more money in the future, people cannot be prohibited from contracting
as they want. Imam Al-Shafi’i nonetheless clearly states that if the two parties had the intention to
reach this outcome, even without explicitly stating it, the transaction is questionable on moral grounds.
However, in court, the judge cannot invalidate the transaction because there is no explicit evidence that
the two parties planned to reach that outcome. The majority of scholars concede that the objectives and
practice of the two parties clearly indicate that the transaction aims to provide a loan with interest (the
principles of actions are judged by their objectives, and custom and convention govern transactions).

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 Islamic Principles of Exchange

As discussed in chapter 1, there are two dimensions through which Shariah judges actions:

1. Moral dimension.
2. Judicial dimension.

While Imam Al-Shafi’i emphasises the explicit stipulation of the two contracts in order to invalidate the
transaction in court, he does point out that, morally, the parties should not pursue this objective.

3
There are many reasons why ‘inah is inconsistent with principles and objectives of Shariah:

1. It is clear that the asset adds no value to the buyer and is used only to legitimise the loan. If the good
was of value to the buyer, he would still be interested in buying it if he had the money available. To
buy a good of no value whatsoever is considered to be misuse of wealth (Israf).
2. By intending to sell the good for a price below the purchase price, the buyer is not acting as a
rational investor who seeks to create wealth and generate positive returns. This also falls under
misuse of wealth (Israf).
3. Transparency is one of the ethics of business activities in Islam, but ‘inah creates a situation in which
the two parties cannot be transparent in stating their objective of the arrangement, which is to
obtain a loan with a stipulated addition.
4. Since the good used in ‘inah is redundant, it can be used over and over again in other transactions
without limitation. Consequently, huge amounts of debt can be created by using a single good. This
allows for the creation of an inverted-debt pyramid with the value of the good at its base, while the
layers of debt on top are created by a potentially unlimited number of ‘inah transactions.

6.4.2 Controversial Contract Combinations – Tawarruq

Tawarruq is a sale transaction in which A buys an asset from B and sells it to a third party C. As long
as C is independent of B, and the two transactions are completely separate, Tawarruq is considered
permissible, although many scholars consider it as undesirable (Makrouh).

If B is involved in the second sales transaction, eg, as an agent for A to sell the goods to C, the
transaction becomes what is known as organised Tawarruq. Most scholars consider organised Tawarruq
unacceptable given the explicit role of seller B in providing funds to buyer A, thereby making the
two transactions structured and arranged explicitly to create a financing arrangement. The OIC Fiqh
Academy ruled that, while Tawarruq is permitted, organised Tawarruq is not.

Reverse Tawarruq is another variety of this product family. In this structure, B provides funds to A as an
agent to buy and sell goods on behalf of B. A, therefore, purchases the goods against spot payment from
the broker on behalf of B. Next, A will buy the same goods for a deferred higher price. Subsequently,
A will sell the goods to a third party, C, for cash. Once the transaction is finalised, A has a deferred
obligation to B to repay an amount of money higher than the amount he originally received. The OIC
Fiqh Academy ruled that reverse Tawarruq, like organised Tawarruq, is not acceptable.

6.4.3 Controversial Contract Combinations – Bai al-Wafa

In a Bai al-Wafa arrangement, A sells a good to B for a cash price, with A having the right to cancel the
sale, return the money and receive the asset back. The right to cancel (khiyar al-shart) is a legitimate

53
option in a sale transaction which gives the holder the right to unwind the sale transaction and return
to the position prior to executing the transaction. It is a means to protect the party from unseen or
unknown circumstances that might negatively affect their position.

The right to cancel can, however, also be used in a manner that creates an illegitimate outcome, in this
case a loan with interest. The two parties agree that A will lend B an amount of money equal to the cash
price of the good. The interest on the loan will be benefits derived from utilising the good during the
loan period. If the good is a leased asset, the interest will be rent payments. The OIC Fiqh Academy has
ruled that Bai al-wafa is a loan with interest in substance, and is therefore unacceptable.

6.5 Challenges for Product Innovation

Islamic banks operate in an environment dominated by interest-based lending. The Islamic financial
industry is less than 2% of the global financial industry. Many clients of Islamic banks have a preference
for Shariah-complaint financial services but still look for products that are comparable to conventional,
interest-based products. Islamic banks may, therefore, find themselves in a position where they need
to be more pragmatic, at least for a transitory period. While ‘inah have widely been applied in Malaysia,
the central bank, Bank Negara Malaysia, has decided to restrict the application of ‘inah in order to
encourage the industry to move to the next stage in their evolution towards realising the full objective
of Islamic finance.

For the Islamic finance industry to achieve the objectives of Islamic economics, it needs to keep the rate
of innovation relatively high in order to be able to not only compete with its conventional counterparts,
but also to be able to be a step ahead and offer genuine Islamic products that serve the needs of its
clients while satisfying the objectives of Shariah.

7. Concluding Remarks
The principles of Islamic finance represent a coherent system of financial activities that aim to create
wealth and achieve prosperity for the community. While there is a diversity of interpretations of Shariah
rules, these interpretations tend to share common understandings that ultimately serve the objectives
of Shariah and meet the needs of parties with respect to justice, transparency and mutual gain.

The preceding discussions aim not only to clarify Shariah rules of exchange and contracting but also to
understand the rationale behind them and understand how to apply them in contemporary markets.

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 Islamic Principles of Exchange

End of Chapter Questions

1. List the values to be observed by market participants.

Answer reference: Section 2.1

2. Name seven of the ten rules relating to commerce.

3
Answer reference: Section 2.2

3. What is the key difference between a loan and a trade?

Answer reference: Section 4.1.1

4. Which type of Riba is associated with Ribawi commodities?

Answer reference: Section 4.1.4

5. Within Riba, what are the three main levels of restrictions?

Answer reference: Section 4.1.4

6. Define the nature of Gharar.

Answer reference: Section 5.1

7. When does Gharar become major Gharar?

Answer reference: Section 5.2.2

8. Why are derivatives contracts not permitted in Shariah?

Answer reference: Section 6.2.1

9. What is the important difference between Salam and Istisn’a?

Answer reference: Section 6.2.2

10. Name the three controversial contract combinations.

Answer reference: Sections 6.4.1–6.4.3

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56
Chapter Four

Basic Contracts and their

Treatment

4
1. Introduction 59

2. Contracts 59

3. Contracts of Exchange 65

4. Contracts Allowing the Transfer of the Usufruct 69

5. Partnership Contracts 70

6. Security Contracts 72

7. The Rules Regarding Foreign Exchange Transactions (Sarf) 73

8. Accounting Treatment 77

9. Concluding Remarks 87

This syllabus area will provide approximately 15 of the 100 examination questions
58
 Basic Contracts and their Treatment

1. Introduction
This chapter outlines the main types of contract: contracts of exchange, with particular reference to sale
contracts; contracts for the transfer of Usufruct (the right to use an asset), ie, lease contracts; partnership
contracts; and contracts providing security, such as guarantees and mortgages; and, finally, foreign
exchange contracts.

The types of contract described in this chapter are sometimes referred to as the ‘nominate contracts’ and
form the very basis of Islamic finance.

4
2. Contracts
Fiqh al Muamalat, Islamic commercial law, includes a key section that deals with contracts. The law
of contract is at the core of any commercial legal system and this applies in the same way to Islamic
commercial law. In Shariah, principles and rules of valid contracts help parties to conduct their business
so that it meets the requirements of Shariah. Three generic types of undertaking exist between two
parties, each of which is briefly described below. The first is the actual contract and the other two are
preliminaries to a contract, and these have generally been deemed binding on the party giving the
undertaking, particularly in the context of modern Islamic banking and finance.

• The Aqd’ (the contract).

• The Wa’d (unilateral promise).
• The Muwaada (bilateral promise).

2.1 Contract (Aqd’)

Learning Objective
4.1.1 Understand the fundamentals of Aqd’ (contract): contracting parties; subject matter;
consideration; offer and acceptance

2.1.1 Definition
An Aqd’ or contract is a transaction that is executed between two or more parties for mutual benefit and
with mutual consent. Aqd’ covers all types of contracts and is valid if it meets the following criteria:

• There must be at least two independent eligible parties.

• There must be offer and acceptance relating to both price and asset.
• Acceptance should match the offer.
• There must be a material effect (ie, transfer of ownership) following exchange of asset and
consideration (payment or fee).

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For example, A offers to sell his car to B for US$15,000. B accepts the offer to purchase the car for
US$15,000. The contract is concluded and is valid because:

• there are two independent eligible parties (A and B)

• A has offered his car for sale and B has accepted the offer
• the acceptance from B matches the offer from A
• ownership of the car is transferred from A to B and, simultaneously (or as agreed), B pays US$15,000
to A.

If B wants to buy A’s car, but only wants to pay US$10,000, he has made a counteroffer. There is no
agreement and hence no contract.

Types of Aqd’
• Compensatory contracts where one person sells something to someone else for a price or other
compensation (consideration).
• Non-compensatory contracts where one person gives something to someone else without any
compensation, eg, in a will, a gift or as a donation.

2.1.2 Components and Conditions Influencing Contracts

The main components in relation to a valid contract are similar to other legal jurisdictions and can be
summarised as follows:

• Contracting parties need to be mature and sane. Maturity implies that the parties need to be adults,
although contracts concluded by minors are acceptable if their parents or legal guardians have
provided consent. Sanity is related to mental soundness at the time of transaction. In the event that
one of the parties is either temporarily or permanently insane, the contract is not valid.
• Subject – the subject of the transaction (assets, goods, skills) needs to be legitimate in the law of the
jurisdiction as well as in Shariah (ie, the subject must be permissible). In addition, the subject must
exist and be in control or possession of the seller. The subject must be defined in sufficient detail.
• Offer and Acceptance – offer and acceptance need to match (see above) and need to be connected.
Acceptance needs to be absolute and unqualified, and cannot be given after the offer has been
withdrawn.

Conditions that Affect Contracts

• A sale with a condition which is a requirement of the contract of sale is lawful, and the condition is
valid. For example, X will not give Y the keys of the car he has sold to him but rather retain them as
collateral (Rahn) until Y has paid X the full agreed purchase price for the car. This condition does not
prejudice the sale; it only declares what is required by the contract and affirms the seller’s rights.
• A sale with a condition in support of a requirement of the contract is acceptable and the condition
is valid. For example, to sell an item on the condition that the buyer gives a pledge in connection
with payment, or that he gives some form of security (collateral) is lawful, and the condition is valid.
However, conditions must be reasonable. For example, for A to buy a car from B on the condition
that B will employ his son in his firm, is invalid due to the fact that the condition is unreasonable.
Reasonable conditions are those which do not go against the contract. For instance, A tells B to
deliver the goods within a month and this is considered a reasonable period.

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 Basic Contracts and their Treatment

• A sale with a condition which is generally accepted, by use and custom in a market and is a well-
known condition is acceptable, and the condition is valid. For example, a sale of a house with a
condition that the locks are replaced is valid if it is common practice to do so. The compliance of the
seller with this condition is in this case necessary. For example, A buys a refrigerator from B with the
condition that B undertakes its service for two years free of charge. The condition being recognised
as a part of the transaction is valid and the sale is lawful under Shariah.
• A sale with a condition, which is not for the benefit of one of the contracting parties, is lawful, but
the contract is voidable. For example, X sells his car to Y with a condition that Y must not sell it to
another person for a period of at least six months.

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2.2 Shariah Options of Sale

Learning Objective
4.1.2 Understand Shariah options of sale

In addition to the components outlined in section 2.1, with regard to the counterparties, subject matter,
consideration, and offer and acceptance, there are five options of sale as formalised in classical Fiqh:

1. Buyer’s option to rescind – time limited, seller has similar option, but ceases before execution of
contract. For example, a ‘cooling-down’ period when buying a large asset.
2. Option of inspection – right to see or appoint a qualified person to inspect the object being sold for
any form of defect.
3. Option of defect – right to return if defective.
4. Option of quality – right to receive the quality of goods as specified.
5. Option of price – right to a fair price within the market range.

2.3 Classification of Contracts

2.3.1 Introduction
This section contains further detail of contract characteristics influencing validity and the effect of the
contract. In addition, the distinction between unilateral and bilateral contracts is explored as well as the
types of unilateral and bilateral contract.

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2.3.2 Validity and Effect of the Contract

Learning Objective
4.1.3 Understand the classification of, and conditions applied to, contracts with respect to their
effect: valid (Sahih) contracts; voidable (Fasid) contracts; invalid (Batil) contracts

A classification of contracts with respect to their effect could divide them into:

• Valid (Sahih) – a valid contract is a contract for which the components and conditions of Shariah
as set out above are met. The effect of such a contract is the immediate transfer of ownership of
the subject matter to the buyer, and the transfer of the price (or consideration) to the seller. Valid
contracts could be either:
• Enforceable (Nafiz) – an enforceable contract is a contract that has been entered into by
parties which have the ability and the authority to enter into the contract. For example, a
contract between two sane and mature individuals, where all the components and conditions
that have been detailed above are fulfilled, is enforceable.
• Unenforceable until authorised (Mawqoof) – a contract that is unenforceable until authorised
is a contract where a person has the ability to enter into a contract but it exceeds his authority;
for example, if an agent exceeds the authority accorded to him by his principal. Such a contract
is unenforceable until authorised by the principal.
• Voidable (Fasid) – voidable contract is a contract that is sound in its essence (the spirit of the
contract) but unlawful in its conditions. The contract is concluded but some of its components are
invalid from a Shariah perspective, eg, in the event an item has been sold for an uncertain price. A
voidable contract can become valid if the component or condition which has led to its voidability is
removed. In the above-mentioned example, this would be achieved by agreeing the price. If delivery
has been made under a voidable contract and the subject matter is destroyed in the hands of the
buyer, the buyer must compensate the seller. However, when a voidable sale has been annulled, the
buyer can keep the item sold until the seller returns the money.
• Invalid (Batil) – an invalid contract is not good in its essence or components. This kind of contract
cannot confer any legal or beneficial consequences. In the event the buyer has received the goods
prior to having paid for them, and they are destroyed without any fault on the part of the buyer, the
buyer is not under an obligation to compensate the seller. Strictly speaking, an invalid contract is
not a contract at all, as it fails to meet the requirements for being recognised as a contract.

2.3.3 Unilateral and Bilateral Contracts

Learning Objective
4.1.4 Know the types of contract with respect to their underlying purpose: unilateral and bilateral

Unilateral Contracts
Unilateral contracts are usually without due consideration (which can be interpreted as free). Uncertainty
or risk is permissible since the contract is free and without consideration.

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 Basic Contracts and their Treatment

Unilateral contracts include the following:

• A gift (Hiba) – a gift can be revoked prior to its actual transfer. A gift does not imply a transfer in
property.
• Borrowing and obtaining benefit of a tangible asset without consideration (Ia’ra) – the
borrowing of the tangible asset is economically similar to a free lease where usage (usufruct) of a
specific object or asset (eg, car, house) is transferred to a recipient for free for a specified period.
• A benevolent loan (Qard) – typically a loan of money, usually given to assist the receiver, for
example, to pay for study costs. The recipient is obliged to return the full amount at the end of the
contract. The recipient may voluntarily (at their absolute discretion) return more than the principal,

4
but this cannot be stipulated in the contract. At present some scholars allow lending institutions
to charge administrative fees on the money lent. However, the extra money charged may not be
benchmarked against interest rates or the cost of capital.
• A will (Wassiyyat) – the last will and testament in which the deceased bestows assets on a
beneficiary.
• An endowment (Waqf) – a trust, generally set up for charitable purposes.

Bilateral Contracts
Bilateral contracts are contracts between two or more parties and they have a cost and benefits
associated with them. These contracts are subject to strict rules, including the components outlined
above. Bilateral contracts may be classified as:

• contracts of exchange (Muawadat)

• contracts of partnership (Shirkah)
• contracts of security (Damanat)
• contracts rewarding the specific work done or agency contracts (Wakala, Juala)
• contracts of safe custody (Wadia).

Bilateral contracts may be subject to Riba (interest), Gharar (uncertainty), Maysir (speculation) or the
lack of knowledge (Jahala), which are not permissible in Shariah and need to be avoided. Bilateral
contracts must include precise specifications and an understanding of the underlying goods or services
which are the subject of the contract. In addition, bilateral contracts need to meet all other contract
conditions outlined in section 2.1.2.

2.4 Wa’d (Promise)

Learning Objective
4.1.5 Understand the concept of Wa’d (promise) and Ah’d (undertaking), the difference between the
two concepts and the conditions which make a commercial promise binding

Ah’d is a covenant, pledge or undertaking to perform certain tasks and to be held accountable for these
tasks. Ah’d is considered binding, and breach of it could be subject to penalties or a claim, particularly in
the event that the counterparty relies on the covenant. Penalties will only be awarded in the event that
a party who has relied on the covenant has suffered a loss.

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Wa’d means promise, and refers to a promise by one party to do, or not to do, something in the future.
The promisor is the party making the promise, and the promisee is the party receiving the promise
from the promisor. For example, A (the promisor) promises to sell his car to B (the promisee) at any
time within the next three months for 25,000 dinars. This is a unilateral promise or Wa’d. The primary
difference between a promise and a contract is that a promise is one-sided (unilateral) and does not
bind anyone but the promissor. A contract, on the other hand, is bilateral and binds both sides. The
binding nature and enforceability of a promise have been subject to debate among scholars.

The Islamic Fiqh Academy ruled that a promise in commercial dealings is binding, subject to the
following conditions:

• It should be one-sided.
• The promise must have caused the promisee to incur some liabilities for the promisee to seek
enforcement on the promisor.
• If the promise is to purchase something, the actual sale must take place at the appointed time by the
exchange of offer and acceptance. A mere promise itself should not be taken as a concluded sale.
• If the promisor backs out of his promise, the court may force him either to purchase the asset or
service, or to pay actual damages to the seller (promisee). Actual damages typically consist of the
cost incurred in relation to the anticipated execution of the promise, but do not include opportunity
cost (eg, the loss of mark-up or profit). For example, A (the promisor) promises to buy B’s (the
promisee’s) car within the next month for 25,000 dinars (which cost B 22,000 dinars). B has the car
cleaned and serviced in anticipation of the sale at a cost of 100 dinars. If A subsequently withdraws
his promise, the court may force A to buy the car or pay damages to B equivalent to the price of the
cleaning and servicing (ie, 100 dinars). Thus, if B can now only sell the car for, say, 20,000 dinars, he
may not claim any damages from A for the opportunity loss of 5,000 dinars. In addition, the promisor
is not bound to make good any loss where the lack of performance is for reasons beyond his control.
For example, in the case where A (the promisor) promises to sell a horse to B (the promisee), and the
horse dies prior to the date of the sale, A does not have to pay damages to B as long as the death
of the horse is not caused by A’s negligence. However, if the death of the horse is caused by A’s
negligence, A must make good the loss to the promisee.

It should be noted that the exercise of a unilateral undertaking by either of the parties does not lead to
an automatic transfer of ownership. A contract of sale will have to be executed after the exercise of the
unilateral undertaking to effect the transfer of ownership.

2.5 Bilateral Promise (Muwaada)

Learning Objective
4.1.6 Know the nature of a Muwaada (bilateral promise) agreement

A bilateral promise consists of two unilateral promises or undertakings extended by two parties on the
same asset or service. For example, A provides a unilateral promise to B that he will purchase B’s house
for US$250,000 any time within the next 12 months. Similarly, B gives a unilateral promise to A that he
will sell his house to A for US$250,000 at any time within the next 12 months. While most scholars agree
on the binding nature of a unilateral promise in commercial transactions, as discussed above, they

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 Basic Contracts and their Treatment

reject the acceptability of two identical unilateral promises as illustrated in the above example. Such a
combination amounts to a forward contract (a contract concluded at a future date for a current price),
which is generally not allowed.

3. Contracts of Exchange

Learning Objective

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4.2.1 Understand the elements and conditions of a contract of exchange

The sale contract or contract of exchange is the most basic form of contract in Islamic law. These
contracts involve the exchange or the transfer of ownership of specific objects or goods from one
person to another, either by exchanging:

• one good for another (barter trading), such as my watch for your bracelet or a quantity of my
potatoes for your bread, or
• one good for money (sale), such as the sale of a book in a bookshop, or the purchase of your car for
£10,000, or
• money for money (Sarf), which represents the exchange of an amount in one currency for an
equivalent amount in another currency; a foreign exchange transaction where both countervalues
must be exchanged on spot.

Permissibility: Allah (SWT) has said in the Quran:

But Allah has permitted trade. (Surat Al-Baqara, 2:275)

The Prophet (PBUH) said:

A sale must be by mutual consent.

Exchange contracts dealing with barter trading or currency exchange could be subject to Riba al-Fadl.
The latter exists in different types of currency exchanges, such as:

• the exchange of two homogeneous goods in unequal amounts and for future delivery, or
• the exchange of two heterogeneous goods for future delivery (ie, without taking immediate
possession of the two exchanged goods), albeit in unequal amounts, which is permissible when the
exchanged goods are different.

3.1 Components and Conditions of a Sale Contract

Contracts of exchange are subject to all the components and conditions mentioned in section 2
(contracting parties, subject matter, consideration, and offer and acceptance), as well as rules regarding
price.

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For a sale to be valid, the primary condition to be fulfilled before the sale contract is concluded is that
the total price and currency has to be specified and agreed. If the price is uncertain, the sale is void. If,
for example, the price is stated as 50 dinars for payment within one month and 55 dinars for payment
after two months, the price is uncertain. The sale is, therefore, void, unless either one of the alternatives
is agreed upon by the parties at the time of sale.

3.2 Exchange Contracts

Exchange contracts include a variety of contracts that differ from each other in terms of legal
requirements, rights, obligations and liabilities, but all have a common obligation: the contract results
in the transfer of ownership of the underlying object from one party to another. The theoretical
underpinning of each of these contracts is detailed in this section. Chapters 5–8 contain their application
in practice.

3.2.1 Cost Plus Sale (Murabaha)

Murabaha comes from the Arabic word for profit and simply means a ‘profit-disclosed sale’. It is a trade
transaction in which a good is exchanged for money. The payment may be deferred to a later date, in
which case it is also known as a deferred payment sale or an instalment credit sale. In its most basic form,
this transaction involves the seller and buyer of a good as can be seen in the figure below:

1. Deliver goods today

Seller Buyer
2. Pay for goods later

The price of the goods, the mark-up, the delivery date and payment date are all specified in detail. The
sale of the goods is immediate, against future payment. In the context of trading, the advantage to the
buyer is that he can use the goods to generate a profit in his business and subsequently use the profit
to repay the original seller.

The underlying asset can vary, and can include raw materials and goods for resale.

3.2.2 Foreign Exchange (Sarf)

A foreign exchange transaction is related to the sale of gold, silver and currency, in which one currency
is sold in exchange for another currency; it is generally referred to as a currency exchange contract. In
this contract, both countervalues must be exchanged on spot.

3.2.3 Short-Term Production Finance (Salam)

Salam may be defined simply as a contract executed with spot payment, in full, for the purchase of
assets which have commodity-like characteristics, such as base metals, eg, copper and zinc, and grain,
promised for future delivery. In contrast to a credit sale Murabaha, under which goods are delivered
and payment is deferred at a price higher than the spot price, in Salam, the agreed price is paid fully in
advance, while delivery of goods is deferred. The Salam seller is, in all circumstances, required to deliver

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 Basic Contracts and their Treatment

the assets to the specified type, quality and quantity. The Salam buyer expects that his future sale price
will be higher than the price he pays; thus, the financier or Salam buyer takes a price risk on the asset. In
a Salam transaction, the goods purchased must be freely available in the market. The goods, which are
the object of a Salam sale, must be of a specified quality and quantity without ambiguity. Although one
might envisage that the goods will be from a specific farm or producer, the Salam contract specifies the
quantity, the quality, the date and the place of delivery.

For example, a shop might specify that it wants to buy Medjool dates, packed in boxes of 12, and
of Grade A quality, with 100 boxes to be delivered on 9 October 2020 to the shop at Beirut airport
departure lounge. Another example is a builder specifying slate roofing tiles of a particular size and

4
colour, with 5,000 to be delivered to a designated construction site on 14 November 2019. The Salam
contract cannot be used for either spot delivery or cross sales.

Salam might be called ‘future delivery pre-financing’ and has been applied, most notably, in the
agricultural sector, since before the life of the Prophet (Peace be Upon Him (PBUH)), when it was a
documented business method in the Hadith. Salam has been expanded in commerce to meet the needs
of trade financiers. It has further expanded into project finance by means of the Istisn’a contract. Salam
is one of the commercial contracts to which the rules related to the existence of the asset and ‘do not
sell what you do not have’ do not apply.

In a Salam, at the time of contracting:

1. the asset does not need to exist, but the specifications as to the type and quantity must exist, and
2. the seller does not need to have ownership of the asset. A condition governing Salam contracts,
perhaps to restrict these concessions and drive them towards processing (agriculture, construction
or manufacture), is that the minimum Salam period, in the view of many scholars, is ideally not less
than 30 days.

3.2.4 Long-Term Production Finance (Istisn’a)

Similar to Salam, Istisn’a, or long-term production finance, is a transaction in which an asset is transacted
before it comes into existence. The asset needs to be manufactured, constructed or sold. Gharar is
avoided by specifying the asset in detail. Among the contract types of Islamic law, it is by far the most
flexible in terms of payment and delivery as it leaves an open field for negotiation. The asset is to be
built according to the buyer’s specification and to be delivered on a specified date at a fixed price.

Payment may be made in a lump sum in advance, or progressively in accordance with the progress
made. The delivery schedule and purchase price are agreed at the outset and take into account aspects
such as material, labour, profit margin and other project costs. Settlement takes place under the Istisn’a
on delivery of the completed goods upon meeting the specifications – equipment, plant or project.

Istisn’a Agreement
Buyer
Manufacturer Cash (or Obligor)

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3.2.5 Down Payment (Arboon)
In an Arboon, the buyer makes a non-refundable down payment against the purchase price following
a sales contract. The buyer enters into a contractual obligation to confirm the purchase but loses the
down payment if he does not conclude the purchase. However, if he continues with the purchase, the
buyer only pays the difference between the agreed price and the down payment he has already made.

3.2.6 Contract in which the Price will be Agreed between Parties

(Musawama)
The Musawama contract is similar to a Murabaha contract in that it is a contract for the sale of an asset.
Contrary to the Murabaha contract however, the price is negotiated and the buyer does not know
the seller’s price or the amount of profit he is making. This type of transaction applies, for instance,
when purchasing an asset at a market stall, or in shops in the majority of GCC and Asian countries. For
example, X wants to sell a carpet which has cost him 1,000 dinars. Y is interested in buying it and X offers
to sell it to him for 1,500 dinars. Y considers the offer and finds it too much, but makes a counteroffer of
1,300 dinars. After further negotiations, X and Y agree on 1,350 dinars and X makes a profit of 350 dinars.

3.3 Problematic Sales Contracts

Learning Objective
4.2.2 Know the problematic sales contracts

3.3.1 Twin Sales (Bai al-Inah)

Back-to-back sales of the same object between the same contracting parties, switching roles in each
sale and the second sale being contingent upon the first are not permitted. Scholars and commentators
have explained that twin sales apply to a transaction in which the same asset is sold between the same
counterparties for a different price.

For example, X sells his car to Y for £25,000 today. Simultaneously, Y agrees that once he owns the car,
he will sell it back to X against a deferred payment of £26,000 payable in two months’ time. Effectively,
Y has extended a loan of £25,000 to X for two months against a mark-up of £1,000. Twin sales are akin to
loans with interest and are thus prohibited.

3.3.2 Twin Contracts (Bai’atayn fi Bai’ah)

A twin contract is the combination of two contracts into one where one of the contracts is conditional
upon the other. The Holy Prophet (PBUH) has disallowed the combination of two contracts in one in the
same manner as he has disallowed twin sales. Examples of this can be:

• A agrees to sell goods at a discounted price to B conditional on B selling his house to A, and
• combining a contract of loan with a contract of sale.

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 Basic Contracts and their Treatment

4. Contracts Allowing the Transfer of the Usufruct

The main form of a contract allowing the transfer of the usufruct (usage of the asset) is the leasing
contract (Ijara).

The Ijara contract is a bilateral contract in which the usage (usufruct) of an asset is transferred to
another party for consideration (eg, money). Ijara is the Arabic word for providing goods or services
for temporary use against a wage. Literally, one sells ‘usage’, or ‘Usufruct’ as it is commonly called
in this context, for a period of time, but the asset ownership remains with the lessor. Ijara is similar

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to a conventional lease where a lessor buys an asset and subsequently leases it to a lessee against a
specific income rental schedule. The duration and the specification of the lease contract are specified
in advance. The Ijara contract has specifications that, in some cases, are different from a conventional
lease. The following are some of the specifications of an Ijara contract:

1. The use of the leased asset must be both specified in the contract and Shariah compliant.
2. The lessor remains the owner of the asset during the Ijara contract.
3. The lessor is responsible for the major maintenance and ownership-related insurance of the
underlying asset for the duration of the lease (in practice the lessor nominates the lessee as his
agent for all maintenance issues).
4. The lessor is held liable for any damage incurred accidentally, unless it has been proven to be
incurred due to the negligence of the lessee; the lessor, in this case, could annul the lease contract
on application to a court of law.
5. The lessee is held liable for maintaining the asset in good shape so that it can continue to be leased.
6. The leased asset should be held in trust in the hands of the lessee. Subleases are permissible with
the consent of the lessor or if similar usage could be expected.
7. The asset or service must have value. Certain consumables, such as money, food and fuel, may not
be leased.
8. Some forms of lease that are permissible include arrangements that are similar to ‘time sharing’,
whereby a specific space is leased at a specific time of the year to a seasonal tenant.

As a rule, it is best to think of an Islamic lease as more like an operating lease but redemption features
may be structured to make it similar to a financial lease.

The rental may either be fixed for the life of the lease or adjusted periodically. Rent may commence
only when the property has been delivered or made available to the lessee at a specific time and
place agreed by the lessee. In many transactions, the bank will appoint the lessee to act as its agent
to purchase assets. The traditional Islamic concept requires the lessor to pay for the ownership costs
and the lessee to maintain the asset in good order. However, as a practical matter, the lessee usually
agrees to insure and maintain the property in commercial deals on behalf of the lessor through a service
agency agreement that specifies duties, values and performance. In retail leases, the lessor customarily
pays the costs of ownership. In a typical true lease, the bank (the lessor) and the client (the lessee) will
agree to the terms and conditions of the lease, specifying the object, when it will be available to rent
and the rent.

In the event of a total loss, the lease is automatically terminated and the lessor has no rental claim from
the lessee. The lessor’s only recourse is to claim any insurance proceeds for which it is eligible. There

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is no Shariah objection to structuring a lease agreement with additional security such as guarantees,
mortgages, liens on receivables or hypothecation of cash accounts.

Two main types of lease exist:

• Ijara – operating lease. In this case, the asset falls back to the lessor at the end of the lease period
• Ijara wa Iqtina/Ijara Muntahia Bittamleek – finance lease. In this case, the lessee provides a promise
to purchase the asset at the end of the lease period.

The process of an Ijara structure is shown below, although the example in this case is an Ijara wa Iqtina
structure:

2. Lease
property
Seller 1. Sell property Bank (Lessor) Lessee
3. Periodic
rentals

4. Sell property

Prior to entering into the lease transaction, the purchaser, willing to finance the purchase of a Shariah-
compliant asset, negotiates the specifications of the asset with the asset seller. The purchaser contacts
the lessor regarding the financing of the asset based on Ijara.

1. The lessor purchases the asset from the seller and appoints the lessee as its agent to buy the asset
from the seller.
2. The seller delivers the goods as directed
3. The lessor leases the asset to the purchaser.
4. At maturity, if the contract between the lessee and lessor is an Ijara wa Iqtina contract, the ownership
of the asset is transferred to the lessee according to specific terms and conditions as agreed.

5. Partnership Contracts
Partnership contracts can be divided into passive partnerships (Mudaraba) and joint ventures
(Musharaka).

5.1 Passive Partnership (Mudaraba)

The Mudaraba contract is a partnership contract. Mudaraba is the technical term for a ‘managed
partnership’ (a partnership between work – a manager or entrepreneur, and capital – one or more
investors). Islamic banks apply the definition from a Quranic verse in which case it means ‘walking and
travelling the earth’ and believe that this is what the Mudarib should do to seek profitable opportunities.
The method was well known prior to the advent of the message of the Prophet Muhammad (PBUH).

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 Basic Contracts and their Treatment

A good example of Mudaraba is the Prophet Muhammad’s (PBUH) partnership with his first wife
Khadijah prior to their marriage. In this relationship, she provided capital with profit sharing for him
as the manager. The Mudarib, as such, generally does not invest capital, but provides (or invests) skill
and effort. In the event that the Mudarib is a co-investor, the structure is typically known as a bilateral
Mudaraba.

The two forms of Mudaraba are Mudaraba al Muqayyada, or ‘Restricted Mudaraba’; and Mudaraba al
Mutlaqa, or ‘Unrestricted Mudaraba’. The former is for a specific business or place and is contractually
limited by time and place, partner and deal type. In the latter, the manager is free to invest the funds, as
long as the investments and the investment process are Shariah compliant.

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The Mudaraba contract can be depicted as follows:

Investing Partner Business Partner

(Rab al Mal) (Mudarib)

2. Profit and 1. Capital 1. Expertise 2. Profit and

Loss Loss

Project or
Enterprise

Once the contract has been agreed between the partners, the process can be broken down into the
following main components:

1. Inputs
• Capital – the investor, also known as Rab al Mal, provides capital to the project or company.
Generally, an investor will not provide any capital unless a clearly defined business plan is
presented to him. In this structure, the investor pays up 100% of the capital.
• Skill and expertise – the Mudarib or business manager’s contribution to the partnership is his
skill and expertise in the chosen industry or area.
2. Profit and Loss
• Any profits accrued are shared between the partners according to the ratio agreed in the
contract. Any losses are distributed in accordance with the proportion of capital provided.
Due to the fact that the Rab al Mal provides all capital, all losses are solely attributable to him.
The only exception to this is when the business manager has been negligent, in which case he
becomes liable for the total loss.

The Mudaraba contract can usually be terminated at any time by either of the parties giving a reasonable
notice.

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5.2 Joint Venture (Musharaka)
Musharaka (or Shirkah) literally means ‘sharing’. The Musharaka contracts are similar to the Mudaraba
contracts with the difference that, in this case, all partners provide capital as well as skills and expertise
to the project. Profits are shared as agreed in the contract and losses are distributed in accordance with
the proportion of capital provided.

6. Security Contracts

Learning Objective
4.3.1 Know the nature of the security contracts: Hawala; Kafala; Rahn

Security contracts consist of the following types:

6.1 Transfer (Hawala) Contract

Hawala is the transfer of an amount from one person (X – the transferor) to another (Z – the transferee).
The transfer is typically conducted via a trusted intermediary or agent who may charge an administration
fee but this fee cannot be proportionate to the amount transferred. For example, X, who is based in
England, transfers £200 to the account of Y, who is based in Belgium. X instructs the bank to effect this
transfer and the bank charges an administration fee of £20. This administration fee is allowed as long as
it does not vary in accordance with the amount transferred.

The basic Shariah conditions are the absence of delay (Nasi’a) and the absence of excess (Tafadul),
according to Ibn Rushd, with the objective being to avoid Riba and Gharar.

6.2 Guarantee (Kafala)

Kafala refers to the addition of a third-party guarantee to an existing obligation with respect to an
action or a project. This contract makes the third party liable, alongside the original debtor (jointly and
severally), if this was stipulated by the guarantor in the security contract. This means that the debtor and
the guarantor are both liable for the full amount of the debt; for example, if one of the parties declares
bankruptcy, the other will be responsible for the whole debt. Generally, scholars are of the opinion that
the guarantor cannot charge a fee for providing a guarantee per se. However, out of necessity, many
scholars have allowed guarantors to charge administration fees as long as they are not proportionate to
the duration of the guarantee period or the amount of the contract.

Example
Kafala Contract X has borrowed US$3,000 from Z to buy a car. X enters a Kafala Contract with Y (the
guarantor) under which Y agrees to repay Z the US$3,000 if X is unable to pay him. Both Y and X are now
responsible for ensuring Z receives his US$3,000. Y could charge X an administration fee for issuing a
letter of guarantee on his behalf.

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6.3 Collateral (Rahn)

Rahn is a contract in which a creditor/seller prefers to mitigate the risk of default by the debtor/buyer by
taking collateral in the form of a mortgage or pledge against an asset belonging to the debtor (registered
pledge) or by taking physical possession of the pledged asset itself (possessory pledge). The payment of
the claim could be taken from the value of the collateralised asset, which may be sold for this purpose,
if the debtor does not meet the contractual terms of payment. Any surplus proceeds in excess of the
outstanding debt realised from the sale of the pledged asset must be returned to the debtor. A pledge
of collateral has the advantage that the owner of the collateralised asset may continue to benefit from it,
providing that he has the creditor’s consent, while at the same time using it as collateral to enhance his

4
creditworthiness. For example, the owner of a car may continue to use it while providing it as security
for a benevolent loan or for deferred payment under a sale contract. Should the pledged asset become
damaged or destroyed while in the creditor’s possession without any negligence or fault of the creditor,
the creditor will not be held liable as the pledged asset is held by him on trust.

7. The Rules Regarding Foreign Exchange

Transactions (Sarf)

Learning Objective
4.4.1 Know the issues associated with the debate regarding Sarf (the purchase and sale of
currencies)

7.1 Introduction
At the time when the Fiqh al Muamalat was originally developed, money consisted of coins made of
gold, silver and copper, the value of which was related to their weight and the quality. At the time,
there was no paper money and the coins of one country were easily accepted in other countries since
their value was based on weight and the type of metal. Such transactions were subject to the rules of
Sarf (exchange of currency). With the introduction of paper money and coins, whose value no longer
relates to the quantity and quality of metal used to create them, Shariah jurists have had to interpret the
original principles of Fiqh al Muamalat to determine the permissibility of foreign exchange transactions
or transactions in which an amount in one currency is exchanged for an amount in another currency.
Most companies operate in a global economy and have, from time to time, requirements for different
currencies. The rules of Sarf also apply to exchanging different denominations of the same currency (eg,
exchanging a £50 note for two £20 notes and one note of £10).

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7.2 Foreign Currency Dealings in Islamic Commercial
Jurisprudence
Although different opinions exist, the majority of scholars treat currency dealing in a similar way
as buying gold and silver (ie, the ‘foreign currencies’ that existed at the time the Fiqh al Muamalat
was originally developed). These general Shariah rulings related to dealing in currencies have been
incorporated in AAOIFI’s Shariah standards and can be summarised as follows:

• It is permissible to trade in currencies under the following Shariah conditions:

• both parties must take immediate possession (actual or constructive) of the countervalues
• the countervalues of the same currency must be of equal amount
• the contract shall not contain any conditional option or deferment clause regarding the delivery
of one or both countervalues
• the dealing in currencies shall not aim to establish a monopoly position
• currency transactions shall not be carried out on the forward or futures market.
For example, X is going on holiday to Paris and wants to have some euros before he departs. He
can go to his bank or an exchange company and exchange an amount of euros for the equivalent
amount in cash of his own currency. Alternatively, if he has an account with the bank, X can request
his bank to deduct the countervalue from his account.
• The majority of Shariah jurists regard dealing in conventional forward currency contracts as
impermissible, mainly because deferring two exchanged currencies is in violation of the spot
requirement in currency trading. So currency dealings cannot be done as forward sale contracts and,
consequently, must be done as spot transactions.
• It is permissible to hedge against foreign currency exposures by recourse to the following:
• to execute back-to-back interest-free loans using different currencies without receiving or
giving any extra benefit, providing that these two loans are not contractually connected to each
other (commonly known as an exchange of deposits)
• where the exposure is in respect of an account payable, to sell goods on credit, eg, using a
Murabaha transaction in which the currency is not the seller’s own currency
• where the exposure is in respect of an account receivable, to buy an asset or goods on credit,
eg. using a Reverse Murabaha transaction, in which the future payment is in a currency which
is not the buyer’s own currency. Thus, forward currency transactions for hedging purposes
can be synthesised in a way considered by some Shariah jurists to be permissible (subject to
certain conditions) by entering into either a Murabaha or a Reverse Murabaha transaction. The
applicable rules are designed to avoid currency dealings being used as a disguised form of Riba.

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 Basic Contracts and their Treatment

7.3 Sale of Foreign Currencies: Rules Regarding Possession

of the Subject Matter

Learning Objective
4.4.2 Know AAOIFI’s Shariah standards on the sale of currencies

A common type of foreign currency transaction is the spot sale or purchase of a foreign currency by a

4
bank to or from a client. In order to prevent interest, such transactions must comply with a number of
rules regarding possession of the currency. In accordance with AAOIFI’s Standard of Foreign Currency
Dealings, a contract concluded for the spot sale of an amount of currency (ie, a Sarf contract) is
permissible in the following circumstances:

• At the closing of the transaction, both parties take possession of the full amount of the countervalue
in the respective currencies; taking partial possession is not sufficient.
• Possession may be either physical or constructive:
• Physical possession takes place by means of simultaneous delivery by hand, ie, cash-for-cash.
• Constructive possession is deemed to have taken place once the parties have taken possession
of the currency and can transact (Tasaruf) in it at will. Constructive possession can take the
following forms:
1. Debit and credit of a bank account:
a. purchase or sale of a cash amount of one currency against a payment from or to an
account in a different currency (eg, transfer £100 into a US$-based bank account. The
bank account will be credited with the countervalue in US$)
b. when the institution debits, by the order of the customer, a sum of money to the
latter’s account and credits it to another account in a different currency, either with
the same or another institution, for the benefit of the customer or any other payee. A
delay in making the transfer is allowed by the institution, consistent with the practice
whereby a payee may obtain actual receipt according to prevailing business practice in
the markets. However, the payee is not entitled to dispose of the currency during the
transfer period.
2. Receipt of a cheque constitutes constructive possession, providing that the balance payable
is available in the account of the issuer in the currency of the cheque and the bank has
blocked the associated amount for payment.
3. The receipt of a credit card slip by a merchant, signed by the credit card holder (the buyer),
is constructive possession of the amount of currency, providing that the card-issuing
institution pays the amount without deferment (ie, within two working days) to the
merchant on presentation of the credit card slip.

7.4 Agency for the Trading of Currencies

Foreign exchange contracts can be executed using an agent who has the authorisation to take
possession of and deliver the countervalue. In addition, an agent can be appointed to sell currencies
without authorising him to take possession of the amount sold, providing that the principal, or someone
on his behalf, takes possession of the currency at the closing of the transaction.

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It is permissible to authorise taking possession of the countervalues after the execution of a contract of
currency exchange, providing that such possession is completed by the authorised agents at the closing
of the transaction.

7.5 Use of Modern Means of Communication for Currency

Trading
Foreign exchange contracts can be concluded face to face and also using modern communication
means such as telephone, fax and email. As with contracts of exchange in general, an offer transmitted
by one of the prescribed means of communication remains binding on the offeror, but can be time
limited. The contract is not completed until acceptance by the offeree within the prescribed period, and
taking possession (either actual or constructive) of the countervalues, by both parties, has taken place.

7.6 Bilateral Promise to Purchase and Sell Currencies

A bilateral promise to purchase and sell an amount of foreign currency constitutes a conventional
forward transaction and is prohibited if the promise is binding, even for the purpose of hedging against
currency risk. However, a unilateral promise (a promise from one party) is permissible even if it is
binding on the promisor.

The parallel purchase and sale of currencies is not permissible as it incorporates one of the following
invalidating factors:

• There is no delivery and receipt of the two currencies bought and sold and, thus, the contract
amounts to a deferred sale of currency.
• It makes one contract of currency exchange conditional on another. Guarantees for the protection
of currency risk are not permitted between the partners in Musharaka or Mudaraba. However, it is
permissible for a third party to volunteer to act as a guarantor for that purpose, providing that this
guarantee is not stated in the contract.

7.7 Exchange of Currencies in the Form of Currency

Denominated Debts
Settling amounts owed in different currencies between two parties and netting (where one party
pays the difference between the amount he owes and that which he is due from another party) are
permissible as long as all the criteria mentioned above are met.

This covers the following cases:

• Discharge of two debts when one party owes an amount to another party denominated in one
currency and the other party owes an amount to the first party denominated in a different currency,
at an agreed exchange rate (set-off).
• A creditor receiving payment of a debt due to him in a currency different from that in which the debt
was incurred, providing that the settlement is effected as a spot transaction at the spot exchange
rate on the day of settlement.

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7.8 Combination of a Currency Exchange and a Transfer of

Money
It is permissible to execute a financial transfer of money (remittances) in a currency different from that
presented by the applicant for the transfer. It is also permissible for the institution to charge a fee for the
transfer.

7.9 Forms of Dealing in Currencies via Institutions

It is not permitted for the customer of an institution to enter into currency trading for an amount of

4
money exceeding the amount of money he owns, using credit facilities granted by the institution which
handles the currency trading. In addition, it is not permitted for an institution to lend the customer a
sum of money on the condition that currency dealing must be effected with that institution and not
with any other.

8. Accounting Treatment

Learning Objective
4.5.1 Understand the conceptual framework of International Financial Reporting Standards (IFRS):
the aims of IFRS; the objectives of financial statements; the qualitative characteristics required
from financial statements; the general principles governing decision making and presentation
of financial data; the fundamental accounting assumptions underpinning financial statements

International accounting regulation applies to all types of industry including finance. Depending on the
country of operation of an Islamic bank, it also applies to Islamic financial institutions. As these rules are
designed with conventional financial institutions in mind, they cannot always easily be applied to the
operations of Islamic financial institutions. In order to overcome these challenges, AAOIFI developed a
set of accounting rules and regulations for Islamic financial institutions, including guidance for Shariah
audit and ethics.

8.1 Introduction
The International Financial Reporting Standards (IFRS) are designed to facilitate transparent, consistent
and comparable information dissemination to interested parties. The absence of transparency and
comparability of financial statements has a negative effect on the efficiency of financial markets, hinders
the development of corporate governance best practices and leaves a void in terms of accounting
standards’ benchmarks.

The need for an international accounting reference has been emphasised in order to:

• facilitate the comparison of financial information across different accounting periods and
jurisdictions

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• provide financial information readily understood by users of global financial markets with
reasonable knowledge of business and economic events
• contribute to the development of financial markets by using a financial language which emphasises
the principle of transparency of financial statements, thereby enhancing the information quality.

The objectives of the IFRS are mainly to:

• ensure efficient functioning of the financial markets

• protect investors and provide an added layer of security for all stakeholders
• preserve confidence in the financial markets.

In addition to setting objectives of general purpose reports, the conceptual framework also sets the:

• qualitative characteristics
• general principles
• basic assumptions.

8.1.1 Qualitative Characteristics

In order to determine usefulness, financial information must be characterised by both relevance
and faithful representation. Usefulness is also enhanced through comparability, verifiability,
understandability and timeliness.

• Relevance – information in financial statements is relevant when it influences the economic

decisions of users. Such influence is determined by the predictive value and/or confirmatory value
(feedback value) of information. Materiality is a component of relevance. Information is material if its
omission or misstatement could influence the economic decisions of users.
• Faithful representation – information should be presented in a way that reflects its substance
rather than its legal form. This representation should hold three characteristics: complete, neutral
and accurate. Although completeness cannot possibly be achieved, the reported information
should at least cover all material economic events. At the same time, this representation should be
free of bias (ie, neutral) and accurate (ie, free of error).
• Comparability – in order to facilitate the users’ decision-making process, information should be
able to identify the similarities and differences between peer group entities and between different
periods of the same entity. Users should, therefore, be able to compare the financial statements
of an entity over time so as to be able to identify trends in its financial position and performance.
In addition, users must be able to compare the financial statements of different entities within
the same economic activity. Comparability does not, however, mean uniformity, and users can
still compare between entities who have adopted alternative standards options, as long as those
entities disclose the effect of such selection.
• Verifiability – information is verifiable if different, knowledgeable and independent accountants
reach a similar result when processing the same economic events. This result could be perfectly
identical if those different accountants used the same alternative standard options.
• Understandability – information should be presented in a way that is readily understandable by
users who have a reasonable knowledge of business and economic activities and accounting, and
who are able to analyse this information diligently.
• Timeliness – this means that information should be available for the users within the time period in
which it is most likely to have an impact on their decisions.

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8.1.2 General Principles

The process of selecting the appropriate accounting rule to be applied is governed by the following
accounting fundamental principles:

• Prudence (conservatism) – financial statements should be prepared prudently, eg, items on the
income statement and balance sheet should be assessed conservatively. This principle raises the
issues of impairment and fair value evaluation.
• Substance over form – transactions and other events should be accounted for and presented in
accordance with their substance and financial reality, and not merely their legal form.
Cost/benefit analysis – when selecting the appropriate accounting standard, a trade-off needs to

4
•
be made, taking into account the cost of applying the standard and the benefits of it.
• Consistency – accounting policies should be consistent, from one financial period to another, in
order to facilitate comparability.
• Accrual – the accrual basis of accounting means that revenues are recognised when they are earned
and expenses are recognised when they are incurred, regardless of when the cash transaction
occurred, ie, irrespective of receiving or paying money.
• Matching – this means that expenses are recognised in the period where their related revenues are
recognised. This matching could be done directly (such as cost of goods sold) or indirectly (such as
depreciation of assets).

8.1.3 Basic Assumptions

There are three fundamental accounting assumptions that apply to businesses which are not explicitly
stated in the financial statements of an entity:

• Going concern – the enterprise is considered to be a going concern, meaning that it is expected to
continue to operate for the foreseeable future. It is assumed that there is neither the intention nor
the necessity of liquidation nor of curtailing significantly the scale of operations.
• The accounting unit concept – business transactions or events can be measured and expressed in
terms of monetary units which are stable and dependable.
• The periodicity concept – this assumes that, for reporting purposes, the organisation’s life cycle
can be divided into discrete accounting periods. The periods are of equal length and are used to
measure the financial progress of the business.

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8.2 AAOIFI Standards

Learning Objective
4.5.2 Understand the need for Islamic accounting standards
4.5.3 Know the role and responsibilities of AAOIFI
4.5.4 Understand the conceptual framework of AAOIFI financial accounting statements: the
qualitative characteristics of accounting information

8.2.1 Introduction
The modern Islamic banking and finance industry has shown significant growth since the early
1990s, and this has increased the diversification in the inputs and outputs. In combination with the
introduction of different financial instruments, such as Murabaha and Mudaraba, this has resulted in the
need for additional accounting standards. As the IFRS does not cater for these new developments, the
need for a new standard-setting body arose, which eventually resulted in the establishment of AAOIFI.
This body has been actively involved in developing Shariah, accounting and governance standards, in
conformance with the trend followed by transnational bodies, such as the International Accounting
Standard Board (IASB), the International Organisation of Securities Commissions (IOSCO) and the Bank
for International Settlements (BIS).

In addition to providing regulations in the aspects of accounting, Shariah and audit and governance,
the standards have contributed to the growth of the Islamic banking industry by increasing investor
confidence and dispelling any concerns relating to issues caused by unfamiliarity with the industry, such
as terrorist financing and money laundering.

8.2.2 The Benefits of Sound Conceptual Principles

In today’s global economy, where institutions operate across national boundaries, the ability to use
a consistent set of accounting standards for all purposes has the potential to achieve economies of
scale and to generate considerable cost savings. This reduces not only the costs of preparing financial
statements, but also the costs of auditing and the costs incurred by financial analysts and rating
agencies in assessing Islamic financial institutions. The effect of this may be that less risk has to be
factored in, which, in turn, may lead to a reduction in the cost of capital.

The Islamic banking industry has recognised that these benefits apply equally to them and established
AAOIFI to devise a set of Islamic financial accounting standards. In a number of non-Muslim jurisdictions,
the accounting processes of Islamic financial institutions are governed by the IFRS, the country’s
regulations, local Generally Accepted Accounting Principles (GAAP) and company law. The IFRS and
local GAAP are not geared to include Shariah requirements and do not fully capture the nature of the
financial transactions of Islamic institutions. AAOIFI standards address this shortfall by complementing
the IFRS with its own standards to cater for the distinctive nature of Islamic financial institutions. Solely
applying the IFRS may result in a situation where Islamic financial instruments are reported in a similar
way to conventional financial instruments.

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8.2.3 Background to AAOIFI

In 1992, AAOIFI began with the development of a core set of accounting and Shariah and, more recently,
auditing and governance standards for Islamic financial institutions. AAOIFI works closely with the IASB,
the BIS and other relevant parties. AAOIFI is actively engaging with central banks, banking supervisors
and relevant professional bodies in order to raise awareness of the benefits of adopting AAOIFI
standards as the benchmark standards for Islamic financial institutions in their jurisdiction. Regulators
and supervisors in a number of countries, such as Bahrain, Syria and Sudan, have made AAOIFI standards
mandatory for Islamic banks, while others, such as those in Saudi Arabia, are specifying AAOIFI standards
as guidelines. Qatar has issued accounting standards based on both AAOIFI standards and the IFRS, and

4
the DIFC in the United Arab Emirates has also prescribed AAOIFI reporting for specific categories of
Islamic firms. In Lebanon, Islamic financial institutions are not required to implement AAOIFI standards
but need to follow unique circulars issued by regulators and supervisors that are based on both AAOIFI
standards and Lebanese laws and regulations.

8.2.4 AAOIFI’s Approach

Conventional IFRS accounting standards are applied by AAOIFI in two ways:

1. The basis for its conceptual framework and standards. AAOIFI uses both IFRS and Shariah
requirements to set the standards.
2. The default accounting rule reference. In the absence of an AAOIFI standard, institutions have the
obligation to apply the IFRS unless otherwise stated by the institution’s jurisdiction/country.

In line with IASB, AAOIFI’s conceptual framework provides a guideline for general practice and setting
standards, and includes the same components as IASB’s conceptual framework – objectives, purposes of
the standards and the general purpose reports. In addition, the framework of AAOIFI covers:

• qualitative characteristics
• basic assumptions
• measuring concepts.

It is important to note that there is disagreement among scholars regarding AAOIFI’s approach in
setting standards, as some state that standards should solely be derived from Shariah principles
and there should not be any dependence on the IFRS. It is essential to understand that the Financial
Accounting Standards (FAS) apply the basic principles of financial accounting, as appropriate, to Islamic
financial transactions and Islamic banks. These concepts or basic principles are, while strongly rooted
in internationally accepted accounting standards, consistent with the broader view of Islamic principles
– a view which does not require that a concept always needs to be derived from Shariah. Islamic
thought accommodates for principles not specifically stated in Shariah as long as they are beneficial or
unharmful to society and do not violate any precept of Shariah.

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8.2.5 Qualitative Characteristics of Accounting Information
AAOIFI specifies that accounting information should possess the following characteristics:

• Relevance – the information should be relevant to the decision-making process of all users of
financial statements. This characteristic requires that the information meets the following three
criteria:
• Predictive value – the user can use the information to make predictive statements regarding
the financial situation of the entity.
• Feedback value – the user can use the information to verify the accuracy of his previous
predictions.
• Timeliness – the information should be reported in due time in order to provide the user with
up-to-date information that supports the decision-making process.
• Reliability – reliable information tends to increase the confidence in the financial statements. To be
reliable, six sub-characteristics should be fulfilled:
• Faithfulness of representation – information should reflect what it purports to represent, ie,
the information should reflect reality.
• Neutrality – accounting information should be presented without bias and without providing
preferential information to some users at the expense of others.
• Substance and form – contrary to the IFRS, which states substance over form, AAOIFI’s view is
that substance should be no different than form; Shariah rejects any conditions, covenants or
clauses that cause the substance or economic reality of the transaction to differ from its legal
form.
• Completeness – information should be complete and given appropriate attention to cost/
benefit. For example, significant information should not be omitted on the basis of cost.
• Verifiability – any accountant should be able to reach the same results when processing the
same data and using the same accounting convention or methodology.
• Consistency – in order to enhance comparability over time, there should be consistency in
adopting accounting standards over the years, and any change should be disclosed along with
its effect.
• Comparability – as with financial reporting under the IFRS, comparability is an important qualitative
characteristic under AAOIFI standards. Comparable financial information allows users to identify
similarities and differences in an entity’s performance in relation to its own previous results and to
those of its peers.
• Understandability – accounting information should be readily understandable by the users in
order for it to be useful for the decision-making process.
• Prudence – caution should be exercised when making estimates. This principle caters for
uncertainties that might arise in order not to overestimate the assets and revenues nor underestimate
expenses and liabilities.

Similarly to the IFRS, when analysing a new financial situation, the FAS stresses two important factors
when selecting the appropriate accounting policies: materiality and cost/benefit analysis.

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8.2.6 Basic Assumptions

AAOIFI has defined a series of basic assumptions that are applicable in all financial statements of banks
following the standards, without the need for continuously disclosing them.

• The accounting unit concept – Islamic jurisprudence recognises the limited liability company,
which allows an Islamic bank to be treated as a separate accounting unit from its owners. In other
words, an Islamic bank can be a separate entity from its owners in terms of assets and liabilities.
The Council of the Islamic Fiqh Academy has declared: ‘there is no objection in Shariah to setting up
a company whose liability is limited to its capital for that is known to the company clientele and such
awareness on their part precludes deception’ (Resolution 130 (14/4)-C).

4
• The going concern concept – like the IASB, AAOIFI recognises the concept of the going concern.
This concept means that a business will continue to operate for the foreseeable future and there
is no intention to liquidate it or to reduce its scale of activities drastically, with the exception of
companies accounted for as not being a going concern. Unless there is evidence to the contrary,
financial accounting assumes the entity is a going concern and, in preparing the entity’s financial
statements, there is no intention or necessity to liquidate the entity. This concept is of importance
for the accounting measurement method. Due to the entity being conceived as a continuous stream
of activities, the measurement method enables the assessment of the real value of its assets without
waiting for liquidation in the market.
• The periodicity concept – this concept assumes that, for reporting purposes, the organisation’s life
cycle can be divided into discrete accounting periods. The periods are of equal length and are used
to measure the financial progress of the business. This concept is persistent within GAAP and is also
accepted by AAOIFI.
• The stability of the purchasing power of the monetary unit – AAOIFI assumes stability of the
purchasing power of the monetary unit. The IFRS, and similar accounting principles, also assume
the stability of the monetary unit, with the exception of inflation accounting standards, such as the
standard on financial reporting in hyperinflationary economies. AAOIFI has not issued a standard to
cater for this effect and there has been no call for such a standard in countries where Islamic banks
operate.
• Accrual Accounting – similar to IFRS, accrual basis accounting is one of the basic principles of
AAOIFI standards, which means that revenue should be recognised when realised, and costs should
be recognised when incurred. There are three conditions for the realisation of revenue:
1. The institution has earned the right to receive the revenue.
2. There is an obligation on the part of the other party to remit the revenue.
3. The amount of revenue should be known and collectible with a high degree of certainty.
These conditions indicate the preference for accrual accounting rather than cash accounting.
Revenue recognition on the basis of accrual accounting meets the Islamic requirement to determine
the real financial performance of an entity. In addition, expenses are recognised either because
the expense relates directly to the earning of revenues or because it relates to the period when
the expense is incurred. This results in the matching principle which, from the Islamic perspective,
results in fairness and justice simultaneously to the shareholders and other stakeholders because it
allocates expenses to their related revenues.

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8.3 Zakat

Learning Objective
4.5.5 Know the methods of calculating Zakat and the accounting treatment

8.3.1 Calculation
Persons possessing more than a specified minimum level of wealth (known as Nisab), usually over a
period of one year, have to pay Zakat, an obligatory charitable tax. The Zakat rate is determined by using
2.5% for a lunar calendar year and 2.5775% for a solar calendar year. Two methods can be used for the
calculation of the Zakat base:

1. The net asset method.

2. The net invested method.

Net Asset Method

The Zakat base is determinable by:

+ Assets subject to Zakat (including cash, cash equivalent, net receivables, trading assets, financing assets)
– Liabilities to be paid during the year ended on the date of the financial statements.
– Equity of investment account holders
– Minority interests
– Equity owned by governments
– Equity owned by endowment funds
– Equity owned by charities
– Equity of non-profit organisations, excluding those owned by individuals.

The following conditions apply:

• Financing assets should be included net of provisions and funds used to acquire fixed assets related
to these financing assets.
• Assets acquired for trading are measured at their cash equivalent value on the date Zakat is due.
• Consideration should be given to the Nisab (the Zakat base) specific to some assets (agricultural
products and livestock).

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Example

Zakatable Assets In millions (US$)

Cash and cash equivalents 1,000
(+) Net receivables (Murabaha, Salam) 1,170
(+) Mudaraba financing 250
(+) Istisn’a financing 150
(+) Musharaka financing 160

4
(+) Assets for trading (marketable securities, inventory, real estates
400
and other assets)
Total Assets 3,130
Customer current accounts 100
Due to banks and financial institutions (due to be paid during the
300
next financial period)
Other liabilities (due to be paid during the next financial period) 90
Equity of investment account holders 2,000
Minority interests 40
Government and endowment funds equities 10
Total liabilities (due to be paid during the next financial period) 2,540
Zakat base = 3,130 – 2,540 590
Zakat due to be paid for the period – lunar calendar year = 590 x 2.5% 14.75
Zakat due to be paid for the period – solar calendar year = 590 x 2.5775% 15.21

Net Invested Funds Method

The Zakat base is determined by:

+ Paid-up capital
+ Reserves
+ Provisions not deducted from assets
+ Retained earnings
+ Net income
+ Liabilities not due to be paid during the year
– (Net fixed assets + investments not acquired for trading + accumulated losses).

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Example

Zakatable Assets In millions (US$)

Owners’ equity 340
(+) Difference between cash equivalent value and book value of asset
50
for trading
(+) Payables (not due to be paid during the next financial period) 600
(+) Provision for investment risk 10
(–) Government and endowment funds equities 10
(–) Investments (not for trading) 50
(–) Other assets for rents 250
(–) Net fixed assets 100
= 590
Zakat due to be paid for the period – lunar calendar year = 590 x 2.5% 14.75
Zakat due to be paid for the period – solar calendar year = 590 x 2.5775% 15.21

8.3.2 Accounting Treatment of Zakat

Cases in which an Islamic bank is obliged to pay Zakat
When an Islamic bank is obliged to pay Zakat, the Zakat shall be treated as a non-operating expense of
the Islamic bank and included in the determination of net income in the income statement.

The bank is obliged to pay Zakat when:

• the law requires the Islamic bank to satisfy the Zakat obligation
• the Islamic bank is required by its charter or by-laws to satisfy the Zakat obligation
• the general assembly of shareholders has passed a resolution requiring the Islamic bank to satisfy
the Zakat obligation.

Unpaid Zakat is treated as a liability and presented in the liabilities section in the financial statements of
Islamic banks.

Cases in which the Islamic bank is not obliged to pay Zakat

• When shareholders ask an Islamic bank to act as agent in meeting the Zakat obligation relating to
their investment in the Islamic bank from their share of distributable profits, Zakat is deducted from
the shareholders’ share of distributable profits.
• When shareholders ask an Islamic bank to act as agent in meeting their Zakat obligation, and
the Islamic bank agrees to do so, even if there are insufficient distributable profits to meet the
shareholders’ obligations, the amount paid by the Islamic bank is recorded as a receivable due from
these shareholders.

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 Basic Contracts and their Treatment

Zakat due from an Islamic bank, as well as amounts of Zakat received from other sources of funds, are
presented in the statements of sources and uses of funds in the Zakat and charity funds.

8.4 Form and Substance

Learning Objective
4.5.6 Understand the relationship between form and substance of contracts

4
The terms ‘form’ and ‘substance’ are typically used when referring to financial statements and how they
reflect the transaction – form refers to the legal form of the transactions and events while substance
refers to the financial reality of the transaction. In Western financial accounting, the practice of
substance over form generally prevails. This means that, if a transaction looks and behaves like a loan
with interest (substance), even though it has a different legal guise (form), it should be reported as a
loan with interest. From a Shariah perspective, both form and substance are important to observe but,
occasionally, necessity and societal circumstances may warrant prioritising one over the other.

The general position of AAOIFI is that substance is important but is not always overriding.

9. Concluding Remarks
The role of Islamic (or Shariah-compliant) contracts (nominate contracts) in Islamic finance cannot be
overemphasised. The various financial instruments and structures used in Islamic finance all have their
basis in these contracts. Combinations of them are used to create the structures needed for major
project financing and for Islamic securitisations (Sukuk issuances). This raises issues regarding the legal
enforceability of these contracts in various jurisdictions. In principle, an Islamic contract that meets the
requirements for validity discussed in section 2 of this chapter should be more readily enforceable as a
contract in a common law jurisdiction, such as the UK and most of the US, than in civil law jurisdictions
which may impose statutory conditions that may not be met. Hence, it is common practice in major
international Islamic financing transactions to stipulate that the law of one of the former jurisdictions
(eg, UK law or New York law) will be the governing law for the transaction. However, problems regarding
the enforceability of security contracts (see section 6 of this chapter), such as obtaining possession of
collateral among others, may still remain.

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 End of Chapter Questions

1. What is Aq’d?
Answer reference: Section 2.1.1

2. List the conditions that affect contracts.

Answer reference: Section 2.1.2

3. What are the five Shariah options of sale?

Answer reference: Section 2.2

4. Describe the validity classifications ‘enforceable’ and ‘unenforceable’.

Answer reference: Section 2.3.2

5. What is the key difference between bilateral and unilateral contracts?

Answer reference: Section 2.3.3

6. Describe the Salam transaction and how it differs from Murabaha.

Answer reference: Section 3.2.3

7. How is an Islamic lease best described?

Answer reference: Section 4

8. Describe the difference between restricted and unrestricted Mudaraba.

Answer reference: section 5.1

9. Describe the difference between Kafala and Rahn.

Answer reference: sections 6.1 and 6.2

10. What are the main objectives of the IFRS?

Answer reference: Section 8.1

11. What is the meaning of accrual accounting?

Answer reference: Section 8.1.2

12. List AAOIFI’s basic assumptions.

Answer reference: Section 8.2.6

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Chapter Five

Financial Contracts and

Techniques Applied by
Islamic Banks

5
1. Introduction 91
2. Types of Contract 91
3. Sources of Funds 92
4. Uses of Funds 96
5. Predictable Return versus Profit-Loss Sharing Modes of Finance 97
6. Wakala (Agency Contract) 98
7. Mudaraba – Shariah Standards 99
8. Musharaka – Shariah Standards 106
9. Murabaha – Shariah Standards 111
10. Ijara and Ijara Muntahia Bitamleek – Shariah Standards 119
11. Salam and Parallel Salam – Shariah Standards 121
12. Istisn’a and Parallel Istisn’a – Shariah Standards 124
13. Off-Balance Sheet Financing (Letters of Credit) 126
14. Application of Wa’d 127
15. Other Contracts 128
16. Summary of Certain Islamic Contracts 128

This syllabus area will provide approximately 25 of the 100 examination questions
90
 Financial Contracts and Techniques Applied by Islamic Banks

1. Introduction
The ban on Riba (explained in chapter 3) results in a situation where earnings and wealth creation must
be linked directly to an economic activity, such as investment, leasing and sales. Under Islam, money
cannot generate money; instead, it is a means to support business activities. In conventional finance,
money can be used to generate more money, by charging interest on loans or speculation. Islamic
finance acknowledges time value of money within the context of economic activities that create wealth,
such as trade and production.

This chapter builds further on the theoretical basis for the different transaction types and shows how
they are used by Islamic financial institutions. The chapter begins with an overview of where funds
come from (individuals and institutions depositing and investing money) and how they are applied or

5
utilised (in profit sharing and project financing enterprises). Current developments that are likely to
lead to the expansion of the Islamic banking industry are included towards the end of this chapter, but
the emphasis here is to explain the practical mechanics and Shariah basis of these activities. Specific
examples are provided throughout the text.

2. Types of Contract

Learning Objective
5.1.1 Know the differences between the different types of contracts: debt-based contracts; equity-
based contracts; other types of contracts

As outlined throughout this chapter, contracts within Islamic finance can be divided into two main
categories: debt-based and equity-based. Debt-based contracts result in a debt being repaid, such as
Murabaha and Salam transactions. Equity-based contracts are those that are based on an underlying
asset or enterprise, such as Musharaka, Mudaraba and Ijara. Other types of contracts that occur in Islamic
financial services are those that are not specifically based on debt or equity and are, for example, Wa’d
(promise) or Arboon (down payment).

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 3. Sources of Funds

3.1 Islamic Financial Intermediation

Learning Objective
5.2.1 Understand the distinction between a conventional bank and an Islamic bank: the relationship
between the bank and its clients; the sources of funds; the use of funds

In conventional banking, the bank acts as a financial intermediary, accepting deposits from clients
and granting loans to others at a higher interest rate than paid to the depositors. The bank generates
profits from commissions, as well as a process known as ‘maturity transformation’, in which short-term,
low-interest deposits are used to lend for longer terms at higher rates. The difference between interest
rates paid to depositors and the interest charged to borrowers is known as the ‘spread’. From a Shariah
perspective, the transformation of deposits into loans does not justify the spread, as this constitutes a
pure return on money, ie, Riba, which is prohibited. In Islam, a return on capital is justified only when
the capital has taken the form of a real (non-monetary) asset, Usufruct, or service. The fact that the
bank has to manage liquidity and credit risk does not constitute a Shariah-acceptable justification for
such a return. In reality, however, businesses and consumers who borrow money use the funds in real
economic activities. Therefore, the banks’ profits are indirectly linked to business economic activities.
On the other hand, when a bank lends money to another bank, who on-lends to yet another bank and
so on, there is no underlying economic activity and, eventually, there will be no profits. From an Islamic
finance point of view, profits must be linked directly with economic activity, thus keeping debt under
control and directing money capital to the most productive uses.

The financial intermediary role of an Islamic financial institution extends to include the responsibility
for identifying projects in which it can invest the customer’s funds. The contract between the customers
and the bank is a type of partnership (Mudaraba) contract in which the bank is the Mudarib (business
manager) and its customers are the Rab al Mal (investors). As a Mudarib or business manager, the Islamic
bank’s prospective income is tied to the underlying transaction and takes the form of a share of the
profit or loss rather than a spread. The profit margin is structured into the transaction.

More significantly, the Arbab al Mal (plural; singular: Rab al Mal) or ‘investment depositors’ are not
lenders or creditors; they are investors. Unlike the structures underlying a conventional current account,
this relationship entitles the depositors to a share of profits as defined in the Mudaraba agreement
and potentially exposes them to a loss of capital. No matter how much the bank mitigates the risks to
which they are exposed by careful selection of investments, investors’ capital (or investment accounts
in an Islamic bank) are ultimately at risk, even if the bank itself remains solvent. This means that an
Islamic deposit account has equity-like characteristics. Figure 1 illustrates the comparison between the
conventional bank and the Islamic bank intermediary functions. The depositors, or more accurately
the named investors, agree to a management agreement (a Mudaraba contract) with the bank (the
Mudarib) who then uses the funds for Shariah-compliant investments.

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 Financial Contracts and Techniques Applied by Islamic Banks

Depositors
Conventional Banks
Lend at 3% Rate Margin @ 5% Loans
Lend at 8%

Islamic Banks

Management

5
Fee
Depositors Business and Investments
Depositors’ share a certain Mandated to invest based
Fund Management
percentage of profits after on the pre-determined
Agreement
deducting the management profit-sharing ratio
fee
Profit or Loss

Figure 1: Conventional versus Islamic financial intermediation (source: M. Ikram Thowfeek, diagram
amended).

The following diagram illustrates the process of how the profit-sharing investment accounts are
compensated for in an Islamic bank:

Sources of Funds Application of Funds

Client Accounts Financing and Investing

– Current – Murabaha
– Savings – Musharaka
– Investment – Mudaraba
– Ijara
Shareholder Funds
– Istisn’a
– Share Capital
– Salam
– Reserves
– Sukuk
Other Funds – Funds
– Off-Balance Sheet
Reserves
(Specific Investments)

Figure 2: Islamic banking – sources and application of funds (source: M. Ikram Thowfeek).

93
Islamic banks offer current accounts allowing customers to deposit funds with the bank. These accounts
cannot earn any profits.

In the case of investment accounts, the bank acts as a manager (Mudarib) on behalf of depositors. When
the bank contributes its own capital (shareholders’ money) to the investments, the bank becomes a
partner (active partner or Sharik) in the transaction and is no longer just the Mudarib. Hence, the bank
only acts as a Mudarib in respect of investors’ money.

Bank and depositors agree on the share of profits for each party. Losses are attributed in accordance
with the capital provided.

Example
Bank A has three investment account holders who have deposited the following amounts:

X = £2,500 (25%)
Y = £4,000 (40%)
Z = £3,500 (35%)

Depositors share 75% of the profits and the bank receives 25%. The bank does not contribute any
capital. In the event the bank makes a profit of £3,000 this will be distributed as follows:

1. The bank receives 25% of the profit = £750

2. Depositors share 75% of the profit = £2,250
a. Depositor X: £562.50, representing 25% of the 75% of the profit.
b. Depositor Y: £900.00, representing 40% of the 75% of the profit.
c. Depositor Z: £787.50, representing 35% of the 75% of the profit.

In the event the bank incurs a loss of £1,000, this will be distributed as follows:

1. The bank does not incur any loss since it has not contributed any capital.
2. Depositors, as the contributors of capital, bear the total loss as follows:
a. Depositor X: £250.
b. Depositor Y: £400.
c. Depositor Z: £350.

The bank may apply different profit-sharing ratios to different accounts, depending on the risks and
periods of time (tenors or terms), as long as the differential is disclosed. The differential may be related to
the amount of funds invested or the mix of funds. For example, an account in which a larger proportion
is held in cash is more liquid and has a lower level of risk. The level of cash held in the account could
differ per term (eg, short-, medium- or long-term accounts could vary in the proportion of cash held).

It is to be noted that Islamic banks are subject to provisions on their profits which affect the final amount
of the distributed returns or profits to investment account holders and shareholders. (See chapter 9 for
more detail on profit reserves.)

The regulatory treatment of investment accounts (discussed further in chapter 9) is, in many countries,
similar to that of conventional client accounts and ignores the equity nature of these accounts.

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 Financial Contracts and Techniques Applied by Islamic Banks

3.2 Current Accounts

Learning Objective
5.2.2 Understand the operation of current accounts in Islamic banking

Like any other instrument, an Islamic current account has to operate under Shariah principles. These are
notable with respect to the application of funds, overdraft facilities, credit card usage and interest either
paid on an overdraft or paid in favour of the client from a deposit.

In a current account, the bank must obtain the permission of the account holder to apply the money
to its operations. The bank effectively borrows the money from the client and is obligated to return the

5
funds on demand or as agreed. The bank bears the risk of the funds and is, therefore, entitled to the
associated returns. No returns are paid on current accounts.

The bank may provide a safekeeping service for valuables or documents, including cash. In this case,
the bank is solely responsible for the safekeeping of the items and will put in place appropriate security
measures. The bank does not guarantee the items.

Typically, an Islamic current account does not include any kind of overdraft facility which is subject to
a predetermined charge, since this would result in Riba. As a consequence, banks will not be able to
process any transaction for an amount in excess of the account balance.

Example
Conventional banks can offer current accounts via Islamic windows. To guarantee Shariah compliance
of the operations, the conventional bank should:

• ensure segregation of funds – Shariah-compliant deposits may not be mingled with the general
funds of the bank and applied to the traditional interest-based lending of the bank. Rather, these
deposits are to be segregated with separate accounts and must be applied solely to Shariah-
compliant transactions.
• submit the relevant information regarding these accounts to a properly constituted Shariah
board – a conventional bank offering Islamic accounts should submit the relevant information
regarding these accounts to a properly constituted Shariah board, whether engaged by the bank or
provided by a third party Shariah adviser (the role of the SSB is described in chapter 9).

95
 4. Uses of Funds

Learning Objective
5.2.3 Understand how funds are used by Islamic banks

Islamic banking is closely aligned with the concept of merchant banking – the concept of conventional
money-lending does not apply in the same way. There are three prospective applications of funds
within an Islamic bank. Foremost among these, and most favoured by Islamic banks, are the deferred
contracts of exchange which are known as fixed-income-type instruments in conventional finance.
Their equivalents in Islamic finance are:

• Murabaha or cost plus profit exchange contract

• Ijara or lease
• Salam or forward sale purchase
• Istisn’a or project finance.

Islamic banks and their regulators prefer these methods due to their predictable returns and relatively
simple implementation (ie, they do not require significant monitoring of the counterparty’s operations
to ensure that the bank receives the returns to which it is contractually entitled). Many Islamic theorists,
on the other hand, prefer the profit-sharing equity methods of Islamic commerce, namely Musharaka
and Mudaraba. Musharaka originally meant ‘general partnership’, but is generally interpreted as any
permitted business combination ranging from unlimited liability general partnerships to limited liability
companies, corporations and most forms of special purpose vehicles. Beyond the risk operations of an
Islamic bank, there are the service-type instruments which include, but are not restricted to, currency-
related services, and agency services.

Profit Area

Asset Finance Equity Services

Murabaha
Hawala
Ijara Musharaka
Sarf
Istisn’a Mudaraba
Wakala
Salam

Figure 3: Islamic techniques which are ideal for business risks

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 Financial Contracts and Techniques Applied by Islamic Banks

5. Predictable Return versus Profit-Loss Sharing

Modes of Finance

Learning Objective
5.2.4 Understand the Islamic banking model and the challenges it faces

Broadly speaking, the Islamic financial model is based on the following transaction types:

• Fixed-income (or mark-up) based.

• Profit and loss sharing.

5
This is contrary to conventional instruments, which are typically based on fixed or variable interest. The
differences in structure are due to the differences between Shariah principles and modern Western
banking practices. The principles of Islamic jurisprudence, as they relate to finance, are well-defined,
although applying the principles to contemporary banking has raised several challenges.

Firstly, Shariah requires the investor or financier to focus on asset or commercial risk in order to earn a
reward. Although the credit rating of the asset or business opportunity must be taken into account, the
starting point is not credit as such, but the actual assets or operations underlying the investment. The
instruments that fit closely to conventional finance are the fixed-income tools of Murabaha and Ijara
which produce the predictable, relatively secure results with which bankers and their regulators are
comfortable. However, these are subject to limitations in their application.

Secondly, the Islamic instruments that are considered ideal for business risks are the profit- and loss-
sharing instruments which are an equity-type instrument. Only relatively recently have profit- and loss-
sharing instruments been implemented in a way that mitigates risks and provides comfort to banking
regulators and credit-driven management (see Figure 3).

There are strong arguments in favour of each of the types of financial instruments mentioned above
but, in the end, the bank’s decision regarding the most suitable offering will mainly evolve around
whether or not they meet the business requirements of their clients, are suitable for the risk controls
in place at a bank, and how they are affected by the Basel III capital adequacy rules. In addition, the
choice of instruments offered depends on the objectives of the financial institution and the nature of
their business. Generally speaking, commercial banks tend to prefer fixed-income type instruments, like
Murabaha and Ijarah, whereas others, such as venture-capital and equity-driven institutions, tend to
be more inclined to use equity-based instruments (Mudaraba and Musharaka). However, institutions
hardly ever use only one type of instrument, since diversity of products is needed to support the
different requirements of clients.

The pricing of fixed-income type instruments, for example, is driven by the creditworthiness of the
client, and can be less attractive to small or starting businesses.

97
 6. Wakala (Agency Contract)

Learning Objective
5.3.1 Know the nature of the Wakala (agency) contract
5.3.2 Be able to apply the Wakala contract

Wakala is an agency contract and is widely applied by Islamic banks and their clients. The concept
ranges from brokerage services in permissible activities to fund management (as an alternative to
Mudaraba) and underwriting management in Islamic insurance to serving as the agent (Wakil) – buyer
or seller – on behalf of a contractor (usually a bank) in several transactions. In principle, an agency
contract is permissible with respect to all activities that are permitted to be discharged by the principal.

There are two types of agency contracts:

• Disclosed agency – in this contract type, the agent discloses his role as agent to others. All
documentation in connection with the subject matter or service undertaken is produced in the
name of the principal. This is considered to be the preferred contract type.
• Undisclosed agency – in this contract type, the agent does not disclose that he acts on behalf of
another party and, to all intents and purposes, he is acting as principal in dealing with third parties.
For example, if A appoints B as his agent, and B buys a car from C for 10,000 dinars on credit and
does not disclose to C that he is acting as an agent for A, C can then only claim his money from B.
However, if B discloses that he is acting on behalf of A then C shall claim his money directly from A
and, therefore, shall bypass B. Applying this rule of agency to Islamic banks leads to the following
situation. A bank appoints an agent, X, to procure specific goods on its behalf from a supplier. Acting
as the bank’s agent, X buys the goods but does not disclose the name of the bank for which he has
bought them. In this case, the suppliers cannot claim payment from the bank; they must make their
claim to X.

Furthermore, it is important to note that the agent has a fiduciary responsibility and hence acts as trustee
in holding the assets of the principal or in executing the service. Accordingly, an agent cannot be held
liable for any loss or damage pertaining to the assets, or for any liability arising from the performance
of the agency contract, unless such loss, damage or liability was caused by the agent’s negligence,
misconduct or breach of the terms of the agency agreement. Similarly, the principal is responsible for all
costs and expenses incurred by the agent in performing the work agreed under the contract and must,
therefore, reimburse the agent accordingly.

Wakala contracts can be used in combination with a wide range of Shariah-compliant transactions.

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 Financial Contracts and Techniques Applied by Islamic Banks

7. Mudaraba – Shariah Standards

7.1 Application of the Mudaraba Contract

Learning Objective
5.4.1 Be able to apply the Mudaraba contract to deposits

7.1.1 Application of the Mudaraba Contract to Deposits

5
Islamic banks usually use Mudaraba contracts with clients who deposit their money using, what is
generally known as, an investment account. In an investment account, the funds are placed with
the bank with the expectation of a return. The bank uses these funds in its capacity as Mudarib, and
provides an anticipated, though not guaranteed, return. This is comparable with savings accounts in
conventional banks, where the bank lends out depositors’ money with a view to generating a higher
return than the deposit rate. Islamic banks invest clients’ money on their behalf.

International banking typically defines saving accounts as deposit accounts with capital protection.
Deposit guarantees are provided by a third party and are generally limited to a maximum amount. In
non-Muslim countries, this deposit guarantee is usually also applied to Mudaraba deposits, since the
economic reality of the transaction is deemed to be the same as conventional savings accounts. The
deposit guarantee is normally defined as a national insurance scheme. In Islamic banking, deposit
insurance could, for example, be implemented through Takaful or Islamic cooperative insurance.

The Process
• The client places his money in an Islamic bank account. In this case, the clients are considered as
Investment Account Holders (IAHs) and are the Arbab al Mal.
• The Islamic bank, as Mudarib, invests the IHAs money in Shariah-compliant businesses.
• The IAHs can choose between Unrestricted Investment Accounts (UIAs) and Restricted Investment
Accounts (RIAs) – these are covered further in section 7.4 of this chapter.
• In an attempt to increase the Islamic bank’s responsibility in its investment selections, Shariah
scholars usually advise the Islamic bank to invest part of its capital together with the IAHs’ money in
the Mudaraba activity. Islamic banks can also be capital providers (Rab al Mal) in Mudaraba activities.
The risk can be reduced by reviewing a feasibility study or business plan drawn up by the Mudarib
and by obtaining collateral or a third party’s guarantee. Collateral and third-party guarantees can
only be enforced in the event of gross negligence or breach of contract by the managing partner
(Mudarib). The two primary parties in a Mudaraba are the managing partner, or Mudarib, and the
investor, or Rab al Mal (literally ‘owner of the capital’). The Mudarib is a fiduciary and does not share
in losses unless the Mudarib is also a co-investor (in a bilateral Mudaraba). The Mudarib’s investment
of skill and effort is subject to the opportunity loss of both his time and his efforts. As managing
partner of the investment or business activity, the Mudarib alone is empowered to make business
decisions. The Mudarib may earn a wage under the investment agreement for performing specific
tasks. Typically, the Mudarib expects to recover his or her expenses from the ordinary proceeds of
the Mudaraba.

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7.2 Returns in a Mudaraba Contract

Learning Objective
5.4.2 Understand the roles of, and the returns received by, the Rab al Mal and Mudarib under a
Mudaraba contract

The Rab al Mal (the investor) is the sole party obligated to contribute capital (Ras al Mal). As a financial
investor, the Rab al Mal has an absolute right to information and to monitor investment activities. In a
typical Mudaraba, the Rab al Mal has the same rights and obligations as a limited partner, a member of
a limited liability company or an investor in a mutual fund company. The investor’s rights are normally
negotiated in advance and defined in the investment management agreement.

In modern Islamic banking, the profit is typically allocated from the business’s gross operating profit
or loss (before deduction of general overhead expenses), rather than the net operating profit or loss.
This is because the Mudarib does not need to be an individual, but can be a firm or a company in which
case the company as a whole acts as the Mudarib. Accordingly, expenses of the company, including
overhead and rent, are not borne by the investor or Rab al Mal.

The termination of a Mudaraba is executed according to the agreement between the two parties. The
parties may agree to terminate the contract while the underlying business is still ongoing. In this case,
net asset value may be pursued as a means to determine the profitability of the business and the share
of each party. The transaction can be exited either by the investor (Rab al Mal) selling his share to a
third party or by the Mudarib voluntarily buying the investor’s share in the business. As a result of its
flexibility, the concept of Mudaraba has become a key organising principle of Islamic banking and asset
management.

7.3 Two-Tier Mudaraba Structure

Learning Objective
5.4.3 Be able to apply the two-tier Mudaraba contract

Islamic banking may be structured in the form of a two-tier Mudaraba whereby the bank collects funds
from depositors on a Mudaraba basis and then invests these funds by forming a Mudaraba between the
bank and a client who requires the funds. In order to understand the two-tier Mudaraba structure, it is
important to first consider how the Mudaraba can be applied with the Islamic bank in the role of the
investor.

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 Financial Contracts and Techniques Applied by Islamic Banks

7.3.1 Application of the Mudaraba in Financing

In addition to the application of a Mudaraba transaction to deposit-taking activities, it can equally be
applied when providing financing. In this case, its application is similar to a direct investment. In this
case, the Islamic bank fulfils the role of the Rab al Mal, which occurs when the bank invests in other
investments as depicted in Figure 4 below.

Shariah-compliant Shariah-compliant Shariah-compliant Shariah-compliant

investment investment investment investment

5
Profits and losses
Bank
(Rab al Mal)

Figure 4: Mudaraba contract

1. Client and Islamic bank enter into a Mudaraba agreement. The latter acts as Rab al Mal (an investor
who provides the capital). The client acts as a Mudarib (an entrepreneur who gives his expertise to
the project).
2. The project‘s profits (if any) are distributed among the two Mudaraba parties (Rab al Mal and
Mudarib).
3. Profits are distributed according to a predefined ratio agreed between the two parties in the
Mudaraba agreement. In case of any loss, material losses are borne by the Rab al Mal only.

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Example

An engineer embarks on a The engineer (the Mudarib) Periodically, the Mudarib and
project to construct a bridge negotiates the terms of the the bank assess the project’s
and needs a partner to provide contract with the bank: the performance. If the project
all the capital for the project. amount the bank will invest performs according to plan,
He approaches a bank with in the project and the profit the bank will recover its
a business plan including a sharing ratio between the capital and profits. Profits are
feasibility study and a cash engineer and the bank. shared between the bank and
flow statement. The bank the Mudarib according to the
The Mudarib contributes
assesses the plan and the pre-agreed ratio.
expertise and management
feasibility of the project and
of the project. The bank Profits can be distributed
enters into a profit-sharing
contributes all the capital periodically as long as the
agreement (Mudaraba) with
(either in a bullet payment or bank’s capital is assured.
the engineer.
in tranches depending upon
If the project makes a loss, the
the nature and requirements
bank bears the loss. Only if the
of the project).
engineer (the Mudarib) has
The bank issues investment been negligent will he be held
deposit certificates/Mudaraba liable for the loss of capital.
certificates to customers
contributing capital.

The application of Mudaraba finance requires a different set of skills and expertise from the bank in
comparison with conventional debt financing.

Shariah-compliant Shariah-compliant Shariah-compliant Shariah-compliant

investment investment investment investment

Rab al Mal

Profits & Losses

Bank Mudarib/Wakil
Profits & Losses

Rab al Mal

Depositor Depositor Depositor Depositor

Figure 5: Two-tier Mudaraba structure

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 Financial Contracts and Techniques Applied by Islamic Banks

Example
Two-Tier Mudaraba

First Mudaraba Contract

Investors deposit US$200,000 with Islamic Bank under a Mudaraba contract for a period of 12 months
and a profit allocation set out in the agreement as 80% to the investors (Arbab al Mal) and 20% to Islamic
Bank (as Mudarib). The investors receive Mudaraba Certificates (investment deposit certificates) in
exchange for their deposits.

Second Mudaraba Contract

Islamic Bank (as Rab al Mal) invests the US$200,000 in Islamic Enterprises (the Mudarib) to build a new
factory. Islamic Enterprises contributes its expertise in managing the project, but no capital. Islamic

5
Enterprises is responsible for the day-to-day management of the project and will receive a share of the
profit of the development. Islamic Enterprises’ Mudarib share is based on a percentage of the profit
and agreed to be 20%. At the end of the Mudaraba, when the factory is completed, it is sold at a pre-
agreed amount of US$220,000. Islamic Bank recovers its US$200,000 capital and the US$20,000 profit is
returned as follows:

• US$4,000 (20%) to Islamic Enterprises, (as Mudarib).

• US$16,000 (80%) to Islamic Bank (the Rab al Mal).

Under the first Mudaraba contract, the US$16,000 profit is distributed between Islamic Bank (as Mudarib)
and the depositors (as investors) as follows:

• US$12,800 to the investors (80%).

• US$3,200 to Islamic Bank as Mudarib (20%).

If the factory is sold at a lower amount than expected, the loss is passed on to the depositors.

The Mudaraba contract is frequently applied to the syndication of large Islamic transactions involving
multiple banks and investors. The Islamic bank has a strong incentive to perform well because, even
though it does not bear the loss, it will still incur expenses of its own, such as overheads and rental.

7.4 Restricted and Unrestricted Investment Accounts

Learning Objective
5.4.4 Understand the nature of restricted and unrestricted investment accounts

The two forms of investment accounts in Islamic banks are restricted and unrestricted investment
accounts. A restricted investment account is contractually limited by one or more restrictions, such
as term to maturity, geographical location, transaction type and partner. The restrictions are agreed
between the parties. In an unrestricted investment account, the manager has the flexibility to invest
the funds within a wide range of activities the bank is involved in, as long as the investments and the
investment process are Shariah compliant.

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7.4.1 Restricted Investment Account Holders (RIAHs)
Restricted investment accounts are a type of collective investment scheme (CIS) in which:

• the asset allocation is restricted as set out in the contract

• there is no secondary market, but investors may be able to withdraw their funds (including
undistributed profits but less any losses) before maturity on account basis as unearned income, with
the agreement of the bank.

In many Islamic banks, the restricted investment account is not implemented through a separate legal
entity such as an investment company or trust but operates under a Mudaraba or Wakala contract,
with the bank as Mudarib or Wakil (agent). In other Islamic banks, restricted investment accounts are
structured as dedicated investment funds which are held off-balance sheet.

During a financial period, the bank is entitled to a percentage share of the investment income (the
Mudarib’s share) for investment management but does not share in losses, with the exception of losses
associated with the capital it has contributed itself.

7.4.2 Unrestricted Investment Account Holders (UIAHs)

Unrestricted investment accounts differ from restricted investment accounts, both from a Shariah
perspective and in terms of their economic function. In a UIAH managed by the bank, the client does
not specify how their funds must be invested or the way in which the investment needs to be taken into
account, as long as the investments are Shariah compliant. Instead, the bank takes on the responsibility
to manage these funds to the best of their ability and the profits are shared between client and bank
in accordance with the contract underlying the transaction. These accounts are subject to complex
governance issues.

The asset allocation of a UIAH is not restricted by contract and the bank can place the funds in any
Shariah-compliant investment at its discretion, subject to its fiduciary duty, ie, its relationship of trust,
to the IAH. This typically includes mingling the UIAH funds with other funds at the bank’s disposal, such
as the bank’s shareholders’ funds and the funds of current account holders. The mingling of funds raises
issues of possible conflicts of interest between the shareholders and the UIAH, with regard to the choice
and riskiness of investments and the allocation of the income from those investments. In principle, the
latter is specified by contract but, because of a lack of transparency in financial reporting and the use of
special-purpose reserves, the management, in fact, has considerable discretion in making this allocation.

Shareholders typically have a higher risk tolerance than the UIAHs, who are likely to be more defensive.
The economic function of UIAHs is to provide a Shariah-compliant substitute for conventional (interest-
bearing) deposit accounts. Conventional deposit accounts are capital guaranteed and enjoy a specified
(fixed or floating) rate of return.

Within the guidelines of Shariah, an investment made on the basis of a Mudaraba or Wakala cannot be
capital-certain. The Rab al Mal is exposed to losses, unless they are due to misconduct and negligence
on the part of the Mudarib. Due to the profit sharing and loss bearing characteristics of the Mudaraba
and Wakala, the rate of return cannot be specified in advance in the same way as an interest payment.

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 Financial Contracts and Techniques Applied by Islamic Banks

The challenge faced by the Islamic financial industry and regulators is to reconcile the Shariah basis
of unrestricted investment accounts with their economic function of providing a Shariah-compliant
substitute for conventional deposit accounts.

This issue has been addressed differently in different countries. In some countries (eg, Jordan, Malaysia
and Qatar), the industry and its supervisor have taken the view that Islamic banks are under some kind
of an obligation to maintain the capital of UIAHs intact and also to pay the account holders a steady
rate of return, similar to that paid on conventional deposits. In Malaysia, the central bank (Bank Negara)
considers explicitly that, since UIAs are marketed as a substitute for conventional deposit accounts,
banks have a constructive obligation by law to maintain the account holder’s capital and to pay them a
steady rate of return on their investment.

In Jordan and Qatar, the position is less explicit and, instead of a constructive obligation in law, there is a

5
commercial obligation of sound banking practice while for prudential matters, such as capital adequacy,
UIAs are treated in effect as conventional deposits.

In other countries, such as Bahrain and other GCC states, the view is that there is no obligation to
maintain the capital of the UIAHs intact or to pay a return as long as the assets in which their funds are
invested have been impaired in the normal course of business. Guaranteeing capital and paying of a
return are considered to be commercial matters associated with the fact that managing IAH funds is
an important source of income for the banks. However, the banking supervisor does consider a failure
to maintain the capital of unrestricted IAHs intact or to pay them returns as bad banking practices
and, therefore, to be avoided. Supervisors fear that such failures may lead to a run on the bank, with
subsequent systemic risk implications. This is typically addressed by enhanced regulations and audits.

In some countries, such as Saudi Arabia, the Islamic banks in general do not offer UIAs. Banks wishing to
offer a deposit-like investment product do so in the form of investment funds, where investors clearly
and explicitly bear the risk of the investment.

In order to obtain a banking licence in the UK, and to be permitted to take deposits, the regulator
requires the facility is capital certain. Firms offering UIAs who wish those to be treated as deposits
under the UK regulator’s definition, have to guarantee the capital. However, the customer has the right
to waive this protection after any loss event has occurred on a voluntary basis. The choice is left to the
customer as to whether or not to opt out of statutory protection and to accept the loss on the UIA, in
order to keep the account Shariah compliant. Firms offering UIAs who do not wish them to be treated
as deposits are not required to offer guarantees on these products. From a corporate governance point
of view, the position of UIAHs in the UK is, therefore, highly ambiguous. The only corporate governance
issues raised by conventional deposits concern the depositors’ rights as creditors in case of default by
the bank (eg, a right to appoint an administrator to manage an insolvent bank on behalf of its creditors).
The situation of UIAHs in the UK is similar. Elsewhere, however, UIAHs are not creditors and do not have
such rights. In fact, the only right they have is that of withdrawing their funds, subject to any contractual
restrictions on their so doing (eg, a notice period and loss of any accrued and undistributed profits).

From the standpoint of transparency, UIAHs are generally in a worse position than RIAHs, since they
are generally uninformed of the asset allocation applied to their funds and the allocation of profits
between them and the bank’s shareholders is generally not transparent and may be manipulated by
the management. Thus, as well as having no control rights, they are not well served in terms of either
information rights or cash flow rights. However, increased competition in the market is likely to change
this situation.

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 8. Musharaka – Shariah Standards

8.1 The Parties to a Musharaka Contract: Provision of Capital

and Management by both Bank and Customer

Learning Objective
5.5.1 Be able to apply the partnership contract of Musharaka

Musharaka transactions generally take either one of two forms: Shirkat al Milk or Shirkat al Aqd.
Shirkat al Milk (or ownership-partnership) is a partnership in which the partners have shared ownership
over a property but none of them manages the property to generate a return or profit. This form of
partnership may be established without a specific contract. The primary limitation of the partnership is
that its object, the underlying property, is not divided or unitised.

Shirkat al Aqd (or contractual partnership) is a partnership by mutually agreed contract in which one
or more of the partners manages the property on behalf of others to generate returns. This is derived
from the principle in Shariah that contractual partnership implies a contract of agency. Musharaka
typically refers to Shirkat al Aqd. Although capital contributions may be in kind or in the form of services
provided, they are typically cash and valued at an agreed par value. The primary basis for the valuation
of contributed capital is mutual agreement between the contracting parties.

Shirkat al Aqd comes in two forms: the permanent, or continuous, Musharaka, and the diminishing
Musharaka contracts.

8.1.1 Permanent or Continuous Musharaka

In this contract, each partner to the Musharaka contract retains their share in the capital until the end
of the project. Any partner can, however, sell their shares in the Musharaka capital to other partners or
to a third party. This contract is used by Islamic banks when investing in a specific project. Similar to the
Mudaraba, the profit ratio is pre-agreed in the contract and losses are distributed in proportion to the
capital provided. When applying Mudaraba or Musharaka, Islamic banks require a feasibility study and/
or cash flow statement for the project as part of the investment decision-making process.

With all methods of Musharaka, the capital is quantified and specific. As with Mudaraba, Musharaka profits
must be shared in the same proportion as set down in the contract. Losses are borne by partners according
to their share in the capital. The profit cannot be structured to give a guaranteed rate or yield to one party.

Example
X and Y are partners in a Musharaka, with X contributing 80% of the capital and Y contributing the
remaining 20%. The agreement specifies that they will share profits in a ratio of 70% to X and 30% to Y,
to reward Y for the work he undertakes for the project. Losses are borne by X and Y according to their
initial contribution of capital (80/20).

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 Financial Contracts and Techniques Applied by Islamic Banks

The process of a Musharaka structure is defined as follows:

1
The Project

Share in capital and expertise Share in capital and expertise

1 1

Partner 1 2 Partner 2

5
Share of profits Share of profits
and losses and losses

Accruing Profits and Losses

3 3
3
Figure 6: Musharaka contract

1. Two or more partners intend to undertake a Shariah-compliant project (eg, to build a manufacturing
plant on land owned by the client) on a Musharaka basis and enter into a Musharaka agreement.
All parties provide capital to the project (the client, for example, provides the land and expertise
in building the manufacturing plant and the bank provides the finances) and have the right to
participate in the project management and operation.
2. The project’s profits (if any) are distributed among the partners. Profits are distributed according to
a predefined ratio agreed between the two parties in the Musharaka agreement.
3. Losses (if any) are born by partners according to their contribution to capital.

A general principle of partnership under Shariah is that partners have the right of pre-emption, unless
the property is tightly defined or there is mutual agreement. This means that, if one party wants to sell his
share, they will first need to be offered to the other partners. This stipulation may be removed by mutual
contract agreement, making Musharaka a more practical proposition for the banking environment.

In theory, every partner may participate in the operating management of the enterprise. Within a
Musharaka, the partners may appoint a deputy to operate the partnership or perform specific functions
of the business. As with the modern corporation, the members of a Musharaka may elect one or more of
themselves or a third party, a non-member, to manage the Musharaka.

Some banks practise Musharaka in a manner similar to Mudaraba and severely reduce the bank’s risk and
operational liability profile. Part of this process of mitigation relates to the process of termination. For
this, the Islamic bank calculates the valuation for interim withdrawal or profit distribution/loss allocation
and advises clients in what is termed ‘constructive liquidation’, ie, the enterprise is not terminated,
rather a member withdraws or sells their position. This is a form of net asset value determination which
seeks to define the price a willing buyer would pay for the assets of the enterprise.

107
Also, similar to the modern corporation, a Musharaka may not be subject to a specific time frame. As
a rule, a Musharaka may not be dissolved without the knowledge of all of its members. Most Islamic
scholars agree that the formal process of notification fulfils this obligation.

Example
Investors place deposits with Islamic Bank, for which it issues them notes of participation, to fund a
Musharaka partnership with Islamic Enterprises to buy a property which is to be rented out. Under
the Musharaka contract with Islamic Enterprises, Islamic Bank provides capital of US$400,000 and
Islamic Enterprises contributes US$100,000. Hence Islamic Bank provides 80% of the capital and Islamic
Enterprises 20%. This joint venture buys the property and successfully rents it out. The rental income is
shared between Islamic Bank and Islamic Enterprises in a ratio of 60% to Islamic Bank and 40% to Islamic
Enterprises. If the property is not rented, the project is not losing cash but is losing an opportunity
return. If the partners decide to sell the property, and the selling price is below US$500,000, then if the
selling price is, say, US$400,000 (loss of US$100,000) the loss is shared 80%:20%; Islamic Bank receives
US$320,000 and Islamic Enterprises receives US$80,000.

8.1.2 Diminishing Musharaka (Musharaka Muntahiya Bittamleek)

Learning Objective
5.5.2 Be able to apply the Diminishing Musharaka contract

Diminishing Musharaka (also called declining balance partnership, or Musharaka Mutanaqisa) has been
a popular tool for banks, with particular success in the property sector. This method is also useful for
pre-export finance and working capital. The Diminishing Musharaka is a special form of a Musharaka
transaction, in which it is agreed at the outset that one of the partners will, over time, purchase units
in the Musharaka venture from one of the other partners at a pre-agreed unit price. At the start of the
agreement, the project is divided into a number of equal units. The purchase can take place gradually
over time at a fixed or increasing number of units per period.

For example, the bank and the client jointly invest in a property that generates rental revenue. The
bank purchases 90% of the property, while the client purchases 10%. In addition, the client promises to
gradually purchase the bank’s share in the property, eg, 30% per year. Once the client has purchased all
the shares, he will be the sole owner. The client promises to purchase the share of the bank at fair value
or at a price agreed at the time of purchase.

The parties jointly own the property or the venture. However, if one partner purchases the share of
another partner, and then immediately resells it to the same partner at a profit, this is considered to be
a form of Inah that is not acceptable in Shariah.

A Diminishing Musharaka may consist of layered contracts and can include binding promises. For
instance, in the case of property, the declining balance partnership is based on a property contract in
which the majority partner is the financier, and the beneficiary of the finance, the client, is the manager
of the property.

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 Financial Contracts and Techniques Applied by Islamic Banks

In the event a client fails to keep up payments on a mortgage under a Diminishing Musharaka, the bank
is technically not in a position to repossess since it owns (part of) the house. However, the bank may
modify the client lease, evict the client or adjust the ownership share to reflect the client’s past due
payments.

For example, X wants to buy a house for his family and enters a Diminishing Musharaka contract with
Islamic Bank. Under the agreement, the Islamic Bank buys 80% of the units in the property and the client
20%. The client promises to purchase shares in the house from the bank over a period of 25 years. The
client rents the part of the property they do not own from the bank. After ten years, X stops making
payments to the bank. Generally, the bank has the following options:

• amend the rental agreement

• evict the client, sell the property and share any profits with the client

5
• adjust the ownership share to reflect the client’s past due payments.

4. 80% of the units

Property Islamic Bank

Seller 4. €80,000
1. Client enters 6. Rent*
into a Musharaka
3. €20,000 3. 20% of the units agreement with
the Islamic bank

Client 2. Unilateral promise to buy shares

5. Sales contracts regarding the units

Figure 7: Example of a Diminishing Musharaka contract for a mortgage contract (Source: Schoon, N. 2016,
Modern Islamic Finance, London: Wiley)

* Rent needs to be adjusted after each acquisition of shares.

109
Client identifies the property and makes an offer of 100,000 which is accepted by the seller.

1. Client enters into a Musharaka agreement with the Islamic bank in which the following is agreed:
• the share of the house the client will initially purchase (in this example 20%)
• the share of the house the bank will initially purchase (in this example 80%)
• the division of the property into equal units
• the length of the rental period.
2. Client provides unilateral purchase undertaking to buy the bank’s share as agreed.
3. Client transfers 20% of the sale price to the seller of the property and receives 20% of the units.
4. Bank transfers 80% of the sale price to the seller of the property and receives 80% of the units.
5. Sales contract is drawn up between the bank and the client governing the sale of the remaining
units which are not currently owned by the client. The transfer of the ownership of the remaining
units can take place gradually over time, at the end of the rental period or as and when it suits the
client (which could be done by a purchase at the end of the Musharaka agreement).
6. Client pays pre-agreed rental payments to the bank. Rental payments can include a component
towards the ownership of the remaining units of the property.

At the end of the contract, the client has full ownership of the property.

Example

A builder enters into a The builder and the bank On conclusion of the project,
project to renovate a block negotiate the term of the the builder and the bank assess
of flats and approaches the Musharaka contract: the the profits. In a continuing
bank for capital. amount of capital each Musharaka, the builder and the
will invest in the project, bank share the rental income
Based on a business plan or
the profit-sharing ratio from the flats in accordance with
equivalent documentation
between the parties, the the agreed proportions – which
the bank enters into
responsibilities of the builder may differ from the ratio of
an equity participation
and the bank for managing capital contributions. Losses are
agreement with the client.
the project. shared by the builder and the
The bank may issue bank according to their capital
notes of participation to contributions.
investors.
In a Diminishing Musharaka, the
builder will buy out the bank’s
share in the property over a
period.

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 Financial Contracts and Techniques Applied by Islamic Banks

9. Murabaha – Shariah Standards

9.1 Murabaha: The Instalment Deferred Sale Contract

Learning Objective
5.6.1 Be able to apply the Murabaha contract

Most Islamic financial institutions base their banking operations on Murabaha as their method of
financing activities. Murabaha refers to a particular kind of sale transaction in which a seller sells an asset
to a buyer, at cost, plus a profit mark-up. Cost price and mark-up are known to both buyer and seller.

5
As an example, X, the seller, agrees with Y, the buyer, that Y will buy 100 kilograms of apples from X for
£120, where the cost of the apples to X was £100 and X has added £20 profit. This example makes clear
that when using Murabaha, the seller discloses to the buyer the actual cost incurred in buying the asset
and the profit added.

Bank or Bank’s Agent Customer

Delivers at £100 Pays in one year £120

Figure 8: Murabaha

The payment in a Murabaha transaction may be at spot or at a later date agreed upon by the parties.
Murabaha does not necessarily imply the concept of deferred payment although, when Murabaha
transactions are used as a method of financing, payment is typically deferred. Murabaha can be used as
the method of finance only when a client purchases the goods with a deferred payment. For example,
if Y needs to purchase apples as an ingredient to make apple pies in his bakery, but lacks the necessary
funds to do so, the bank can purchase the apples from the supplier on the basis of spot payment and
then sell them to Y on a deferred payment basis.

The bank does not typically choose to be a principal and instead appoints an agent. The agent could be
the ultimate buyer or a third party. The process of a Murabaha structure is defined in Figure 9.

1. Binding
3. Pay spot promise to
purchase
Supplier Bank/Investor Purchaser
2. Deliver goods 4. Sell goods

5. Pay deferred

Figure 9: Murabaha contract

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Prior to the start of the contract, the buyer of the goods defines their requirements and negotiates the
specifications and characteristics of the goods with the seller in advance. Goods should be permissible
in Shariah.

1. The buyer promises to buy the goods from the Islamic bank. The promise could be binding or not
depending on the agreement between the two parties. In practice, the promise is deemed binding
which is reflected in AAOIFI’s standards. The Islamic bank may ask the customer to provide a down
payment in the form of earnest money (Hamish Jeddiyah). This payment shows the buyer’s good
faith in the transaction. Upon signing the Murabaha, the down payment becomes part of the agreed
price and thus reflects on the total price.
2. The Islamic bank enters into a sales contract with the seller and buys the goods as agreed between
the buyer and the seller (pre-step 1). Islamic banks can either buy the goods directly (as principal) or
appoint an agent to buy the goods.
3. The seller transfers the ownership of the goods to the Islamic bank, who becomes the owner of the
goods, and, therefore, bears ownership-related risks. Due to the ownership transfer, the Islamic bank
is eligible to earn profits.
4. The Islamic bank enters into a deferred-payment sale agreement with the ultimate buyer and sells
the goods to the buyer at a higher, deferred price (price with a mark-up).
5. The buyer pays the Islamic bank the agreed amount on the specified future date.

When used by a bank, the typical Murabaha agreement is a purchase and sale agreement between
the bank and its client. If the bank is unable or unwilling to buy the goods for reasons such as legal
restrictions or insufficient knowledge about the goods to be purchased, the bank may execute an
agency agreement appointing the client as its agent to buy the goods. According to AAOIFI, this should
be limited to situations where the Islamic bank is unable to undertake the transaction directly or through
an independent agent with the seller. When the client acts as an agent, the technical ownership of the
goods resides with the bank. The agency agreement typically incorporates inspection of the goods by
the agent of the bank and a waiver of inspection for the purchase and sales agreement between the
bank and the buyer. The bank may seek appropriate security for the payment in the form of a guarantee,
lien, charge or mortgage.

In the event that a Murabaha is structured as a deferred sale contract, the transaction date and the
payment date must clearly be defined. Collateral in the form of a registered lien, charge or mortgage is
permissible and the sold goods or property may be reclaimed in the event of foreclosure or other form
of legal seizure. In the event of late payment, the seller may not claim a late payment fee or penalty
charge, although the actual cost associated with the recovery of the payment can be charged. If a bank
decides to charge a penalty, the bank may not benefit from it and any amount over and above the actual
cost incurred to recover the funds must be donated to charity.

Various risk mitigants are used against the risk of such losses, in the form of Hamish Jeddiyah (earnest
money) retained in part or entirely to cover any loss, or Arboon (a non-returnable down payment). In the
context of Murabaha, Hamish Jeddiyah applies after providing the promise to purchase but before the
parties enter into the actual Murabaha contract. Arboon is a non-refundable deposit, which is provided
by the purchaser after the Murabaha contract is signed.

The most common form of risk mitigation is the unilateral promise to purchase the goods from the
bank. In many jurisdictions, including the UK and the US, the promise to purchase is sufficient to pursue

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 Financial Contracts and Techniques Applied by Islamic Banks

a collection judgment against the client (ie, the courts will allow the bank to collect the payment) if the
client refuses to accept delivery when the goods meet the contractual specifications.

An alternative technique to hedge the risks facing the bank is for the bank to buy the goods from the
seller with the right to cancel the sale within a certain period, for example, 24 hours. The bank then
notifies their client that the goods are available for purchase for a shorter period, eg, 12 hours. If the
client completes the purchase, the Murabaha transaction is concluded. Otherwise, the bank has the
right to cancel the purchase transaction with the seller and thus hedge the risk of reselling the goods.

9.2 Murabaha Export Financing

Learning Objective

5
5.6.2 Understand the use of Murabaha in export finance

When a supplier is not in a position to provide deferred payment conditions to a buyer, the buyer can
involve a bank and undertake a Murabaha contract as a financing agreement. In this case, the following
steps occur:

1. The buyer approaches the bank for the financing of specific goods.
2. The bank buys the goods from the supplier and pays them spot.
3. The bank sells the goods to the buyer against deferred payment as agreed.
4. The bank instructs the seller to deliver the goods to the buyer.

In a similar way, Murabaha transactions can be used to provide pre-export or import finance. After
completing the Murabaha steps outlined above, the bank instructs the buyer (the client) to act as its agent
to sell the goods onwards in the market. This has the benefit of providing working capital finance to the
client. Alternatively, the client may provide financing to the end buyer if the final sale is on credit basis. This
is particularly helpful if the end buyer is not a customer of the bank. In order to collect the payment, the
client may appoint the bank as its agent to collect the receivable against a fee payable to the bank.

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9.3 Differences between Murabaha and a Loan

Learning Objective
5.6.3 Know the differences between a Murabaha sale and a loan of money

Many bankers and their regulators are comfortable in taking the view that Murabaha is a synthesised
loan or form of debt. There are, however, a number of major differences between a Murabaha sale and
the loan of money:

1. The banker in a Murabaha must have some form of actual ownership of the underlying goods or
services, registered or not, constructive or physical.
2. In Murabaha, the finance and sale transaction are fully integrated, since the financing is related to a
real transaction. In a loan, there is no contractual link between the financing and the real transaction.
Hence, finance and economic activities may diverge.
3. The payment date for a Murabaha transaction may be extended but this may not result in an
increase in the mark-up or a penalty fee. Any increase or penalty violates the basic rule of Riba.
4. If the payment is late, no form of penalty may be charged for the profit of the creditor.
5. Most Islamic scholars do not like net sales, sales discounts or early payment discounts when these
are structured into the contract. Scholars find it acceptable if the financier (ie, the bank) elects on its
own to give discounts at its absolute discretion and shall not be contractually pre-agreed.

As a rule, the same object cannot be sold back to the original seller, or associates which the seller has
control over, at a different price. This is a twin sale and mimics loans involving interest, which is forbidden.

Example
Islamic Enterprises produces copper tubing. Islamic Enterprises specifies the quality of the copper it wishes
to buy and obtains a quotation from Vendor (the seller of the copper) which is valid for two months.
As a customer, Islamic Enterprises enters into a Murabaha arrangement with Islamic Bank (the buyer),
promising to buy the copper for the cost of the ingots, plus an agreed-upon mark-up. Islamic Bank agrees
to buy the copper from Vendor and pays Vendor US$1,000 for each copper ingot. Islamic Bank bears the
costs of the secure delivery of the ingots to Islamic Enterprises. Islamic Enterprises buys the copper ingots
from Islamic Bank at a price of US$1,100 for each ingot. Islamic Enterprises notifies Islamic Bank that it has
taken delivery of the copper in the capacity of the bank’s legal representative. Islamic Bank and Islamic
Enterprises sign the Murabaha sale contract, which requires payment to the bank one month after delivery
of the ingots. This one-month period is the period of financing under the contract and, during this period,
Islamic Enterprises lodges tubing of equivalent value with the bank as collateral.

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 Financial Contracts and Techniques Applied by Islamic Banks

9.4 Commodity Murabaha And Tawarruq

Learning Objective
5.6.4 Understand the operation of Tawarruq and Commodity Murabaha

9.4.1 Commodity Murabaha

The Commodity Murabaha is the instrument most commonly used by Islamic financial institutions
to provide short-term interbank liquidity or, in the case of retail finance, unsecured personal loans. A
Commodity Murabaha is, like the basic Murabaha transaction, a deferred payment sale or instalment
credit sale and uses a commodity, usually a base metal, as the underlying asset for the transaction.

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Unlike basic Murabaha, however, when the commodity is sold to the buyer, the buyer immediately
liquidates it (ie, sells it for spot cash).

The objective of this transaction, therefore, is not to facilitate the ownership of the client of the
underlying commodity. Rather, it is to replicate a conventional money market transaction or unsecured
loan. The banks do not typically hold the underlying commodity nor is the client interested in owning
it. The metals are purchased and sold solely to obtain cash now against a higher payment in the future,
using techniques that are compliant, in form at least, with Shariah principles.

Because Commodity Murabaha does not finance real ownership of goods and services, but rather
replicates a conventional loan, it has been subjected to criticisms at various levels and on many
occasions. The transaction is considered to be a compromise to meet urgent needs that could not
otherwise be met. As outlined in chapter 3, flexibility in case of necessities or surmounting difficulties
is embedded within Shariah. Many Islamic banks are actively seeking alternatives to Commodity
Murabaha to reduce the costs of the transactions, whilst at the same time satisfying the objectives of
Islamic finance.

As Commodity Murabaha transactions are fixed-rate, they are typically for a relatively short term. The
Commodity Murabaha is executed using a commodity as the underlying asset, which has to be non-
perishable, freely available and uniquely identifiable. Any commodities that were originally used as
a means of exchange or money – ie, gold, silver, barley, dates, wheat and salt – are not acceptable.
The majority of Commodity Murabaha transactions use London Metal Exchange (LME) base metals as
an asset since they meet all criteria for a commodity and are easily identifiable via warrants. (An LME
warrant is a certificate for a specific metric tonnage of an approved brand of metal stored in an LME
approved warehouse. The warrant is a bearer document and signifies ownership of the underlying
metal to the holder.)

In comparison to conventional deposits, Commodity Murabaha transactions attract an additional cost

associated with the purchase and sale of the warrants, which can be dependent on volume and contract
size. For longer-dated contracts, this is not necessarily an issue, as the additional cost is spread over a
longer period. It does, however, significantly increase the price of shorter-dated deposits.

Figure 10 describes the transaction where an Islamic bank wants to provide a deposit to its counterparty
to generate a return. The process flow is as follows:

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 1. Deliver warrants

Islamic Bank Metal Broker

2. Pay (spot)

4. Sell warrants as agent

3. Sell 6. Pay
warrants deferred

5. Pay (spot)
Counterparty Metal Broker

Warrants
Cash

Figure 10: Commodity Murabaha (Source: Schoon, N. 2016, Modern Islamic Finance, London: Wiley)

The individual steps are defined below, using an example of a Commodity Murabaha to deposit £1
million with its counterparty:

1. The Islamic bank buys warrants from a metal broker. The ownership of the warrants transfers from
the metal broker to the Islamic bank. The Islamic bank purchases warrants for the value of the
deposit, £1 million.
2. The Islamic bank pays spot. The bank initiates payment of £1 million to the metal broker spot in
return for the warrants.
3. The Islamic bank sells warrants to the counterparty. The Islamic bank sells the warrants to its
counterparty on a deferred payment basis and agrees that the counterparty will pay for the warrants
in three months’ time for an amount of £1.05 million.
4. The counterparty requests the Islamic bank to sell warrants on its behalf. The Islamic bank is
requested to act as an agent, on behalf of the counterparty, to sell the warrants at spot. The Islamic
bank sells the warrants at the spot price of £1 million to a metal broker.
5. Payment from end buyer to counterparty. The metal broker (end buyer) pays the counterparty spot
in return for the warrants. In this example, the metal broker pays £1 million to the counterparty
(using the Islamic bank as an agent to facilitate payment). At this point during the transaction, the
counterparty is in the possession of £1 million and does not have to pay the Islamic bank until three
months later, when they will have to pay £1.05 million to the Islamic bank.
6. Payment from counterparty to Islamic bank. This payment takes place at a pre-agreed time in the
future and consists of the principal of the original purchase (£1 million) plus a pre-agreed mark-up
(£0.05 million).

The net result of the above movements of warrants and cash is that the counterparty now holds an
amount of money against an offsetting payment to the Islamic bank, for a pre-agreed principal, plus a
mark-up at a pre-agreed future date, thus creating a synthetic deposit. It is important to note that each
of the steps has to take place in the correct sequence and that the ownership of the warrants will have
to transfer from one party to the next before the next action can take place.

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 Financial Contracts and Techniques Applied by Islamic Banks

In steps 1–3, the Islamic bank buys the warrants as a principal and subsequently sells them to the client
on a deferred payment basis. The client now owns the warrants and can sell them, which is often done
by requesting the Islamic bank to act as an agent on his behalf to sell the warrants in the spot market.
The Islamic bank arranges for the sale to a metal broker resulting in a synthetic interbank deposit placed
by the Islamic bank with the client.

Example
Commodity Murabaha to place a deposit. An Islamic bank wants to place a deposit with XYZ Bank, a
conventional bank, of £1 million for a period of six months using a Commodity Murabaha. Islamic Bank
and XYZ Bank have a Master Murabaha agreement in place. The trade takes place on 16 March 2014, for
value date 16 March, and maturity date 18 September 2014. The following steps are taken on different
dates:

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1. Trade Date – 16 March 2016:
The Islamic bank purchases £1 million worth of aluminium alloy from the metal trader.

2. Trade Date – 16 March 2016:

The Islamic bank receives warrants from the metal trader.

3. Trade Date – 16 March 2016:

The Islamic bank offers to sell £1 million of aluminium alloy to XYZ Bank for a deferred payment
on 18 September 2016 of £1.05 million.

4. Trade Date – 16 March 2016:

XYZ Bank accepts the offer.

5. Trade Date – 16 March 2016:

The Islamic bank transfers ownership of the warrants to XYZ Bank (which is now the owner of the
warrants).

6. Trade Date – 16 March 2016:

XYZ Bank sells the warrants by requesting the Islamic bank to act as its agent and sell the warrants
on a spot basis for £1 million with the money to be received on 18 March 2016.

7. Trade Date – 16 March 2016:

The Islamic bank sells £1 million of aluminium alloy to the metal trader on behalf of XYZ Bank, with
the payment to be made to XYZ Bank.

8. Value Date – 18 March 2016:

The Islamic bank pays £1 million to the metal trader.

9. Value Date – 18 March 2016:

The metal trader pays £1 million to XYZ Bank.

At this point in time, XYZ Bank has received £1 million against a deferred obligation of £1.05 million to
the Islamic bank which has created a synthetic interbank placement.

10. Maturity Date – 18 September 2016:

XYZ Bank pays £1.05 million to the Islamic bank.

There are variations in the market on the above structure.

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9.4.2 Tawarruq
Tawarruq is a transaction in which a person purchases a good on a deferred-payment basis, then sells
it to a third party to obtain cash. Accordingly, Commodity Murabaha discussed above is essentially a
Tawarruq transaction. The Tawarruq has, however, some Shariah issues associated with it. The main
Shariah issue with Tawarruq transactions relates to the fact that the intention behind the purchase of
the commodity is not to own and use the commodity. Instead, the commodity is sold instantaneously
in order to obtain the required funds. Historically, although the minority of the schools of Islamic
jurisprudence have rejected the Tawarruq for that reason, the majority have approved it only subject
to certain conditions, such as an auditable ownership transfer of the commodity and separation of the
purchase and sale arrangements.

Organised Tawarruq is a Tawarruq transaction in which the bank acts as an agent to the client to sell the
commodity for cash, collect the cash and deposit it in the client’s account. The two major Fiqh academies
of the Islamic world, the OIC Fiqh Academy (resolution No. 179 in 2009) and the Muslim World League
Fiqh Academy (in 2003 and 2007), both rejected organised Tawarruq because it results in Riba.

The two Fiqh Academies also rejected Reverse Tawarruq, a transaction type in which the bank is the
party seeking financing. In this transaction, the bank collects cash from the investor as an agent to
buy commodities on their behalf. Then the bank purchases these commodities from the investor on a
deferred-payment basis. Reverse Tawarruq is used to imitate saving deposits to investors and replicates
a loan with interest.

AAOIFI Standard (No. 30 in 2006) stipulates that ‘the client should not sell the commodity except by himself
or through an agent other than the institution, and should duly observe the other stipulations’.

The standard allows the bank (the institution) to act as an agent only if the regulations do not permit the
client or a third party to sell the commodity.

The standard further stipulates that:

‘monetisation is not a mode of investment or financing. It has been permitted when there is a need
for it, subject to specific terms and conditions. Therefore, the institutions should not use monetisation
as a means of mobilising liquidity for their operations, instead, it should exert effort for fund
mobilisation through other modes, such as Mudaraba, investment proxy, Sukuk, investments funds
and the like. The institution should resort to monetisation only when it faces the danger of a liquidity
shortage that could interrupt the flow of its operations and cause losses for its clients’.

Although Tawarruq may not be a perfect instrument and has serious Shariah issues associated with it, it
does serve a purpose when value added tax (VAT – a tax on purchases in many countries), stamp duty
(a UK tax on the purchase of shares and property) or other taxation rules pose limitations on Islamic
finance and Tawarruq is more often than not the only feasible transaction type available.

The Tawarruq transaction can graphically be depicted in the same way as the Commodity Murabaha in
Figure 10.

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Example
Bank A wishes to place $1,000,000 with another bank, applying a Commodity Murabaha for a period
of three months. As commodity prices are in US$, Bank A and B have decided to use US$ LIBOR as a
benchmark for the mark-up. Taking into consideration risk factors, such as creditworthiness, liquidity
risk, commodity price risk, US$ three-month LIBOR of 2.15%, and a brokerage cost for buying and selling
the underlying commodity of 25bp, Banks A and B agree on a mark-up of US$22,500.

10. Ijara and Ijara Muntahia Bitamleek – Shariah

Standards

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Learning Objective
5.7.1 Be able to apply the Ijara contract

In an Ijara transaction, the bank will buy the asset from the seller or manufacturer and take possession;
the bank will then become the lessor and lease the asset to the client (the lessee). A sale and leaseback
transaction, in which the owner sells the asset and then leases it back, is also permissible in Shariah. The
sale and the lease should not be conditional on each other.

Shariah permits the assignment of a lease, providing that due consideration is paid for passing the
title, or sufficient elements of the asset’s ownership are transferred, and all rights and obligations of
the lease are assumed by the new lessor. The assignment or sale of rent only is not permitted. This has
important implications for securitising leased assets.1 The certificate representing the securitised asset
must be attached to asset ownership and include proportionate rights and obligations. The certificate
represents an undivided part of an identified asset or pool of assets.

Leases have a wide range of applications and can, for example, be used for the lease of individual
equipment to companies, or for cars to individuals.

10.1 Ijara Wa Iqtina

Learning Objective
5.7.2 Understand the redemption of a lease through Ijara wa Iqtina/Ijara Muntahia Bitamleek

Most Ijara transactions have a formal redemption feature where the lessee will take possession of the
asset at the end of the lease. This type of transaction takes two forms:

• Ijara Muntahia Bitamleek – lease ending in ownership, or

• Ijara wa Iqtina – lease with acquisition.

1 Pooling of financial assets which offer an income stream, eg, rental income/mortgages and repackaging them as tranches
of securities which generate cash flows with different risk profiles.
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The general view is that these represent a synthesised version of a financing lease. The transfer of
ownership is typically arranged via a unilateral promise of transfer. The promise can be provided by the
lessor or the lessee and tends to be at a pre-negotiated price. The promise is not a contract by itself and
hence the property does not transfer automatically to the customer. A sale and purchase agreement
must be signed to formally transfer the property ownership to the customer.

The purchase price for the asset may be market value, at a discounted or fixed price. Ideally, the lease
itself is not contingent on any promise to sell or buy, but they may be executed at maturity. Leases
may be terminated early by mutual consent. The lessor may not force the lessee to buy the asset and
the lessee may not oblige the lessor to sell at a discounted price. Similar to the Ijara or operating lease,
periodic modification or repricing is allowed during the lifetime of the lease transaction.

Example
Islamic Bank buys cement mixers from Islamic Enterprises (the vendor). Islamic Bank then enters a
12-month lease for the cement mixers with the customer (and lessee) for use in his property construction
business. The customer pays a monthly rent to Islamic Bank for the use of the mixers. Under a standard
operating Ijara, title to the cement mixers remains with Islamic Bank. Under an Ijara wa Iqtina, title to the
mixers passes to the client at the end of the contract by means of a separate purchase and sale contract.

10.2 Ijara Mawsoofa Bil Thimma

Learning Objective
5.7.3 Understand the use of Ijara Mawsoofa Bil Thimma (forward lease)

Leasing is often applied in project finance. In this case, the application of leasing is usually a combination
of construction finance (Istisn’a) followed by an Ijara wa Iqtina that buys out the completed project,
either in tranches or as a whole on completion. When agreed in advance with the initial construction
transaction, it is known as Ijara Mawsoofa Bil Thimma (forward lease). Shariah scholars permit leases
to be executed for a future date and may be pre-paid in advance, thereby providing working capital for
construction. Pre-rentals are payable by the lessee on the understanding that the equipment will be
leased once completed. If the plant is not manufactured or acquired according to the specifications laid
down in the agreement to lease by a certain date, such pre-rentals will be repayable by the lessor.

In the event of late payment, the late instalment may be recovered as long as there is no penalty (see
Murabaha section previously). In addition, the lease may be terminated or renegotiated with the lessee
if there is a history of late payments or other problems such as evidence of poor treatment of the leased
item.

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Pricing a Lease
The price of a lease transaction is made up of the following components:

Component Finance Lease Operating Lease

Term, repayment profile and payment in
 
advance or in arrears
Deduction or inclusion of servicing fees  
Fees and commissions payable  
Cost of funds  
Counterparty credit risk  

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Value of the underlying asset  
Country and other risks  
Residual value risk 
Residual value realisation 

11. Salam and Parallel Salam – Shariah Standards

Learning Objective
5.8.1 Be able to apply the Salam contract

When applied in the financial markets, the Salam contract effectively provides a means of placing short-
term funds. Banks and investors can make a return by paying funds in full to a trader for future delivery
of commodities, knowing there will be a third-party buyer and a supply coming into the market. The
buyer may secure the transaction with a mortgage, guarantee or letter of credit. The financier in a Salam
transaction often appoints the trader as agent to sell the goods to a third party at a higher price on a
cash or deferred basis. Payment to the Salam seller is made as a lump sum in advance. The delivery
schedule and purchase price are agreed at the outset and take into account aspects such as material,
labour, profit margin and costs. Settlement under the Salam is delivery of the goods.

Salam is a useful tool for pre-export and working capital finance. In this case, the beneficiary is the
supplier as opposed to the buyer, although it is conceivable that in a bank-managed deal, the bank as
buyer is providing purchase finance to the end buyer on the other side of a deal. Like Murabaha debts,
Salam deliveries may be secured.

Most Salam transactions take between three and 12 months. The investor in a Salam transaction seeks to
profit from the end sale of a purchased commodity, often securing a LIBOR mark-up over the investor’s
funds. Repayment at maturity is through the delivery (and on-sale) of commodities. Salam transactions
may be syndicated in bilateral, international or domestic syndications.

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The pricing of the investor’s profit in a Salam transaction is comparable to similar conventional trade
finance facilities. The pricing may only be determined on a case-by-case basis, in line with tenor (term),
credit quality of supplier and strength of security. Salam transactions are accounted for as pre-payments.

11.1 Salam Documentation

Learning Objective
5.8.2 Understand the documentation associated with a Salam contract

Salam documentation is similar to conventional trade purchase and sales documents and includes
a sales agreement for deferred delivery of goods (the Salam). There may be a master agreement for
renewing facilities or multiple shipments. When the buyer is not a direct consumer of the goods, the
Salam is exited through a parallel sales contract. Otherwise, a letter of credit, purchase order or open
account documentation suffices to establish delivery of goods as paid for and ordered under the
documents. An agency agreement is included in the event the bank relies upon a third party to execute
the purchase and on-sale of goods. In addition, there may be various contract notes supporting the
different obligations. Syndicated purchases include an investment management agreement. Security
documents, including guarantees, mortgages, receivables and cash, are all acceptable, depending upon
the terms of the Salam.

As a general rule, it is not permissible to sell something one does not have. This rule, however, does not
apply to Salam and Istisn’a transactions. Salam transactions involve a future sale of a specific asset for
a pre-agreed quality and quantity against full payment at spot. The contract is binding and the seller
needs to deliver. In the event the seller has not been able to produce the asset by the delivery date,
they are obliged to procure the goods from the market and deliver them to the buyer. Therefore, assets
subject to a Salam transaction need to be freely available in the market.

The process of a Salam structure is defined as follows:

2
Salam seller Salam purchaser

$120,000

1 Delivery of goods 1

Salam Parallel Salam

$100,000 Islamic Bank (financier)

purchaser/seller

Figure 11: Salam contract

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1. An Islamic bank (financier) enters into a Salam contract as the purchaser and pays US$100,000 to the
seller for delivery of the assets in one month. The Islamic bank may appoint an agent to enter into
the contract with the Salam seller. The agent typically also acts as the agent to sell the goods (in this
case at US$120,000) to the ultimate buyer in the parallel Salam contract.
2. Goods are delivered to the Islamic bank under the Salam agreement. The Islamic bank delivers the
goods to the Salam purchaser under the Parallel Salam agreement. Since the bank makes a payment
for the assets in advance, they will often require some form of security from the trader, which may
be in the form of a requirement for the Salam seller to secure an ultimate buyer for the goods,
effectively resulting in a Parallel Salam, or exit for the bank’s initial purchase.

11.2 Parallel Salam

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Learning Objective
5.8.3 Understand the use of Parallel Salam in managing bank assets acquired under a Salam contract

Similar to the binding promise to purchase in a Murabaha contract, the Parallel Salam has evolved as a
tool for Islamic banks with the following purpose:

• Manage cash.
• Arrange exits or hedge positions (exposures to price risk).

As a consequence of the purchase, the bank ends up owning the goods and is subject to a level and type
of risk that is unacceptable from a regulatory point of view. To mitigate the risk, most regulators require
the bank to enter into a parallel sales agreement. This is usually an outright purchase of the goods by a
customer of the original seller or structured at a future date. The supplier usually acts as agent for the
bank to arrange the onward sale and collecting payment in favour of the bank. The parallel sale can be
secured by a promissory note, a letter of credit or another Salam agreement. The ultimate buyer needs
to be an independent third party and the two Salam contracts must be separate and independent from
each other.

The structuring of a Parallel Salam transaction results in the unwinding of the original transaction in
such a way that it transforms the Salam transaction into a financing tool (see Figure 12).

4. Delivery and ownership

transfer after one month
Financier Final Buyer
2. Parallel Salam contract
3. Delivery and Contract value €110
ownership
transfer after 1. First Salam contract
one month Contract value €100

Client

Figure 12: Parallel Salam contract

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 12. Istisn’a And Parallel Istisn’a – Shariah Standards

12.1 The Nature of Istisn’a

Learning Objective
5.9.1 Be able to apply the Istisn’a contract

Istisn’a is commonly used for project or pre-export finance in which the bank acts as an intermediary
between the producer (construction firm or manufacturer) and the ultimate customer (the obligor).

The obligor is often appointed by the bank as an agent to manage the relationship with the manufacturer
on their behalf under a Wakala (agency) agreement. The obligor cannot be the manufacturer or have a
stake of 30% or more in the ownership of the manufacturer. The exit or off-take agreement may be
in the form of a back-to-back Istisn’a (parallel Istisn’a – see section 12.2), or in the form of transfer of
ownership of the asset upon full payment.

Under the Istisn’a agreement, the buyer enters into an Istisn’a agreement with the manufacturer. For
large assets, the buyer usually requires financing, in which case, the bank will enter into the agreement
with the manufacturer appointing the buyer (obligor) as the Islamic bank’s agent (under an agency
agreement). The buyer receives the funds to pay the manufacturer as per the agreement. Although
payment is usually made on an instalment basis according to the work progression, it may also be a
lump sum in advance. When the asset is completed, the ownership will be transferred to the bank. The
bank can then sell the asset to the client, or lease it to the client for an agreed period of time.

12.2 Parallel Istisn’a

Learning Objective
5.9.2 Understand the reasons for Parallel Istisn’a contracts

A Parallel Istisn’a is usually applied either because the bank is unable to manufacture the asset or is
unwilling to hold the asset after completion. Therefore, the bank enters into two mutually independent
Istisn’a contracts with the same product specifications. The difference in price between the two contracts
is the spread or margin earned by the bank. Neither contract is dependent. Thus, if the manufacturer
fails to deliver according to specification, the bank is still required to deliver the asset (see Figure 14).

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4. Ownership transfer
Financier Client
2. Parallel Istisn’a contract
3. Ownership transfer Contract value €120

1. First Istisn’a contract

Contract value €100

Manufacturer

Figure 14: Parallel Istisn’a contract

5
Example
Islamic Enterprises provides equipment for hospitals and requires funding for the manufacturing of
100 hospital beds. The Islamic bank pays the bed manufacturer to produce the beds and adds a profit
margin to the purchase price to determine the price the beds will be sold for to Islamic Enterprises.
The Islamic bank agrees to produce and deliver the beds on 1 June 2016. The Islamic bank enters into
an Istisn’a contract with the bed manufacturer for 100 beds according to the specification of Islamic
Enterprises with a delivery date of 1 June 2016. On 1 June 2016, the bed manufacturer delivers 100 beds
to Islamic Enterprises and checks the delivery to ensure it matches the specification.

12.3 Salam Versus Istisn’a

Learning Objective
5.9.3 Understand the differences between Istisn’a and Salam contracts

Istisn’a is considered to be a variant of Salam used for the financing of manufacturing or construction.
There is no debt in the form of a conventional loan since the obligation is for the delivery of
manufactured goods, not for money.

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The differences between Istisn’a and Salam contracts can be summarised as follows:

Salam Istisn’a

Deliverables have commodity-type Deliverables are manufactured goods or constructed

characteristics and must be fungible property subject to detailed specification.
like base metals or grain.

The contract may not be cancelled. The contract may be cancelled unilaterally before work
starts.

The full price must be paid in advance. The price may be paid in advance, in instalments
according to progress, post delivery, in instalments
without reference to progress or at delivery. Payment
schedules are agreed in the contract.

No penalty for late delivery. However, Progress payments may be deferred and may attract
in the event the seller fails to produce pre-agreed penalties for the late delivery of the
the commodity, he will need to source contracted assets. To be valid, all specifications, delivery
it in the open market and deliver to options, payment conditions and pricing must be
the buyer. agreed in the Istisn’a contract. Typically, the financier
subcontracts the manufacture or construction of the
object. However, they remain responsible for the
product warranties, even if they are able to assign or
otherwise cover this risk.

Delivery is on a specific date. Delivery date does not need to be specific, but should
fall within a pre-agreed time frame.

13. Off-Balance Sheet Financing (Letters of Credit)

Learning Objective
5.10.1 Know the use of letters of credit and guarantees in Islamic finance contracts

13.1 Letters of Credit and Guarantees

A letter of credit is a document from a bank guaranteeing that a seller will receive payment in full as long
as certain delivery conditions have been met. In the event that the buyer is unable to make payment
on the purchase, the bank will cover the outstanding amount. Letters of credit are typically used in
import/export transactions. Within the context of Islamic finance, letters of credit are commonly used in
Murabaha and Salam transactions, either as a form of guarantee, or as a means of assuring that payments
will be processed in accordance with customary documentary procedures. Islamic scholars generally
consider that the payment of a fee for a guarantee is prohibited. Extending a fee on a promise to pay to

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a loan is deemed to equate to Riba. A letter of credit, on the other hand, is a customary instrument of
international trade, allowing two parties to conduct a sale with a trusted intermediary who assures that
the terms of documents are complied with prior to payment taking place. On this basis, letters of credit
and other documentary assurances between distant or unfamiliar parties are permitted in a trading
transaction.

Recently Islamic banks have started to bundle the letter of credit and processing services into either
the Murabaha price or enter into a Musharaka agreement with the client. In the latter case, the costs
of providing a letter of credit is incorporated in the profit share together with the bank’s capital
contribution. The characteristics of a letter of credit can be provided via a Wa’d (promise) under which
the Islamic bank buys the asset and then sells it to their client by means of a Murabaha transaction. In
this case, the Islamic bank’s promise is viewed as binding to the seller and will be honoured as long as
the documents are presented correctly. The Islamic bank will not charge for its promise, but will charge

5
administrative costs and adjust the Murabaha profit to incorporate their expected costs and profits
relating to the letter of credit.

Guarantees, Kafala or Dhamana, are permitted and both the debt and the delivery of goods can be
guaranteed. A guarantee cannot apply to business performance and may not be used to assure the
returns or profits on a Musharaka, as this will turn the investment into a loan. A third-party guarantee
can be attached to a Mudaraba for certain activities, but not from the manager or Mudarib. Generally,
Islamic law does not permit a fee to be charged for guarantees, although some scholars permit this as
long as the guarantee is associated with true services such as the preparation of a feasibility study and
credit risk analysis.

14. Application of Wa’d

Learning Objective
5.11.1 Be able to apply the concept of Wa’d (promise) and the concept of Ah’d (undertaking), and the
conditions which make a commercial promise binding

Although highly controversial, the Wa’d is often used to provide a level of security to both parties
regarding a future event. It is most commonly used in the following structures:

1. Ijara wa Iqtina/Ijara Muntahia Bittamleek (finance leases) – in a finance lease, the lessee provides
a promise to purchase the asset from the lessor at the end of the lease period. This promise to
purchase is binding (see chapter 3) and is given at the start of the lease period. The promise cannot
be a condition for the lessor to enter into the lease transaction.
2. Forward foreign exchange contracts – in a forward foreign exchange contract, one party promises
to purchase or sell a specific amount of one currency against a specific amount in a different
currency. Some scholars disagree on the permissibility of a forward foreign exchange contract, as
they are often equated to speculation. However, there are circumstances in which there is a defined,
non-speculative, requirement for an exchange of currency at a future date. For example, an import/
export business that pays bills and receives funds in other currencies cannot necessarily take the risk
of exchange-rate fluctuations on its payments and receivables.

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3. Profit rate swaps – profit rate swaps are often structured as one long-dated, fixed-rate, Commodity
Murabaha transaction in combination with a series of sequential short-dated, reverse, Commodity
Murabaha or Musawama transactions, for which the maturity date of the final transaction matches
the maturity of the Murabaha transaction. Beyond the current short-dated transaction, one party
will promise the other to enter into the other transactions at an agreed interval, until the end-date of
the long-dated Commodity Murabaha.

Ah’d, or covenant, can be part of any transaction and, for example, provide additional security to the
contract.

15. Other Contracts

15.1 Arboon

Learning Objective
5.12.1 Know how Arboon is used to synthesise option behaviour

Arboon is a down payment on a sales contract in which the buyer has neither paid the full price nor
taken possession of the goods. Thus, it is not like Salam, in which full payment is made for goods to be
delivered in future. Although it is often used to replicate a conventional call option giving the holder the
right, but not the obligation, to buy a fixed quantity of an underlying asset on or before a specified date
in the future, it is not an option in the conventional sense for the following reasons:

• The Arboon cannot be traded or sold to a third party.

• It is typically exercised on a specific date rather than at will.
• The seller of the Arboon has to have the underlying asset in their possession or else they are
‘shorting prior to exercising’ which is a condition that will result in a void contract.
• At the time of exercise, the buyer only pays the difference between the price and the down payment.

Nonetheless, it is used by many parties to synthesise option behaviour. If the buyer decides not to
take the goods by the stipulated time, the down payment may be kept by the seller. This form of
down payment formally constitutes a part of the purchase price and, thus, is not refundable. Arboon is
becoming a common tool of modern Islamic banking.

16. Summary of Certain Islamic Contracts

Note: the term commodity, as used in this chapter, refers to the raw materials used by industry, which
are traded on specialist markets such as the London Metal Exchange, eg, aluminium and copper.

128
 Financial Contracts and Techniques Applied by Islamic Banks

Instrument Mudaraba Musharaka Murabaha Salam Istisn’a Ijara

Equivalent (Direct) Direct Deferred/ Short-term Long-term Finance
contract. equity equity instalment production project and
investment. investment. payment finance and finance. operational
sale. agricultural leases.
forward (non-
tradeable).
Type of Profit and Profit and Sale at Contract Contract Leasing in
contract. loss sharing loss sharing cost + for the for the which the
partnership partnership profit production or production or lessee pays
(investment (joint mark-up. manufacturing manufacturing rental to
financing). venture). of a good in of a good in the lessor.
Material loss Partners which the full which the Lessor

5
is borne by have payment is at payment may have
one capital unlimited spot against is made exposure to
provider liability. delivery of progressively the residual
to the goods at a during the value of
Mudaraba future date. project against the asset in
unless Buyer is delivery of operational
negligence exposed to goods at a lease.
is proven. the asset in future date.
the event the
client is unable
to deliver
the goods or
the goods do
not meet the
specification
of the Salam
contract.
Parties Rab al Mal The The Salam seller The purchaser The lessor
to the (investor/ business principal (the producer pays (owner of
contract. capital partners, (seller of of the goods) progressively the leased
owner/ both called goods). receives according to asset).
bank). Musharik The end money in a predefined The lessee
Mudarib (investor user advance. schedule. The (beneficiary
(business and (buyer Salam manufacturer of the
manager). business of the purchaser or contractor leased
Mudarib manager goods). (the financier) manufactures asset).
is a silent whether receives the or builds the
partner. both are goods at asset and
active, or maturity. progressively
one is a receives
sleeping money from
partner). the investor.

129
Instrument Mudaraba Musharaka Murabaha Salam Istisn’a Ijara
Type of 1. Mudarib, All partners A buyer Salam Investors The lessor
business in who has a provide requires goods purchaser approach a (the owner
practice. business capital as but lacks advances manufacturer of the
activity, well as cash. He then money to the to leased
approaches (business- approaches Salam seller manufacture asset)
investors related) a bank and to purchase an asset leases a
to provide expertise. expresses his an asset which doesn’t Shariah-
capital. In practice wish to buy that does exist at time compliant
one of the from the bank not exist at of contract. asset to the
2. Investors partners at a pre-agreed the time of Detailed lessee (the
(Arbab could price once the contract. specifications beneficiary
Al Mal – provide a bank acquires The latter of the of the
plural of contribution the title/ delivers the object to be leased
Rab al Mal) in kind (eg, ownership and commodities manufactured asset). The
approach land) which possession of (goods) at or constructed lessee pays
a Mudarib is valued the goods. maturity to must be a periodic
to invest as a capital the Salam stated. rent to the
their funds investment. 1. The bank purchaser. (Contract is lessor.
in Shariah- Another buys goods (Contract can typically used
compliant partner at spot from be used in in project
projects. provides a seller (First agriculture finance.)
Can be used cash. Both Sale: spot finance or
to deposit partners payment and short-term
funds with invest in immediate project
an Islamic a Shariah- delivery of the finance.)
bank. compliant asset).
project.
2. The bank
sells the same
goods to the
end buyer for
the principal
amount plus
a fixed mark-
up payable at
a later date.
(Contract
can be used
for working
capital
finance.)

130
 Financial Contracts and Techniques Applied by Islamic Banks

Instrument Mudaraba Musharaka Murabaha Salam Istisn’a Ijara

How are Profits are Profits are Not Investor’s Investor’s Lessee pays
profits shared shared applicable profit usually profit agreed rent to
shared between between as there based on at outset lessor. Rent
between the the is no the term of covering is either
the Mudarib partners partnership the contract, material, fixed for life
partners? and the according between the credit quality labour, profit of project
Rab al Mal to a contracting of the Salam margin and or adjusted
according percentage parties: seller. It project costs. periodically.
to a agreed mark-up/ is usually There is no There is no
percentage in the profit goes benchmarked partnership partnership
agreed Musharaka to the bank to LIBOR. between the between
in the agreement. (seller). There is no contracting the

5
Mudaraba partnership parties. contracting
agreement. between the parties.
contracting
parties.
In the Losses are Losses are In theory, In theory, In theory, Borne by
event of a distributed distributed there should there should there should the lessor
loss, which in in not be any not be any not be unless
party bears proportion proportion loss unless loss unless any loss due to
the loss? to the to the the user the Salam unless the negligence
capital capital becomes seller is manufacturer of the
provided. provided. insolvent unable to is unable to lessee. In
Rab al Mal (ie, unable deliver, in complete the the event
as sole to pay the which case work. Actual of total
provider instalments, the they damages loss of the
of capital in which should buy or loss are asset, the
bears case the the goods borne by the lessor has
all loss, securities from the purchaser, no further
unless the held by the market. One unless the recourse
Mudarib bank may be of the criteria manufacturer to rental
has been enforced). of Salam is is negligent. payments
negligent. that the asset from the
A penalty is commonly lessee,
for late available in but has
payment is the market recourse
not allowed. to make to any
the delivery insurance
possible at payments.
any time.

131
Instrument Mudaraba Musharaka Murabaha Salam Istisn’a Ijara
What Termination Termination End user Salam seller Manufacturer Asset
happens of the of the pays all the delivers the delivers the reverts
at Mudaraba – Musharaka – Murabaha commodities manufactured to lessor
maturity Rab al Mal is Partners are instalments to to the Salam goods to the in case
of the entitled to entitled to the merchant buyer. purchaser. of Ijara
project? receive his receive their bank (seller). (operating
investment. investments. lease) or
Profit (if any) Profit (if any) ownership
is distributed is distributed transfers
among among to the
Mudarib and partners lessee in
Rab al Mal according to case of
according to a predefined Ijara wa
the contract. ratio. Loss (if Iqtina
Loss (if any) any) is borne (finance
is borne by by partners lease).
Rab al Mal. according
to their
proportionate
share in the
capital.

Timing of Rab al Mal According to Delivery of Full payment Payment can Not
sale and pays spot. the interest the asset is is immediate, be lump sum applicable.
payment. of the immediate, delivery of in advance,
partnership payment the asset is progressive
(spot or is usually deferred. payments, at
deferred). deferred. delivery or by
instalments
post-delivery.
Delivery of
the asset is
deferred.
Penalties,
agreed in
advance for
late delivery,
can be
charged.
Forms. Restricted. Shirkat al Murabaha to
Unrestricted. Milk. Shirkat the purchase
al Aqd. orderer.
Commodity – – –
Murabaha.
Murabaha
account.

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 Financial Contracts and Techniques Applied by Islamic Banks

Instrument Mudaraba Musharaka Murabaha Salam Istisn’a Ijara

Variants. Two-tier Diminishing Parallel Parallel Ijara wa
–
Mudaraba. Musharaka. Salam. Istisn’a. Iqtina.
Contracts Commodity
used for Murabaha,
liquidity a fixed-
management. income-type
transaction
which includes
some minimal
exposure of
– – – – –
the Islamic
bank to the

5
asset during
the period
when the
Islamic bank
holds the
asset.

133
 End of Chapter Questions

1. How does Islamic financial intermediation differ from conventional intermediation?

Answer reference: Section 3.1

2. What are the two types of Wakala and how do they differ?
Answer reference: Section 6

3. Describe the process of Mudaraba applied to deposits.

Answer reference: Section 7.1.1

4. In a Mudaraba contract, what is the incentive for the Islamic bank to perform well?
Answer reference: Section 7.3.1

5. What is the difference between restricted and unrestricted investment accounts?

Answer reference: Section 7.4

6. What is a Diminishing Musharaka?

Answer reference: Section 8.1.2

7. Describe the difference between ijara wa iqtina and Ijara mawsoofa bil thimma.
Answer reference: Section 10

8. What are the differences between Murabaha and a loan?

Answer reference: Section 9.3

9. What is the purpose of Parallel Salam?

Answer reference: Section 11.2

10. What are the differences between Salam and Istisn’a?

Answer reference: Section 12.3

11. List how wa’d can be used in forward foreign exchange contracts.
Answer reference: Section 14

12. Why is Arboon not an option in the conventional sense?

Answer reference: Section 15.1

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Chapter Six

Islamic Asset Management

1. Islamic Banking and Sustainable Investing 137

2. Asset Management 137

3. Selection of Shariah-Compliant Investments 138

4. The Definition of a Fund 140

6
5. Islamic Fund Management Structures 142

6. Types of Funds 143

7. Concluding Remarks 149

This syllabus area will provide approximately 12 of the 100 examination questions
136
 Islamic Asset Management

1. Islamic Banking and Sustainable Investing

Learning Objective
6.1.1 Know the similarities and differences between Islamic finance and Socially Responsible
Investing (SRI)
6.1.2 Understand the similarities between the UN Sustainability Goals (SDG) and Islamic Finance

There is a growing trend among investors to demand more socially responsible investments that provide
more than just a rate of return. Common themes are the avoidance of investments in companies that
produce or sell harmful products or services, such as alcohol, gambling and tobacco. Instead of a passive
strategy, investors prefer an active strategy. This involves, in addition to abstaining from investing in
harmful products, investing in companies engaged in social justice, environmental sustainability and

6
alternative energy/clean technology efforts. However, in the wider context of Maqasid of Shariah, these
ought to be included.

The underlying principles of socially responsible investing (SRI), as well as environmental, social, and
governance (ESG) investing, are largely similar to the ethical principles underpinning Islamic financial
services. However, Shariah-compliant investments do not necessarily meet all SRI and ESG criteria. The
Shariah industry screens (see section 3 of this chapter) typically do not include social and environmental
components.

One possible source, to derive ethical principles from, are the UN Sustainable Development Goals
(SDGs). The SDGs consist of 17 distinct items which include poverty alleviation, quality education,
gender equality, clean water, sustainable cities and communities, climate action, and environmental
issues. These goals have been adopted by all UN member states and provide a shared blueprint for
peace and prosperity. These goals are inherent in the principles underlying Shariah. Climate change,
reduction of pollution, clean water and energy, for example, are covered under the ‘stewardship on
earth’ principle. Poverty reduction, equality, and zero hunger are covered in the Sunnah and the Quran.
Islamic financial institutions are, therefore, in a prime position to ensure the implementation of SDG in
their local communities.

2. Asset Management1

Learning Objective
6.2.1 Understand the principles of Islamic investing

Within Islam, investing in enterprises and assets is encouraged not only because of the wealth increase
for the individual investor, but also because it advances the economy and, at the same time, allows
others to increase their wealth. This, in turn, results in better wealth distribution.

1 This chapter is based on Schoon, N (2016) Modern Islamic Finance London: Wiley & Sons; and Schoon, N (2011)
Islamic Asset Management: an asset class on its own? Edinburgh: Edinburgh University Press

137
Conventional and Islamic investors have common objectives such as capital preservation, yield
maximisation and ensuring a balance between liquidity and profitability, in addition to which Islamic
investors also look for Shariah compliance. Not every investor has the time to manage their investments
actively and, like conventional investors, Islamic investors often turn to fund or asset management
solutions.

Like conventional investment managers, Islamic investment managers can invest in a wide range of
Islamic and conventional products and asset classes, including shares and other securities. The main
difference between conventional and Islamic investment managers is that the latter must ensure that
his individual investments, as well as his fund, remain compliant with Shariah. In addition, Islamic fund
managers cannot use derivatives, pay or receive interest or apply stock lending techniques.

Fund structures are typically similar to conventional structures although, again, Shariah compliance is a
key factor. An SSB, which is typically made up of three to five members, is involved from the start of the
fund. The SSB is not responsible for any operational and strategic decisions the fund manager makes as
long as the fund continues to be Shariah compliant. The SSB is, however, involved in the definition of
the framework the fund operates in and defines issues such as which industries are deemed compliant.

The remainder of this chapter outlines the AAOIFI Shariah standards for the selection of Shariah-
compliant investments and presents a view on how Islamic asset management can successfully be
applied in practice.

3. Selection of Shariah-Compliant Investments

Learning Objective
6.3.1 Know the components of the industry screen
6.3.2 Know the components of the financial screen
6.3.3 Be able to apply the industry and financial screens
6.3.4 Understand what happens when an investment becomes non-compliant

When investing in a company, there are two basic screening processes that need to be applied prior
to deciding whether or not a stock should be allowed to be part of the investment universe. Within
Shariah, a number of business activities are deemed to be non-permissible (Haram), in which one should
not invest.

3.1 Industry Screen

The first selection when deciding whether to accept a share in the investment universe is often referred
to as the ‘industry screen’ or ‘qualitative screening’. Although it is preferable to allow only fully Shariah-
compliant assets in the universe, increasing globalisation, diversification and market demand does
not always make this possible. As a result, a particular share or business can be a Shariah-compliant
investment opportunity, even when an insignificant amount of its turnover is deemed to be Haram.

138
 Islamic Asset Management

Although the definition of ‘insignificant’ varies between SSBs, it is generally accepted to be 5% or less
of total turnover. The industry screen is meant to eliminate any non-permissible businesses from the
investment universe and excludes the following business activities:

• Conventional banking and insurance – conventional banking and insurance is associated with
interest and is, therefore, not permissible.
• Alcohol – the prohibition of alcohol extends to distilling, marketing and sale and includes working
in the industry. There are limited circumstances, however, in which alcohol is permitted, such as, for
example, medicinal use. Permissibility needs to be assessed on a case-by-case basis.
• Pork-related products and non-compliant food production – non-compliant food production
covers everything which is not prepared in a halal way and covers, among others, meat which is not
slaughtered in an acceptable fashion.
• Gambling – this covers casinos, betting shops, bingo halls and online betting.
• Tobacco – as with alcohol, this includes the production, marketing and sales of tobacco and
associated products.
• Adult entertainment – any activity associated with adult entertainment including escort services,

6
brothels and movies with explicit sexual content.
• Weapons, arms and defence manufacturing.

These industries or sectors should not form part of the portfolio of any Islamic investor.

3.2 Financial Screen

In addition to the industry screen, companies that use too much leverage are also excluded from the
investment universe. Although the exact financial ratios can vary between SSBs, the generally accepted
financial ratios are as follows2:

• Conventional debt/market capitalisation < 30%.

• Interest bearing deposits/market capitalisation < 30%.
• (Total interest + income from non-compliant activities)/income < 5%.

3.3 Application of the Industry and Financial Screen

Although not all scholars agree on this, the general approach is that any income from non-permissible
activities should be purified via the dividend payments. This is a pragmatic approach to allow Islamic
funds to be set up and operate within the Shariah framework. The Shariah-compliant indices that have
been developed over time may use more lenient or more stringent criteria. Dow Jones, for instance, uses
the following for the Dow Jones Islamic Market Index (DJIM):

• Industry Screen – exclude alcohol, tobacco, pork and pork-related products, financial services,
defence/weapons and entertainment.
• Financial Screen – the financial screens are all taken over market capitalisation and apply a
24-month rolling average to enable a smoother picture, and any firm should meet the following
criteria:
• Total debt/trailing 24-month average market capitalisation < 33%
• (Cash + interest-bearing securities)/trailing 24-month average market capitalisation < 33%
• Accounts receivable/24-month average market capitalisation < 33%

2 AAOIFI Shariah Standard No. 21

139
On the other hand, the FTSE Shariah Global Equities Index Series (GEIS) applies the following rules:

• Debt/total assets < 33.33%

• (Cash + interest bearing securities)/total assets < 33.33%
• (Cash + accounts receivable)/total assets < 50%
• Total interest and non-compliant activities should not exceed 5% of total revenue.

The exact screening criteria applied to an individual fund or index strongly depends on the framework
of the fund or index and the opinion of Shariah scholars.

3.4 Non-Compliance
No matter how thorough the screening, a situation could occur where an investment becomes
(temporarily) non-compliant. It is the responsibility of the fund manager to report this to the SSB,
together with his recommendation on how to proceed. If the stock is deemed to be temporarily non-
compliant, the SSB could allow the stock to remain part of the investment universe. All income from the
stock in that period will need to be purified for as long as the non-compliance occurs.

Some SSBs, however, do not allow any period of non-compliance and a share that becomes non-
compliant will need to be sold within a given number of days, whether it is expected to get back to
being compliant or not. However, once a share is compliant again, it can be added to the fund, although
the fund manager will probably incorporate the fact that a share was non-compliant and the likelihood
of this occurring again in his decision-making.

If permanent non-compliance occurs, divestment will always be required. However, within the framework
of the fund, and in order to protect investors’ interests, the SSB is likely to allow this to be a phased process.

4. The Definition of a Fund

Learning Objective
6.4.1 Know the definition of a fund
6.4.2 Know the definition of an Islamic fund
6.4.3 Understand the difference between a conventional and Islamic fund

The Oxford Dictionary of Finance and Banking3 provides the following definition for the term ‘fund’:

1. A resource managed on behalf of a client by a financial institution.

2. A separate pool of monetary and other resources used to support designated activities.

From the perspective of asset management, a fund combines both of these definitions into one. It is a
separate pool of resources managed on behalf of one or more clients. From an investor’s point of view,
an investment in a fund is typically a financial investment made with the expectation of a monetary gain.

3 Oxford Dictionary of Finance and Banking (1997), Second Edition, Oxford: Oxford University Press

140
 Islamic Asset Management

The Oxford Dictionary of Finance and Banking defines a financial investment as:

‘The purchase of assets, such as securities, works of art, bank and building-society deposits, etc.,
with a primary view to their financial return, either as income or capital gain. This form of financial
investment represents a means of saving. The level of financial investment in an economy will be
related to such factors as the rate of interest, the extent to which investments are likely to prove
profitable, and the general climate of business confidence’.

For the purpose of this chapter, an investment in a fund is defined as the purchase of assets (the fund
units) with a view to generate monetary return, typically with a medium- to long-term time horizon.

From an investor’s perspective, there are many advantages to investing in funds. Due to the longer
investment horizon and increased risk levels, the return on investment tends to be higher than the
return on a deposit account. Different types of funds cater for different risk appetites and, as a result,
different levels of potential profit or loss. However, even the types of funds with the lowest risk profiles,
such as enhanced cash funds, tend to provide the potential for a higher return than deposit accounts,

6
which is mainly due to a combination of a longer time horizon and the possibility to invest in a more
diversified asset.

Diversification is an important tool for an investor since it reduces volatility, spreads risks and smooths
returns. This can be achieved by actively managing a portfolio of direct investments. However, this
would require the investor to spend significant amounts of time monitoring the portfolio and to have
a broad knowledge base of the market. In addition, the investor is likely to incur significant transaction
costs which have a much lesser impact on larger investment amounts. For the majority of individual
investors, this is not a feasible option because of monetary and/or time constraints. Investing in one or
more funds offers a viable alternative. On the one hand, the required investment amounts are typically
lower which makes funds accessible to a larger audience. On the other hand, the fund manager has
large amounts of assets under management, which allows for larger diversification opportunities and
lower transaction costs, and has access to large-scale resources to analyse investment opportunities and
monitor current investments. As a result, investing in funds gives the investor access to the benefits of
large-scale investments against relatively small invested amounts.

4.1 Shariah-Compliant Fund

Within Islam, investing in enterprises and assets is encouraged not just because of the wealth increase
for the individual investor, but also because it advances the economy and, at the same time, allows
others to increase their wealth. This, in turn, results in better wealth distribution.

Conventional and Islamic investors have common objectives such as capital preservation, yield
maximisation and ensuring a balance between liquidity and profitability in addition to which Islamic
investors also look for Shariah compliance. The fund manager of a Shariah-compliant fund assumes full
responsibility for the Shariah compliance of the investments. In the event of direct investments, initial
and ongoing monitoring of Shariah compliance, which is the responsibility of the individual investor, is
difficult to ensure and is time-consuming, resulting in uncertainty as well as additional cost.

Similar to conventional investment managers, Islamic investment managers can invest in a wide range
of Islamic and conventional products and asset classes including shares and other securities. The main
difference between conventional and Islamic investment managers is that the latter will have to ensure

141
that his individual investments, as well as his fund, remain compliant with Shariah. In addition, Islamic
fund managers cannot use derivatives, pay or receive interest or apply stock lending techniques.

AAOIFI defines a fund as follows:

‘Funds are investment vehicles, which are financially independent of the institutions that establish
them. Funds take the form of equal participating shares/units, which represent the shareholders’/
unitholders’ share of the assets, and entitlements to profits or losses. The funds are managed on the
basis of either a Mudaraba or Wakala contract’. (AAOIFI Financial Accounting Standard 14, appendix
B).

It is clear that, besides the way a Shariah-compliant fund is managed, the definition of a fund does
not vary significantly from the general definition of funds as outlined previously. From an investor
perspective, there is equally hardly any difference in his objectives.

The same standard further specifies that:

‘Investment funds are permissible by Shari’a. Because funds are a form of collective investment that
continue throughout their term, the rights and duties of participants are defined and restricted by
the common interest, since they relate to third parties’ rights. Hence, in case the fund is managed
on the basis of agency the shareholders/unitholders waive their right to management, redemption
or liquidation except in accordance with the limitations and conditions set out in the statutes and
by-laws’. (AAOIFI Financial Accounting Standard 14, appendix B).

5. Islamic Fund Management Structures

Learning Objective
6.5.1 Understand the Mudaraba fund management structure
6.5.2 Understand the Wakala fund management structure

The general fund management structure can be depicted graphically as follows:

Shariah-compliant Shariah-compliant Shariah-compliant Shariah-compliant

investment investment investment investment

Fund manager
Profits and Losses as Rab al Mal/ Muwakkil Profits and Losses

Fund investor Fund investor Fund investor Fund investor

Rab Al Mal/Muwakkil Rab Al Mal/Muwakkil Rab Al Mal/Muwakkil Rab Al Mal/Muwakkil

Figure 1: Islamic Asset Management Structure

142
 Islamic Asset Management

The fund investors are generally known as the Rab al Mal or the providers of capital. The relationship
between the investors and the fund is based on a Mudaraba or Wakala contract, in which the fund
manager is either the Mudarib or business manager – who provides investment knowledge, expertise
and experience – or, in the case that the fund management contract is based on a Wakala contract, the
Wakil or agent. When it comes to the investment process however, the fund manager takes on the role
of the capital provider on behalf of the fund unit holders.

Fund management can be undertaken under either a Mudaraba or a Wakala transaction.

1. Mudaraba – in this instance, the fund investors are the Rab al Mal and the fund manager acts
as the business manager bringing in investment expertise. When making investments, the fund
manager acts as the Rab al Mal investing the funds in a range of Shariah-compliant investments. The
Mudaraba contract can usually be terminated at any time by either of the parties giving reasonable
notice. Typically, conditions governing termination are included in the contract so that any damage
to the business or project is eliminated in the event that the investor would like to take his equity
out of the venture. Mudaraba contracts are particularly suited to fund management since two

6
distinct roles can be defined in the process – that of the investor and that of the fund manager. The
fund manager typically does not invest any money in the funds they manage. They are paid a a pre-
agreed percentage of the profits of the fund.
2. Wakala – in this instance, the fund investors are the Rab al Mal and the fund manager acts as an
agent on their behalf investing the funds in Shariah-compliant investments. The agent or Wakil is
entitled to a fee for his services. In addition, any profit made by him over and above a pre-agreed
anticipated profit rate can be granted to him as an incentive. Within the context of Shariah-
compliant fund management, the Wakala agreement can be used for the purpose of managing the
fund but also as a liquidity instrument within the range of products available to the fund manager.

6. Types of Funds

Learning Objective
6.6.1 Know the characteristics of fixed-income funds
6.6.2 Know the characteristics of lease funds
6.6.3 Know the characteristics of commodity funds
6.6.4 Know the characteristics of real estate funds
6.6.5 Know the characteristics of equity funds
6.6.6 Know the characteristics of exchange-traded funds
6.6.7 Know the characteristics of hedge funds

Generally, the types of funds offered are very similar to the ones offered in the conventional world. Fund
structures are typically similar to conventional structures, although Shariah compliance is a key factor.
An SSB is involved from the start of the fund and is not responsible for any operational and strategic
decisions the fund manager makes – it is solely concerned with Shariah compliance.

143
6.1 Fixed-Income Funds
Outperformance in a fund is typically generated by investments with longer maturities, such as Sukuk
and Ijara. Wakala and commodity Murabaha transactions provide the necessary liquidity. The exact
asset allocation will depend on the framework of the fund and its objectives. As a broad rule of thumb,
the underlying investments of fixed-income funds can be categorised into the following types:

1. Cash.
2. Wakala.
3. Commodity Murabaha.
4. Collective schemes.
5. Sukuk.
6. Ijara.

The majority of the outperformance of an income-producing fund will be generated by investments in

instruments with longer maturities, such as Sukuk and potentially large Ijara positions. The necessary
liquidity in the fund will be generated from the short-term instruments, like Wakala and Commodity
Murabaha transactions. The exact allocation of the different instruments in the fund will depend on the
framework of the fund and its objectives and also on the availability of instruments in the primary and
secondary markets and economic circumstances. As a broad rule of thumb, fixed-income funds can be
divided into the following types:

• Deposit funds – typically invest in deposit-type instruments that have an average maturity of 60
days, with a maximum of one year per individual asset. Investors can generally redeem on a daily
basis providing them with a high level of liquidity. A deposit fund typically invests in the most
conservative assets, such as cash, Wakala and Commodity Murabaha. Contrary to liquidity funds,
deposit funds do not invest in any non-cash-type instruments.
• Liquidity funds – typically invest in deposit-type instruments with a small portion (likely up to 20%)
of the funds invested in short-dated Sukuk. The average maturity of the assets is 60 days, with a
maximum of two years per individual asset. Investors can generally redeem on a daily basis.
• Money market funds – typically invest in a diversified mix of cash, Wakala, Commodity Murabaha,
Sukuk and Ijara. The proportion of funds invested in Sukuk and Ijara is likely to be up to 50% of
the total holdings. The average maturity of the underlying assets is around one to two years, with
a maximum maturity of ten years for an individual instrument. Although redemption is daily, the
settlement period is typically three to four working days.
• Enhanced cash funds – typically invest in a diversified mix of cash, Wakala, and Commodity
Murabaha and, in addition, allocate a large proportion (50–80%) to Sukuk and Ijara. The average
maturity of the underlying assets is one to five years, with a maximum of ten years for an individual
instrument. Redemption takes place daily, with an average settlement period of three to four
working days.
• High-yield funds – typically invest in a diversified mix of cash, Wakala, and Commodity Murabaha
and, in addition, allocate a large proportion (typically up to 80%) to Sukuk and Ijara. The average
maturity of the underlying assets is one to five years, with a maximum of ten years for an individual
instrument. In addition, unhedged currency exposure can be part of the investment strategy.
Redemption takes place daily, with an average settlement period of three to four working days.

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Comparative Risk, Return and Liquidity

The following chart provides an indication how these funds can be compared given their risk, expected
return and level of liquidity. It goes without saying that a higher risk is not necessarily accompanied by a
higher return. After all, the value of investments can go up as well as down. However, funds with a lower
level of liquidity typically do have higher returns associated with them due to the fact that the money
can be invested for a longer period.

Cash
High yield
Enhanced cash Wakala
Commodity Murbaha
Collective schemes
Money market
Sukuk

High risk/high return Ijara

Liquidity

6
Medium risk/medium return
Return %

Deposit

Low risk/low return

Risk % (standard deviation)

Figure 2 – Comparative risk return and liquidity (Schoon, N , 2011, Islamic asset management)

6.2 Lease Funds

Lease-based funds are generally considered to be slightly higher risk and potentially provide a higher
return than fixed-income funds. The higher risk is mainly associated with the potentially less diversified
portfolio and the ownership risk on the underlying asset. The advantages of a lease fund are:

• The fund owns the asset.

• The lessee – ie, the user of the asset – relies on the availability of the asset for his operations and is,
hence, less likely to default on the rental payments.
• Finance leases do not take residual risk on the asset and, since the periodic payment includes
a principal payment as well as a rental contribution, the cash streams are predictable over the
duration of the investment.

In addition to leases, the fund typically holds around 10–20% of its funds in relatively short-term liquid
instruments such as cash, Commodity Murabaha and Wakala in order to meet its liquidity requirements.

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The structure of a lease fund can, for example, be depicted as follows:

Investment
Special purpose Shariah-compliant
vehicle (SPV) Periodic Shariah-compliant
leases
rental Shariah-compliant
leases
leases

Investment
Special purpose Shariah-compliant
Lease fund Shariah-compliant
leases
vehicle (SPV) Periodic
rental Shariah-compliant
leases
leases

Investment
Special purpose Shariah-compliant
Shariah-compliant
leases
vehicle (SPV) Periodic
Shariah-compliant
leases
rental
leases

Figure 3: Lease Fund Structure (Schoon, N , 2011, Islamic asset management)

Investors’ funds are invested in one or more special purpose vehicles (SPVs). The SPV owns the leases
on behalf of the investors, which has the advantage that the underlying assets are retained by the SPV.
This may prevent any potential tax and ownership transfer issues that might occur depending on the
jurisdiction of the lessor.

The SPV, in its role of lessor, purchases the assets and leases them to the lessee. The SPV manages the
receipt of periodic rental payments from the lessee and manages any other functions a lessor has. The
SPV makes periodic payments to the fund manager as agreed and reinvests the proceeds in any asset
category, depending on its requirements.

6.3 Commodity Funds

In a commodity fund, the fund manager uses the investments in the fund to purchase commodities with
the intention to sell them at a profit. In order for an investment to be eligible, it needs to fulfil a number
of criteria associated with a valid sales contract.

• Ownership – the commodity must be owned by the seller at the time of sale. Short-selling is not
permitted.
• Forward selling – forward sales are not permitted unless the transaction is associated with short- or
long-term production finance (Salam or Istisn’a).

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 Islamic Asset Management

• Acceptability – the commodity has to be lawful or halal and cannot, for instance, be alcohol, pork or
any other commodity prohibited in Shariah.
• Possession – the seller must have physical or constructive possession of the commodity, which
implies that the ownership risk is with the seller.
• Price – the price at which the commodity is sold needs to be certain and unconditional.

The risk of investing in a commodity fund is higher due to the price volatility of the underlying
commodities. Shariah-compliant commodity funds typically invest in base metals, precious metals and
oil- and gas-related commodities.

6.4 Real Estate Funds

Real estate funds can invest in commercial and residential real estate and generate a yield from rental
income and increase in value. Rental income is generally reinvested in the fund or used to repay any
mortgage financing. The use of any property needs to be Shariah compliant and its use will need

6
to be monitored for ongoing compliance. Commercial properties that are leased to conventional
financial institutions or any other unlawful industries cannot be included in the fund and any income
associated with the non-compliant use must be donated to charity. In the event a property becomes
non-compliant, it must be disposed of in an organised manner. Generally, a reasonable period of time is
allowed for the disposal process in line with market conditions so as not to disadvantage the investors.

6.5 Equity Funds

Equity funds occur in the following main variations:

• Private Equity – funds investing in non-public companies either via direct investment or by
obtaining shares. Investment in private equity is particularly suited to Shariah due to the partnership
and profit- and loss-sharing principles underlying the transaction. The performance of funds
investing in private equity is, however, difficult to determine as a private enterprise does not have
a market value since the shares are not tradeable and the enterprises are typically relatively small.
• Listed Equity – funds can either be actively managed, through investment in listed companies via
share purchases in the open market, or passively managed, in which case they track the performance
of an assigned index. All major index providers have also introduced Shariah-compliant indices,
such as the Dow Jones Islamic Market Index (DJIM) and the FTSE Shariah Global Equity Index Series.
Besides the fact that these indices contain only those equities that are Shariah compliant, they are
similar to other equity indices.

All equity needs to meet both the industry and financial screening criteria.

Individual Islamic indices may apply different screening criteria depending on the requirements defined
by their SSB.

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Examples
The Dow Jones Islamic Market Index (DJIM) applies the AAOIFI industry screen and three financial
screens to exclude companies which have:

• Total debt/trailing 24-month average market capitalisation < 33%.

• (Cash + interest-bearing securities)/trailing 24-month average market capitalisation < 33%.
• Accounts receivable/trailing 24-month average market capitalisation < 33%.
The trailing 24-month average market capitalisation is applied to reduce volatility.

The FTSE Shariah Global Equity Index Series applies the AAOIFI industry screen and adopts the
following financial screens:

• Debt/total assets < 33.33%.

• (Cash + interest-bearing securities)/total assets < 33.33%.
• (Cash + accounts receivable)/total assets < 50%.
• Total interest and non-compliant activities should not exceed 5% of total revenue.

The MSCI Islamic Index Series applies the AAOIFI industry screen and also specifically excludes hotels,
cinema and music from its investment universe and applies the following financial screen:

• Total debt /total assets < 33.33%.

• (Total cash + interest bearing securities)/total assets < 33.33%.
• (Total cash + accounts receivable)/total assets < 33.33%.

6.6 Exchange-Traded Funds (ETFs)

Islamic exchange-traded funds (ETFs) are securities that track the performance of an Islamic index or
basket of commodities in the same way as an index fund does. However, the ETFs can be traded on an
exchange in the same way as securities. The price of ETFs changes during the day as a result of units
being bought and sold. The fund is not required to keep liquid instruments, since the investor can
liquidate his holdings by selling them in the open market.

A physical or conventional ETF invests in stocks with the aim to replicate the performance of an index.
Provided the underlying investments are Shariah compliant, this type of ETF is suitable for Shariah
investors.

A synthetic ETF has the same aim (replication of the performance of an index), but achieve this by
investing in derivatives and swaps to achieve the result. Due to their use of derivatives, synthetic ETFs
are not suitable for Shariah investors. However, synthetic ETFs that are constructed using different types
of instruments, such as swaps, can be.

6.7 Hedge Funds

Due to the prohibition on short-selling, hedge funds are still contentious. Some scholars have permitted
the use of structures, including Salam, Arboon, and Wa’d, to overcome the prohibition of short-selling,
although these are not generally accepted. Some Shariah-compliant single-manager equity hedge

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 Islamic Asset Management

funds are available in the markets that make advance payments against forward asset purchases
through the utilisation of the Salam contract.

7. Concluding Remarks
Similar to conventional financial services, Shariah-compliant fund management provides diversification
in investments. A range of different fund types is available with different levels of risk. The main
difference between conventional and Shariah-compliant fund management is that all transactions and
operations of an Islamic fund must comply with Shariah.

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 End of Chapter Questions

1. What are the two basic screening processes?

Answer reference: Section 3

2. List the excluded business activities when selecting Shariah-compliant investments.

Answer reference: Section 3.1

3. When applied to an individual fund or index, what are the exact screening criteria dependent upon?
Answer reference: Section 3.3

4. In what circumstance is divestment always required?

Answer reference: Section 3.4

5. What is the definition of a fund?

Answer reference: Section 4

6. Why is diversification an important investor tool?

Answer reference: Section 4

7. What is the role of the fund manager within the investment management process?
Answer reference: Section 5

8. Why are Mudaraba contracts particularly suited to fund management?

Answer reference: Section 5

9. List the types of fixed income funds.

Answer reference: Section 6.1

10. When is forward selling permitted?

Answer reference: Section 6.3

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Chapter Seven

Sukuk Market
1. Definition, Management and Characteristics of Sukuk 153

2. Structuring Sukuk Transactions 157

3. The Different Types of Sukuk 159

4. The Main Types of Sukuk 160

5. Sukuk Rule Changes 2008 170

7
6. Capital Market Considerations Relating to Sukuk 171

7. Concluding Remarks 172

This syllabus area will provide approximately 11 of the 100 examination questions
152
 Sukuk Market

The emergence of Sukuk has been one of the most significant developments in the Islamic capital
markets in recent years, and can be traced back to a February 1988 decision of the Fiqh Academy of
the OIC ruling ‘... any collection of assets can be represented in a written note or bond; and that this bond or
note can be sold at a market price provided that the composition of the group of assets, represented by the
security, consists of a majority of physical assets and financial rights, with only a minority being cash and
interpersonal debts’.

Shortly thereafter, in 1990, the first Sukuk was issued with the following characteristics:

• Issuer – Shell MDS of Malaysia.

• Issue amount – RM125 million (equivalent to approximately US$30 million).
• Underlying transaction type – Bai’ Bithaman Ajil (deferred payment sale).

The first sovereign Sukuk was issued by the Government of Bahrain for an amount of US$100 million,
based on an Ijara structure. This was followed by the first global Sukuk (US$600 million Sukuk al Ijara)
issued by the Malaysian government and the first Sukuk issued outside an Islamic country (Saxony-
Anhalt, Germany, US$123 million Sukuk al-Ijara). In 2006, the first fund investing solely in Sukuk was
launched; in 2012, France modified its legislation to accommodate Sukuk issuance and, in 2014, the UK
issued a sovereign Sukuk issue of GBP 200 million. As of September 2016, US$37 billion was issued out of

7
the Middle East and North Africa (MENA) region, US$12 billion in Asia, US$7 billion in Europe and US$500
million in both Africa and the US1.

Sukuk has bond-like characteristics, and is an instrument that generates predicable income (yield) until
maturity. At maturity, the capital is repaid.

The first part of this chapter details the differences between conventional bonds and Sukuk, and
emphasises the importance of assets in the issuing process. The second part outlines the issuing process,
and the third part explains some of the most commonly used structures.

1. Definition, Management and Characteristics of

Sukuk

1.1 Conventional Debt Securities and Sukuk

Learning Objective
7.1.1 Know the differences between conventional securities and Sukuk
7.1.2 Understand the difference between asset-backed and asset-based Sukuk

1.1.1 Conventional Debt Securities

Debt securities or bonds are tradable financial instruments issued by a company or corporation to borrow
a significant amount of money. Bonds are long-term loans allowing the holder to receive interest before
the distribution of profits to shareholders. Bonds can be redeemed at the due date or upon liquidation,

1 International Islamic Financial Market (2017) Sukuk Report - 6th edition.

153
and have priority for repayment over shareholders in the event a company becomes insolvent. They can
be sold and bought in both the primary and secondary markets and have the following characteristics:

1. The borrowing entity is either a government or a corporate.

2. Funds are borrowed for a defined period of time.
3. They pay a fixed or variable interest rate.

Redemption is generally at the due date or upon liquidation, with bondholders having priority over
shareholders in the event of insolvency. Bonds may be secured or structured to have priority over other
classes of debt.

The trading and pricing mechanism for conventional debt securities is based on the buyer’s and seller’s
view of expected movements in interest rates.

Debt securities are important tools to achieve a balanced portfolio or to assure income. Prior to the
advent of Sukuk, there were no true Islamic investment securities meeting the same need.

1.1.2 Islamic Securities – Sukuk

Case Study – Saxony-Anhalt Private Funding
In 2004, the German federal state of Saxony-Anhalt decided to raise €100 million from the international
debt markets to meet its funding requirements. The local government decided to reach out to Islamic
investors from the GCC and issued a Sukuk to comply with the Shariah rulings in relation to:

1. Riba – the coupon should not represent an interest rate but a return on the asset.
2. Liability justifies return/reward is linked to risk – the coupons and capital redemption should be
linked to the performance of the underlying assets.
3. Tradability – Sukuk should be tradable on a secondary market.

A US$123 million Sukuk al-Ijara was issued in July 2004.

AAOIFI defines Sukuk as follows:

‘Certificates of equal value representing undivided shares in ownership of tangible assets, Usufructs and
services or (in the ownership of) the assets of particular projects or special investment activity.’ (AAOIFI,
2004:298).

This definition clearly establishes the link between the instrument and ownership of assets. Although
not the same, Sukuk, as a financial instrument, is often compared to conventional bonds.

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 Sukuk Market

Case Study – Saxony-Anhalt Sukuk (1)

In order to be able to issue the Sukuk, the arranger of the Saxony-Anhalt Sukuk required an asset with
the following characteristics:

1. Tradable – the asset can be sold to raise the required funds.

2. Useable – the asset can generate a regular stream of income to pay the periodic return.
3. Redeemable – at the end of the period, the asset can be sold back to the issuer.

The underlying structure is a sale and leaseback of real estate owned by the state. The assets were sold
to the SPV for the amount of €100 million and leased back to the state of Saxony-Anhalt. The Sukuk
holders are paid a periodic return on the basis of the rental received. At maturity, the real estate is
bought back by the state, and the proceeds of this are used to repay the initial capital investment of the
Sukuk holders.

The Essential Role of Assets

From a Shariah compliance perspective, the asset is essential, and pricing in the primary and secondary
market should be based on the buyer’s and seller’s views of the value of the underlying asset. The

7
profit levels should be calculated according to the performance of the underlying assets or projects.
In practice, however, the primary role of the asset is to act as a security and pricing is based on
creditworthiness, market conditions and benchmark rates.

Income received by the Sukuk holder is legitimate, since it is linked to a proportionate share of the
underlying asset owned by them.

The security of the capital of the Sukuk holder depends on the contractual agreement as well as whether
or not the Sukuk is secured. In a secured Sukuk, the capital is collateralised by the underlying asset. A
secured Sukuk is secured by an existing asset. In addition, the asset that is constructed with the Sukuk
proceeds may be used as additional collateral. In an unsecured Sukuk, on the contrary, the asset cannot
be considered to be collateral, resulting in lower levels of security for the Sukuk holder.

Asset-based versus Asset-backed Sukuk

The terms ‘asset-based’ and ‘asset-backed’ refer to whether the Sukuk is secured (asset-backed) or
unsecured (asset-based).

Asset-backed Sukuk involve a true sale (transfer of ownership) of the underlying asset from the
originator to a SPV. The SPV will hold the asset in trust on behalf of the Sukuk holders. Sukuk holders, as
the owners of the asset, are exposed to the risks and potential losses associated with ownership. In the
event of bankruptcy of the obligor, the Sukuk holders have recourse to the asset and will be repaid from
the proceeds of the sale.

Asset-based Sukuk are unsecured and typically only provide beneficial ownership of the asset to the
SVP. A beneficial owner is defined as: ‘a legal term where specific property rights (‘use and title’) in equity
belong to a person even though legal title of the property belongs to another person’ (Black’s Law Dictionary
(2nd Pocket ed. 2001 pg. 508).

155
The legal owner, in this case, retains the ownership of the asset.

Case Study – Saxony-Anhalt Sukuk (2)

The state of Saxony-Anhalt sells the beneficial ownership of the buildings to the SPV and pays a rental to
the SPV for the continued use of the assets until maturity of the Sukuk.

In the event of bankruptcy, the assets in an asset-based Sukuk revert back to the obligor (legal owner)
and the claim of the Sukuk holders will rank pari passu with other unsecured debtors.

1.1.3 Differences Between Sukuk and Conventional Debt Securities

The differences between Sukuk and conventional debt securities are summarised in the following table:

Sukuk Conventional Debt Securities

Sukuk represent a share of the ownership of Debt securities are a negotiable or tradable
the underlying asset used by the company liability or loan. Debt holders do not bear losses
issuing the securities. Sukuk holders are as a result of the performance of the borrower
exposed to appreciation or depreciation of the company since there is no direct link between
asset. the securities and the company’s assets.
The income of the Sukuk holders is linked to The income of the investors is linked to interest
the performance of the underlying asset. rates and creditworthiness of the borrower.
Sukuk holders have the right to profits but
Bondholders are not exposed to losses unless
may bear losses if the underlying asset
the issuer declares bankruptcy.
underperforms.
Sukuk holders bear various ownership costs Bondholders are not liable for any costs
that are paid out of their share of the profits. associated with ownership of an asset.
The term to maturity of the Sukuk corresponds The term to maturity of a conventional
with the completion of the project or activity debt security is not necessarily linked to an
financed. underlying project.
The capital of debt securities holders is
The capital of Sukuk holders is at risk of a loss in
guaranteed to be repaid at maturity except for
the value of the asset.
in the instance of bankruptcy.

The differences between Sukuk and conventional debt securities have an impact on the tasks and
responsibilities of the Sukuk manager. The Sukuk manager represents the Sukuk investors and works on
their behalf. They may be dismissed by the Sukuk holders which results from the fact that, as owners,
Sukuk holders are entitled to decide who is most qualified to manage their property or project.

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 Sukuk Market

2. Structuring Sukuk Transactions

2.1 The Basic Sukuk Issuance Process

Learning Objective
7.2.1 Understand the basic processes and applications involved in the issuance of Sukuk in different
jurisdictions

The usual format for issuing Sukuk is as follows:

• Set-up of the general framework and organisational structure. All legal, procedural and organisational
issues need to be incorporated in the subscription prospectus.
• Creation of a SPV as a tool for asset acquisition.
• Underwriting the subscription. A commitment should be made to regulate the subscription process
for any unsold Sukuk. This commitment is made by the party who undertakes to underwrite the
issue to buy all the unsubscribed Sukuk; usually, this is the Islamic bank.

7
Figure 1 below provides an example of a Sukuk structure.

Originator

Sale of Periodic
asset rental/cash
flows, etc

Proceeds Sale of
of asset asset
sale (less
commission) Proceeds

Issue Sukuk/Sale of asset

Investors Proceeds of asset sale Issuer (SPV)

Periodic payments

Sale of asset

Proceeds

Issue
Maturity

Figure 1: A Sukuk Structure (Source: Schoon, N (2016) Modern Islamic Finance London: Wiley)
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Similar to conventional bonds, the purpose of a Sukuk is to mobilise funds from multiple investors to a
company which requires funds for a project. The parties involved in a Sukuk are:

1. Originator/obligor – a company or government seeking funds to undertake a project. The obligor

will approach a bank to organise the issuance process.
2. Arranger – the bank that sets up the structure and establishes a SPV that will issue the Sukuk and
manage the process on the behalf of the investors. The arranger is typically responsible for the
prospectus, the underwriting of the issue and promotion and marketing.
3. Issuer – the SPV, that issues the Sukuk to the investors (the subscribers), collects their funds,
manages the issue and distributes profits. The SPV has the following characteristics:
• It is bankruptcy remote – in the event of bankruptcy of the obligor, any trade creditors cannot
stake a claim on the assets held in the SPV or otherwise interfere with the rights of the Sukuk
holders with respect to the underlying asset.
• It is domiciled in a tax-efficient jurisdiction such as the Cayman Islands, Luxembourg, Jersey,
Bahrain or Labuan.
• It acts as a trustee – the SPV often acts as a trustee on behalf of the investors.
4. The assets/project – the underlying assets, Usufruct, or services will be owned by the investors until
maturity.
5. Investors – Sukuk holders receive Sukuk certificates from the SPV in return for their funds.
6. Manager – the investors are represented by the manager of the SPV. He manages the investment
of their funds in accordance with the terms of the Sukuk documentation. This manager can be an
Islamic bank.
7. Underwriter – party committed to buy all unsubscribed Sukuk.

Case Study – Saxony-Anhalt Sukuk (3)

Obligor – State of Saxony-Anhalt

Arranger – Citi Islamic Investment Group

Issuer – Stichting Sachsen-Anhalt Trust, Luxembourg

Asset – state-owned administrative buildings

Investors – varied across type and geographic jurisdiction and included investors from the US, the UK,
Saudi Arabia, Bahrain, Malaysia, Japan, Hong Kong and Germany.

Pricing – 100bp (1%) over six-month EURIBOR

Tenor – five years

2.2 Calculating Sukuk Return

Sukuk periodically pays a target rate of return which, in the documentation, may be referred to as the
expected return. Unlike a conventional bond’s coupon, there is no obligation to pay the expected
return. Pricing should be based on the expected return on the asset but is, in practice, typically driven by
elements such as the creditworthiness of the obligor, market conditions, interest rate environment and
other benchmark offerings.

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 Sukuk Market

3. The Different Types of Sukuk

By definition, Sukuk are subject to fluctuating profits, possible losses and uncertainty of repayment of
the capital. Investors desire stable income and capital preservation. Sukuk structures are designed to
cater for these opposing interests.

3.1 AAOIFI Classification of Sukuk

AAOIFI’s Shariah standard No 17 identifies 13 different Sukuk structures, each with a specific purpose
and asset type:

1. Sukuk al Ijara (certificates of ownership in leased assets).

• Purpose – securitisation of existing tangible leased assets.
• Asset owned – securitised assets.
2. Sukuk Ijara Mawsoofa Bil Thimma (certificates of ownership in described future leased assets).
• Purpose – mobilisation of funds to meet the acquisition cost of tangible to-be-leased assets.
• Asset owned – described future leased assets.
3. Sukuk Manfaa Ijara (certificates of ownership in the usufruct of leased assets).

7
• Purpose – securitisation of the Usufruct of existing leased assets.
• Asset owned – the usufruct of the leased assets.
4. Sukuk Manfaa Ijara Mawsoofa Bil Thimma (certificates of ownership in the Usufruct of
described future leased assets).
• Purpose – securitisation of the Usufruct of assets to be acquired and leased.
• Asset owned – the Usufruct of the assets to be acquired and leased.
5. Sukuk Milkiyat al-Khadamat (certificates of ownership of services of a specified party).
• Purpose – pre-sale of the cost of services and their expected benefits.
• Asset owned – the services.
6. Sukuk al Salam (certificates of ownership of future goods or commodities).
• Purpose – pre-sale of future goods or commodities.
• Asset owned – goods or commodities to be delivered at a future date.
7. Sukuk al Istisn’a (certificates of ownership of future manufactured or constructed assets).
• Purpose – mobilisation of funds to cover the cost of construction and manufacturing of specific
assets.
• Asset owned – manufactured or constructed assets to be delivered at a future date.
8. Sukuk al Murabaha (certificates of ownership of goods to be sold under Murabaha).
• Purpose – mobilisation of funds required for the acquisition cost of goods to be sold under a
Murabaha.
• Asset owned – goods to be sold under Murabaha.
9. Sukuk al Musharaka (certificates of partnership in a venture).
• Purpose – sale of capital participation in a partnership.
• Asset owned – shares of the venture.
10. Sukuk al Mudaraba (certificates of ownership in a Mudaraba operation).
• Purpose – mobilisation of funds from capital providers for a Mudaraba transaction.
• Asset owned – project or activities managed under the Mudaraba.
11. Sukuk al Wakala (certificates of ownership of goods entrusted to an agent).
• Purpose – mobilisation of funds for the acquisition of certain goods that are entrusted to an
agent.
• Asset owned – the goods entrusted to the Wakil (agent).

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12. Sukuk al Muzara’ (certificates of ownership of a share of a crop).
• Purpose – mobilisation of funds for the cultivation of land.
• Asset owned – share of crops to be produced.
13. Sukuk al Musaqa’ (certificates of ownership of a share of a crop or a share of ownership of land
and its trees).
• Purpose – mobilisation of funds for the planting or irrigation and maintenance of fruit bearing
trees.
• Asset owned – share of the crops of fruit-bearing trees, or the land and its trees.

Although the AAOIFI standards cover multiple structures, in practice, only a few are used. The majority
of Sukuk instruments are based on lease transactions or business partnerships with predictable income
streams.

4. The Main Types of Sukuk

The focus of this section is on those types of Sukuk that are most commonly used in practice:

• Sukuk al Ijara.
• Sukuk al Wakala.
• Sukuk al Musharaka.

It will also cover those used to a lesser extent:

• Sukuk al Murabaha.
• Sukuk al Istisn’a.
• Sukuk al Salam.
• Sukuk al Mudaraba.

The distinction between these different types is based on the type of contract that underpins the
structure or that is used to generate the Sukuk holder’s income.

4.1 Sukuk al Ijara

Learning Objective
7.2.2 Be able to apply Sukuk al Ijara

Sukuk al Ijara is the most popular type of Sukuk. The structure is relatively simple and, due to the
underlying transaction type (Ijara), has regular payments throughout the life of the arrangement. In
addition, it provides flexibility to tailor the payment profile and method of calculation to generate a profit.

The structure of the Sukuk al Ijara follows the rules of the underlying Ijara transaction and is typically
a sale and leaseback transaction. The Sukuk certificates constitute shares in a leasing project (usually
equipment or real estate), providing holders with the right to receive rental fees and the ability to
dispose of the properties without affecting the lessee’s rights. Ijara Sukuk are tradable, since the seller
will also sell their proportionate share in the assets and can be listed on an exchange.

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 Sukuk Market

Case Study – Dubai Department of Finance (DOF)

The Dubai DOF Sukuk was issued in November 2009 as the first dual-currency Sukuk. The structure was
composed of two tranches, one of US$1.25 billion and one of 2.5 billion Arab Emirates Dirham. Investors
received twice yearly returns of 6.396% calculated on the face value of their holding.

The US$ tranche detailed below was redeemed on 3 November 2014.

The Dubai DOF Sukuk issue was structured as follows:

Government as Government as Government as Government as

Seller Lessee Servicing Agent Purchaser

3 4 5 6 8 9 10 11

Global Sukuk Company ltd (Trustee)

7
2 1 7 12

Investors

• Phase A
1. Dubai DOF Sukuk ltd issues Sukuk in order to
2. raise funds.

• Phase B
3. Dubai DOF Sukuk ltd uses the proceeds of the certificates to
4. purchase, from the government of Dubai, a portfolio of assets including airport infrastructure,
storm water drainage systems, an Emirates operation tunnel, a crisis centre and a car park.

• Phase C
5. Dubai DOF Sukuk ltd leases the acquired assets to the government of Dubai.
6. The government (as lessee) makes periodic rental payments equal to the distribution amount
payable for the corresponding period.
7. Dubai DOF Sukuk ltd uses those imbursements to pay its due to the certificate holders on each
periodic distribution date.
8. Dubai DOF Sukuk ltd appoints the government as its servicing agent to carry out certain of
its obligations under the lease agreement, namely the obligation to undertake any major
maintenance, insurance and payment of taxes in connection with the lease assets.
9. Dubai DOF Sukuk ltd reimburses the government for any expenses incurred while undertaking
these duties.

• Phase D
10. On the scheduled dissolution date, Dubai DOF Sukuk ltd requires the government to purchase
all of its rights, title, interest, benefits and entitlements in the assets portfolio.
11. The exercise price is paid by the government.
12. The final dissolution amount is payable by Dubai DOF Sukuk ltd to the certificates’ holders.

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Main Contracts Used
• Phase A
Trust deed – the trust assets, in respect of each series, comprise Dubai DOF Sukuk ltd’s rights, title,
interest and benefits in the relevant lease assets; its rights, title, interest and benefits, present
and future, in the transaction documents; and any amounts standing to the credit of the relevant
transaction account.

According to the trust deed, Dubai DOF Sukuk ltd will, in relation to each series:

1. hold the relevant trust assets on trust for the certificate holders as tenants in common pro rata
according to the face value of the trust certificates held by each of them, and
2. act as trustee in respect of the relevant trust assets, distribute the income from the relevant trust
assets and perform its duties in accordance with the provisions of the trust deed.

• Phase B
Purchase agreement – according to this agreement, the government will sell Dubai DOF Sukuk ltd
and Dubai DOF Sukuk ltd will buy from the government rights, interest, title and benefits to certain
assets described in each supplemental purchase agreement, free and clear of any encumbrance or
other rights of third parties.

• Phase C
Lease agreement – under the terms of the lease agreement, Dubai DOF Sukuk ltd will lease to the
government, and the government will lease from Dubai DOF Sukuk ltd, certain assets identified
in supplemental lease agreements. The government agrees to use the relevant lease assets at its
own risk. Accordingly, it shall bear the risk of loss or damage to the relevant lease assets or arising
from the usage or the operation of the said assets. In addition, Dubai DOF Sukuk ltd will not be
liable (and the government will waive any claim or right, howsoever arising, to the contrary) for any
indirect, consequential or other losses, howsoever arising, in connection with the government use
or operation of the relevant lease assets.

Under the lease agreement, the government will also agree to be responsible, at its own cost and
expense, for the performance of all ordinary maintenance and repair required for the lease assets.
Dubai DOF Sukuk ltd will be responsible for:

a. the performance of all major maintenance and structural repair

b. the payment of any proprietorship or other relevant taxes, and
c. insuring the leased assets.

The rental amounts (less any servicing agency expenses incurred by the government in relation to
the relevant lease assets for the relevant period), payable under each lease agreement, will equal
the periodic distribution amounts payable on the periodic distribution dates for the relevant series.

Service agency agreement – Dubai DOF Sukuk ltd and the government enter into a service agency
agreement according to which the government is appointed servicing agent to manage the lease
assets portfolio.

• Phase D
Purchase undertaking – the government enters into a purchase undertaking in favour of Dubai DOF
Sukuk ltd pursuant to which the government undertakes irrevocably to purchase all of Dubai DOF
Sukuk ltd’s rights, interest, title benefits and entitlements in the lease assets on the relevant maturity
date or any earlier dissolution date.

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 Sukuk Market

Sale undertaking – Dubai DOF Sukuk ltd, as trustee for the certificate holders, enters into a sale
undertaking in favour of the government. According to this agreement, the government may, by
exercising its right under the sale undertaking and serving notice on Dubai DOF Sukuk ltd no later
than 45 days prior to the relevant dissolution date, oblige Dubai DOF Sukuk ltd to sell all of its rights,
benefits and entitlements in and to the lease assets of the relevant series on the relevant dissolution
date at the exercise price.

Finally, the government will be entitled under a substitution undertaking to substitute new assets for
existing lease assets, at its own cost.

4.2 Sukuk al Musharaka

Learning Objective
7.2.3 Be able to apply Sukuk al Musharaka

7
The funds raised via a Sukuk al Musharaka are invested in a new project, the development of an existing
project or to finance a business activity. Unlike Sukuk al Murabaha and Sukuk al Ijara which generate
a steady flow of income, the partners of Sukuk al Musharaka share in the profits and losses of the
enterprise. Hence, the revenues may fluctuate and repayment of the capital cannot be guaranteed.

This level of risk does not meet the requirements of all investors and arrangers may attempt to design
a structure that could smooth the income of the investors and guarantee capital. Shariah compliance
may, however, be an issue with this.

Case Study – United Real Estate Company (URC) Sukuk ltd

In 2007, the Kuwaiti United Real Estate Company (UREC) issued a US$100 million Sukuk al Musharaka
with a five-year maturity.

The URC Sukuk ltd issue was structured as follows:

4
UREC as UREC as UREC as
6 Musharaka partner Obligor Management Agent

Musharaka
9 10 7 8
Agreement

5
URC Sukuk ltd (trustee)
3

1 2 11 12

Investors

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• Phase A
1. URC Sukuk ltd issues Sukuk in order to
2. raise funds.

• Phase B
3. URC Sukuk ltd is based on a Musharaka agreement which contributes US$100 million raised
from the market to the capital of the Musharaka.
4. UREC participates in kind with rights, benefits, interest to use certain real estate and properties
that have a market value of US$30 million.
5. The partners agree that the URC Sukuk ltd will receive 90% of the profit of the Musharaka.
6. UREC receives 10% of the profit of the Musharaka.
7. UREC is appointed as manager of the Musharaka.
8. UREC receives management fees for performing their task.
9. UREC is nominated obligor.
10. As such, they agree to a purchase and sale undertaking that binds them to buy back units of the
Musharaka at the request of the trustee.

Main Contracts Used

• Phase A
Declaration of trust – the issuer will hold certain assets, primarily consisting of all of its rights, title
and interest in the Musharaka entered into with the UREC as a partner and the rights under the
transaction documents and the transaction account and all proceeds of the foregoing.

On the 13th day of each March, June, September and December commencing on the first periodic
distribution date, the issuer will pay a periodic distribution amount to the certificate holders
calculated on the basis of:

• LIBOR plus 1.50% per annum, on the outstanding principal amount of the certificates as at the
beginning of the relevant return accumulation period on an actual/360 basis, plus
• in respect of each periodic distribution date, an amortisation payment of:
• US$20 million, being 20% of the initial principal amount of the certificates, plus
• any additional costs.

• Phase B
Musharaka agreement – according to the Musharaka agreement, the Musharaka partners agree to
enter into an unincorporated joint venture (the Musharaka). The Musharaka will commence on the
date of the Musharaka agreement and will terminate and dissolve on the date at maturity.

Upon its creation, the capital of the Musharaka is US$130 million. The issuer contributes US$100
million and UREC makes a contribution, in kind, of no less than US$30 million. UREC’s contribution
consists of the vesting into the Musharaka of all UREC’s rights, benefits and interests to use certain
real estate and properties that have a market value of US$30 million.

Each Musharaka partner is entitled to share in the profits of the Musharaka with 90% of all net cash
profit to be distributed to the issuer and 10% to UREC. If the issuer’s profit share is in excess of the
periodic distribution amount, the surplus distributable profit is paid to the management agent as
incentive fees for acting as manager under the management agreement. The Musharaka partners
will also bear the losses of the Musharaka. It will be borne by the partners, in proportion to the units
held by each one in the Musharaka.

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 Sukuk Market

Purchase undertaking – under the purchase undertaking, UREC (as obligor) undertakes irrevocably
to purchase one unit from the issuer when the latter exercises its option. UREC will purchase this
unit at the relevant exercise price to be determined on the relevant exercise date.

Sale undertaking – pursuant to the terms of the sale undertaking, the obligor may oblige the
issuer to sell its units. The issuer will sell those units to the obligor at the relevant exercise price
determined on the relevant exercise date.

Management agreement – according to the management agreement reached between the

Musharaka partners and the managing agent, the managing agent shall be appointed as manager
of the Musharaka.

The managing agent is authorised to carry out all necessary action on behalf of the Musharaka to
achieve the Musharaka’s objectives. In consideration for acting as managing agent, the managing
agent is entitled to incentive fees to be paid out of any surplus distributable profit after payment
and/or settlement in full of any amounts owing under the certificates.

• Phase C
The Sukuk holders receive the:

7
11. periodic distribution amount, and
12. the dissolution amount.

4.2.1 Profit Distribution Challenges

There is often a contradiction between the prospectus and the terms and conditions of the Musharaka
transaction. From the information incorporated in the transaction, it is often easily inferred that the
Sukuk will provide a foreseeable income. The Musharaka agreement itself, however, states that profits
may fluctuate and that investors’ capital is at risk. This is resolved within the purchase undertaking, the
sales undertaking and the management agreement.

Example – Profit Distribution in Sukuk al Musharaka

Assume the periodic payment calculated using the methodology of the prospectus is equal to
US$1,748,219. Three different scenarios can be considered.

Profit distribution – Scenario 1

The Musharaka makes a profit of US$1,942,466. According to the Musharaka agreement, US$194,247
(10%) is paid to UREC and US$1,748,219 (90%) to URC Sukuk ltd. The share of the trustee is equivalent to
the sum due to the Sukuk holders and the amount is transferred to their accounts.

Profit distribution – Scenario 2

The Musharaka makes a profit of US$2,500,000. According to the Musharaka agreement, US$250,000
(10%) is paid to UREC and US$2,250,000 (90%) to URC Sukuk ltd. The trustee is obliged to transfer only
US$1,748,219 to Sukuk holders. This sum is transferred to their accounts and the balance (US$501,781) is
transferred to the management agent in accordance with the management agreement.

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Profit distribution – Scenario 3
The Musharaka makes a profit of US$1,300,000. According to the Musharaka agreement, US$130,000
(10%) is paid to UREC and US$1,170,000 (90%) to URC Sukuk ltd. The trustee is obliged to transfer
US$1,748,219 to Sukuk holders. Hence, there is a deficit of US$578,219. According to the purchase
undertaking, URC Sukuk ltd asks UREC to buy some of its units to cover the shortfall and transfers the
whole amount to the Sukuk holders.

From the scenarios in the example, it is clear that the risk to investors is minimised by the purchase
undertaking, which specifies that: ‘UREC will purchase (the) unit at the relevant exercise price on the
relevant exercise date’ and the sales undertaking states that ‘the issuer will sell (the) units to the obligor at
the relevant exercise price’.

The meaning attached to the expression ‘relevant exercise price’ depends on the time during the
transaction the purchase undertaking is invoked.

• At the time of periodic distribution of profits, the US$ amount is equal to the periodic distribution.
• At the time of maturity, the US$ amount is equal to the dissolution distribution amount.

As a result, Sukuk holders have the certainty that they will receive the expected return on their
investment and are highly likely to recover their whole capital at maturity.

4.3 Sukuk al Wakala

Learning Objective
7.2.4 Be able to apply Sukuk al Wakala

This type of Sukuk is structured on the basis of a Wakala transaction, an arrangement whereby one party
entrusts another party to act on its behalf. The agent (Wakil) uses its expertise to select and manage
investments on behalf of the investor to ensure that the portfolio will generate the expected profit rate
agreed by the principal.

Case Study – Jebal Ali Free Zone (JAFZ)

In 2012, JAFZ2 issued trust certificates to the value of US$650 million. The funds were used by the
SPV (JAFZ Sukuk ltd) to buy a Wakala portfolio from JAFZ with a maturity date of 19 June 2019. Until
maturity, Sukuk holders will receive twice-yearly periodic payments on the 19 of June and December of
US$35 for every US$1,000 invested.

2 Jabal Ali Free Zone (JAFZ) is a major industrial and commercial development in Dubai and one of the largest
operating free zones in the GCC. In 2012, it included approximately 55 square kilometres and hosted approximately
6,700 companies from over 100 different countries (with approximately 125 Fortune 500 and large multinational
companies as tenants). JAFZ was established as a free zone establishment on 5 March 2006 with a mandate to realize
the maximum commercial value from operational and commercial activities within the free zone. Its activities consist
of leasing, commercial and administrative services.

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 Sukuk Market

The JAFZ Wakala Sukuk issue is structured as follows:

JAFZ as JAFZ as JAFZ as

Seller Servicing Agent Purchaser

3 4 5 6 8 9

JAFZ Sukuk ltd (Trustee)

2 1 7 10

Investors

Phase A

7
•
1. JAFZ Sukuk ltd issues Sukuk in order to
2. raise funds.

• Phase B
3. JAFZ Sukuk ltd uses the proceeds of the certificates
4. to purchase from JAFZ a portfolio of identified income generating real estate assets, consisting
of plots of land and, in cases where JAFZ owns the building, the attached buildings.

• Phase C
5. JAFZ Sukuk ltd appoints JAFZ as the servicing agent to manage the Wakala portfolio.
6. Prior to each periodic distribution date, JAFZ, as servicing agent, pays to the trustee an amount
reflecting the returns generated by the Wakala portfolio during the relevant Wakala distribution
period.
7. The funds are intended to be sufficient to fund the amounts payable to the certificate holders.
8. On the scheduled dissolution date, JAFZ Sukuk ltd has the right to require JAFZ to purchase all of
its rights, title, interests, benefits and entitlements in the Wakala portfolio.
9. The exercise price payable by JAFZ, together with any Wakala portfolio revenues then held
by the JAFZ as a servicing agent and payable to JAFZ Sukuk ltd under the Service Agency
Agreement, are intended to:
10. fund the final dissolution amount payable by JAFZ Sukuk ltd to the certificates holders.

Main Contracts Used

• Phase A
Declaration of trust – the trust assets include all of the:

1. trustee’s rights, title, interests and benefits, present and future in the assets constituting the
Wakala Portfolio
2. trustee’s rights, title, interests and benefits, present and future in the transaction documents
3. monies standing to the credit of the transaction account
4. proceeds of the foregoing.

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 According to the declaration of trust, the trustee will:

a. hold the trust assets on trust absolutely for the certificate holders pro rata on an undivided
basis according to the face amount of the certificates held by each of them
b. act as trustee in respect of the trust assets, distribute the income from the trust assets and
perform its duties in accordance with the provisions of the declaration of trust.
Investment agency deed – this agreement appoints Dubai Islamic Bank as investment agent to enter
into facility finance documents on the behalf of the participants and JAFZ.

• Phase B
Sale and purchase agreement – according to this agreement, JAFZ sells and the investment agent
purchases a portfolio consisting of real estate assets which are leased to third parties and generates
an income stream for onward distribution to investors.

• Phase C
Service agency agreement – the investment agent and JAFZ enter into a service agency agreement
according to which JAFZ is appointed servicing agent to manage the Wakala portfolio.

• Phase D
Purchase undertaking – JAFZ enters into a purchase undertaking in favour of the investment agent
pursuant to which JAFZ will irrevocably undertake to purchase from the investment agent all or part
of the Wakala assets upon the occurrence of certain designated events.

Sale undertaking – the investment agent enters into a sale undertaking in favour of JAFZ pursuant
to which the investment agent will irrevocably undertake to purchase from JAFZ all or part of the
Wakala assets upon JAFZ exercising its rights.

4.3.1 Equalisation of the Periodic Distribution Amounts

Even though the income from the Wakala portfolio is variable, the periodic distribution to JAFZ Sukuk
is structured as regular income by means of the Wakala reserve collection amount. This is similar to the
Musharaka reserve profit account and is used to smooth the income of the investors by accumulating
the surplus of profit and compensating any possible loss.

4.4 Other Sukuk Structures

Learning Objective
7.2.5 Understand the structure of the following: Sukuk al Murabaha; Sukuk al Istisn’a; Sukuk al Salam;
Sukuk al Mudaraba
7.2.6 Understand how Green Sukuk is emerging to help tackle environmental and climate change
concerns

4.4.1 Sukuk al Murabaha

Sukuk al Murabaha are based on a Murabaha transaction in which an asset is sold against a deferred
payment and are typically used to finance the purchase of commodities. The SPV uses the proceeds

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 Sukuk Market

of the Sukuk to acquire specific Shariah-compliant commodities from a third party at the request
of the obligor. Delivery of the commodities and the payment of the purchase price are immediate.
The SPV then sells the commodities to the obligor on the basis of Murabaha, in which delivery of the
commodities is immediate and payment is deferred.

4.4.2 Sukuk al Istisn’a

Sukuk al Istisn’a is generally applied to the financing of larger-scale projects, such as infrastructure, and
is similar to conventional project finance contracts. Sukuk al Istisn’a typically consists of the following:

• Istisn’a agreement to secure the financing of the manufacturing of the assets. Payments to the
construction company are typically made in instalments in accordance with pre-agreed milestones.
• Leasing agreements including a forward lease and a finance lease ensure investors receive regular
payments according to a defined schedule. The forward lease is incorporated to enable payment to
investors prior to the completion of the asset.

Although the Sukuk is tradable, the prevailing view is that the certificates cannot be traded prior to
the completion of the asset. All funds are raised at the start of the project. Given that payment to the

7
construction company is phased, a significant number of funds may be idle until further payments
are made. Unless the Sukuk manager identifies other yielding assets, these funds may potentially not
generate any returns.

4.4.3 Sukuk al Salam

Sukuk al Salam is comparable with a zero coupon bond, with the investor paying the funds up front
and receiving the return once the goods bought under Salam are delivered and sold at the end of the
contract period. Interim delivery of goods, and thus interim payments to investors, are permissible.
The certificates cannot be traded on the secondary market and the structure is subject to all conditions
associated with a Salam contract.

Sukuk al Salam is typically applied as a short-term liquidity management instrument by central banks
including, but not restricted to, the Central Bank of Bahrain, the Central Bank of Yemen and the Central
Bank of Gambia.

4.4.4 Sukuk al Mudaraba

In a Sukuk al Mudaraba, the underlying transaction type is Mudaraba, in which only one of the partners,
the SPV acting on behalf of the Sukuk holders, provides the capital and acts as the Rab al Mal. The SPV
invests in a project or company governed by a Mudaraba agreement, and the investment of the SPV
is divided into equal units and sold to the Sukuk holders. At the end of the period, the investment is
liquidated in any Shariah-compliant manner and investors get their principal plus or minus net returns.

4.4.5 Green Sukuk

With growing climate and environmental concerns, the demand for green or environmental investment
opportunities is increasing. Over recent years, a number of green sukuk have been introduced to meet
the demand. The underlying principles of Shariah are closely aligned with environmental and climate
change, and a green sukuk can be issued under any structure.

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 5. Sukuk Rule Changes 2008

Learning Objective
7.3.1 Understand the Sukuk regulations

The incorporation of profit-smoothing structures, such as the Wakala reserve account and the purchase
undertaking in the Sukuk al Musharaka, negate all risks and are not considered to be Shariah compliant.
In February 2008, AAOIFI issued the following restrictions to the Sukuk regulations:

• Purchase undertaking – an issuer’s purchase undertaking constitutes an integral part of the Sukuk
structure. It guarantees that the Sukuk holders will recover their initial investment at the maturity of
the certificates. The price that will be used for the purchase undertaking can be pre-agreed at the
beginning of the transaction only in the case of Sukuk al Ijara which is based on a sale and lease-
back transaction. In any other Sukuk structure, a purchase undertaking is permitted but the price
cannot be agreed in advance. At maturity, the market price of the underlying asset or partnership
needs to be used.
• Sukuk manager guarantee – the Sukuk manager, acting as an agent of Sukuk holders, cannot
provide a guarantee to compensate the shortfall of any income to the Sukuk holder.
• Reserves – the Sukuk manager may build up reserves out of the profit or rentals generated by the
Sukuk to cover any potential future shortfall. However, amounts will have to be assigned to specific
reserves before distributing the profit to the Sukuk holders.

The Musharaka Profit Reserve Account

The main result of the new regulations was the creation of the Musharaka profit reserve account which
is used as a buffer to smooth the income of the investors. This is how the prospectus of JAFZ Sukuk ltd
(page 2) describes this account:

‘If the profit payable to the Trustee is greater than the relevant Periodic Distribution Amount, any
surplus profit distributable to the Trustee over the Periodic Distribution Amount will be recorded by
the Managing Partner in the Musharaka Accounts as a credit to the line item entitled ‘‘Musharaka
Profit Reserve Amount’’.

Any amount standing to the credit of the Musharaka Profit Reserve Amount column in the Musharaka
Accounts on the Musharaka End Date will, subject to the terms of the Musharaka Agreement, be paid
to the Company as an incentive fee for acting as Managing Partner … If (the) profit is less than the
relevant Periodic Distribution Amount or if for any other reason the funds available in the Transaction
Account on the Periodic Distribution Date are not sufficient to enable the Trustee to pay the relevant
Periodic Distribution Amount due on the relevant date, in full for any reason, the Managing Partner
will deduct such shortfall from the Musharaka Profit Reserve Amount.

If the amounts standing to the credit of the Musharaka Profit Reserve Amount are insufficient, the
Managing Partner shall meet the shortfall through the provision of Shari’a compliant financing
and in the event this is not possible it will provide an interest free loan to the Trustee which shall be
repayable solely from profits of the Musharaka.’

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 Sukuk Market

6. Capital Market Considerations Relating to Sukuk

Learning Objective
7.4.1 Understand the capital market considerations relating to Sukuk: rating the issue; distribution;
tradability and non-tradability

There are two critical issues to consider when issuing a Sukuk: should the issue be rated? and; how
should it be distributed?

6.1 Rating the Issue

In Malaysia, rating an issue is mandatory and issuers typically seek the rating of one of the domestic
agencies. Issuers outside Malaysia do not always chose to rate the issue, partly due to a lack of domestic
and regional specialised rating agencies, and partly because the alternative, ie, the use of international
rating agencies, has a high cost associated with it.

7
International rating agencies (Standard & Poor’s, Moody’s and Fitch Ratings) have been active in Sukuk
rating since 2002. When rating a Sukuk, the rating agencies consider whether the issue can have a rating
better than its country of domicile and whether Shariah, the civil code or the national rules, can hinder
the securities issuance process and ratings, including, for example:

• Enforceability of the asset under the relevant laws.

• Presence of a trust law.
• Interpretations of Shariah.

When rating an individual issue, a rating agency analyses the same five factors in determining an
obligor’s capacity to make scheduled or promised payments:

• Cash – does the issuer have cash balances, reserves or standby access that will assure timely
payment in the event of a cyclical or unexpected interruption of cash flow?
• Cash flow – what is the nature, history and consistency of the issuer’s cash flow? What coverage
does this provide for future obligations?
• History – what is the originator, asset class and underlying obligor payment history? What is their
business history? Does the prior history of each component (the originator, asset class and obligor)
meet a standard that gives a reasonable prediction of future payment?
• Security – is the underlying sufficient to secure repayment in the event of servicer (party collecting
monthly payments), issuer or originator-related problems including default? Or must additional
security including extra assets, reserve funds or guarantees be added to arrive at an attractive rating?
• Servicing – will the originator service collections related to the underlying? Is the originator
sufficiently skilled and competent to do this? If the originator fails, has a back-up servicer known to
the investing community been identified and contracted to step in and replace the original servicer
without harm to the investors?

Shariah compliance is not considered as a criteria since rating agencies consider that Shariah compliance
does not impact the ability of the issuer to make payments.

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6.2 Distribution
Popular listing platforms for cross-border Sukuk include Luxembourg, London, Dubai, Bahrain and
Labuan. Each has its own tax regime designed to facilitate global investors. Although Sukuk investors
are mainly institutional investors, there is increasing distribution to retail investors through direct sales,
Sukuk funds, mixed or balanced funds, and listings on public exchanges.

For a number of reasons, the Sukuk market has mainly been a market of primary issues:

• Relatively small number of eligible issuers.

• No programme issues, such as Freddy Mac or Fanny Mae. Hence, there is no standard delivery
platform into a market for specific investment types with defined characteristics.
• Pressure on Islamic banks to reduce Commodity Murabaha transactions resulting in Islamic banks
buying and holding Sukuk.

The lack of programme issues may soon be addressed by Islamic banks as they have to start considering
securitising many of their existing and future assets to meet Basel capital adequacy standards.

6.3 Tradability
Generally, Sukuk are tradable both in a primary and secondary market. They are listed on national and
international exchanges and the units can be bought and sold publicly as well as privately. However,
Sukuk al Murabaha and Sukuk al Salam cannot be traded freely for money as this violates the rules of
debt trading.

7. Concluding Remarks
The Sukuk market is growing rapidly for many reasons, one of them being the increased sophistication
of global Islamic banks and their clients. Further growth is likely to be fuelled by the Basel capital
adequacy requirements which encourage the reconstruction of risks into investment securities which
have greater prospects of monetisation. In light of the relatively short history of Sukuk, the diversity of
issuances and the quality of instruments is impressive and will no doubt lead to programmes by high-
quality issuers.

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 Sukuk Market

End of Chapter Questions

1. What are the differences between conventional debt securities and Sukuk?
Answer reference: Section 1.1.3

2. What is the second phase in the Sukuk issuance process?

Answer reference: Section 2.1

3. In a Sukuk, who is the arranger and what are their responsibilities?

Answer reference: Section 2.1

4. Which type of Sukuk is based on a Murabaha transaction in which an asset is sold against deferred
payment and when is it typically used?
Answer reference: Section 4.4.1

5. To which type of conventional bond can a Sukuk al Salam be compared?

Answer reference: Section 4.4.3

7
6. Describe the Musharaka profit reserve account.
Answer reference: Section 5

7. List the Sukuk rule changes of 2008.

Answer reference Section 5

8. List the rating factors.

Answer reference: Section 6.1

9. Why do rating agencies not consider Shariah compliance?

Answer reference: Section 6.1

10. List the reasons why the Sukuk market has mainly seen primary issues.
Answer reference: Section 6.2

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174
Chapter Eight

Islamic Insurance – Takaful

1. Introduction 177

2. Types of Takaful Undertaking 185

3. Structure of Takaful Undertakings 186

4. Underwriting Surplus and Technical Provisions 190

5. Insurance Industry Considerations 191

6. Reinsurance and Retakaful 192

7. Shariah Governance and Compliance 193

8
8. Concluding Remarks 193

This syllabus area will provide approximately 9 of the 100 examination questions
176
 Islamic Insurance – Takaful

Students should understand the main similarities and main differences between conventional insurance
and Islamic co-operative insurance (Takaful), with particular reference to mutual or co-operative
insurance (both conventional and Islamic) and to the legality of Takaful in Fiqh al Muamalat, and how
the latter differentiates Islamic from conventional mutual insurance. There is no intention to deal at
length with Fiqh relating to Takaful. It is assumed that students will initially have some awareness of the
insurance industry.

1. Introduction

Learning Objective
8.1.1 Understand the position of Islam regarding insurance
8.1.2 Understand the origins of Takaful: the characteristics of mutual insurance; the nature of
conventional mutual insurance; the nature of a Takaful undertaking and the need to avoid
Gharar through Tabarru’ (donation) and Riba through the use of non-interest bearing assets;
the structure of Takaful undertakings: non-profit and commercial

8
1.1 Why Islamic Insurance?
Position of Islam Regarding Insurance
Islam permits the taking of measures to reduce risks. This is illustrated by the Hadith in which the Prophet
(PBUH) advises a Muslim to have faith in Allah (SWT) and tie up his camel, rather than relying just on his
faith in Allah (SWT) to prevent the animal from wandering off. However, Islam does not permit contracts
for the buying or selling of indemnities or guarantees. This is because such contracts contain elements of
speculation (Maysir) and uncertainty (Gharar) which are forbidden.

In a conventional insurance contract with a proprietary (not a mutual) insurance company, the insurer
takes money (the premium) from the insured in the hope of making a commercial profit. The company
anticipates that the claims made by the insured for the period covered by the insurance will be less than
the amount of the premium. This is Maysir. Also, the insured pays for an uncertain benefit, which may be
nil if there is no claim or may greatly exceed the amount of the premium. This is Gharar. In order to avoid
Maysir and Gharar, Islamic insurance takes the form of co-operative or mutual insurance – Takaful, which
is the Arabic word for solidarity or mutuality.

Origins of Islamic Insurance

Forms of mutual insurance arrangements existed in the early years of Islam and, indeed, the origins of
conventional insurance are to be found in mutual insurance (risk pooling) arrangements. Muslim jurists
acknowledge that the basis of shared responsibility in the system of Aquila, as practised between
Muslims of Mecca and Medina, laid the foundation of Islamic mutual insurance. In the case of Aquila, as
approved by the Prophet Muhammad (PBUH), if a person was killed by another from a different tribe, this
made the members of the killer’s tribe liable to pay blood money to the heirs of the dead person. The
operation of Aquila provided the funds necessary to pay the blood money.

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Although practised before, Islamic insurance gained greater popularity in the early second century of
the Islamic era (roughly the 9th century AD in the Christian calendar) when Muslim Arabs expanding
trade into Asia mutually agreed to contribute to a fund to cover anyone in the group who incurred
mishaps or robberies during the numerous sea voyages.

Characteristics of Mutual Insurance

In mutual insurance, the insured (or policyholders) co-operate to create a risk pool for a defined
category of their risks and contribute to a mutual underwriting fund from which benefits are payable
to indemnify them in the case of losses arising from such risks. The underwriting fund belongs to the
policyholders. There is thus no buying or selling of indemnities (legal exemptions from liabilities for
damages) as the owners and the insured are the same, ie, the policyholders, and any surpluses or
deficits on underwriting are not commercial profits or losses but are attributable to the policyholders.
In contrast to the profit-making objective of underwriting in commercial or proprietary insurance, the
objective of mutual underwriting is that the expected value of underwriting surpluses should be zero
(with surpluses and deficits averaging out over time), except to the extent that surpluses are sought for
the purpose of building up reserves in the underwriting fund.

1.2 Comparing Conventional Mutual Insurance and Islamic

Insurance

1.2.1 Conventional Mutuals

In the conventional insurance sector, many insurance undertakings are mutuals, in which the capital
of the undertaking is owned by the policyholders who are, therefore, both the owners and the insured.
In recent years, however, there has been a tendency for mutual insurance companies, including some
of the largest, to demutualise by converting themselves into proprietary insurance companies (limited
companies with capital owned by shareholders) and making public issues of shares. The reasons for
this are twofold: (a) the need for access to new capital in an industry in which size and the resultant
economies of scale are crucial when competing in global markets; and (b) the effects of regulation in
recent decades on the need for capital in order to meet capital adequacy and solvency requirements.
For these reasons, it is hard to imagine a new insurance undertaking starting today as a mutual, as many
did in previous centuries before the introduction of regulatory capital requirements, subsequently
building up reserves (policyholders’ equity) that are now adequate to meet current requirements.

1.2.2 How Takaful Undertakings Differ

Introduction
Islamic Takaful undertakings differ in three main ways from conventional mutual undertakings: they are,
of course, subject to the rules of Islamic commercial jurisprudence (see section 7 of this chapter) and,
therefore, operate on a different legal basis, and they have a different structure.

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Juristic Basis: Avoidance of Gharar (by the use of Tabarru’) and of Riba
Avoidance of Gharar
There is an important difference of a legal nature between conventional mutual insurance and Takaful,
which explains why the development of Islamic insurance is quite recent. Islamic scholars considered
that, in conventional mutuals, while the contractual basis related to premiums and benefits in a mutual
undertaking are free from Maysir (as there is no speculative profit objective), they are not free from
Gharar. This is due to the element of uncertainty of the benefits still being present (the insured pays
premiums to cover for an event that may or may not occur in future and, if it occurs, it is uncertain
to what degree). It was necessary to replace this contract with another which avoided this problem.
The solution took some time to find, but was eventually achieved by applying the concept of Iltizam
bi al-Tabarru’ (a commitment to a donation) as developed by the Maliki school of Fiqh al Muamalat
(Islamic commercial jurisprudence).

In Takaful, the contributions of the insured to the Takaful underwriting fund as insurance premiums are
made with the intention of donation. Hence, a payment of a benefit made to an insured in the case of
that insured’s loss contains an element of intentional donation from the other insured. Although Gharar
still exists, it is permissible, on the basis that Gharar only affects contracts of exchange and not Tabarru’
(gratuitous contract).

Avoidance of Riba
All insurance undertakings invest liquid funds in income-producing assets, the income from which

8
increases the amounts available to meet claims and conventional insurance undertakings may
borrow funds on an interest-bearing basis. In contrast, Islamic insurance undertakings avoid what is
non-permissible (including, but not restricted to, Riba) by investing liquid funds only in non-interest-
bearing assets and by not borrowing on an interest-bearing basis.

Structure (Overview)
Takaful undertakings do not generally have a pure mutual form. Instead, various hybrid, two-tier forms
are found in which the management of the undertaking is provided by a limited company with share
capital: a Takaful operator. The Takaful (underwriting or risk) funds are owned by the Takaful participants
(policyholders), as in a conventional mutual, but are managed by the Takaful operator. This relationship
is governed by different contracts as described in section 3 of this chapter. The Takaful operator is also
responsible for managing the investments of the Takaful (underwriting) funds and, in the case of life
or family Takaful (see below), the investment funds. If an underwriting deficit occurs during a period
in which the amount of the reserves in an underwriting fund are exceeded, the capital of the Takaful
operator stands behind that of the underwriting fund.

The deficit is covered in one, or a combination, of the following three ways:

1. Through any permissible finance arrangement.

2. Through an interest-free loan from any party, including the Takaful operator at the expense of the
fund against future profit.
3. Through further contributions by the policyholders, if agreed upon at the time of signing the
contract.

The mechanisms for achieving this are discussed in section 3 of this chapter.

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Currently, Takaful is offered through the following business forms:

• Non-profit, whereby, regardless of the formal legal structure, the business is run on a purely mutual
or co-operative basis for the participants in the Takaful scheme. The board runs the business on
behalf of all participants and there is no separate entity managing the business. There is thus no
two-tier structure. Some Islamic insurance undertakings are government-owned (eg, the National
Company for Co-operative Insurance in Saudi Arabia) and operate on a non-profit basis.
• Commercial, whereby a commercial entity (Takaful operator) is entrusted with managing the
Takaful fund. Depending on the specific rules in each jurisdiction, the fund may be embedded
within the operator (as life funds commonly are in conventional insurers) with a clear separation
between shareholders’ and participants’ funds, or the fund may be set up as a company separate
from the operator. In some countries, a Takaful scheme may be offered through the window of a
conventional insurer. In family (life) Takaful, the participant’s contribution is typically divided into
two portions, one forming part of the Takaful pool to cover mortality risk, and the other, in effect,
constituting a personal investment account (as a sub-account of the investment fund). The Takaful
operator will usually provide an interest-free loan to cover any deficiency in the Takaful fund. The
loan has to be repaid from any future surpluses of the Takaful fund.

Takaful Operator
Policyholders’ Funds
(limited cie (company))

1’ 1
2
Share Capital Underwriting Funds
and Reserves and Reserves
2’

(Same as conventional (Does not exist in

insurance) conventional insurance)

Figure 1: Simplified illustrative capital structure of a general (non-life) Takaful undertaking

1 – In the case of a separate company, underwriting funds are vested in a separate company.
1’ – Takaful operator is a limited liability company which has its own share capital and reserves.
2 – Takaful operator provides management and underwriting.
2’ – Takaful operator provides interest-free loans in case of an underwriting deficit.

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 Islamic Insurance – Takaful

Takaful Operator
Policyholders’ Funds
(limited cie)

1’ 1
2
Share Capital Underwriting Funds
and Reserves and Reserves
2’

Investment Fund

(Same as conventional (Does not exist in

insurance) conventional insurance)

8
Figure 2: Simplified illustrative capital structure of a life (family) Takaful undertaking

1 – In the case of a separate company, underwriting funds are vested in a separate company.
1’ – Takaful operator is a limited liability company which has its own share capital and reserves.
2 – Takaful operator provides investment and underwriting.
2’ – Takaful operator provides interest-free loans in case of an underwriting deficit.

Policyholders’ funds = underwriting funds + investment funds.

Insurance Company

Share Capital and Reserves

Underwriting Funds and Reserves

Liabilities
Obligations in respect of benefits
payable to policyholders

Figure 3: Illustrative capital structure of a proprietary undertaking

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The Takaful operator provides capital backup, if needed, to the underwriting funds by means of a Qard
Hassan (interest-free) loan, which is repaid out of subsequent underwriting surpluses. The management
contracts for underwriting and investment management may be Wakala contracts or Mudaraba
contracts (see section 3.2).

The structures of Takaful undertakings shown in Figures 1 and 2 may be compared to those of
conventional mutual and conventional proprietary insurance companies as follows.

Conventional Mutual Insurance Company

The left-hand sides of Figures 1 and 2, representing the Takaful operator’s capital and reserves, do
not exist in the case of a conventional mutual company, as the company’s capital belongs to its
policyholders.

Conventional Proprietary Insurance Company

The right hand sides of Figures 1 and 2, representing the policyholders’ capital and reserves, do not exist
in the case of a conventional proprietary company. The underwriting funds and reserves are part of the
shareholders’ reserves. So far as the investment funds in a life company are concerned, they also belong
to the shareholders but the company has obligations towards the policyholders in respect of benefits
payable to the latter which are represented by liabilities in the balance sheet. This includes the case
where some life policyholders have policies with benefits containing a participation (profit-sharing)
element, such as with-profit endowment life policies but, in this case, the profit-sharing element of the
benefit does not become a liability until the amount of profit payable to the policyholders (known as
bonuses) has been determined (see Figure 3).

1.2.3 Comparison Between Takaful and Conventional Insurance

(Proprietary and Mutual)

Learning Objective
8.2.1 Understand the differences between conventional proprietary insurance, conventional mutual
insurance and Takaful

The set-up of Takaful is similar to conventional mutual insurance companies, in that the company is
owned entirely by the policyholders, although, in mutual insurance, such ownership may be restricted to
a certain class of policyholders. The management of Takaful, however, is similar to proprietary insurance,
where the proprietary company shares in the profit generated from the investment operations.

The following table provides a comparison between conventional proprietary insurance, conventional
mutual insurance and Takaful for general insurance. A similar comparison may be made between
conventional insurance and Takaful for life insurance. In the latter case, in both conventional mutuals
and Takaful, investment profits belong to the policyholders, except that, in Takaful, the operator may
share in these profits through a Mudarib share for fund management. There are also some products
(such as whole life cover and defined benefit pensions) which Takaful does not offer, as they are not
Shariah compliant.

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 Islamic Insurance – Takaful

Conventional
Conventional Insurance
Insurance Takaful
(Mutual)
(Proprietary)
Contract. A policy in A policy in the form A risk-sharing indemnity
the form of of a risk-sharing based on a combination
an exchange indemnity contract of Tabarru’ (donation) and
contract (sale between the individual Dhamman (indemnity)
and purchase) insured and the contracts between the
between pool of insureds as individual insured and
the insured represented by the the pool of insureds
(policyholder) co-operative insurance (policyholders) as
and the insurance company. represented by the Takaful,
company, the and agency (Wakala) and/
subject matter or profit sharing (Mudaraba)
of which is contracts between the
an indemnity insureds and the Takaful
provided by the operator.
insurer to the
insured.
Responsibility of Policyholders to Policyholders pay Participants make

8
policyholders/ pay a premium to contributions to the contributions to the scheme.
participants. the insurer. pool in the form of
Any underwriting surplus
premiums paid to the
belongs to the policy
co-operative insurance
holders who are also liable
company.
for any deficit. Practices
Any underwriting regarding disposal of annual
surplus belongs to underwriting surpluses or
the policyholders deficits vary.
who are also liable
In some Takaful, the Takaful
for any deficit.
operator shares in the
Annual surpluses are
underwriting surplus.
normally retained in
underwriting reserves,
out of which any
annual deficits are
met.

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 Conventional
Conventional Insurance
Insurance Takaful
(Mutual)
(Proprietary)
Liability of Insurer is liable Pool is liable to pay Takaful operator acts as the
the insurer/ to pay claims claims according to administrator of the scheme
operator. according to the the policy using the and pays the Takaful
policy, using the underwriting fund. benefits from the Takaful
underwriting fund (underwriting) fund.
and, if necessary,
In the event of deficiency in
shareholders’
the Takaful fund, the Takaful
funds.
operator is expected to
provide an interest-free loan
to the Takaful fund to cover
the deficiency.
Access to Access to share No access to share Access to share capital by
capital. capital and debt capital, but access to Takaful operator but not
with possible use debt with possible use to debt, except interest-
of subordinated of subordinated debt. free loan from operator to
debt. underwriting fund.
Investment of There is no There is no restriction Assets of the Takaful funds
fund. restriction apart from those are invested in Shariah-
apart from imposed for prudential compliant instruments.
those imposed reasons.
for prudential
reasons.

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 Islamic Insurance – Takaful

2. Types of Takaful Undertaking

Learning Objective
8.2.2 Know the two types of Takaful: general; life

2.1 Introduction
In insurance, a distinction is generally made between life and non-life (general and accident) insurance.
The distinction is important because life insurance typically includes savings products (eg, endowment
policies and pension plans), rather than pure life (ie, whole life) policies. The performance of a life
insurance undertaking depends not just on the quality of the underwriting but also on the investment
performance. In non-life insurance, investment performance is less critical (see, however, the comments
on long-term risks in section 5).

2.2 General Takaful and Life (or Family) Takaful

Islamic insurance can cover almost all of the risks covered by conventional insurance, so long as the
subject matter associated with such a risk is permitted by Shariah and a distinction similar to that above

8
can be made between general Takaful and life (or family) Takaful.

One important exception concerns whole life policies, in which the benefit is paid only on the death of
the insured. This is considered to be un-Islamic because it contains the elements of Maysir and Gharar. In
place of these, Islamic life insurance offers endowment-type policies, which are essentially savings plans
with a maturity date incorporating a specified benefit in case of the death of the insured before that
date. This type of policy, commonly referred to as ‘family Takaful’, may also incorporate features such as
pension plans, savings plans for the education of children, and health insurance (although the latter has
the risk characteristics of general insurance). As Takaful undertakings do not invest in interest-bearing
assets, the ability to make appropriate investments is particularly important in family Takaful.

2.3 Pioneering Islamic Insurance Undertakings

Some of the pioneering Islamic insurance undertakings are listed below. Islamic banks have played
an important role in the foundations of the early Takaful undertakings, partly because of their own
requirements to insure assets. Although their Shariah boards typically allowed these banks to use
conventional insurance out of necessity, as the industry evolved, Takaful started to emerge.

1. The Sudanese Islamic Insurance Co., which was the very first Islamic insurance company and
founded in 1399 AH/1979 in Khartoum by the Faisal Islamic Bank of Sudan.
2. The National Company for Cooperative Insurance, founded in Riyadh, Kingdom of Saudi Arabia, in
1401 AH/1981 by a Royal decree and is a 100% government-owned company.
3. Takaful Malaysis Sdn Brhd, founded in Malaysia in 1984.
4. The Arab Islamic Insurance Co. (AIIC), which was established in 1399 AH/1979 in Dubai by the Dubai
Islamic Bank.
5. The Islamic Company for Insurance and Reinsurance, founded in1405AH/1985 in Bahrain.

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6. The International Islamic Insurance Company, founded in 1412AH/1992 in Bahrain. The Bahrain
Islamic Bank had an important role in its foundation and in the investment of its funds.
7. Islamic Insurance ltd, founded in 1416AH/1995 in Jordan by the Jordan Islamic Bank.

3. Structure of Takaful Undertakings

Learning Objective
8.3.1 Understand the structure of Takaful: separation of participants’ funds from those of the Takaful
operator; the role of Qard Hassan (interest free loan)

3.1 Introduction
As noted in section 1.2.2, Takaful undertakings normally have a two-tier structure, consisting of (a) a
fund or funds that belong to the policyholders and (b) a limited company with share capital (the Takaful
operator) which undertakes the management of the undertaking, including its underwriting and
investment activities. The funds that belong to the policyholders consist of an underwriting fund and, in
the case of life or family Takaful, an investment fund (as discussed below).

In countries where mutual or co-operative forms of companies (with no share capital) are recognised
by law, the policyholders’ funds are vested in such a company, which is separate from, but linked
contractually to, the Takaful operator company. In countries where the law does not permit the
incorporation of companies without share capital, the policyholders’ funds cannot be vested in a
separate legal entity, but are treated as funds under management of the Takaful operator (rather
like the investment accounts of an Islamic bank). However, in both cases, it should be clear that the
policyholders’ funds are not part of the Takaful operator’s shareholders’ funds (see Figures 1 and 2 in
section 1.2.2).

Takaful involves two functions:

• Underwriting (insurance services), such as the preparation of the insurance policy; collection of
contributions (premiums; assessments of claims; and the distribution of compensations.
• Investment services by way of managing the investment funds on either a Mudaraba basis or
investment Wakala basis.

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 Islamic Insurance – Takaful

3.2 The Two-Tier Structure and its Mechanisms

Learning Objective
8.3.2 Understand the three models for underwriting and managing the investments of the Takaful
fund: Wakala; Mudaraba; the combined model

One important reason (indeed, the only economic, as opposed to legal, reason) for the two-tier structure of
Takaful undertakings is the need for the underwriting fund to have capital backing, in case an underwriting
deficit occurs that exceeds the amount of reserves in the fund and may result in the insolvency of the fund.
This capital backing is, in principle, provided by the Takaful operator, a limited company with share capital.
The mechanism by which the limited company may provide capital backing to the underwriting fund is
by making an interest-free (Qard Hassan) loan facility available to the underwriting fund, which can be
drawn down to cover the amount of the deficit. The loan must be repaid out of subsequent underwriting
surpluses. Thus, the Takaful operator is not directly exposed to underwriting risk, as this is not compliant
with Shariah. Note that the loan does not remove the deficit, as it does not increase the net assets of
the underwriting fund, but it is intended to enable the fund to meet its current obligations. Such a loan
might also be needed for a fund that is not in deficit, but which lacks enough liquid assets to meet
current liabilities.

8
As a Qard Hassan loan is juristically a benevolent loan, the Takaful operator cannot be contractually
obliged to make it. Instead, the obligation needs to be imposed by regulation with legal backing. The
situations in which such a loan is needed are attributable, at least to some extent, to the management
policies and actions of the Takaful operator, which thus has some responsibility for them.

This raises the question of the remuneration of the capital of the limited company. The limited company
will be required by the regulatory authority to have enough capital and reserves to provide the Qard
Hassan loan facility. If drawn down, the loan itself is not remunerated, nor can any charge be made for
the facility as such. The Takaful operator, however, receives a fee for its work as Takaful operator, which
includes underwriting and managing the investments of the underwriting fund and, in the case of life
Takaful, the policyholders’ investment fund. Although other models have been advocated, this work is
typically performed on one of three legal bases or models:

1. Wakala Model (a Wakala contract between the limited company and the
policyholders)
In this model, the principal-agent relationship is used for both underwriting and investment activities (It
is important to understand what is meant by the principal-agent relationship here. The principal is the
party paying for services and the agent is the party providing the services). In underwriting, the Takaful
operator acts as an agent on behalf of the participants to run the Takaful fund.

All risks are borne by the fund and any operating surplus belongs exclusively to the participants
(policyholders). The Takaful operator does not share directly in either the underwriting risk borne by the
fund or any surplus/deficit of the fund. Instead, the operator receives a set fee called a Wakala fee for
managing the operation on the participants’ behalf, which is usually a percentage of contributions paid.
However, the operator’s remuneration generally includes a performance fee, from the generated profit,
as an incentive to manage the Takaful fund effectively. The investment of the Takaful fund is also based

187
on a Wakala contract, whereby the operator charges the participants a fee in exchange for services
rendered and this fee may also have a performance-related component.

2. Mudaraba Model (a Mudaraba contract between the limited company and

the policyholders)
In this model, the Takaful operator acts as a Mudarib (entrepreneur) and the participants as Rab al Mal
(capital provider). The contract specifies how the investment profit and/or surplus from the Takaful
operation are to be shared between the Takaful operator and the participants. Losses are borne solely
by the participants as the providers of capital (unless the operator is guilty of misconduct or negligence)
but, in case of a loss, the Mudarib is not entitled to receive any compensation for its efforts. In this
model, the underwriting fee takes the form of a specified percentage of any underwriting surplus and
the fee for investment management is a specified percentage of any investment profits. However, as
explained below, it may be considered permissible for the Mudarib to share in the investment income
only, which leads to a third model.

3. Combined Model (combination of Wakala and Mudaraba contracts)

In this model, the Wakala contract is adopted for underwriting activities, while the Mudaraba contract
is employed for the investment management of the Takaful fund. In addition to a fixed fee as Wakil
for underwriting, the insurance operator as Mudarib for investment management receives a specified
percentage of the investment income, including income earned on investments financed by the
underwriting fund. This approach, which is favoured by some international organisations and financial
sector regulators (eg, the Central Bank of Bahrain), is widely adopted by Takaful undertakings in practice.

Some Islamic scholars object to the second mechanism mentioned above (the pure Mudaraba model)
for the following main reasons:

• A pure Muduraba model implies that the Mudarib operates purely for the sake of making a profit,
which is only possible from investment returns.
• A pure Muduraba model would expose the Takaful operator to a greater risk as it will only obtain a
return if, and only if, the investments it has made generates a profit.

An underwriting surplus in a mutual insurance undertaking is not the same as a profit, since in a mutual
insurance the expected value of the underwriting surplus is zero (as surpluses and deficits should
average out over time), except to the extent that there is an intention to build up reserves in the
underwriting fund. Any underwriting surplus should be considered as belonging to the policyholders,
with the possible exception of a specified percentage of the income from investments financed by the
underwriting fund, as in mechanism three.

The second mechanism (pure Mudaraba model) could motivate the Takaful operator to aim for
substantial underwriting surpluses in order to receive a larger remuneration, which is not consistent
with the interests of the policyholders or with the concept of mutual insurance. Moreover, as Mudarib,
the limited company will share in underwriting surpluses but not in deficits. In contrast, the third
mechanism (combined model) motivates the Takaful operator to seek investment profits but not
excessive underwriting surpluses.

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 Islamic Insurance – Takaful

3.3 Fiqh Contracts used in Takaful – Summary

Learning Objective
8.3.3 Know the Islamic financial contracts used in Takaful

As indicated above, the main contracts of Fiqh al Muamalat used in Islamic insurance are those of
guarantee or indemnity between the insured and the mutual underwriting pool, Iltizam bi al-Tabarru’
(donation) as the basis on which the contributions are paid by the policyholders, and Wakala and/or
Mudaraba as the basis on which the Takaful operator undertakes management of underwriting and
investment on behalf of the policyholders.

Example
X, Y and Z each decide to take out a family Takaful policy with Islamic Insurance (II) to provide protection
for their families against them dying or suffering a short- or long-term disability, which will result in
expenses such as funeral costs or hospital bills. Each pays an annual contribution of £5,000. The latter
contribution is divided into two portions which make up the policyholders’ underwriting (mortality
and sickness risk) fund and investment fund, respectively. The mortality and sickness benefits are
specified in the contract. The investment fund is similar to a savings plan with a maturity of ten years.

8
II is an independent company. II’s share capital and reserves (shareholders’ funds) are maintained
separately from the policyholders’ funds (underwriting and investment). II manages the policyholders’
underwriting fund on a Wakala basis and the policyholders’ investment fund on a Mudaraba basis. In the
investment fund, the policyholders act as Arbab al Mal and the Takaful operator as Mudarib. According to
the Mudaraba agreement, the profit-sharing ratio between the Mudarib (Takaful operator) and the Rab
al Mal (policyholders) is respectively 20% : 80%. II, as Wakil (agent) for the underwriting fund, invests the
fund’s money in Shariah-compliant investments. During a fiscal year, the underwriting fund generates
£10 million. II’s fees are calculated as 5% of the profit (£0.5 million). The remaining surplus (£9.5 million)
belongs to the policyholders and is retained in the underwriting fund to provide policyholders’ equity
for solvency purposes. In the investment fund, II as Mudarib (entrepreneur), invests the fund’s money
in Shariah-compliant investments. During a fiscal year the investment fund generates £20 million. II’s
Mudarib share of the profit is calculated as 20% (£4 million). The remaining surplus (£16 million) belongs
to the policyholders and would normally be reinvested in the investment fund. In case of the death of
X before the maturity of the investment policy, II as Wakil of the policyholders’ funds will pay X’s heirs
the specified death benefit. At the end of the Takaful agreement, the investment fund will pay back the
investors’ capital in the investment fund, ie, the total amount invested plus any reinvested income or
profits less any losses. Y and Z (as Arbab al Mal) thus receive the money they invested in the investment
fund plus any reinvested income or profits, less any losses.

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 4. Underwriting Surplus and Technical Provisions

Learning Objective
8.3.4 Understand the rules on distribution of underwriting surpluses in Takaful: the definition
of an underwriting surplus; the nature and allocation of technical provisions; the rules for
distributing underwriting surpluses

4.1 Definitions
The underwriting surplus for a period is defined as:

• contributions received or receivable for the period, plus

• income from investments generated by the underwriting fund, less
• claims arising during the period (paid or payable), net of reinsurance (see below)
• underwriting expenses, including the underwriting fee payable to the Takaful operator, plus or
minus
• changes in technical provisions.

The technical provisions, being estimates of future claims payable in respect of insured events that have
already happened (or the consequences of such events that are covered by the policy) are liabilities
and not part of capital. Amounts set aside out of premium income in a period for retention in technical
provisions are not part of the underwriting surplus for the period, while amounts released from technical
provisions are included in the underwriting surplus.

4.2 Application to Takaful

In Takaful, as in mutual insurance undertakings, underwriting surpluses belong to the policyholders.
Therefore, if a surplus for a period is not required to build up reserves or to repay an interest-free loan
from the Takaful operator, it may be redistributed to the policyholders. There are various rules that may
be applied for making such distributions:

• Distribution in proportion to the contributions paid by each policyholder for the period, without
reference to any claims that the policyholder has made.
• Distribution in proportion to the premium contributions paid by each policyholder for the period,
but taking account of whether the policyholder has had a claim paid, in one of the following ways:
• Policyholders who have had a claim paid during the period receive no distribution.
• In calculating the proportionate shares to be distributed, policyholders who have had a claim paid
during the period receive half of what they would have received if they have had no claim paid.
• Policyholders who have had a claim paid during the period receive their proportionate share
of the surplus after deducting the amount of any claims paid to them during the period. If the
amount of the claim(s) paid to a policyholder is equal to or greater than his share of the surplus,
the amount distributed to him is nil.

In some Takaful undertakings, there is a rule according to which only a specified percentage of the
surplus is distributed to the policyholders, the remainder being retained in reserves.

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 Islamic Insurance – Takaful

5. Insurance Industry Considerations

Learning Objective
8.4.1 Understand the risks associated with Takaful claims and their mitigation: the nature of
technical provisions for general Takaful; implications of the size of the risk pool; the nature of
the underwriting and investment fund in life Takaful; internal risk pooling arrangements

5.1 General Takaful (Non-Life)

An important feature of general and accident insurance is the maintenance of adequate technical
provisions. This is particularly the case with so-called ‘long-tailed’ risks with which claims may be made
many years after the period in which the insured event occurred. A notorious example of this is claims
under employers’ liability policies, such as those for cases of industrial diseases suffered by former
employees. In insurance undertakings with substantial technical provisions, the investment returns
earned on the funds retained can make a significant contribution to the underwriting fund.

In contrast, risks such as those covered by motor or fire policies tend to be ‘short-tailed’, as the vast
majority of claims are made within a relatively short period after the insured event has occurred, and

8
hence there is not the same need for substantial technical provisions.

Amounts required for technical provisions are calculated by actuaries on the basis of statistical tables
and claims’ histories for each category of risk and, in some cases, the category of policyholder. The
use of reinsurance (as discussed in section 6 of this chapter) reduces the amount needed in technical
provisions by transferring part of the risk to the reinsurer. Reinsurance allows pooling of risks between
different insurance undertakings.

The larger a risk pool, the more the law of large numbers applies to the total amount of claims being
made for a period, which is averaged out over a greater number of policyholders, thereby providing a
smoother overall claims history with less likelihood of a substantial underwriting deficit. With smaller
risk pools (ie, fewer policyholders), there is a greater risk of a substantial deficit occurring before
adequate reserves have been built up. This is the main reason why economies of scale are important in
the insurance industry. Similar to conventional insurance, Takaful faces market, liquidity and credit risk.
In addition, it is subject to Shariah risk, or the non-compliance with Shariah and conflict of opinions.

5.2 Life or Family Takaful

In life Takaful, the function of the underwriting fund is to meet the requirements to pay death benefits
in cases where the policyholder dies before the policy matures. Statistical tables compiled by actuaries,
known as mortality tables, are used to calculate the premiums taking account of the age, sex and other
personal characteristics (eg, occupation, smoker or non-smoker) of the policyholder. On this basis,
taking account of the amount of the specified death benefit, the premiums paid by a policyholder are
divided between the underwriting fund and the investment fund.

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The investment fund is subdivided into personal investment accounts, one for each policyholder. The
balance on a policyholder’s account consists of the parts of the policyholder’s premium contributions
that were credited to the investment fund, plus the proportionate share of the investment returns
earned on the assets of the fund.

Takaful Pensions
Takaful pension plans are of the defined contribution type and not the defined benefit type. In other
words, the amount of the pension payable on the maturity of the policy is not a specified amount but
depends on the balance on the policyholder’s account and the available returns on the assets in which
this balance can be invested.

5.3 Internal Risk-Pooling Arrangements

Within an insurance undertaking, there may be a number of different risk pools and underwriting
funds for different categories of risk, eg, fire, motor, marine. In a given period, one fund may have an
underwriting surplus, while another has a deficit. If surpluses are allowed to offset deficits by means
of an internal risk-pooling (ie, Takaful) arrangement, the risk of insolvency is substantially reduced,
especially for an insurance undertaking of modest size. On the other hand, if one fund is regularly in
deficit, this implies that the premiums (or, in case of Takaful, contributions) being paid by policyholders
for that category of risk are too low. In such a case, to continue relying on surpluses arising from other
funds to maintain solvency, rather than increasing the premiums for the category of risk covered by the
fund that is in deficit, will amount to the policyholders covered by the latter being unfairly subsidised by
other policyholders. To avoid such unfairness, Takaful undertakings typically have rules setting out what
is permissible for internal risk pooling.

6. Reinsurance and Retakaful

Learning Objective
8.4.2 Understand how Retakaful operates: the funding of Retakaful; the place of Retakaful; resorting
to reinsurance in the absence of viable Retakaful options

Reinsurance is a form of insurance in which the policyholders are insurance undertakers which use
reinsurance to reduce excessive concentrations of risks. They pay a proportion of their premiums
receivable to the reinsurer in return for the cover of a proportion of their risks in a specified category if
these exceed prudent underwriting limits. An insurance undertaking which transfers some of its risks
and its premium income to a reinsurer is known as a cedant. There are two basic forms of reinsurance:
proportionate and stop-loss. In proportionate reinsurance, the cedant shares the risks with the reinsurer
according to agreed proportions. In stop-loss, the reinsurer meets any claims above an agreed limit.
The reinsurance industry sector is dominated by a small number of very large international reinsurance
undertakings operating on conventional principles. There are only a few reinsurance undertakings
operating on Islamic insurance principles (Retakaful), and these are considerably smaller and operate

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 Islamic Insurance – Takaful

only in national or regional markets. However, reinsurance is important in the Takaful sector because of
the relatively small size and limited capital of many Takaful undertakings.

Consequently, some Islamic scholars consider it to be permissible for Takaful operators to reinsure with
conventional reinsurers under the principle of need or necessity. However, this is controversial and it
is likely that steps will be taken in the future to extend the coverage offered by the Retakaful industry
sector. Any use of conventional reinsurance is subject to Shariah board approval on a case-by-case basis.

7. Shariah Governance and Compliance

Learning Objective
8.4.3 Know the responsibility of the Takaful operator for Shariah compliance

As with other Islamic financial institutions, the operations of Takaful undertakings are governed by
Shariah rules of Islamic commercial jurisprudence (Fiqh al Muamalat). In some countries, such as Malaysia
and Sudan, there is a central Shariah authority which issues applicable interpretations of Shariah, ie,
Fatawa (the plural of Fatwa), with which Islamic financial institutions must comply. In Malaysia, the

8
Shariah parameters are issued by the Central Bank and are binding. The responsibility for Shariah
compliance lies with the board of directors and the management of the Islamic financial institution,
which needs to put in place an appropriate internal organisation to ensure Shariah compliance, which
will normally include at least one part-time independent Shariah adviser. The internal audit function
may be organised so as to provide an internal check of Shariah compliance and the external auditors
may also include Shariah compliance in the scope of their examination and report. In the case of a
Takaful undertaking, the management is that of the Takaful operator. In the majority of countries, there
is no central Shariah authority and each Islamic financial institution has its own SSB which issues the
applicable Fatawa. In this case, the SSB is a key part of the governance structure of all Islamic financial
institutions, including Takaful undertakings.

8. Concluding Remarks
Managing risk is deemed to be appropriate behaviour, but is only permitted on a mutual basis in which
the insured cover each others losses for defined adverse events. Pensions, health, and other insurance is
permitted, however life insurance is not.

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 End of Chapter Questions

1. Where does insurance fit within Islam?

Answer reference: Section 1.1

2. How do Islamic Takaful undertakings differ from conventional mutual insurance undertakings?
Answer reference: Sections 1.2.1–1.2.2

3. How does conventional proprietary insurance compare with Islamic insurance?

Answer reference: Section 1.2.3

4. Describe the Takaful two-tier structure.

Answer reference: Section 3.2

5. What are three models used to remunerate the Takaful operator for its work as an operator?
Answer reference: Section 3.2

6. As far as policyholders are concerned, what is the disadvantage of the pure Mudaraba model as a
mechanism to remunerate the Takaful operator?
Answer reference: Section 3.2

7. What is a technical provision?

Answer reference: Section 4.1

8. Outline how the investment fund in family Takaful is structured.

Answer reference: Section 5.2

9. What is Retakaful and how does it work?

Answer reference: Section 6

10. In a Takaful undertaking, who is responsible for Shariah compliance?

Answer reference: Section 7

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Chapter Nine

Islamic Corporate
Governance
1. Corporate Governance 197

2. Corporate Governance in Financial Institutions 200

3. Shariah Supervisory Board 201

4. Internal Shariah Audit 205

5. Governance Standards 206

6. Shariah Compliance and Investment Account Holders 208

7. Corporate Governance Implications for Islamic

9
Insurance (Takaful) 213

8. Concluding Remarks 214

This syllabus area will provide approximately 10 of the 100 examination questions
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 Islamic Corporate Governance

1. Corporate Governance

Learning Objective
9.1.1 Know the origin and nature of corporate governance
9.1.2 Understand how corporate governance principles are incorporated in Shariah
9.1.3 Know the corporate governance mechanisms available to stakeholders to exercise their rights

Corporate governance is a set of organisational arrangements designed to align, as much as possible,

the actions of the management of a corporation with the interests of its stakeholders.

In this context, the following terms are relevant:

Arrangement
• Units within the organisation referred to as ‘organs of governance’, such as boards of directors and
their committees.
• Procedures, such as annual general meetings and external audits.

Stakeholders
• Anyone with certain rights with respect to the corporation, in particular property rights and rights to
information.
• Rights of stakeholders may be established by law, the legal article of incorporation or codes of

9
corporate governance.

Corporation
• Includes both private sector firms and public sector bodies having a corporate form as legal entities.

Corporate governance started to gain importance during the early decades of the 20th century. The
increasing size of corporations required additional capital and companies started to issue shares.
Subsequently, control and ownership of the corporation were increasingly separated with share capital
widely held and the company managed by professional managers. Corporate governance enables
shareholders to safeguard their interests given that the management might pursue their own interests
at the expense of those of the shareholders. Although in the UK and the US stakeholders are typically
restricted to shareholders, other EU states have a wider view on stakeholders and include, for example,
employees, government, suppliers, unions and anyone else with an interest in the workings of the
corporation.

The OECD Principles of Corporate Governance (June 1999) define corporate governance as involving: ‘a
set of relationships between a company’s management, its board, its shareholders and other stakeholders.
Corporate governance also provides the structure through which the objectives of the company are set,
and the means of attaining those objectives and monitoring performance are determined...’. The Basel
Committee for Banking Supervision (BCBS) ‘Enhancing Corporate Governance for Banking Organisations’
(September 1999, revised version February 2006) defined corporate governance as follows: ‘Stakeholders
include employees, customers, suppliers and the community. Due to the unique role of banks in national and
local economies and financial systems, supervisors and governments are also stakeholders [of banks]...’.

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These broad definitions raise various issues, such as:

• Which individuals or groups have rights as stakeholders?

• What rights do the various groups of stakeholders have?
• How are such rights enforced and safeguarded?

Broadly speaking, stakeholder rights may consist of rights to control; rights to information; and rights to
cash flows, profits and other benefits. For example, rights of shareholders are a matter for company law
and a company’s own statutes. Ordinary shareholders with voting rights have all three of these types of
rights (control, information and cash flows) to some extent, while non-voting ordinary shareholders do
not have control rights but rely on the voting shareholders to protect their interests.

Islamic financial institutions are based on the foundations of Islamic religious ethics. For this reason,
their sound governance from a Shariah perspective is crucial to their proper functioning. Shariah
states that Allah’s (SWT) rights, if breached by mankind, may be forgiven by Him. However, people’s
rights, financially or otherwise, if infringed, cannot be forgiven, save by people themselves, and Allah
(SWT) may not interfere at all. Similarly, the management of an Islamic bank is regarded as a seller of
its management services, and the shareholders/stakeholders buy those services by paying the price
in the form of salaries. Shariah wants to ensure that the consideration of this transaction (ie, the salary
paid to management) and the subject matter of this transaction (ie, the services provided in managing
the institution) are well defined and meet the agreed specifications. Hence, corporate governance
requirements in Islamic finance are not only necessary following the segregation of ownership and
management, but are also dictated by Shariah.

Corporate governance, in its broadest sense, applies well beyond stakeholders’ rights to control,
information, cash flow and other benefits. It governs how the corporation handles its relationships with
its wider sphere of customers, employees, suppliers and the community, as well as shareholders and
its regulator. From an Islamic perspective, the modern concept of corporate governance reflects the
principles and foundations laid down by Shariah. As such, a corporation which works to a high standard
of corporate governance will arrange its activities and operations in ways which, for example:

• are not harmful to mankind and/or the environment – and the corporation may well take steps to
make its actions beneficial
• deal fairly and properly with customers: products are suitable for their needs; staff interactions with
clients are courteous and efficient
• compete properly with its rivals: hoarding and monopoly are out, and any manipulation to corner
the market is rejected
• ensure personal and confidential information on the corporation’s customers and staff are held
securely and not open to abuse
• ensure staff are treated fairly and, in turn, staff respect the corporation and act professionally in their
dealings with the corporation and its customers
• are transparent – the customer’s ignorance of the market cannot be deliberately exploited or
abused. A failure to operate to high standards can lead to a slow decline in the effectiveness and
profitability of a corporation and, at worst, can lead to significant adverse media coverage which
brings rapid decline.

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 Islamic Corporate Governance

Similar to other organisations, Islamic financial institutions operate in an open system and are required
to align their internal and external processes to avoid conflicts among various stakeholders. In this
context, stakeholders include shareholders, depositors, boards of directors, senior management,
internal auditors, external auditors, employees, systems, information technology (IT), SSBs, associations,
central banks, central and national Shariah boards and governments.

The underlying principles of Islamic finance have a strong basis in social responsibility. As such, they
are closely aligned to Corporate Social Responsibility (CSR). CSR is a voluntary code of practice, in which
companies make a conscious effort to work in ways that benefit society.

1.1 Mechanisms
Corporate governance depends on a number of mechanisms, whereby stakeholders may exercise
their rights. Most of these mechanisms are required by national company law but some are set out in
voluntary codes. Generally, two types of board structure are recognised, one-tier (or unitary) and two-
tier. The main difference between these two types of organisations is that a two-tier organisation does
not only have an executive board, but also an additional organ of governance in the supervisory board.
The most important corporate governance mechanisms are set out below.

1. Board structure.

Unitary Board Two-tier Board

CEO may also be chairman of the board, although
codes of corporate governance generally (but

9
Supervisory board is independent from
not in the US) consider this to be bad practice as
executive board.
it concentrates too much power in the hands of
one individual.
Supervisory board is composed entirely
of non-executive directors. The CEO is in
attendance but has no vote.
Board comprises of executive and non-executive
The executive board is composed of the top
directors.
management and chaired by the CEO.

Stakeholder interests, such as workers’ councils,

may be represented on the supervisory board.
Board committees are part of the supervisory
Board committees are part of the unitary board.
board.
Board committees:
• Audit committee to which both external and internal auditors report with particular responsibility
for the appointment of the external auditors.
• Nominations committee which has the responsibility of nominating candidates for membership
of the board of directors.
• Remuneration committee with the responsibility for approving the remuneration of board
members and, in principle, ensuring this is not excessive.

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2. Directors – non-executive directors must be independent and grey directors need to be avoided.
Grey directors are directors who are supposed to be independent but whose independence is
compromised by an indirect relationship with the corporation or its senior management.
3. Annual report – serves to discharge the responsibility of the executive board.
4. Independent external auditors – independent review and verification of the annual report.
5. General meeting of shareholders – provides a medium for shareholders to question management
and to appoint and remove directors and external auditors.
6. Insolvency procedures – in case the corporation is unable to pay its creditors, certain rights of
governance pass to creditors’ representatives in order to minimise their losses.

In general, these mechanisms are intended to protect the interests of shareholders and, in the case of
insolvency procedures, those of lenders and creditors.

2. Corporate Governance in Financial Institutions

Learning Objective
9.1.4 Understand the reasons why banks face special corporate governance challenges

There are a number of reasons why banks are considered to be a special case in relation to corporate
governance, which can be summarised as follows:

• A wider definition of ‘stakeholders’ (cf, BCBS definition).

• The issue of ‘systemic risk’.
• Regulation and compliance issues.
• Depositors need for protection.
• The need for strong internal control and risk management.
• Issues of transparency and information asymmetry.
• Issues of related party transactions (and ‘grey directors’) which are particularly sensitive for banks.

As such, banks are required to have a two-tier board.

In the case of banks, the BCBS defines stakeholders as more than just shareholders and creditors,
including, but not restricted to, employees, customers, suppliers and the community, supervisors,
and governments. The BCBS cites ‘the unique role of banks in national and local economies and financial
systems’ as one of the main reasons for this but also considers systemic risk resulting from the
contagious nature of financial distress which may be transmitted from one bank to other banks within
the system. The health of the whole economic system can be threatened by widescale bank failures.
The soundness of banks is, therefore, a matter of public interest, which is one reason why banking is a
regulated industry. Various guarantee schemes exist for the protection of depositors. However, from
a corporate governance point of view, the very existence of such schemes gives rise to a concern that
insured deposits entail an element of moral hazard, namely that management may be induced to take
risks with the depositors’ money (eg, credit risks in lending) that it would not take in the absence of such
insurance, as such risks would jeopardise the solvency of the bank.

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 Islamic Corporate Governance

Some specific corporate governance considerations applicable to banks are mentioned in Pillars 2 and 3
of the Basel Capital Accord (BCA). Pillar 2 is concerned with the process followed by banking supervisors
in their supervisory review of banks, and the need for them to pay particular attention to the quality
of risk management. Pillar 3 deals with market reporting and transparency, drawing attention to the
potential disciplining role of the market.

There is a considerable lack of transparency in relation to off-balance sheet positions which may expose
banks to risks which are far from obvious. In addition, it should be noted that banks are particularly
vulnerable to the negative effects of related party transactions, in particular, because of the danger of
credit being given on a ‘non-arm’s length basis’ (ie, credit given on unduly favourable terms or without
proper prudence) to related parties. Loans made on this basis have frequently led to banking crises and
failures in different global markets.

Grey directors are problematic with banks. Independent directors who are not truly independent, and
promote the making of unsound loans for their own private benefit, cause the bank to suffer losses,
which, if the loans are not repaid, may result in insolvency.

Shariah governance is characterised by similar terms to those found in corporate governance, such as
transparency, justice, fairness, disclosure and accountability. These terms are an integral part of the
Quran and the Prophet’s (PBUH) tradition (Sunnah) and, in turn, Islamic jurisprudence.

In addition to the corporate governance requirements outlined above, Islamic financial institutions
are required to have an additional organ of governance in the form of a SSB. Of particular interest,
from a corporate governance perspective, are investment account holders (IAHs), for which there is no

9
alternative in conventional financial institutions.

3. Shariah Supervisory Board

Learning Objective
9.2.1 Understand the position, remit and characteristics of the Shariah Supervisory Board
9.2.2 Know the roles of the Shariah Supervisory Board: advisory; approval; audit
9.2.3 Understand the operational issues surrounding the Shariah Supervisory Board: membership;
governance; delegated responsibility; reporting; other duties

The SSB is an independent body in the governance structure of an Islamic financial institution and reports
directly to shareholders as the owners of the organisation. Conventional financial institutions offering
Shariah-compliant financial services either have their own SSB, or may use the services of a Shariah
advisory company. Either way, the governance issues are the same for both types of organisations.

It is important to note that the role of the SSB is restricted to ensure conformity with Shariah rules
and regulations, and does not extend to an executive or managerial role. As such, the SSB ensures all
transactions and operations are Shariah compliant, but does not have any input in the commercial
aspect of the institution.

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The purpose of the SSB is twofold:

1. Financial institutions need to ensure that the products and services they offer are genuinely Shariah
compliant and are in line with the institutions’ standards, principles and shareholders’ requirements.
2. Investors’ and clients’ need to be able to ensure their investments are in line with Shariah. Ultimate
responsibility for Shariah compliance remains with senior management of the organisation.

Shariah governance is defined in the IFSB Shariah Governance Standard number 10, issued in December
2009, as a set of institutional and organisational arrangements through which an Islamic Financial
Institutions ensures effective independent oversight of Shariah compliance over the following
structures and processes:

• Issuing Shariah resolutions.

• Dissemination of information on Shariah resolutions to management.
• Shariah compliance review and audit.

Any decisions must be communicated throughout the organisation in a clear and transparent way and
are binding on the organisation.

The SSB reports to the shareholders and may be present at the annual general meeting (AGM) to read
the Shariah report. Compliance with Shariah principles is included in audit and compliance functions.

3.1 Role of the SSB1

Five main criteria are generally identified when considering the role of the SSB:

1. Independence – independence of the SSB and its members is a fundamental requirement to function
effectively. The SSB and its members must be independent from the management of the bank.
2. Confidentiality – due to the nature of the SSB members’ work and duties, they are exposed to a
great amount of proprietary information which dictates a detailed confidentiality requirement.
3. Competence – due to the multifaceted nature of the SSB members’ role, they are required to have
specialist knowledge and expertise in Fiqh al Muamalat (Islamic law of contracts) as well as have an
understanding and knowledge of modern financial and banking practices and products.
4. Consistence – the SSB needs to remain consistent in its decisions, guidelines and advice in order to
build up and maintain consumer confidence.
5. Disclosure – disclosure and transparency are a vital part of the SSB roles and functions. By disclosing
procedures, decisions, Fatawa and structural details, the SSB encourages and promotes confidence
not only for shareholders but also the industry and the wider public.

The role of the SSB can be divided into three main areas: advisory, approval and the audit role.

3.1.1 The Advisory Role

Islamic financial Institutions turn to a Shariah scholar for clarifications or opinions on specific or general
Shariah principles. In line with industry best practice and AAOIFI recommendations, this is often an
in-house Shariah specialist with in-depth knowledge of Shariah teachings. Having an in-house specialist
enhances the knowledge available within the institution, and can improve the effectiveness of the SSB
due to the fact that issues can, in the first instance, be referred to the in-house specialist.

1 This section is adapted from Schoon, N (2016) Modern Islamic Finance, London: Wiley & Sons

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 Islamic Corporate Governance

3.1.2 The Approval Role

The generic SSB approval process spans several steps:

1. Reviews of the initial structures and concepts to ensure they are in line with Shariah.
2. Approval of the legal documentation. This process can extend to several revisions depending on the
transaction and the legal and SSB requirements.
3. Final approval for specific transactions where the structures are highly individual in nature and for
more complex structures, eg, syndications.

Product/
Structuring Internal
concept Legal
product Sharia´a SSB review Finalise
approval documentation
in-house review
from SSB

Not approved

Figure 1: Shariah approval process for a new product or structure

Amendments to existing products follow a similar, albeit shorter path.

3.1.3 The Audit Role

It is the responsibility of the SSB to ensure ongoing compliance by verifying that all transactions and

9
operations of the Islamic financial institution have indeed complied with the SSB guidelines and
associated Fatawa. Although the audit process varies from institution to institution, it is generally
done on the basis of a departmental audit. The regularity of the audit varies depending on the size of
the institution and the number of transactions. Part of the SSB audit and control function may be the
calculation of Zakat obligations. Depending on the institution and local regulations, Zakat contributions
are either made by the institution or are delegated to shareholders. Either way, the SSB provides the
Zakat obligations on a per share basis.

3.2 SSB Membership

SSB members are typically Shariah scholars with extensive knowledge of Islamic jurisprudence. In
addition, knowledge of finance, banking, law, and economics is important to ensure they are able
to provide balanced advice and assistance to the financial institution. A well-balanced SSB has
diversity among its members in the schools of Islamic jurisprudence as well as other professional and
academic backgrounds. Typically, an SSB has a minimum of three Shariah scholars, although larger
institutions tend to have larger boards to accommodate for the diversity and complexity of the banking
requirements. SSB members are nominated by the CEO and board of directors and presented to the
general meeting of shareholders for appointment. Any dismissal of a SSB member follows the same
process. The engagement period of SSB members may vary as agreed between the financial institution
and the SSB members or could be limited by supervisory authority regulations. Regulations such as a
limited period (eg, three years) with a limited number of renewals are in place to ensure the objectivity
of scholars and to avoid conflicts of interest. Contracts may typically be signed for a full engagement
period or on an annual renewable basis.

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3.3 Governance and Reporting
Responsibilities and activities of SSB are governed by the terms of reference (TOR) or SSB charter. The
TOR stipulates all the functions and responsibilities of SSB members including the number of meetings,
appointment of the chairman and responsibility for the Shariah audit. The chairman and members of
the SSB consider the primary and secondary sources of Shariah as well as the different schools of Islamic
jurisprudence in their decision-making process. Based on their deliberations, the SSB establishes the
Shariah principle for their ruling, applying the most suitable and practical Shariah reference without
affecting the authenticity. The SSB needs to issue its ruling in a clear written document, signed by the
members. This document will be disclosed to the general public if required. At a minimum, the SSB
rulings will be made available to customers of the institution.

Annualy, the SSB submits a report to shareholders which includes the following information:

1. Description of the scope of work completed.

2. Opinion on the Shariah compliance of the financial transactions and operations.
3. Any major observations.
4. Zakat statement (if required).
5. Donations to charity resulting from non-compliant earnings.

Members are paid a fee as specified in their contract for attending meetings as well as travel and
accommodation expenses (if applicable). The level of remuneration tends to be market conform, but
there are variations between institutions.

In addition to SSB reports, the SSB and the board of directors interact regularly to discuss issues of
mutual interest. Depending on local regulations SSB performance may need to be assessed by an
external governance committee, consisting of some members of the board of directors.

3.4 Shariah Executive Committee and Internal Shariah

Expert
The SSB typically meets on a quarterly basis which may not be sufficient to cater for the challenges the
institution faces on a day-to-day basis. For this purpose, the institution may appoint an internal Shariah
expert or Shariah executive committee. The internal expert or executive committee will act as the first
point of contact and is more easily available to the institution. A Shariah executive committee can issue
Shariah rulings within the already approved SSB product programmes and Shariah guidelines.

The presence of a Shariah executive committee or internal expert will alleviate the demands on the SSB
outside its normal meeting times. However, the SSB will still need to be available when required and
must be fully aware of and in agreement with any Shariah-related decisions.

In the event an SSB resolution is obtained prior to the meeting by means of a circulation of
documentation, there must be the full agreement of either all, or an agreed majority of, the members
for it to be effective.

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 Islamic Corporate Governance

3.5 Other Duties and Guidance

Additional rules and regulations for SSBs are incorporated in the regulatory frameworks provided by
AAOIFI, IFSB and central banks to ensure better practice of SSB.

One of the main concerns is related to intellectual independence and objectivity. SSB members need to
avoid conflicts of interest with the business objectives of the Islamic Financial Institutions and ensure
prudent rulings and solutions for the Islamic Financial Institutions.

Generally, there are hardly any restrictions on the number of boards a Shariah scholar can be a
member of. In Malaysia and Oman, however, the regulator places restrictions on the number of board
memberships. In these countries, scholars are only permitted to be a member of one board of each type
of institution (bank, asset manager or Takaful) to ensure they can dedicate sufficient time to fulfil their
obligations, as well as to avoid any conflict of interest, thus enabling them to better serve the purposes
of all institutions concerned.

As part of their role, SSB members may be requested to provide training to staff members and other
stakeholders including clients. These events may be held in public venues and include conferences.
However, the SSB should not be involved in marketing since this may have an adverse effect on the
image of the SSB members and the financial institution.

4. Internal Shariah Audit

9
Learning Objective
9.3.1 Know the Shariah audit regulations

AAOIFI governance standard No. 3, issued in January 2000, outlines the requirements for the internal
Shariah audit. The internal Shariah audit is a non-executive function and is an integral part of the audit
function within the institution. Similar to the conventional audit function, the internal Shariah audit
department operates on the basis of a clear set of processes and procedures clarifying its objectives,
authorities, and responsibilities. The manual has to be prepared in compliance with Shariah rules and
regulations set by the SSB and approved by the board of directors. The AAOIFI requirements can be
summarised as follows:

1. Independence and objectivity – the internal Shariah audit unit needs to have the right level
of authority within the organisation to allow it to undertake its responsibilities independently
and without being hindered. Auditors need to have direct contact with all levels of staff in the
organisation and have access to all documents and reports they require.
2. Professional competency – Shariah auditors are required to commit to the ethical and moral
covenant of the external accountant and auditor for Islamic Financial Institutions issued by AAOIFI,
and maintain discipline, knowledge and the necessary skills to complete the internal Shariah audit,
knowledge of the principles and rulings of Islamic Shariah in general; and financial transactions
jurisprudence especially. Professional conservatism and care should be taken in conducting the
Shariah audit function and ensuring the adequacy of the followed procedures.

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3. Audit plan – the audit needs to be planned in such a way that it can be executed effectively and
efficiently. The plan should be developed adequately to include the full understanding of the Islamic
Financial Institutions operations with regard to products, size of operations, locations, branches and
divisions, and should cover all activities and products.
4. Audit steps – the audit plan needs to follow the following consecutive steps:
a. Establish the objective of the audit and the scope of work.
b. Determine the necessary resources required to complete the audit.
c. Define a work plan and share it with appropriate parties.
d. Collect information related to the audited activity.
e. Obtain the rulings, guidelines and instructions of the SBB, and the result of the audit of the
previous year.
f. Contact all relevant individuals.
g. Determine the method and date to report the results.
5. Audit – the auditor collects, analyses, explains and documents the information evidencing the audit
findings. This includes documents, inquiries, analysis and discussions with management and staff.
6. Reporting – the responsible auditor and (if required their manager) discusses the results,
observations and recommendations with the related department heads. A final written report will
be provided to the SSB, management and the audit committee.
7. Follow-up – although it is the responsibility of management to implement the recommended actions
and to remedy the findings, a follow-up will be required to verify all required actions have been taken.

Shariah audit procedures must be in place detailing the work, structure of the audits, and roles and
responsibilities. Procedures include checklists to ensure all relevant activities have been undertaken.

5. Governance Standards

Learning Objective
9.3.2 Know the governance standards

There are a number of standards associated with the SSB and Shariah audit. Although these standards
are devised by internationally recognised regulatory authorities in Islamic financial services, they are not
binding in every jurisdiction.

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 Islamic Corporate Governance

Governance Standard Clause Definition

2 Rulings and decisions of the SSB are binding on the
institution.

14 The responsibility of the SSB within the annual report is

to stipulate that ‘our responsibility is restricted to disclose
AAOIFI Standard (1) –
an independent opinion’.
Shariah Supervisory Board
21 If a violation to the SSB rulings and decisions is
incurred by management, then this violation should be
exhibited in the paragraph disclosing the independent
opinion.
4 Confirm that the operations of the Islamic Financial
Institution do not contravene Shariah.
AAOIFI Standard (2) –
Internal Shariah Audit 5 The SSB is responsible for establishing and disclosing
an independent opinion, but the responsibility of
application is borne by management.
2 The objective of the internal Shariah audit is to
examine the extent of compliance with Shariah and
SSB rulings by the institution.

4 The internal Shariah auditor has no executive authority

or responsibility towards the reviewed transactions.

9
17 The scope of work is to examine and evaluate the
efficiency and effectiveness of the internal Shariah
AAOIFI Standard (3) – audit system.
Internal Shariah Audit
19 Data should provide a valid base to arrive at the final
results and recommendations.

21 Disputes between the internal Shariah audit and

management are referred to the SSB.

22 Confirm the execution of the SSB recommendations;

and management is responsible for addressing any
non-compliance issues.
The institution is bound to abide by the SSB rulings
if it is a ‘mandatory’ ruling, and if the ruling entails
AAOIFI Standard (29) – permissibilities, the institution is entitled not to abide.
6/1
Guidance for Shariah rulings If the institution’s management violates the SSB
rulings, the violation is advised to the general assembly
of shareholders.

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 6. Shariah Compliance and Investment Account
Holders
The IFSB’s approach to the corporate governance issues outlined above has been to focus on the
governance aspects of Shariah compliance and the rights of IAHs. The following subsections are broadly
consistent with the approaches taken by the IFSB but are not intended to be followed in detail.

The IFSB’s draft Guiding Principles of Corporate Governance emphasises the status of the SSB as a key
organ of governance in an Islamic bank. The draft refers to the need for co-ordination between the SSB,
the audit committee and another committee whose establishment is recommended, the governance
committee, with particular regard to issues of Shariah compliance.

The SSB has a key governance role whether it has the function of issuing Fatawa for application to the
bank’s operations and supervising their subsequent application or that of supervising the application
in the bank of Fatawa issued by a central Shariah authority. Nevertheless, the ultimate responsibility for
Shariah compliance falls on the bank’s board of directors.

6.1 Rights of IAHs

Learning Objective
9.4.1 Understand the distinction between information rights, control rights and cash flow rights for
restricted investment account holders and unrestricted investment account holders

These rights may be classified as information rights, cash flow rights and control rights. Information
rights concern transparency and relate to matters of asset allocation, fund performance, use of reserves
and profit allocation. Cash flow rights concern the right to the profit earned from the investment of their
funds, subject to the deduction of the bank’s share as Mudarib. Control rights are a more controversial
matter given the contemporary interpretation of the Mudaraba contract, and are discussed further
below.

6.1.1 Information Rights – Restricted Investment Account Holders

(RIAHs)
RIAHs should receive similar information on fund performance to that received by members of a
conventional Collective Investment Scheme (CIS) in well-developed markets.

These include:

• Income statement (statement of total return).

• Cash flow statement.
• Portfolio statement.
• Balance sheet.
• Summary of material portfolio or asset allocation changes.

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 Islamic Corporate Governance

• Notes.
• Distribution table showing differences between profits and distributions and ‘equalisations’ of the
latter.

6.1.2 Information Rights – Unrestricted Investment Account Holders

(UIAHs)
Since UIAH funds are typically mingled with other funds under the control of the banks, it is not
practicable to provide all the same information as with RIAHs. Moreover, there are other issues of
transparency that are of particular relevance to UIAHs. In particular, in order to be able to maintain the
UIAHs’ capital intact, and to pay them a steady rate of return, Islamic banks have developed certain
practices involving the use of reserves such as a profit equalisation reserve (PER) and an Investment Risk
Reserve (IRR).

6.1.3 Profit Equalisation Reserve (PER)

The PER is built up by appropriations from income earned on investments of UIAH funds prior to
the profit allocation between the bank as Mudarib and the IAH as Rab al Mal. It thus comprises a
shareholders’ portion and an IAHs portion. Amounts may be released from this reserve to increase
the profit payout to IAHs in years when the income earned on IAHs investments is low, without any
corresponding reduction in the dividend payout to shareholders.

Example

9
The annual report of an Islamic bank X shows a net profit of US$1,000,000 to be distributed among
shareholders and investment account holders. The shareholders’ share of the profit is valued at
US$250,000 while the IAHs share in the profit is valued at US$750,000. In order to smooth the profit
distributed and compete with other banks in the market when profits are low during the coming years,
the bank decides to retain 5% of the net profit (US$50,000) in the PER.

6.1.4 Investment Risk Reserve (IRR)

The IRR is built up by appropriations from the share of profit allocated to the IAH after deduction of the
bank’s Mudarib share. Amounts may be released from this reserve to reduce the amount of any loss
attributable to the UIAH funds. (In principle, the same mechanisms may be used in connection with
RIAHs, but this is rare as there are not the same pressures to maintain capital intact and to pay a steady
rate of return. Moreover, the situation is more transparent as there is little or no mingling of funds).

Example
The annual report of an Islamic bank X shows a net profit of US$1,000,000 to be distributed among
shareholders and IAHs. The shareholders’ share of the profit is valued at US$250,000 while the IAHs’
share in the profit is valued at US$750,000.

In order to cushion against future potential losses, the bank decides to retain 4% of the IAHs’ net profits
(US$30,000) in the investment risk reserve.

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PER and IRR differ from conventional revenue reserves.

PER and IRR are introduced to reduce displaced commercial risk. This type of risk is related to the
common practice among Islamic banks to ‘smooth’ the financial returns to IAHs by varying the
percentage of profit taken as the Mudarib share. The use of these reserves (PER and IRR) has similarities
with the use of conventional revenue reserves (eg, retained profits as maintained by both conventional
and Islamic banks) to smooth dividend payouts to shareholders. There are, however, some important
differences.

On the one hand:

• Financial reports make a clear distinction between profits attributable to ordinary shareholders and
amounts paid or payable to them as dividends.
• Ordinary shareholders have the right in AGMs to vote for or against the dividend proposed by the
board of directors and their use of revenue reserves.
• Amounts held in conventional revenue reserves belong to the ordinary shareholders and, all other
things being equal, are reflected in the value of their shares.

On the other hand:

• Financial reports may not make a clear distinction between profits attributable to UIAHs and their
profit payout. There is a tendency to confuse the two.
• IAHs have no right to vote for or against the use of reserves decided by the board of directors in
making the profit payout to them. At best, their investment contract may place some limits on the
amounts the board may appropriate to these reserves (see under cash flow rights below).
• Amounts held in the IAHs’ portion of the PER and in the IRR do not belong to the IAHs. When an
IAH receives the balance of his investment, in accordance with the investment contract, he or she
gets no share of the balance of these reserves. For these reasons, it is important that IAHs be clearly
informed about the investment of their funds by the bank, including:
• asset allocation and changes in this, making clear the risk characteristics of the asset classes
• the extent and nature of mingling, and the allocation of IAHs and other funds to different
investments
• allocation of profit between IAHs and shareholders, including the composition of profit
attributable to IAHs before deducting the bank’s Mudarib share, the calculation of the latter and
the use of the reserves (PER and IRR) making clear the distinction between the profit earned and
the profit distributed.

The use of PER and IRR by the management staff of Islamic banks thus raises some very important
corporate governance issues with regard to the information rights, cash flow rights and control rights of
UIAHs. The position taken on these issues by the IFSB in its Guiding Principles of Corporate Governance is
outlined below, with particular reference to control rights.

Cash Flow Rights – RIAHs

In general, cash flow rights for RIAHs are not problematic. They are entitled to the profit from the
investment of their funds, subject to the deduction of the bank’s Mudarib share. Issues regarding the
use of reserves for the purpose of smoothing their profit payout, thus limiting their cash flow rights, may
arise, but this is not normal for RIAHs.

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 Islamic Corporate Governance

Cash Flow Rights – UIAHs

Cash flow rights for UIAHs are normally limited by management’s right to withhold part of their share of
profit in order to build up reserves (PER and IRR) for the purpose of smoothing their profit payout. Unlike
ordinary shareholders, UIAHs have no control rights allowing them to challenge management’s use
of these reserves if they believe that they are not being used to the advantage of the UIAH (see under
control rights below).

Control Rights – RIAHs

As with conventional CIS, the issue of control rights does not arise in connection with RIAHs. This is
provided that the bank, as Mudarib, acts in accordance with the investment contract. In other words, the
issue is one of investor protection rather than one of corporate governance. The corporate governance
issue is that of information rights, as set out above.

Control Rights – UIAHs

The issue of control rights for UIAHs arises insofar as their capital is exposed to losses, ie, they have
the status of residual claimants without the legal protection afforded to creditors. The contemporary
interpretation of Shariah jurisprudence concerning the Mudaraba contract is that the Rab al Mal should
not interfere in management. In fact, shareholders do not have the right to interfere in management but
they do have the right, if they can form a majority of votes, to change the board of directors, to overturn
dividend decisions and to approve the appointment of external auditors and various other important
control rights. All of these rights are denied to UIAHs.

9
On the other hand, it is doubtful whether most UIAHs would wish to play an active role in exercising
control rights. Moreover, in spite of the potential for conflicts of interests, their interests largely coincide
with those of ordinary shareholders. Rather than rights to attend and vote at general meetings, it seems
more practicable to propose that they receive some representation in the bank’s governance structure.
This may be achieved by the establishment of a committee of the board of directors with a specific
responsibility to provide oversight on behalf of the UIAH.

The composition of such a committee might be as follows:

• At least three members, including:

• a member of the audit committee who, as such, should be an independent non-executive
director
• a Shariah scholar from the bank’s SSB
• a further independent non-executive director (selected on the basis of his or her experience and
ability to contribute to the process).

In the execution of its functions, the committee is empowered to:

• oversee and monitor the implementation of the bank’s governance policy framework by working
together with the senior management, the audit committee and the SSB
• provide the board of directors with reports and recommendations based on its findings in the
exercise of its functions.

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The IFSB’s Guiding Principles suggest the title ‘Governance Committee’ for such a committee. It is also
proposed that the governance committee should be accorded special attention by the supervisory
authority, with the selection of an independent non-executive director who is to sit on that committee
requiring the supervisor’s specific approval.

6.2 IAH and Shareholders

Learning Objective
9.4.2 Understand the distinction between the rights of shareholders and investment account
holders

Funds of UIAHs are mingled with the funds of the shareholders and invested in the bank’s day-to-day
operations. The UIAHs share in the profits as well as the losses and they run the risk of losing their
capital. Similarly, shareholders invest their funds in the bank, share in the profit and run the risk of
losing their capital. Unlike shareholders however, UIAHs cannot sell their holdings, although they can, of
course, take the funds out of their account and deposit them with another bank.

6.3 UIAHs and RIAHs

Learning Objective
9.4.3 Understand the distinction between the rights of restricted investment account holders and
unrestricted investment account holders

In the place of depositors, who provide funds to a conventional bank in accordance with a debt contract
and are hence entitled to interest on those funds at either a fixed or a floating rate, Islamic banks receive
funds from IAHs who place their funds on the basis of a Mudaraba profit-sharing and loss-bearing
contract, in which they are the Rab al Mal (investors) and the bank is the Mudarib (investment manager).
The Mudaraba contract is described in section 5 of chapter 5. A Mudaraba contract may be of two major
types: restricted or unrestricted.

IAHs have no governance rights under existing interpretations of Mudaraba in which the Rab al Mal
is expected to be an entirely passive investor. The main corporate governance issues arising from this
state of affairs concern the IAHs’ rights to information about the riskiness and performance of the assets
in which their funds are invested and to some form of oversight of this performance. This has different
implications for RIAHs and UIAHs.

RIAHs are provided with information on riskiness when they invest as the asset allocation is known to
them, but this is not the case with UIAHs.

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7. Corporate Governance Implications for Islamic

Insurance (Takaful)

Learning Objective
9.5.1 Understand the corporate governance issues facing the Takaful industry

7.1 Introduction: Nature and Structure of Takaful

Takaful is a form of cooperative or mutual insurance that is Shariah compliant. Its characteristics
are described in detail in chapter 8 of this workbook. Takaful undertakings normally have a two-tier
structure: a mutual tier and a limited company. The mutual tier, which belongs to the policyholders,
comprises a fund or funds which underwrite the insured risks (underwriting funds) and, in the case of
life or family Takaful, represent the savings of policyholders (investment funds). The limited company
(Takaful operator) provides underwriting and investment management services to the policyholders in
return for a fee under either a Wakala (agency) or a Mudaraba contract or a combination of both (Wakala
for underwriting and Mudaraba for investment management). Like conventional mutual insurers,
Takaful undertakings include both life (or family) and non-life (or general) insurance.

7.2 Corporate Governance Issues in Takaful

9
The corporate governance issues that arise in Takaful undertakings are, in some respects, similar to
those in Islamic banks:

• Shariah governance is a key issue.

• Policyholders’ rights (in place of IAHs’ rights) are another major issue, with possible conflicts of
interest between policyholders and shareholders.
• However, the issues of systemic risk that affect Islamic banks do not have the same relevance for
Takaful undertakings. A distinction needs to be made between non-life and life policyholders:
• The value of a life policyholder’s investment depends on management performance in asset
management, while non-life policyholders have much less concern for asset management but
are greatly affected by underwriting performance.
• Life policyholders are not free to switch their policy to another Takaful undertaking as non-life
policyholders may do. Hence, life policyholders have a greater need for governance rights,
both to information on the performance of their investments and to some form of control or
oversight, such as that which could be provided by a governance committee.

7.2.1 Forms of Contract

The form of contract used for the management of underwriting (Mudaraba or Wakala) is also relevant,
especially for non-life policyholders. In principle, by virtue of the mutuality of underwriting in a Takaful,
any underwriting surplus or deficit is attributable to the policyholders, not the shareholders. The
Takaful operator may opt to distribute part or all of a surplus to policyholders in line with the terms and
conditions. If the Takaful operator performs the underwriting services under a Mudaraba contract, the

213
operator as Mudarib will nevertheless be entitled to a percentage share of any underwriting surplus,
without bearing any share of an underwriting deficit. This may result in a conflict of interest between
the Takaful operator (ie, the shareholders) and the policyholders with regard to a desirable underwriting
policy.

The policyholders do not seek a short-term underwriting surplus, once sufficient reserves have been
built up in the underwriting fund to meet an occasional deficit. By contrast, the operator has a motive
to seek underwriting surpluses. For this reason, sound governance principles suggest that a Wakala
contract is preferable to a Mudaraba contract for underwriting. On the other hand, a Mudaraba contract
may be suitable for investment management, providing that policyholders’ governance rights are
recognised and respected.

7.2.2 Legal Structure

A further issue relates to the legal structure of the Takaful undertaking, ie, as to whether the underwriting
and investment funds are legal entities separate from the Takaful operator or are funds set up by the
operator under a Mudaraba or Wakala contract (as IAH funds are set up under a Mudaraba contract by
an Islamic bank). In some countries, the legal system does not permit the setting up of companies with
a mutual or co-operative structure and no share capital. In that case the underwriting and investment
funds cannot be separate legal entities. However, where this is possible, the use of separate legal
entities as vehicles for these funds seems preferable from a corporate governance point of view, as it is
likely to afford more protection for policyholders.

8. Concluding Remarks
The principals underlying Sharia’a are closely related to the principals incorporated in good corporate
governance. Sharia’a compliant financial institutions have an additional body of governance in the
Sharia’a supervisory board, but follow the same governance principles and structures.

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 Islamic Corporate Governance

End of Chapter Questions

1. What are the mechanisms of corporate governance?

Answer reference: Section 1.1

2. Why are banks considered to be a special case for corporate governance?

Answer reference: Section 2

3. What is the purpose of the SSB?

Answer reference: Section 3

4. Define the criteria of the SSB.

Answer reference: Section 3.1

5. Describe the approval role of the SSB.

Answer reference: Section 3.1.2

6. List the AAOIFI requirements for the internal Shariah audit.

Answer reference: Section 4

7. Describe the different rights of investment account holders.

Answer reference: Section 6.1

9
8. Who benefits from the PER?
Answer reference: Section 6.1.3

9. How is the IRR built up?

Answer reference: Section 6.1.4

10. Compare and contrast the rights of shareholders and investment account holders.
Answer reference: Section 6.2

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216
Glossary
218
 Glossary

There is no standardised system for translating Bai bi Thamin al Ajil/Bai’ Bithaman Ajil (BBA)
Arabic terms/words into English. (Deferred sales contract)
A deferred sales contract typically used for
This text uses one spelling of Arabic words but financing. When securitised in Malaysia, it is call
there are others. For example, this book uses a BBA bond. In the Malaysian regulatory scheme,
Shariah but readers may well find spellings this is a long-term contract, with Murabaha being
such as Sharia and Syariah in other texts; these a short-term contract.
are equally valid. The examination will use the
spellings given in this glossary. Batil (Invalid)
Invalid (contract).
Ah’d (Undertaking)
Ah’d is a covenant, pledge or undertaking to Cedant
perform certain tasks and to be held accountable
An insurance undertaking that transfers some of
for these tasks. its risks and its premium income to a reinsurer.

Amanah (Trust) Conventional bank

Refers to deposits in trust. A person can hold
Used throughout this workbook, and throughout
a property in trust for another, sometimes by
the industry, to identify banks that are not based
express contract and sometimes by implication
on Islamic principles.
of a contract. Current accounts may be regarded
as Amanah (trust).
Dhaman/Daman (Guarantee)
Aqd’/A’qd (Contract) A guarantee or security.
Contract, a bilateral obligation meriting financial
Fasid (Voidable)
consideration.
Voidable (contract).
Aqidah (ideology)
Fatwa (pl. Fatawa) (Decree)
Islamic creed.
A legal pronouncement in Islam provided by an
Aquila (Shared Rresponsibility) Islamic legal jurist.
Shared responsibility; the foundation of Islamic
Fiqh (Jurisprudence)
mutual insurance.
The science of Islamic jurisprudence or Islamic
Arboon/Arbun/Arboun/Urbun/Urboon (Down law.
payment)
Fiqh al Muamalat (Commercial jurisprudence)
Down payment; a non-refundable deposit paid
by a buyer retaining a right to confirm or cancel Islamic commercial jurisprudence or the rules of
a sales contract. transacting in a Shariah-compliant manner.

Bai al ‘inah (Sale and repurchase) Gharar (Unnecessary uncertainty)

A contract which involves the sale and repurchase Any element of uncertainty in any business
of assets between the same buyer and seller. A or contract which is otherwise preventable or
seller will sell the asset to a buyer on a cash basis. avoidable.
The seller will later buy back the same asset on a
deferred payment basis where the price is higher Hadith (pl. Ahadith) (Words and sayings of the
than the cash price. This contract is rejected by prophet)
most Islamic scholars. Words of the Prophet (PBUH), traditions. The
narrative record of the sayings, actions and tacit
approval of the Prophet Muhammad (PBUH).

219
Halal (Permissible) Ijma/Ijma’ (Consensus)
Anything permitted by Shariah. Lawful; one of Consensus of all or a majority of the leading
the five major Shariah categorisations of human qualified jurists on a certain Shariah matter in a
acts. certain age.

Hamish Jeddiyah/Gedyyah (Earnest money) Ijtihad (Interpretation)

Security deposit, ‘earnest money’. An amount This refers to an endeavour (literally, toil) of a
of money paid by the purchaser when giving qualified jurist to derive or formulate a rule of
an order, upon the request of the seller to make law to determine the true application of Shariah
sure that the order giver is serious in his order in a matter on which the Holy Quran and the
of the asset. However, if the promise is binding Sunnah are not explicit, and when a previous
and the purchase order declines to purchase precedent for the issue at hand has not been set.
the asset, the actual loss incurred to the seller is
made good from this amount. Illah (Underlying rationale)
Underlying rationale.
Hanafi
One of the Islamic schools of jurisprudence. Istihsan (Judicial preference)
Judicial preference for one legal analogy over
Hanbali another, usually to give preference for the public
One of the Islamic schools of jurisprudence. welfare.

Haram (Prohibited) Istisn’a (Production finance)

Anything prohibited by Shariah. Non- This is a contractual agreement for
permissible, unlawful; one of the five major manufacturing goods and commodities,
Shariah categorisations of human acts. allowing any combination of cash payment in
advance, progressive payments over time, future
Hawala/Hawalah (Transfer) payment and future delivery. A manufacturer
Literally, it means transfer; legally, it is an or builder agrees to produce or build a well-
agreement by which a debtor is freed from a described good or building at a given price on
debt by another person accepting to receive a a given date in the future. The price can be paid
transfer of the obligation, or the transfer of a in instalments, step by step as agreed between
claim of a debt by shifting the responsibility from the parties. Istisn’a can be used for providing
one person to another – contract of assignment the facility for financing the manufacture or
of debt. It also refers to the document by which construction of houses, plants, projects and
the transfer takes place. building of bridges, roads and highways.

Hiba/Hibah (Gift) Jahala or Jahl (Ignorance)

Gift. Ignorance, lack of knowledge; indefiniteness in a
contract, sometimes leading to Gharar.
Ijara/Ijarah (Lease)
Kafala
Leasing. Sale of a definite Usufruct of any non-
monetary asset in exchange for definite reward. The addition of a third-party guarantee to an
existing obligation with respect to an action or
Ijara Mawsoofa Bil Thimma (Financial lease) a project.
A lease agreed upon, perhaps even with a
deposit, for delivery and use of an asset in the Khiyar al-shart (Optional right to cancel)
future. An option in a sale contract concluded at the
time of signing the agreement, giving one of the
two parties to the contract a right to cancel the
sale within a stipulated time.
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 Glossary

Lien Murabaha (Cost Plus Financing)

A charge, claim, hypothecation or mortgage This is a contract sale between the bank and
pledging an asset to a creditor. its client for the sale of goods at a price which
includes a profit margin agreed by both parties.
Manfa’a/Manfaa (Usufruct) As a financing technique, it involves the purchase
Usufruct or benefit derived from an asset. of goods by the bank as requested by its client.
The goods are sold to the client with an agreed
Mawqoof (Unenforceable until authorised) mark-up.
This is an unenforceable-until-authorised
Musharaka/Musharakah (Partnership)
contract, where a person has the ability to enter
into the contract but exceeds his authority; This Islamic financing technique involves two or
for example, where an agent exceeds the more parties who both provide capital towards
authority accorded to him by his principal. Such the financing of a project or business. Both
a contract is unenforceable until authorised by parties share profits on a pre-agreed ratio but
the principal. losses are shared on the basis of contributed
capital. Management of the project may be
Maysir (Speculation) carried out by both the parties or by just one
party. This is a very flexible arrangement where
Speculation. Maysir is one of the fundamental
the sharing of the profits and management can
prohibitions in Islamic finance and is one of
be negotiated and pre-agreed by all parties.
the reasons that led to the design of a specific
business model for Islamic insurance. Musharaka Muntahiya Bittamleek/
Diminishing Musharaka or Musharaka
Mudaraba/Mudarabah/Mudharabah (Trust
Mutanaqisa (Partnership)
Financing)
A form of partnership whereby one partner buys
This is an agreement made between two parties,
out the shares or units of the other according to
one of whom usually provides 100% of the
a specific schedule.
capital for a project and has no control over
the management of the project; another party, Muwaada (Combination of unilateral
known as a Mudarib, manages the project
promises)
using his entrepreneurial skills. Profits arising
from the project are distributed according to Two unilateral promises extended by two parties
a predetermined ratio, and financial losses are on the same subject matter.
borne by the provider of capital.
Off-balance sheet
Mudaraba al Muqayyada (Restricted An item not recognised for accounting purposes
partnership) as being on the balance sheet.

Restricted Mudaraba – applies when the Parallel Salam

agreement relates to a specific business or place
A contract taken out to offset the delivery
and it is contractually limited by time, place,
obligations of the Salam contract.
partner and deal type.
Qard (Loan)
Mudaraba al Mutlaqa (Unrestricted
The literal meaning is ‘to cut’. It is so called
partnership)
because the property is really cut off when it is
Unrestricted Mudaraba – where the Mudarib is lent to the borrower. Legally, Qard means to lend
free to act within traditional Shariah parameters. anything having value so that the borrower could
avail himself of the same for his benefit with the
Mudarib (Business manager) condition that the same or similar amount of
Mudarib manager in a Mudaraba contract. The that thing will be paid back on demand or at the
Mudarib does not invest capital but provides skill agreed time. Qard is meant to be benevolent, or
and effort. non-commercial.
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Qard Hassan (Loan without interset) Riba al-Naseeyah/Riba Al-Nasiah
A form of loan identified in the Quran as a means (Riba Al-Quran and Riba Al-Jahiliyyah)
of charity or helping others in need; an interest- (Predetermined interest on a loan)
free loan. Riba Al-Nasiah or Riba of delay is due to an
exchange of money today for more at a later
Qimar (Speculation) date. Interest, in all modern banking transactions,
Speculation. qualifies as Riba Al-Nasiah.

Qiyas (Analogy) Ribawi (Containing interest)

Literally, this means measure, example, Susceptible or containing Riba.
comparison or analogy. Technically, it means a
derivation of a rule on the analogy of an existing Ribawi commodities
law if the basis (Illah) of the two is the same. In Gold, silver, wheat, barley, dates, salt; anything
the order of priority, it is the fourth tool of Islamic which is used as money.
law.
Sahih (Valid)
Quran Valid (contract).
Text of God, the primary source of Islamic
jurisprudence. The Book of Divine Revelation Salam (Short-term production finance)
that was delivered to humankind by the Prophet A contract for the purchase of a commodity for
Muhammed (PBUH). deferred delivery in exchange for immediate
payment in full according to specified conditions.
Rab al Mal (Investor)
The party providing the capital – the investor. Sarf (Exchange)
Literally, this means exchange. The rules of
Rahn (Pledge) sarf restrict the methods of exchanging and
Pledge/mortgage. depositing money in order to prevent Riba.
These rules are based on the Hadith.
Ras al Mal (Capital)
Capital. Securitisation
The conversion of assets into financial
Retakaful instruments, which may be sold in a manner
Where a Takaful operator mitigates part of that cuts the asset off from the seller, making it
the risk associated with its Takaful funds by truly the property of the buyer of the financial
transferring part of the risk to another Takaful or instrument.
a Retakaful operator.
Shariah (Islamic law)
Riba (Interest) Islamic canon law derived from primary sources,
An excess of, or increase in, interest. Technically, the Quran and the Hadith practice, and traditions
it means an increase over the principal in a loan of the Prophet Muhammed (PBUH).
transaction.
Shirkah (Partnership)
Riba al-Fadl (Riba al-Quran/Riba al-Jahiliyyah) An alternative term for Musharakah. A
(Interest based on unequal exchange) partnership or company.
An exchange of similar commodities, defined as
money or certain foods, in unequal amounts. Its Shirkat al Aqd (Contractual partnership)
prohibition is meant to close the door to Riba in Partnership by mutual agreed contract.
lending.

222
 Glossary

Shirkat al Milk (Property owner partnership) Underlying asset

Partnership of two or more owners of a property An asset which is the object of a contract, a
held in common. specific Sukuk issuance, derivative, or guarantee.

Sukuk (Investment certificates) Usufruct

This is a document or certificate evidencing an The right to enjoy the benefit of property which
undivided pro rata ownership of an underlying is vested in another person.
asset. Usually referred to as an Islamic bond.
Usury
Sunnah/Sunna (Customs) Excessive interest.
Custom, habit or way of life. Technically, it refers
to the utterances of the Prophet Muhammad Usul al-fiqh (Principles of Islamic
(PBUH) other than the Holy Quran known as jurisprudence)
Hadith, or his personal acts, or sayings of others, Principles of Islamic jurisprudence.
tacitly approved by the Prophet (PBUH).
Wa’d (Promise)
Tabarru’ (Donation)
Promise by one party regarding future actions.
A donation/gift the purpose of which is not
commercial. Any benefit that is given by a person Wadia/Wadiah (Safe custody)
to another without getting anything in exchange
Safe custody, trust, deposits.
is called Tabarru’. The concept of Tabarru’ has
been applied within Takaful (Islamic insurance)
Wakala/Wakalah (Agency agreement)
schemes.
A contract of agency in which one person
Takaful (Mutual insurance) appoints someone else to perform a certain task
on his behalf, usually against a certain fee.
A Shariah-compliant system of mutual
protection, insurance, in which the participants
Wakil/Wakeel (Agent)
donate part or all of their contributions to a
common fund. These may be used to pay claims Agent, representative for commercial purposes
for damages suffered by any of the participants. with a capacity similar to a power of attorney.
The company’s role is restricted to managing
the insurance operations and investing the Waqf (pl. Awqaf) (Charitable trust)
insurance contributions. Investments or properties which are charitable
grants with limited or infinite life, which may be
Tawarruq (Credit sale) used to support specific beneficiaries designated
A form of reverse Murabaha which is tolerated by the grantor.
as it involves three sales contracts and three
independent parties, frequently used to deliver Zakat/Zakah (Mandatory almsgiving)
money to a person wishing to avoid borrowing A religious obligation of almsgiving on a Muslim
at interest. Considered objectionable by most to pay 2.5% of certain kinds of his wealth
Muslim scholars. annually to one of the eight categories of needy
Muslims. Literally, it means blessing, purification,
Tenor increase, or cultivation of good deeds. In Shariah,
The term of the contract. it is an obligation to pay Zakat on wealth above
a specified minimum for defined beneficiaries, as
Ummah (Nation of Islamic states) noted in the Quran.
The collective nation of Islamic states. The Islamic
universal community.

223
224
List of Arabic Terms
226
 List of Arabic Terms

The following terms used in the workbook need to be known for the examination. Where pronunciation
might not be evident, written guidance is given in the right hand column – although listening to Arabic
speakers is strongly recommended.

Ah’d

Akhlaq

Amanah

A’qd/Aqd’ A’kd

Aqidah

Arboon A’r boon

Fatwa (Fatawa, plural)

Fiqh

Fiqh al Muamalat Fikh al Mu a’a malat

Gharar

Hadith (Ahadith, plural) Ha deeth (Aha deeth, plural)

Halal

Haram

Hawala

Ijara

Ijara Mawsoofa Bil Thimma

Ijara Muntahia Bitamleek/Ijara wa Iqtina I ja ra Mun ta hi a Bi tam leek/I ja ra wa Iq ti na

Ijma’

Ijtihad

Istisn’a Is tis n’a

Kafala

Maysir

Muamalat Mu a’a malat

Mudaraba/Mudarib Mu da ra ba/Mu da rib

Murabaha Mu ra ba ha

Musharaka/Musharik Mu sha ra ka/Mu sha rik

Parallel Salam

227
Qard Kard

Qard Hassan Kard Ha ss an

Qimar

Qiyas

Quran Kor an

Rab al Mal (Arbab al Mal, plural) Rab al Mal (Ar bab al Mal, plural)

Rahn

Retakaful Re Ta ka ful

Riba Ri ba

Riba al-Fadl Ri ba al-Fadl

Riba al-Naseeyah Ri ba al - Na see ya h

Sadaqah (Sadaqaat, plural) Sa da ka (Sa da kat, plural)

Salam

Sarf

Shariah Sha ri a’a

Sukuk Su kook

Sunnah Su nn ah

Tabarru’ Ta ba rro

Takaful Ta ka ful

Tawarruq Ta wa rruk

Wa’d

Wadia

Wakala Wa ka la

Wakil Wa keel

Waqf

Zakat Za kat

228
Multiple Choice
Questions
230
 Multiple Choice Questions

1. Where Arboon is used in a sales contract, what happens to the down payment if the buyer decides
not to take the goods by the stipulated time?
A. It must be returned in full to the buyer
B. It may be retained in full by the seller
C. It will be split equally between the buyer and the seller
D. It should be forwarded to an independent third party

2. Combining two contracts into one is permitted as long as the contracts are:
A. Conflicting
B. Signed simultaneously
C. Between the same parties
D. Increased in value by the combination

3. When a client fails to keep up payments on a mortgage under a Diminishing Musharaka, the bank
may:
A. Evict the client and keep the profits from the sale of the property
B. Sublet the property to generate additional income
C. Amend the rental agreement
D. Charge a penalty interest

4. The IFSB‘s main purpose is to promote:

A. Best accounting practices
B. Standardisation of transactions
C. Islamic capital markets
D. Soundness and stability of the industry

5. In a Wakala agreement, the agent can be either disclosed or undisclosed. In an undisclosed Wakala
agreement, the agent:
A. Acts in his own best interest
B. Does not have fiduciary duties
C. Can be held liable for any loss or damages to the assets
D. Does not reveal he acts on behalf of a third party

6. In a Mudaraba agreement, the Mudarib is entitled to a pre-agreed share of the profit but does not
share in the losses. Profits are typically allocated from:
A. Gross operating profit or loss
B. Net operating profit or loss
C. Net earnings
D. Retained earnings

231
7. The main difference between a trade and a loan are that a trade is related to:
A. Equal quantities of a good
B. Equal qualities of a good
C. Identical items
D. Different items

8. Which of the following is not part of the industry screen?

A. Gambling
B. Adult entertainment
C. Music and films
D. Alcohol

9. Salam is a contract with:

A. Spot payment in full and deferred delivery
B. Spot delivery and deferred payment in full
C. Spot payment in full and spot delivery
D. Deferred payment in full and deferred delivery

10. Arboon transactions in modern Islamic finance can:

A. Not be sold
B. Be sold to the bank
C. Be sold to a party approved by the bank
D. Be sold to any party

11. In a Diminishing Musharaka transaction, the purchasing party pays:

A. Less rent as they buy more units
B. The same rent until the end of the contract
C. More rent as they buy more units
D. No rent

12. Ijtihad, one of the secondary sources of Shariah, is associated with interpretation and is best
described as:
A. Scholarly
B. Pragmatic
C. Contemporary
D. Analogical

232
 Multiple Choice Questions

13. A Wa’d or promise can be used in a finance lease transaction as a promise to purchase the asset:
A. From the lessor at the beginning of the lease period
B. Then sell it to the lessor, and lease it back
C. From the lessor at the end of the lease period
D. From the lessee at the end of the lease period

14. Equity funds can invest in:

A. Private equity only
B. Listed equity only
C. Private and listed equity
D. Index funds only

15. The originator in a Sukuk is best described as the:

A. Person seeking to raise funds
B. Investor
C. Manager of the SPV
D. Creditor

16. When a conventional financial institution operates a branch model for the offering of Islamic
financial services, which of the following needs to be segregated:
A. Operations and accounts only
B. Operations, accounts and distribution channel
C. Accounts and distribution channel only
D. Operations and distribution channel only

17. Under which of the following types of transaction are letters of credit most likely to be used?
A. Ijara
B. Salam
C. Parallel Istisn’a
D. Diminishing Musharaka

18. Which of the following is not a condition for the realisation of revenue under the accrual accounting
method?
A. The institution has earned the right to receive the revenue
B. There is an obligation on the other party to remit the revenue
C. The amount of revenue is known
D. There is no certainty about the collectability of the revenue

233
19. Which of the following meets the industry and financial screens?
A. A tobacco firm with conventional debt/market capitalisation of 29%
B. A children’s movie production company with interest bearing deposits/market capitalisation
of 32%
C. An illicit drugs trader with debt/market capitalisation of 28%
D. A woollen mill with interest bearing deposits/market capitalisation of 22%

20. Which of the following is not a characteristic of an exchange-traded fund?

A. It tracks an equity index
B. The price is stable throughout the day
C. It is not required to keep liquid instruments
D. It can be bought and sold

21. The assets in a real estate fund can be both commercial and residential. Any income from non-
compliant use of the asset needs to be:
A. Given to charity
B. Declared to investors and paid out immediately as dividend
C. Reinvested in Shariah-compliant assets
D. Used to purchase social housing

22. Mudaraba and Musharaka transactions are equity-type transactions in which:

A. Profits and losses are shared according to a pre-agreed ratio
B. Profits are shared according to a pre-agreed ratio, losses proportionate to capital
C. Profits are shared proportionate to capital, losses according to a pre-agreed ratio
D. Profits and losses are shared proportionate to capital

23. Which of the following is not a Ribawi commodity?

A. Sugar
B. Salt
C. Dates
D. Barley

24. Person X wishes to buy an asset from Person Y, with the finance provided by Islamic Bank XYZ
under an Ijara wa Iqtina contract. Who will act as lessee under this arrangement?
A. X only
B. XYZ only
C. X and XYZ jointly
D. Y and XYZ jointly

234
 Multiple Choice Questions

25. Which of the following needs to be met by the commodity in a commodity fund?
A. The commodity may be sold forward
B. Any commodity is acceptable
C. The seller must have constructive possession
D. The price may be determined after the purchase

26. When a financial institution provides a guarantee, it may:

A. Charge a fee as a percentage of the guarantee amount
B. Charge an administration fee not related to the amount
C. Charge its own cost to the client
D. Never charge a fee

27. When investing in a company, the investor needs to make an initial selection on the basis of:
A. The industry screen
B. The financial screen
C. Either the industry or the financial screen
D. Both the industry and the financial screen

28. Fahad is expanding his car dealership and wishes to issue a Sukuk. He approaches a bank which
advises him to enter into a Sukuk al-Ijara, using the premises he owns as the asset. In this scenario,
which of the following is correct?
A. The special purpose vehicle is the lessee and the Sukuk holders are the lessor
B. The special purpose vehicle is the lessor and the Sukuk holders are the lessee
C. Fahad is the lessee and the special purpose vehicle is the lessor
D. Fahad is the lessee and the Sukuk holders are the lessor

29. There are a number of rules that specifically apply to the role of business in society which are
intended to ensure that:
A. Business and wealth creation are linked to social values
B. Muslims do not engage in wealth creation
C. All trades are undertaken in a fair and transparent way
D. Trades are free from Riba and Gharar

30. Exchange contracts are subject to what can be termed ‘rules of exchange’. Which of the following
is an example of rules of exchange?
A. Do not sell what you do not own
B. Overbooking or overselling is permissible
C. Purchase and sale of debt
D. No profit without liability

235
31. The principle of freedom of contracting implies that:
A. Every type of transaction is permissible as long as agreed between parties
B. All economic activities are permissible unless otherwise stated by Shariah
C. Transactions are restricted to Ribawi commodities
D. Contracts are impermissible unless otherwise stated

32. In order to earn a return, Islamic banks need to focus on:

A. Asset and commercial risk
B. Credit and obligor risk
C. Displaced commercial risk
D. Product development risk

33. One of the key differences between a conventional bond and a Sukuk is that:
A. A conventional bond exposes the holder to asset level risks
B. A conventional bond has a fixed maturity date
C. A Sukuk grants the holder undivided beneficial interest in the underlying asset
D. A Sukuk will not result in the holder incurring a loss

34. Which of the following is true regarding charitable distributions?

A. Zakat is voluntary
B. Sadaqat is voluntary
C. Both Sadaqat and Zakat are voluntary
D. Neither Sadaqat nor Zakat are voluntary

35. When rating a Sukuk, a rating agency will not consider:

A. Shariah compliance
B. Cash flow
C. Underlying asset
D. History of originator and asset

36. Sukuk certificates are defined as:

A. A financial right
B. A right to a fixed income
C. An ownership share in the asset
D. No right to the asset

37. Which of the following is not one of the roles of the SSB?
A. Advisory
B. Risk
C. Approval
D. Audit

236
 Multiple Choice Questions

38. Going concern is an accounting term best described as the concept that:
A. A business will continue to operate for the foreseeable future
B. There is no hyperinflation in the foreseeable future
C. The company is divided into equal units
D. The economy will continue to grow at the current rate

39. In a Sukuk al Musharaka, the special purpose vehicle is the:

A. Musharik
B. Rab al Mal
C. Obligor
D. Profit and loss sharing partner

40. An Islamic bank is not obliged to pay Zakat when:

A. The bank appoints shareholders to pay Zakat
B. The bank is based in a jurisdiction where Zakat is not recognised
C. The bank is based in a jurisdiction with a solar calendar
D. The bank has a legal exemption

41. X and Y are partners in a Musharaka contract with X contributing capital of $800,000 and Y
contributing capital of $200,000. The agreement states that 70% of profits will go to X and 30% to
Y. If losses of $50,000 are incurred, how much of this (if any) must be borne by Y:
A. None
B. $10,000
C. $15,000
D. $25,000

42. The rationale underlying the prohibition on the sale of a debt for a debt is that:
A. It is unfair on one of the parties
B. It is a supply contract
C. The transaction creates interest
D. There is no link between economic activity and finance

43. When applied to investment accounts, the Mudaraba transaction is deemed similar to a
conventional savings account and under the regulatory regime which, generally, is:
A. Not subject to deposit guarantees
B. Subject to deposit guarantees for principal and expected return
C. Subject to deposit guarantees for principal only
D. Subject to deposit guarantees for expected returns only

237
44. In a lease fund, the fund acts as the:
A. Special purpose vehicle
B. Lessor
C. Lessee
D. Investor

45. A bilateral promise is best described as:

A. Two unilateral promises by two different parties on the same asset
B. Two unilateral promises by two different parties on two different assets
C. One unilateral promise by one party and a promise to purchase
D. Two bilateral promises by one party on the same asset

46. Which of the following type of conventional life policy bears the closest resemblance to a family
Takaful?
A. Level term
B. Endowment
C. Whole of life
D. Decreasing term

47. In a current account, the bank may apply the funds:

A. In any way it sees fits
B. Only to pre-agreed investments
C. Only to pre-agreed risk levels
D. In any way it sees fit, but only if allowed to do so by the client

48. Which of the following is not an AAOIFI requirement for SSB in relation to the internal Shariah
audit?
A. Independence
B. Objectivity
C. Audit
D. Personal competency

49. Within a Sukuk structure, guarantees are:

A. Typically not allowed
B. Allowed if provided by a third party
C. Allowed if provided by the Sukuk manager
D. Incorporated as standard

238
 Multiple Choice Questions

50. Under the Mudaraba contract, who is normally liable for material losses which arise other than
through negligence or contractual breach?
A. The Rab al Mal only
B. The Mudarib only
C. Both the Rab al Mal and the Mudarib in equal shares
D. Both the Rab al Mal and the Mudarib according to the profit distribution ratio

51. Fahad offers to pay £5,000 for Ali’s car and Ali says he is willing to sell his car for £7,500. This is a:
A. Contract
B. Promise
C. Murabaha agreement
D. Counteroffer

52. In a permanent Musharaka:

A. One partner holds all the shares to the end
B. Each partner retains their share to the end
C. One partner sells all shares over time to the other
D. Both partners sell their shares to a third party

53. In an Istisn’a transaction the:

A. Asset has commodity-type characteristics
B. Contract may not be cancelled
C. There is no penalty for late delivery
D. Delivery date should fall within a pre-agreed time frame

54. Internal risk pooling occurs when a pool that has a deficit is:
A. Temporarily covered by a surplus from another pool
B. Permanently covered by a surplus from another pool
C. Temporarily covered by an interest-free loan
D. Permanently covered by an interest-free loan

55. The Islamic Fiqh Academy has defined a number of rules which have to be met for a promise to be
binding. Which of the following is not part of these rules?
A. The promise has to be bilateral
B. The promise must incur some liabilities
C. In a promise to purchase the actual sale still needs to take place
D. Only actual damages can be awarded

239
56. In accordance with the AAOIFI Sukuk rules of 2008, a purchase undertaking is:
A. Never allowed
B. Allowed at original purchase price
C. Allowed at market value
D. Allowed at any price agreed between parties

57. The concept of selling what you do not have refers to a sale in which the seller:
A. Does not own the asset
B. Is not authorised to sell the asset
C. Owns or is authorised to sell and controls the asset
D. Sells a stolen asset

58. In a Mudaraba transaction, profits are typically allocated from:

A. Net profit
B. Gross operating profit
C. Net operating profit
D. Profit after tax

59. AAOIFI accounting standards are based on:

A. IFSB
B. IFRS
C. ACCA
D. IAS

60. Roads’R’Us is starting a major infrastructure project in Sharjah and is considering issuing a Sukuk to
fund this project. Which of the following is most appropriate?
A. Istisn’a Sukuk
B. Ijara Sukuk
C. Musharaka Sukuk
D. Mudaraba Sukuk

61. A Murabaha contract is:

A. An instalment credit sale with profit mark-up
B. An Islamic bond
C. A profit and loss sharing partnership contract
D. A sale/purchase with profit mark-up

240
 Multiple Choice Questions

62. Gharar is best defined as which of the following?

A. Gambling
B. Risk with a small probability of risk
C. Uncertainty involving risk
D. Sale by means of pebbles

63. Stop-loss reinsurance is a reinsurance contract in which the reinsurer takes:

A. An agreed proportion of the loss
B. A proportion of the loss to be determined when the loss occurs
C. Any claims up to an agreed limit
D. Any claims above an agreed limit

64. When accepting funds under an unrestricted investment account agreement, Shariah scholars
typically prefer for the bank to:
A. Keep its own funds separate
B. Invest with the clients exactly the same amount
C. Invest with the clients some of its own capital
D. Invest with the clients an amount higher than the client

65. After paying back loans and making provision for reserves, what is the maximum proportion of the
remaining underwriting surplus of a Takaful fund which can be redistributed to policyholders:
A. 75%
B. 80%
C. 90%
D. 100%

66. Shariah standards are issued by:

A. The statutory regulator
B. AAOIFI
C. Banks
D. IIRA

67. Which of the following is true regarding cash flow and control rights for unrestricted investment
account holders? The account holders have:
A. Limited cash flow rights, limited control rights
B. Full cash flow rights, limited control rights
C. Limited cash flow rights, full control rights
D. Full cash flow rights, full control rights

241
68. A fund is best defined as a:
A. Collection of investments managed by an individual
B. Resource managed on behalf of a client by a financial institution
C. Purchase of units to generate monetary return
D. Financial investment as a means of saving

69. One of the main differences between Takaful and conventional mutual insurance is that in Takaful:
A. The insured from a risk pool for a defined category of risk
B. Benefits are payable from the underwriting fund
C. The expected value of the underwriting surplus should be zero
D. Policyholders’ funds are vested in a separate commercial entity

70. The profit equalisation reserve is built up of appropriations from:

A. Income prior to profit allocation between bank and IAH
B. Income after profit allocation between bank and IAH
C. Profit share allocated to IAH before tax
D. Profit share allocated to IAH after tax

71. Restricted investment accounts:

A. Have no secondary market
B. Do not allow for the investor to withdraw their funds prior to maturity
C. Are a separate legal entity
D. Have no restrictions on asset allocation

72. Which of the following is not a type of Riba?

A. Riba al Naseeyah
B. Riba al Gharar
C. Riba al Jahliyyah
D. Riba al Fall

73. Fixed-income funds are known for typically having:

A. Low risk and high liquidity
B. Medium risk and low liquidity
C. Medium risk and high liquidity
D. High risk and low liquidity

242
 Multiple Choice Questions

74. One of the main differences between Takaful and proprietary insurance is that any deficiencies in
the Takaful fund will normally be addressed by:
A. A one-off levy on all policyholders
B. A scaling down of future claims payments
C. An interest-free loan from the Takaful operator
D. An appropriate reduction in the level of Zakat

75. In a Salam transaction, the:

A. Asset has commodity-type characteristics
B. Contract may be cancelled unilaterally
C. Price may be paid in advance
D. Delivery date should fall within a pre-agreed time frame

76. Under the two-tier Mudaraba contract, what does the bank normally do with the money it collects
from clients?
A. Provides safekeeping for the funds
B. Invests it with another client requiring funds
C. Returns it to the clients on a staggered basis
D. Returns it to the clients as a short-term loan

77. AAOIFI has to date not developed inflation accounting principles due to the fact that:
A. This is not Sharia compliant
B. Islamic banks do not operate in hyperinflation countries
C. Murabaha transactions are immune to inflation
D. There is no interest in Islamic financial transactions

78. Which of the following is not a criteria generally associated with the role of the SSB?
A. Dependence
B. Confidentiality
C. Competence
D. Disclosure

79. Major Gharar is a transaction in which the dominant outcome is:

A. Win-win
B. Win-lose
C. Lose-lose
D. Mutual liability

243
80. In a Shariah-compliant fund, the fund manager acts as the:
A. Rab al Mal
B. Mudarib
C. Mudarib or the Rab al Mal
D. Musharik

81. What are two types of reinsurance?

A. Adequate and stop-risk
B. Proportionate and stop-loss
C. Disproportionate and stop-risk
D. Adequate and stop-loss

82. Which of the following is not a characteristic of an SPV?

A. Bankruptcy remoteness
B. Domiciled in tax efficient jurisdiction
C. Acts as guarantor
D. Acts as trustee

83. Banks are considered a special case in relation to corporate governance due to:
A. Narrower definition of stakeholders
B. Absence of regulation and compliance
C. Presence of systemic risk
D. Information symmetry

84. Which of the following is not a principle of Islamic contracting?

A. Limitation in contracting
B. Judging actions by objectives
C. Liability justifies return
D. Incorporation of custom and convention

85. The issue of corporate governance was identified as a result of the fact that:
A. Corporations became larger
B. Shareholders became more aware of their rights
C. Control and ownership of corporations was increasingly separated
D. Senior management refused to share information

244
 Multiple Choice Questions

86. John has designed his dream house and is now looking to appoint a builder. Unfortunately, he
does not have the funds available to pay for the building works and he is discussing his options for
financing with the bank. Which of the following transaction types is best suited to his requirement?
A. Commodity Murabaha
B. Mudaraba
C. Salam
D. Istisn’a

87. Which of the following is not a part of a Sukuk?

A. Undertaker
B. Arranger
C. Investor
D. Obligor

88. The Takaful model in which all risks are borne by the fund and any operating surplus belong
exclusively to the participants is known as a:
A. Pure Wakala model
B. Pure Murabaha model
C. Combined model
D. Pure Musharaka model

89. The asset allocation on an unrestricted investment account is determined by:

A. The bank and the investor
B. The investor
C. The bank
D. The Shariah Supervisory Board

90. Amounts from the investment risk reserve may be released in which of the following events?
A. Increase profit pay-out to IAH
B. Increase dividend pay-out to shareholders
C. Reduce the amount of loss attributable to IAH
D. Reduce the amount of loss attributable to shareholders

91. Which of the following is not a Shariah option of sale?

A. Seller’s option to rescind
B. Option of defect
C. Option of quality
D. Option of price

245
92. Which of the following is not a main contract of Fiqh al Muamalat used in Islamic insurance?
A. Dhaman
B. Tabarru
C. Murabaha
D. Wakala

93. Unrestricted investment accounts:

A. Have a guaranteed return
B. Are higher risk than restricted investment accounts
C. May be co-mingled with other funds at the bank’s disposal
D. Have no restriction on asset allocation

94. Fund management is typically either undertaken on the basis of:

A. Musharaka
B. Murabaha
C. Mudaraba
D. Musawama

95. The Wa’d is often used:

A. To provide a level of security

B. Instead of a Wakala
C. To guarantee performance
D. To ensure Shariah compliance

96. Which of the following is true in relation to gambling?

A. It is a type of major Gharar

B. It is a type of minor Gharar
C. It is not a type of Gharar
D. It is a type of Qimar

97. Corporations that work to a high standard of corporate governance will ensure their activities:
A. Are environmentally friendly
B. Are culturally sensitive
C. Are inflexible
D. Deal with customers fairly

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 Multiple Choice Questions

98. Islamic financial institutions have an intermediary function in which the relationship with the client
is based on a Mudaraba transaction. The return to the depositors is based on the institution’s:
A. Overall profit
B. Profit after Mudarib share
C. Profit after provisions
D. Profit before Mudarib share

99. Banks are regarded as a special case when it comes to corporate governance because of their
strong need for:
A. Risk management
B. External control
C. Executive management
D. Audit

100. There are two different types of contract – compensatory or bilateral contracts and non-
compensatory or unilateral contracts. Which of the following is a non-compensatory contract?
A. Murabaha
B. Mudaraba
C. Qard
D. Ijara

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 Answers to Multiple Choice Questions

1. Answer: B Chapter 5, Section 15.1

If the buyer decides not to take the goods by the stipulated time, the down payment may be kept by
the seller.

2. Answer: D Chapter 3, Section 6.4

Combining two or more contracts, therefore, is restricted only if these contracts are contradictory or
in conflict with each other and the combination does not add value. However, if the contracts are in
agreement, the combination may very well bring in value that could not have been achieved by treating
the contracts separately.

3. Answer: C Chapter 5, Section 8.1.2

When a client fails to keep up payments on a mortgage under a Diminishing Musharaka, the bank
typically has the following options:

• Amend the rental agreement.

• Evict the client, sell the property and share any profits with the client.
• Adjust the ownership share to reflect the client’s past due payments.

4. Answer: D Chapter 2, Section 2.3.2

The IFSB is an international standard-setting organisation with a mission to promote and enhance the
soundness and stability of the Islamic financial services industry, by issuing global prudential standards
and guiding principles for the industry, broadly defined to include banking, capital markets and
insurance sectors.

5. Answer: D Chapter 5, Section 6

In an undisclosed agency agreement, the agent does not disclose that he acts on behalf of another
party and is, to all intents and purposes, acting as a principal in dealing with third parties. Agents have a
fiduciary duty and act as trustees in holding the assets of the principal in executing the service. They are
not liable for any loss or damage to the asset unless this is caused by the agent’s negligence.

6. Answer: A Chapter 5, Section 7.2

The Mudarib is entitled to a pre-agreed share of any profit, but does not share in losses (unless the
Mudarib has been negligent). In modern Islamic banking, the profit is typically allocated from the
business’s gross operating profit or loss (before deduction of general overhead expenses) rather than
the net operating profit or loss. This is because, although he does not participate in the expenses of the
investments, he must incur certain expenses in his capacity as Mudarib, such as overhead expenses, and
premises rental.

7. Answer: D Chapter 3, Section 4.1.1

A trade is when the underlying items are of a different nature or quality, while a loan is when the
underlying items are identical in quality and nature.

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 Multiple Choice Questions

8. Answer: C Chapter 6, Section 3.1

The industry screen excludes the following business activities:

• Conventional banking and insurance.

• Alcohol.
• Pork-related products and non-compliant food production.
• Gambling.
• Tobacco.
• Adult entertainment.
• Weapons, arms and defence manufacturing.

9. Answer: A Chapter 4, Section 3.2.3

Salam may be defined simply as a contract executed with spot payment in full for the future delivery of
assets which have commodity-like characteristics.

10. Answer: A Chapter 5, Section 15.1

Although it is often used as an option (ie, a conventional covered call option giving the holder the right,
but not the obligation, to buy a fixed quantity of an underlying asset on or before the maturity date), an
Arboon cannot be traded or sold to a third party.

11. Answer: A Chapter 5, Section 8.1.2

As the purchasing party owns more units, he owns a larger proportion of the asset and thus pays lower
rent to the other party.

12. Answer: A Chapter 1, Section 3.2.1

First recourse is to the Quran to determine a course of action. If they were unable to find a solution to
their problem in the Quran, they would turn to the Sunnah. When the indications in the Ahadith were
insufficient to deal with the problem fully and the problem was not confirmed by Ijma’ or Qiyas, an
exhaustive scholarly examination of the textual evidences (Ijtihad) was used to resolve the question.

13. Answer: C Chapter 5, Section 14

In a finance lease transaction, the promise is given by the lessee to purchase the asset from the lessor at
the end of the lease period.

14. Answer: C Chapter 6, Section 6.5

Equity funds can invest in both private and listed equity as long as it meets the industry and the financial
screen.

15. Answer: A Chapter 7, Section 2.1

The originator or obligor is the person or entity seeking to raise funds.

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16. Answer: B Chapter 2, Section 2.2
Islamic financial services can be offered by conventional financial institutions using a windows, branch,
or subsidiary model. In all cases, operations and accounts need to be segregated. In a windows model,
the same distribution channels are used for both conventional and Islamic financial services. In a branch
model, the services are offered via a separate distribution channel. A subsidiary is a separate legal entity.

17. Answer: B Chapter 5, Section 13.1

Recently, Islamic banks have started to bundle the letter of credit and processing services into
Musharaka agreements with the client.

18. Answer: D Chapter 4, Section 8.2.6

There are three conditions for the realisation of revenue:

1. The institution has earned the right to receive the revenue.

2. There is an obligation on the part of the other party to remit the revenue.
3. The amount of revenue should be known and collectible with a degree of certainty.

19. Answer: D Chapter 6, Section 3.2

Only the woollen mill meets the industry screen and the financial screen.

20. Answer: B Chapter 6, Section 6.6

Islamic exchange-traded funds are securities that track the performance of an Islamic index or basket of
commodities in the same way as an index fund does. However, the ETFs can be traded on an exchange
in the same way as securities. The price of ETFs changes during the day as a result of units being bought
and sold. The fund is not required to keep liquid instruments since the investor can liquidate his
holdings by selling them in the open market.

21. Answer: A Chapter 6, Section 6.4

Any income associated with the non-compliant use must be donated to charity.

22. Answer: B Chapter 4, Section 5

In Mudaraba and Musharaka transactions, profits are shared in accordance with a pre-agreed ratio and
losses are distributed in proportion to the capital provided.

23. Answer: A Chapter 3, Section 4.1.4

Ribawi commodities are gold, silver, wheat, barley, dates and salt.

24. Answer: A Chapter 5, Section 10.1

In an Ijara transaction, the bank will become the lessor and lease the asset to the client (the lessee).

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 Multiple Choice Questions

25. Answer: C Chapter 6, Section 6.3

The commodity needs to fulfil the following criteria:

• Must be owned by the seller at the time of sale.

• Forward sales are not permitted.
• Commodity has to be lawful.
• Seller must have physical or constructive possession.
• The price needs to be certain and unconditional.

26. Answer: B Chapter 4, Section 6.2

Although a charging a fee to act as a third-party guarantor is not allowed, Shariah scholars are of the
opinion that on the basis of the principle of necessity, financial institutions may charge an administration
fee as long as it is not proportionate to the amount guaranteed.

27. Answer: D Chapter 6, Section 3

Firms that use too much leverage must be excluded from the investment universe in addition to
meeting the industry screen.

28. Answer: C Chapter 7, Section 4.2 and 2.1

The structure of the Sukuk al Ijara follows the rules of the underlying Ijara transaction. The Sukuk
certificates constitute shares in a leasing project.

29. Answer: A Chapter 3, Section 2.2

The rules prove that Islam links business and wealth creation to social values.

30. Answer: D Chapter 3, Section 6

Rules of exchange are:

1. No profit without liabilities.

2. Do not sell what you do not have, which includes a prohibition on overbooking and overselling.
3. No debt for debt.
4. Restrictions on combining two contracts into one.

31. Answer: B Chapter 3, Section 3.1

In accordance with the principle of permissibility, all economic activities are permissible unless
otherwise stated by Shariah.

32. Answer: A Chapter 5, Section 5

Shariah rules require the investor or financier to focus on asset or commercial risk in order to earn a
reward.

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33. Answer: C Chapter 7, Section 1.1.3
Sukuk represents a share of the ownership of the underlying asset used by the company issuing the
securities. Sukuk holders are exposed to appreciation or depreciation of the asset.

34. Answer: B Chapter 1, Section 2.2

Zakat, one of the five pillars of Islam, is mandatory almsgiving and is levied on anyone who has in excess
of a minimum level of wealth (Nisab). The Quran also encourages Muslims to make voluntary charitable
donations (Sadaqat), the amount of which is dependent on the goodwill of the donor. Individuals are
encouraged to prioritise the distribution of their charity.

35. Answer: A Chapter 7, Section 6

When rating a Sukuk, a rating agency considers the same matters as for a comparable conventional
issue. Shariah compliance is typically not considered.

36. Answer: C Chapter 7, Section 1.1.2

AAOIFI defines Sukuk as certificates of equal value representing undivided shares in ownership of
tangible assets, Usufructs and services or (in the ownership of) the assets of a particular projects or
special investment activities.

37. Answer: B Chapter 9, Section 3.1

The roles of the SSB are advisory, approval, and audit.

38. Answer: A Chapter 4, Section 8.1.3

Going concern means that a business will continue to operate for the foreseeable future and there is no
intention to liquidate it or to drastically reduce its scale of activities.

39. Answer: A Chapter 7, Sections 4.3 and 2.1

In a Musharaka Sukuk, the SPV acts as a Musharik on behalf of the Sukuk investors.

40. Answer: A Chapter 4, Section 8.3.2

Cases in which the Islamic bank is not obliged to pay Zakat are:

• When shareholders ask the Islamic bank to act as agent in meeting the Zakat obligation relating to
their investment in the Islamic bank from their share of distributable profits, Zakat is deducted from
the shareholders’ share of distributable profits.
• When shareholders ask the Islamic bank to act as agent in meeting their Zakat obligation and
the Islamic bank agrees to do so, even if there are insufficient distributable profits to meet the
shareholders’ obligations, the amount paid by the Islamic bank is recorded as a receivable due from
these shareholders.

41. Answer: B Chapter 5, Section 8.1.1

Losses are borne by the investors in proportion to the capital provided. Y provides 20% of the capital
and is therefore subject to 20% of the loss.

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 Multiple Choice Questions

42. Answer: D Chapter 3, Section 6.3

The exchange of a debt for a debt is prohibited. The rationale for this restriction relates to the link
between finance and real economic activity. Debt for debt exchange creates debt obligations without
real transactions, ie, without possession of any tangible object at the time of contracting.

43. Answer: C Chapter 5, Section 7.1.1

International banking typically defines savings accounts as deposit accounts with capital protection.
In non-Muslim countries, this deposit guarantee is usually also applied to Mudaraba deposits since
the economic reality of the transaction is deemed to be the same as conventional savings accounts.
The deposit guarantee is normally defined as a national insurance scheme. In Islamic banking, deposit
insurance could, for example, be implemented through Takaful or Islamic cooperative insurance.

44. Answer: B Chapter 6, Section 6.2

In a lease fund, the fund owns the asset and acts as the lessor.

45. Answer: A Chapter 4, Section 2.5

A bilateral promise consists of two unilateral promises or undertakings extended by two parties on the
same asset or service.

46. Answer: B Chapter 8, Section 2.2

Islamic life insurance offers endowment-type policies.

47. Answer: D Chapter 5, Section 3.2

In a current account, the bank must obtain the permission of the account holder to apply the money to
its operations.

48. Answer: D Chapter 9, Section 4

The AAOIFI requirements can be summarised as:

1. Independence and objectivity.

2. Professional competency.
3. Audit plan.
4. Audit steps.
5. Audit.
6. Reporting.
7. Follow-up.

49. Answer: A Chapter 7, Section 5

Financial guarantees are not typically allowed in Sukuk. This means that the investment is not normally
guaranteed for investors.

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50. Answer: A Chapter 5, Section 7.3.1
Profits are distributed according to a predefined ratio agreed between the two parties in the Mudaraba
agreement. In case of any loss, material losses are born by the Rab al Mal only.

51. Answer: D Chapter 4, Section 2.1.1

Acceptance must match the offer. If the counterpart offers a higher price, he has made a counteroffer.

52. Answer: B Chapter 5, Section 8.1.1

In permanent Musharaka, each partner to the Musharaka contract retains their share in the capital until
the end of the project.

53. Answer: D Chapter 5, Section 12.3

In an Istisn’a transaction:

• Deliverables are manufactured goods or constructed property subject to detailed specification.

• The contract may be cancelled unilaterally before work starts.
• The price may be paid in advance, in instalments according to progress, post-delivery, in instalments
without reference to progress or at delivery. Payment schedules are agreed in the contract.
• Progress payments may be deferred and may attract pre-agreed penalties for the late delivery of the
contracted assets. To be valid, all specifications, delivery options, payment conditions and pricing
must be agreed in the Istisn’a contract. Typically, the financier subcontracts the manufacture or
construction of the object. However, they remain responsible for the product warranties, even if
they are able to assign or otherwise cover this risk.
• The delivery date does not need to be specific, but should fall within a pre-agreed time frame.

54. Answer: A Chapter 8, Section 5.3

In a given period, one fund may have an underwriting surplus, while another has a deficit. If surpluses
are allowed to offset deficits by means of an internal risk-pooling arrangement, the risk of insolvency is
substantially reduced, especially for an insurance undertaking of modest size.

55. Answer: A Chapter 4, Section 2.4

Contrary to a contract, a promise has to be unilateral.

56. Answer: C Chapter 7, Section 5

Purchase undertakings are allowed as long as the price is determined on the basis of the current market
value. Only in case of Ijara can the purchase undertaking be at a pre-agreed price.

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 Multiple Choice Questions

57. Answer: C Chapter 3, Section 6.2

The concept ‘what you do not have’ refers to the combination of ownership or authority, possession and
control. In order to be able to sell an asset, the seller needs to either own the asset or be authorised to
sell it, and be in control of it (ie, be able to deliver it). An agent who acts on behalf of the owner to sell
an asset is able to do so since he is authorised to do so by the owner, and is in control of the asset. What
you do not have, therefore, can be distilled into the following:

1. The seller has the legal ability to sell, ie, he owns the good, or has permission of the owner to sell on
his behalf.
2. The seller has the physical ability to deliver the good, ie, he has it in his possession.
3. The seller can control the asset.

A sale is valid when point 1 (ownership or authority) is fulfilled in combination with either one of the
other two (possession or control). Solely having the asset in possession and having control over it is,
however, not sufficient.

58. Answer: B Chapter 5, Section 7.2

In modern Islamic banking, the profit is typically allocated from the business’s gross operating profit or
loss.

59. Answer: B Chapter 4, Section 8.2.4

AAOIFI standards are based on IFRS and GAAP.

60. Answer: A Chapter 7, Section 4.4.2

Sukuk al Istisn’a is generally applied to the financing of larger-scale projects.

61. Answer: D Chapter 4, Section 3.2.1

A Murabaha is a cost plus sale in which the price of the goods, the mark-up, the delivery date and
payment date are all specified in detail. The sale of the good is immediate, against future payment.

62. Answer: C Chapter 3, Section 5.1

Gharar is uncertainty that involves risk, ie, the possibility of failure, damage or loss in which the
likelihood of loss or failure is substantial.

63. Answer: D Chapter 8, Section 6

In stop-loss, the reinsurer meets any claims above an agreed limit.

64. Answer: C Chapter 5, Section 7.1.1

In an attempt to increase the Islamic bank’s responsibility in its investment selections, Shariah scholars
usually advise the Islamic bank to invest part of its capital together with the Investment Account
Holders’ money in the Mudaraba activity.

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65. Answer: D Chapter 8, Section 4.2
In Takaful, as in mutual insurance undertakings, underwriting surpluses belong to the policyholders.

66. Answer: B Chapter 2, Section 2.3.1

AAOIFI has issued standards for the following:

• Shariah.
• Accounting.
• Auditing.
• Governance.
• Ethics.

67. Answer: A Chapter 9, Section 6.1.4

UIAH cash flow rights are normally limited by management’s right to withhold part of the profit to build
up PER and IRR. The Rab al Mal (UIAH) should not interfere with management and has no control rights.

68. Answer: B Chapter 6, Section 4

A fund is defined as:

1. A resource managed on behalf of a client by a financial institution.

2. A separate pool of monetary and other resources used to support designated activities.

69. Answer: D Chapter 8, Section 1.2.2

In Takaful, the policyholders’ funds including the underwriting funds and reserves are, where possible,
vested in a separate commercial entity.

70. Answer: A Chapter 9, Section 6.1.3

The PER is built up by appropriations from income earned on investments of UIAH funds after the profit
allocation between the bank as Midrib and the IAH as Rab al Mal.

71. Answer: A Chapter 5, Section 7.4.1

Restricted investment accounts are a type of CIS in which the asset allocation is restricted as set out in
the contract. There is no secondary market but investors may be able to withdraw their funds prior to
maturity.

72. Answer: B Chapter 3, Section 4.1.4

The types of interest are referred to under the following Arabic names:

• Simple interest – Riba al Naseeyah.

• Compound Interest – Riba al Naseeyah/Riba Al Jahiliyyah.
• Sale-based Interest – Riba Al Fadl.

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 Multiple Choice Questions

73. Answer: A Chapter 6, Section 6.1

Comparatively fixed-income funds are low risk and low return and offer a high level of liquidity.

74. Answer: C Chapter 8, Section 1.2.2

The Takaful operator provides capital back-up, if needed, to the underwriting funds by means of a Qard
Hassan (interest-free loan).

75. Answer: A Chapter 5, Section 12.3

In a Salam transaction:

• Deliverables have commodity-type characteristics and must be fungible like base metals or grain.
• The contract may not be cancelled.
• The full price must be paid in advance.
• There is no penalty for late delivery. However, in the event the seller fails to produce the commodity,
he will need to source it in the open market and deliver to the buyer.
• Delivery is on a specific date.

76. Answer: B Chapter 5, Section 7.3.1

Under the two-tier Mudaraba contract, a bank normally invests money it collects from clients with one
or more other banks.

77. Answer: B Chapter 4, Section 8.2.6

AAOIFI assumes stability of the purchasing power of the monetary unit but has not developed inflation
accounting standards due to the fact that there has been no call for such a standard in the countries
where Islamic banks operate.

78. Answer: A Chapter 9, Section 3.1

The five main criteria are independence, confidentiality, competence, consistency and disclosure.

79. Answer: B Chapter 3, Section 5.2.2

Excessive or major Gharar (Gharar Katheer) – transactions in which the win-lose outcome is either
significant or the dominant outcome. This type of Gharar is forbidden since it leads to obtaining wealth
for nothing and may be harmful to society.

80. Answer: C Chapter 6, Section 5

Depending on which side of the investment the fund manager is on, he acts either as the Rab al Mal or
the Mudarib.

81. Answer: B Chapter 8, Section 6

There are two basic forms of reinsurance: proportionate and stop-loss.

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82. Answer: C Chapter 7, Section 2.1
The SPV is bankruptcy remote, domiciled in a tax-efficient jurisdiction and acts as a trustee.

83. Answer: C Chapter 9, Section 2

Banks are considered to be a special case of corporate governance due to:

• A wider definition of ‘stakeholders’ (cf, BCBS definition).

• The issue of ‘systemic risk’.
• Regulation and compliance issues.
• Depositors need for protection.
• The need for strong internal control and risk management.
• Issues of transparency and information asymmetry.
• Issues of related party transactions (and ‘grey directors’) which are particularly sensitive for banks.

84. Answer: A Chapter 3, Section 3

The principles of contract are:

• Freedom of contracting.
• Actions are judged by objectives.
• Do no harm.
• Flexibility in the case of hardship.
• Incorporation of custom and convention.
• Liability justifies return.

85. Answer: C Chapter 9, Section 1

The issue of corporate governance was first identified in relation to private sector corporations since, by
the early decades of the 20th century, the control of corporations was increasingly separated from the
ownership of the corporations.

86. Answer: D Chapter 5, Section 12

Istisn’a transactions are typically most suited to project-finance-type transactions such as construction.

87. Answer: A Chapter 7, Section 2.1

The parties to a Sukuk are originator/obligor, arranger, assets/project, investors and manager. Other
associated parties, such as SPV, vendor and underwriter, may be involved.

88. Answer: A Chapter 8, Section 3.2

In a pure Wakala model, all risks are borne by the fund and any operating surplus belongs exclusively
to the participants.

89. Answer: C Chapter 5, Section 7.4.2

The asset allocation of a UIAH is not restricted by contract and the bank can place the funds in any
Shariah-compliant investment at its discretion, subject to its fiduciary duty.

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 Multiple Choice Questions

90. Answer: C Chapter 9, Section 6.1.3

Amounts from the IRR may be released to reduce the amount of any loss attributable to the UIAH funds.

91. Answer: A Chapter 4, Section 2.2

The Shariah options of sale are:

1. Buyer’s option to rescind – time limited, seller has similar option, but ceases before execution of
contract. For example, a ‘cooling-down’ period when buying a large asset.
2. Option of inspection – right to see or appoint a qualified person to inspect the object being sold for
any form of defect.
3. Option of defect – right to return if defective.
4. Option of quality – right to receive the quality of goods as specified.
5. Option of price – right to a fair price within the market range.

92. Answer: C Chapter 8, Section 3.3

The main contracts of Fiqh al Muamalat used in Islamic insurance are those of Dhaman (guarantee or
indemnity) between the insured and the mutual underwriting pool, Tabarru’ (donation) as the basis on
which the premiums are paid by the policyholders and Wakala and/or Mudaraba as the basis on which
the TO undertakes management of underwriting and investment on behalf of the policyholders.

93. Answer: C Chapter 5, Section 7.4.2

The funds of an unrestricted account holder can be mingled with other funds at the bank’s disposal
and invested as the bank sees fit. They are profit- and loss-sharing and cannot attract a guaranteed
return under Shariah. They may attract a higher risk than restricted investment accounts, but this is not
necessarily the case.

94. Answer: C Chapter 6, Section 5

Fund management can be undertaken either on a Mudaraba or Wakala basis.

95. Answer: A Chapter 5, Section 14

Although highly controversial, the Wa’d is often used to provide a level of security to both parties
regarding a future event.

96. Answer: A Chapter 3, Section 5.2.1

Gambling (Qimar) is a type of major Gharar since it is a transition in which each party is either a winner
or a loser.

97. Answer: D Chapter 9, Section 1

Corporations which work to a high standard of corporate governance will, among other things, ensure
their activities are arranged in such a way that they deal fairly and properly with customers; products are
suitable for the customers’ needs and staff interactions with clients are courteous and efficient.

259
98. Answer: B Chapter 5, Section 3.1
Depositors receive a share of the profit after deducting the management fee (Mudarib share).

99. Answer: A Chapter 9, Section 2

The need for strong internal control and risk management is a reason why banks are a special case as
regards corporate governance.

100. Answer: C Chapter 4, Section 2.3.3

Qard is a benevolent loan and, although the receiving party has the obligation to repay the principal,
there is no compensation for the lender.

260
References and Websites
262
 References and Websites

References
Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) (2004); Accounting,
Auditing and Governance Standards for Islamic Financial Institutions, AAOIFI, Manama, Kingdom of
Bahrain.

Adam, Nathif and Abdulkader Thomas; Islamic Bonds: Your Guide to Issuing, Structuring and Investing in
Sukuk (London: Euromoney, 2004).

Al-Omar, Fuad and Abdel-Haq, Mohammed; Islamic Banking; Theory, Practice & Challenges
(Oxford University Press, Karachi & Zed Books Ltd, New Jersey, 1996).

Archer, S and Karim, R; Islamic Finance: Innovation and Growth (London: Euromoney, 2002).

Chapra, Muhammad Umer; Islam and the Economic Challenge (Leicester: Islamic Foundation, 2000).

Chapra, Muhammad Umer; Towards a Just Monetary System (Leicester: Islamic Foundation, 1985).

Comair-Obeid, Nayla; Les Contrats En Droit Musulman Des Affaires (Paris: Economica, 1995).

Haron, Sudin and Bala, Shanmugam: Islamic Banking System: Concepts and Applications (Kuala Lumpur:
Pelanduk Publications, 1997).

Kamali, Mohammad Hashimi; Islamic Commercial Laws: An Analysis of Futures and Options (Selangor,
Malaysia: Ilmiah Publishers, 2002).

Khan, Tariqullah and Ahmed, Habib; Risk Management: An Analysis of Issues in Islamic Finance Industry
(Islamic Development Bank, Islamic Research and Training Institute: Occasional Paper 5 – freely available
from www.sbp.org.pk/departments/ibd/Risk_Management.pdf).

Khan, M.Akram; Islamic Economics and Finance: A Glossary (London: Routledge, 2003).

Obaidullah, Mohammed; Islamic Financial Services (freely available from http://islamiccenter.kau.edu.sa/

english/publications/Obaidullah/ifs/ifs.html).

Obaidullah, Mohammed; Islamic Financial Markets (New Delhi: Institute of Objective Studies, 2004).

Saleh, Nabil A with Ahmad Ajaj; Unlawful Gain and Legitimate Profit in Islamic Law (London: Graham &
Trotman, 1992).

Schoon, Natalie; Islamic Banking and Finance (London: Spiramus Press, 2008).

Thomas, Abdulkader; Interest in Islamic Economics (Oxford: Taylor & Francis, 2005).

Thomas, Abdulkader, Cox, Stella and Kraty, Bryan; Structuring Islamic Finance Transactions
(London: Euromoney, 2009).

Usmani, Muhammad Taqi; An Introduction to Islamic Finance (Karachi: Idarutul Ma’arif, 1998).

Usmani, Muhammad Imran; The Meezan Bank Guide to Islamic Banking (Karachi: Idarutul Ma’arif, 1999).

Warde, Ibrahim; Islamic Finance in the Global Economy (Edinburgh University Press, 2000).

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Websites
Accounting and Auditing Organisation for Islamic Financial Institutions
www.aaoifi.com

Bank Negara Malaysia

www.bnm.gov.my

Banque du Liban/Central Bank of Lebanon

www.bdl.gov.lb

Bloomberg
www.bloomberg.com

Central Bank of Bahrain (formerly the Bahrain Monetary Agency)

www.cbb.gov.bh

Dow Jones Islamic Index

https://us.spindices.com/index-family/shariah/dow-jones-islamic-market

Dubai International Financial Centre

www.difc.ae

Failaka’s iFunds Review

www.failaka.com

Fitch Ratings
www.fitchratings.com

IBF Net
www.iiibf.com

Islamic Development Bank

www.isdb.org

Islamic Finance
www.islamicfinance.de

Islamic Finance Information Services

www.globalcapital.com/emerging-markets/islamic-finance

Islamic Financial Services Board

www.ifsb.org

Islamic Finance News

www.islamicfinancenews.com

Journal of Islamic Banking and Finance

www.jibfnet.com

LMC Liquidity Management Centre

www.lmcbahrain.com

264
 References and Websites

Moody’s Investors Service

www.moodys.com

Qatar Financial Centre Authority

www.qfc.qa/en/Pages/default.aspx

Reuters UK
www.reuters.com

Standard & Poor’s

www.standardandpoors.com

265
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Syllabus Learning Map
268
 Syllabus Learning Map

Syllabus Unit/ Chapter/

Element Section

Element 1 The Basis of Islamic Banking and Finance Chapter 1

On completion, the candidate should:
Understand the ethical underpinning of Islamic finance:
• Islamic moral guidance governing property and wealth given
through the Quran and Sunnah
1.1.1 • to make charitable distributions: Zakat (obligatory) and Sadaqah 2
(voluntary)
• the role of trade and investment in wealth creation
• prohibition of Riba, gambling and Gharar
1.1.2 Understand the role and the purposes of Shariah 3
Know the sources of the Shariah:
1.1.3 • primary sources (Quran & Sunnah) 3.2
• secondary sources (Ijma’, Qiyas, Ijtihad)
Know the authorities that are able to interpret the Quran and Sunnah
and their role:
• the scholars within the schools of jurisprudence
1.1.4 3.2.4
• the Islamic Fiqh Academy
• the Shariah supervisory boards of regulatory and industry
institutions

Element 2 An Introduction to Islamic Banking and Finance Chapter 2

On completion, the candidate should:
Know the development of Islamic finance and banking:
• the beginnings of Islamic banking
2.1.1 • Islamic banking in the GCC, Africa and the Middle East countries 1
• Islamic banking in Southeast and South Asia and Australasia
• Islamic banking in Europe and the Americas
Know the constraints and challenges on the development of the
2.1.2 1.4
Islamic banking and finance industry
2.1.3 Know the main functions of Islamic banks 2.1
Know the operating structures and organisational forms adopted by
the Islamic financial services industry:
• the window model
2.1.4 2.2
• branches
• subsidiaries
• fully fledged banks
Know the bodies overseeing and/or supporting Islamic banking and
finance:
• the regulators (central banks or other authorities)
2.1.5 2.3
• the standard-setters (AAOIFI and IFSB)
• other institutions supporting the development of Islamic finance
and banking (IIFM, CIBAFI, IIRA, IILM and IsDB Group)

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 Syllabus Unit/ Chapter/
Element Section
Know other components of the Islamic finance industry:
• the Shariah-compliant equity markets
• the market for Sukuk (Islamic capital market instrument)
• Islamic investment funds
2.1.6 • the Islamic insurance companies – Takaful 2.4
• the Waqf properties (Islamic charitable trust)
• the Zakat funds (funds constituted of charitable obligatory tax)
• Islamic microfinance
• purification of non-permissible income (Haram)
2.1.7 Know the impact of fintech in Islamic finance 2.4.7

Element 3 Islamic Principles of Exchange Chapter 3

Islamic Principles Relating to Business
3.1
On completion, the candidate should:
3.1.1 Know the ethical precepts relating to Islamic business 2
3.1.2 Know the Islamic teachings relating to business 2.2
3.1.3 Understand the general principles governing contracts in Islamic law 3
Riba
3.2
On completion, the candidate should:
3.2.1 Know the nature of Riba 4
3.2.2 Know the rationale for the prohibition of Riba 4
3.2.3 Understand the different types of Riba 4
Gharar
3.3
On completion, the candidate should:
3.3.1 Understand the nature of Gharar 5
3.3.2 Know the rationale for the prohibition of Gharar 5
3.3.3 Understand the different types of Gharar 5
Rules of Exchange
3.4
On completion, the candidate should:
3.4.1 Understand the concept of profit and liability 6
3.4.2 Know the rationale for being liable for a good or service 6
3.4.3 Understand the concept of selling what you have 6.2
3.4.4 Know the rationale prohibiting the sale of what you do not have 6.2
3.4.5 Understand the concept of debt for debt 6.3
3.4.6 Know the rationale prohibiting the sale of debt for debt 6.3
3.4.7 Understand the concept of two sales in one 6.4
3.4.8 Know the rationale prohibiting two sales in one 6.4

270
 Syllabus Learning Map

Syllabus Unit/ Chapter/

Element Section

Element 4 Basic Contracts and their Treatments Chapter 4

Contract
4.1
On completion, the candidate should:
Understand the fundamentals of Aqd’ (contract):
• contracting parties
4.1.1 • subject matter 2.1
• consideration
• offer and acceptance
4.1.2 Understand Shariah options of sale 2.2
Understand the classification of, and conditions applied to, contracts
with respect to their effect:
4.1.3 • valid (Sahih) contracts 2.3.2
• voidable (Fasid) contracts
• invalid (Batil) contracts
Know the types of contracts with respect to their underlying purpose:
4.1.4 • unilateral 2.3.3
• bilateral
Understand the concept of Wa’d (promise) and Ah’d (undertaking),
4.1.5 the difference between the two concepts and the conditions which 2.4
make a commercial promise binding
4.1.6 Know the nature of a Muwaada (bilateral promise) agreement 2.5
Contracts of Exchange
4.2
On completion, the candidate should:
4.2.1 Understand the elements and conditions of a contract of exchange 3
4.2.2 Know the problematic sales contracts 3.3
Security Contracts
4.3
On completion, the candidate should:
Know the nature of the security contracts:
• Hawala
4.3.1 6
• Kafala
• Rahn
Foreign Exchange
4.4
On completion, the candidate should:
Know the issues associated with the debate regarding Sarf (the
4.4.1 7
purchase and sale of currencies)
4.4.2 Know AAOIFI’s Shariah standards on the sale of currencies 7.3

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 Syllabus Unit/ Chapter/
Element Section
Accounting Treatment
4.5
On completion, the candidate should:
Understand the conceptual framework of International Financial
Reporting Standards (IFRS):
• the aims of IFRS
• the objectives of financial statements
4.5.1 • the qualitative characteristics required from financial statements 8
• the general principles governing decision making and
presentation of financial data
• the fundamental accounting assumptions underpinning financial
statements
4.5.2 Understand the need for Islamic accounting standards 8.2
4.5.3 Know the role and responsibilities of AAOIFI 8.2
Understand the conceptual framework of AAOIFI financial accounting
4.5.4 statements: 8.2
• the qualitative characteristics of accounting information
4.5.5 Know the methods of calculating Zakat and the accounting treatment 8.3
4.5.6 Understand the relationship between form and substance of contracts 8.4

Element 5 Financial Contracts and Techniques Applied by Islamic Banks Chapter 5

Types of Contracts
5.1
On completion, the candidate should:
Know the differences between the different types of contracts:
• debt-based contracts
5.1.1 2
• equity-based contracts
• other types of contracts
Funds in Islamic Banking
5.2
On completion, the candidate should:
Understand the distinction between a conventional bank and an
Islamic bank:
5.2.1 • the relationship between the bank and its clients 3.1
• the sources of funds
• the use of funds
5.2.2 Understand the operation of current accounts in Islamic banking 3.2
5.2.3 Understand how funds are used by Islamic banks 4
5.2.4 Understand the Islamic banking model and the challenges it faces 5
Wakala
5.3
On completion, the candidate should:
5.3.1 Know the nature of the Wakala (agency contract) 6
5.3.2 Be able to apply the Wakala contract 6
Mudaraba
5.4
On completion, the candidate should:
5.4.1 Be able to apply the Mudaraba contract to deposits 7.1
Understand the roles of, and the returns received by, the Rab al Mal
5.4.2 7.2
and Mudarib under a Mudaraba contract

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Syllabus Unit/ Chapter/

Element Section
5.4.3 Be able to apply the two-tier Mudaraba contract 7.3
Understand the nature of restricted and unrestricted investment
5.4.4 7.4
accounts
Musharaka
5.5
On completion, the candidate should:
5.5.1 Be able to apply the partnership contract of Musharaka 8.1
5.5.2 Be able to apply the Diminishing Musharaka contract 8.1.2
Murabaha
5.6
On completion, the candidate should:
5.6.1 Be able to apply the Murabaha contract 9.1
5.6.2 Understand the use of Murabaha in export finance 9.2
5.6.3 Know the differences between a Murabaha sale and a loan of money 9.3
5.6.4 Understand the operation of Tawarruq and Commodity Murabaha 9.4
Ijara
5.7
On completion, the candidate should:
5.7.1 Be able to apply the Ijara contract 10
Understand the redemption of a lease through Ijara wa Iqtina/Ijara
5.7.2 10.1
Muntahia Bitamleek
5.7.3 Understand the use of Ijara Mawsoofa Bil Thimma (forward lease) 10.2
Salam
5.8
On completion, the candidate should:
5.8.1 Be able to apply the Salam contract 11
5.8.2 Understand the documentation associated with a Salam contract 11.1
Understand the use of Parallel Salam in managing bank assets
5.8.3 11.2
acquired under a Salam contract
Istisn’a
5.9
On completion, the candidate should:
5.9.1 Be able to apply the Istisn'a contract 12.1
5.9.2 Understand the reasons for Parallel Istisn’a contracts 12.2
5.9.3 Understand the differences between Istisn’a and Salam contracts 12.3
Letters of Credit
5.10
On completion, the candidate should:
Know the use of letters of credit and guarantees in Islamic finance
5.10.1 13
contracts
Wa’d and Ah’d
5.11
On completion, the candidate should:
Be able to apply the concept of Wa’d (promise) and the concept of
5.11.1 Ah’d, (undertaking) and the conditions which make a commercial 14
promise binding
Arboon
5.12
On completion, the candidate should:
5.12.1 Know how Arboon is used to synthesise option behaviour 15.1

273
 Syllabus Unit/ Chapter/
Element Section

Islamic Asset Management and Socially Responsible Investing

Element 6 Chapter 6
(SRI)
Comparison of Conventional and Islamic Financing
6.1
On completion, the candidate should:
Know the similarities and differences between Islamic finance and
6.1.1 1
Socially Responsible Investing (SRI)
Understand the similarities between the UN Sustainability Goals
6.1.2 1
(SDG) and Islamic Finance
Islamic Investing
6.2
On completion, the candidate should:
6.2.1 Understand the principles of Islamic investing 2
Selecting Shariah-Compliant Investments
6.3
On completion, the candidate should:
6.3.1 Know the components of the industry screen 3
6.3.2 Know the components of the financial screen 3
6.3.3 Be able to apply the industry and financial screens 3
Understand what happens when an investment becomes non-
6.3.4 3
compliant
Funds
6.4
On completion, the candidate should:
6.4.1 Know the definition of a fund 4
6.4.2 Know the definition of an Islamic fund 4
6.4.3 Understand the difference between a conventional and Islamic fund 4
Fund Management
6.5
On completion, the candidate should:
6.5.1 Understand the Mudaraba fund management structure 5
6.5.2 Understand the Wakala fund management structure 5
Types of Fund
6.6
On completion, the candidate should:
6.6.1 Know the characteristics of fixed-income funds 6
6.6.2 Know the characteristics of lease funds 6
6.6.3 Know the characteristics of commodity funds 6
6.6.4 Know the characteristics of real estate funds 6
6.6.5 Know the characteristics of equity funds 6
6.6.6 Know the characteristics of exchange-traded funds 6
6.6.7 Know the characteristics of hedge funds 6

Element 7 Sukuk Market Chapter 7

Characteristics of Sukuk
7.1
On completion, the candidate should:
7.1.1 Know the differences between conventional securities and Sukuk 1

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Syllabus Unit/ Chapter/

Element Section
Understand the difference between asset-backed and asset-based
7.1.2 1
Sukuk
Structuring Sukuk
7.2
On completion, the candidate should:
Understand the basic processes and applications involved in the
7.2.1 2.1
issuance of Sukuk in different jurisdictions
7.2.2 Be able to apply Sukuk al Ijara 4.1
7.2.3 Be able to apply Sukuk al Musharaka 4.2
7.2.4 Be able to apply Sukuk al Wakala 4.3
Understand the structure of the following:
• Sukuk al Murabaha
7.2.5 • Sukuk al Istisn’a 4.4
• Sukuk al Salam
• Sukuk al Mudaraba
Understand how Green Sukuk is emerging to help tackle environmental
7.2.6 4.4
and climate change concerns
Sukuk Regulations
7.3
On completion, the candidate should:
7.3.1 Understand the Sukuk regulations 5
Capital Market Considerations
7.4
On completion, the candidate should:
Understand the capital market considerations relating to Sukuk:
• rating the issue
7.4.1 6
• distribution
• tradability and non-tradability

Element 8 Islamic Insurance – Takaful Chapter 8

History of Takaful
8.1
On completion, the candidate should:
8.1.1 Understand the position of Islam regarding insurance 1
Understand the origins of Takaful:
• the characteristics of mutual insurance
• the nature of conventional mutual insurance
8.1.2 • the nature of a Takaful undertaking and the need to avoid Gharar 1
through Tabarru’ (donation) and Riba through the use of non-
interest-bearing assets
• the structure of Takaful undertakings: non-profit and commercial
Types of Takaful
8.2
On completion, the candidate should:
Understand the differences between conventional proprietary
8.2.1 1.2.3
insurance, conventional mutual insurance and Takaful
Know the two types of Takaful:
8.2.2 • general 2
• life

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 Syllabus Unit/ Chapter/
Element Section
Structure of Takaful
8.3
On completion, the candidate should:
Understand the structure of Takaful:
• separation of participants’ funds from those of the Takaful
8.3.1 3
operator
• the role of Qard Hassan (interest-free loan)
Understand the three models for underwriting and managing the
investments of the Takaful fund:
8.3.2 • Wakala 3.2
• Mudaraba
• the combined model
8.3.3 Know the Islamic financial contracts used in Takaful 3.3
Understand the rules on distribution of underwriting surpluses in
Takaful:
8.3.4 • the definition of an underwriting surplus 4
• the nature and allocation of technical provisions
• the rules for distributing underwriting surpluses
Takaful Industry Considerations
8.4
On completion, the candidate should:
Understand the risks associated with Takaful claims and their
mitigation:
• the nature of technical provisions for general Takaful
8.4.1 5
• implications of the size of the risk pool
• the nature of the underwriting and investment fund in life Takaful
• internal risk pooling arrangements
Understand how Retakaful operates:
• the funding of Retakaful
8.4.2 6
• the place of Retakaful
• resorting to reinsurance in the absence of viable Retakaful options
8.4.3 Know the responsibility of the Takaful operator for Shariah compliance 7

Element 9 Islamic Corporate Governance Chapter 9

Corporate Governance
9.1
On completion, the candidate should:
9.1.1 Know the origins and nature of corporate governance 1
Understand how corporate governance principles are incorporated in
9.1.2 1
Shariah
Know the corporate governance mechanisms available to stakeholders
9.1.3 1
to exercise their rights
Understand the reasons why banks face special Corporate Governance
9.1.4 2
challenges

276
 Syllabus Learning Map

Syllabus Unit/ Chapter/

Element Section
Shariah Supervisory Board
9.2
On completion, the candidate should:
Understand the position, remit and characteristics of the Shariah
9.2.1 3
Supervisory Board
Know the roles of the Shariah Supervisory Board:
• advisory
9.2.2 3
• approval
• audit
Understand the operational issues surrounding the Shariah
Supervisory Board:
• membership
9.2.3 • governance 3
• delegated responsibility
• reporting
• other duties
Corporate Governance Regulations and Standards
9.3
On completion, the candidate should:
9.3.1 Know the Shariah audit regulations 4
9.3.2 Know the governance standards 5
Investment Account Holders
9.4
On completion, the candidate should:
Understand the distinction between information rights, control rights
9.4.1 and cash flow rights for restricted investment account holders and 6.1
unrestricted investment account holders
Understand the distinction between the rights of shareholders and
9.4.2 6.2
investment account holders
Understand the distinction between the rights of restricted investment
9.4.3 6.3
account holders and unrestricted investment account holders
Corporate Governance in Takaful
9.5
On completion, the candidate should:
Understand the corporate governance issues facing the Takaful
9.5.1 7
industry

277
 Examination Specification
Each examination paper is constructed from a specification that determines the weightings that will be
given to each element. The specification is given below.

It is important to note that the numbers quoted may vary slightly from examination to examination as
there is some flexibility to ensure that each examination has a consistent level of difficulty. However, the
number of questions tested in each element should not change by more than plus or minus two.

Candidates should note that in Elements 5 and 7 more than one question may be set on certain learning
objectives to test that candidates have fully grasped the nature and use of the contracts.

Element Number Element Questions

1 The Basis of Islamic Banking and Finance 2
2 An Introduction to Islamic Banking and Finance 3
3 Islamic Principles of Exchange 13
4 Basic Contracts and Their Treatment 15
5 Financial Contracts and Techniques Applied by Islamic Banks 25
6 Islamic Asset Management 12
7 Sukuk Market 11
8 Islamic Insurance – Takaful 9
9 Islamic Corporate Governance 10
Total 100

278
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