Instruments of Islamic banking in operation
This is a research-based article dealing with various aspects of Islamic finance
and its wider application in today’s banking environment.
The article has been divided in five parts; part-V (final) will be published in the
next issue of Business & Finance Review
By Dr Shahid Hasan Siddiqui
(I) Trade based modes
(i) Murabaha-Muajjal: murabaha means mutually stipulated margin of profit in a sale transaction where the cost of the commodity is made known to the buyer. The parties negotiate the profit margin on the known cost. If payment of the sale price is deferred, it becomes murabaha-muajjal. Credit sale is allowed by the texts of the Shariah. The installments sale with price higher than the cash market price is also permitted as a normal reflection of market-based commercial
activities. The price and the due date of payment must be fixed in an
unambiguous manner. Other terms used for similar transactions are installments sale, cost-plus/mark-up based sale, etc.
Murabaha, as in vogue in Islamic banking, is used with a prior promise to buy or a request made by a person interested in acquiring goods on credit from a bank. The customer is normally appointed as agent of the bank for purchase of the item on it’s behalf. As such, it is called ‘murabaha to Purchase Orderer’ (MPO) which normally comprises three separate agreements including promise to buy or to sell, agency contract and the actual murabaha contract.
According to contemporary Shariah scholars, murabaha is legitimate provided the risk of the asset being sold is borne by the bank until the possession is passed on to the murabaha customer. For such a transaction to be legal, the bank must purchase a commodity through a contract and sell it to the customer under a separate contract. Murabaha can be used only where a commodity is intended to be purchased by the customer. Banks can promise to sell something that is not yet owned or possessed by them. However, the actual sale will have to be
effected through offer and acceptance after the commodity comes into the
physical or constructive possession of the seller (bank).
The ideal way of conducting murabaha is that the bank itself purchases the commodity directly form the supplier and after taking it’s delivery, re-sells it on
murabaha basis. Alternatively, bank may take the services of a third party for the acquisition of goods. Keeping in view the problems involved in purchasing directly or through third party agent, the Shariah experts have allowed that a bank makes the customer his agent to buy the commodity on it’s behalf. Whatever the procedure for Shariah compliance, the commodity before selling it to the client must remain at the risk of the bank, the seller in this finance-cum-trade
transaction. The appointment of customer as bank’s agent is not however,
Banks should make sure that the client really intends to purchase the commodity. The buy-back arrangement is not allowed. The purchase price should be paid directly to the supplier instead of giving funds to the customer. The client should not be made dual agent doing every thing himself and purchase by the bank
should be evidenced by invoices or similar other documents to ensure that all conditions of valid murabaha are fulfilled. The commodity must come into the
possession of the bank, whether physical or constructive, in the sense that it must be at bank’s risk. The bank should arrange for physical inspection on random basis of the purchased commodities so that the supplier and the client may not end up in any under-hand dealing.
In case of default, murabaha contract cannot be rolled over because the goods once sold by the bank are property of the client and hence cannot be resold by the bank. As the murabaha is basically a sale, all the necessary ingredients of sale acceptable to Shariah must be duly observed otherwise it may involve an element of riba. The fuqha have accordingly laid down strict parameters for its permissibility. The following requirements should therefore, be strictly observed by Islamic banks:
(a) The commodity being sold must be in existence at the time of sale. (b) Seller must have a good title to the commodity and should be competent to sell it.
(c) The commodity must be in physical or constructive possession of the seller. The constructive possession means that although physical delivery of the commodity has not been taken, it has come into bank’s control that has also assumed the risk of it’s loss or destruction even though for a very short period.
(ii) Musawamah (Bargaining on Price)
Musawamah is a general and regular kind of sale in which price of the commodity to be traded is bargained between seller and the buyer without any reference to the price paid or cost incurred by the former. Thus, it is different from murabaha in respect of pricing formula. Unlike murabaha, seller in musawamah is not obliged to reveal his cost. Both the parties negotiate on the price. All other conditions relevant to murabaha are valid for musawamah as well. Musawamah can be used where the seller is not in a position to ascertain precisely the costs of commodities that he is offering to sell.
Musawamah can be both cash and credit sale but, when used by banks, it will generally be a deferred payment sale in which they will bargain with clients on the price of the goods/assets. Islamic banks may sometimes get a discount from the supplier over the normal retail price. If the purchase price or the actual profit is not brought into the notice of the customer, such sale should be conducted through musawamah and not murabaha.
Salam is a forward sale contract for future delivery of specified goods with up-front payment of price. It is also called Salaf or Taslif meaning a sale by advance payment. Salam has been permitted by the holy Prophet (PBUH) notwithstanding the general principle of the Shariah that the sale of a commodity which is not in possession of the seller is not permitted. People in Madinah used to pay in advance the price of fruits (or dates) to be delivered within one, two or three years. But such a sale was carried out without specifying the measure, weight and the date of delivery.
The holy Prophet ordained: Whoever pays money in advance (for dates) should pay it for a known specified measure, weight and time. The list of items covered by salam included wheat, barley, dates and grapes. The conquest of Syria added new items like olive and dried large grape. The jurists have now expanded the list to cover all homogeneous (mithly) commodities that can be precisely determined in terms of quality and quantity. Monetary units, wherein exchange has to be simultaneous, are excluded.
Salam can be applied in those commodities only that are normally available in the market and whose quality and quantity can be specified exactly. It may include any marketable goods with definable features, trade marks, etc. like raw materials, agricultural produce or manufactured goods. The seller in salam need not necessarily be a producer of the goods. He can enter into a salam contract for supply of goods in future against full pre-payment.
Banks should not set-off their receivables for payment of salam price as salam sale cannot be contracted against a loan, or partly cash and partly loan, in which case the contract will be valid only to the extent of cash payment. If the seller does not deliver the goods at agreed date, the buyer shall have the options to wait until the commodity is available, to cancel the contract and recover the paid price or to agree to a replacement with mutual consent and subject to the relevant rules of exchange. It is pertinent to observe here that the bank has a right to take the goods that it has purchased, it can purchase from the proceeds of the security / pledge, but if it decides to get cash from the customer, it has the right to get only the price given in advance at the time of the contract. For disposal of goods purchased under salam, Islamic banks have a number of options including: i) enter into a parallel salam contract, ii) agency contract with any third party or with the customer (seller) to sell the goods on behalf of the bank and / or iii) sale in the open market by the bank itself by entering into a promise with any third party or direct selling upon taking the delivery. In case of agency, the salam agreement and agency agreement should be separate and independent from each other. The purchased goods cannot be sold back to the salam seller. Hence, parallel salam cannot be entered into with the original seller – prohibited due to being a buy-back. Bank may take promise from any third party which would purchase the goods of stipulated specifications at any stipulated price.
Istisna?a, like salam, is a special kind of sale where sale of a commodity is executed before it comes into existence. It is an agreement culminating into a sale at an agreed price whereby the purchaser places an order to manufacture, assemble, construct, or cause so to do, anything to be delivered at a future date. Al-Saani (manufacturer) would arrange both the raw material and the labour. If material is supplied by the purchaser, it will be the contract of Ujrah (Service contract).
The seller may enter into a parallel contract with a manufacturer to provide the subject matter of istisna?a. On this basis, the banks may undertake financing by getting the subject of istisna?a manufactured through parallel istisna?a contracts. Istisna?a contract must state the type, dimensions and specifications of the asset / property being manufactured, and time and place of delivery, whether the asset
has to be manufactured by any specific manufacturer, or by use of specific materials, as may be agreed between the two parties.
It is not necessary in istisna?a that the price is paid in advance. Payments can be made in installments within a fixed time period. Against the general rule set out for salam, the jurists have legalised it on the basis of analogy and istihsan as istisna?a involves personal labour, effort and commitment of the seller. The price should be known in advance, which once settled, cannot be unilaterally increased or decreased. However, as manufacturing of huge assets may involve longer time, sometimes necessitating many changes, price can be readjusted by the mutual consent of the contracting parties because of making material modification in the commodity or due to unforeseen contingencies or changes in prices of inputs. Istisna?a contract may also contain a penalty clause stipulating an agreed amount of money for compensating the purchaser adequately if the manufacturer is late in delivering the asset. Such compensation is permissible only if the delay is not caused by intervening contingencies (force majeure). In Fiqh, this principle is termed as Shart-e-Jaz?i or the condition of decreasing the price on account of delay in delivery of the subject matter of istisna?a.
The Parallel istisna?a contract should be without any condition or linkage with the original istisna?a contract. The two contracts cannot be tied up in a manner that the rights and obligations of one contract are dependant on the rights and obligations of the other contract. Further, Parallel istisna?a is allowed with a third party only.
The bank working as a manufacturer must assume liability for ownership risk, maintenance and Takaful expenses prior to delivering the subject-matter to the purchaser as well as the risk of theft or any damage.
(II) Ijarah based modes
Ijarah is a contract under which one party obtains the right of usufruct of an asset owned by another party for an agreed period against an agreed consideration namely rent. The term Ijarah is very much similar to the ‘leasing’. The rules of Ijarah in the sense of leasing are similar to the rules of sales because both cases involve transfer of some property to another. The only distinctive feature is that in the case of sale, the corpus of property is transferred to the purchaser while in the case of Ijarah, the corpus of the property remains in the ownership of the lessor and only its usufruct is transferred. The following are two basic differences between leasing by conventional banks and the Ijarah financing by Islamic banks.
(i) In leasing, the lessee’s liability to pay rent starts from the date the payment has been made by the conventional bank to the supplier and not from the date the delivery of the asset is taken by the lessee. The Islamic bank however, charges rent only from the date the delivery of the asset in working condition is taken by the lessee and not from the date the price has been paid to the supplier. (ii) In case of Ijarah, Islamic bank, being owner of the asset, assumes full risk of the corpus of the leased asset. If the asset is destroyed during the period of Ijarah contract or the asset looses it’s usufruct without misuse or negligence on the part of the lessee, the Islamic bank cannot claim rent while interest-based banks are entitled to receive interest in such cases also, unless there is a contract to the contrary.
In its origin, leasing is one of the normal real sector business activities like sale and not a mode of financing. Like conventional banks, Islamic banks are extensively using leasing not only for the tax benefits available in case of leasing but also for the reason that it has a number of flexibilities and wider potential for promoting Islamic finance that is essentially real assets-based.
Ijarah is valid for things which possess Manafa?ah and which can be utilised but their corpus or substance (‘Ayn) is not consumed. The goods like candles, yarn, cotton, food or fuel are suitable for sale, not for leasing or hiring. Hence Dirhams, Dinars, any other currencies, bullions etc that are ‘Ain, not usufruct and all those goods taking benefit from which is not possible without consuming them cannot be given on lease. Any form of perishable item may not also be a subject of lease. Rentals in Ijarah can be fixed for the whole lease period or floating / variable subject to mutual understanding. It can be agreed upon that the rent shall be increased after a specified period like a year or so. Contemporary scholars have also allowed to tie up the rent with a well-defined reference rate or benchmark or to enhance the rent periodically according to a mutually stipulated proportion (e.g. 7.5 percent per year) subject to the condition that other requirements of Shariah for a valid lease are duly fulfilled.