Essentials of Islamic Banking and Finance IQRA University Gulshan Campus IRSHAD AHMAD AIJAZ

1. Islamic modes of Financing Essentials of Islamic Banking and Finance IQRA University Gulshan Campus IRSHAD AHMAD AIJAZ irshad786@gmail.com

2. Contents of the lecture • Mode of financing; • Islamic modes; • Trade based modes of Financing; • Rental based mode of financing; • Participatory mode of financing; • Q & A;

3. Mode of financing • Mode of financing: • Mode of financing means way of supplying funds to those who need funds; • Supply of fund from a financial institution to a company is called financing; • Conventional banks supply funds under one and only mode of financing that is LENDING of money; • Every banking product, whether it is a car loan, industry loan, investment loan, personal loan or a governmental loan, is offered under this mode;

4. Islamic mode of financing • Islamic mode of financing: • Islamic modes of financing mean the way of supplying funds that is acceptable to Islam; • As we have learned Islamic mode of financing could not be based on lending of money as lending of money is not a remunerative way of financing; • Prohibition of interest does not allow utilization of loan/lending as mode of earning; • Therefore, there must be a way of funding that does not contain element of interest; • There are three type of financing available under Islamic concept of funds supply: • Trade-based modes of financing; • Rental-based mode of financing; and • Participation-based of financing;

5. Capital provisioning Non-remunerative Remunerative (partnership based financing) Partnership Loan Gift Permanent Temprory Financial activities Exchange of goods or services Ijarah (services rendering) Murabahah (cost disclosed sale) Musawamah (simple bargain sale) Salam (future sale) Istisnaa' (Manufacturing Sale)

6. Trade-based modes of financing • Trade-based mode of Financing means a way of financing in which Islamic banks provide financing through sale and purchase of commodities and assets; • Trade-based modes are secure modes because they create debt and payables upon debtors/customers; • Islamic banks buy a commodity/asset (directly or through its agent) from the market and sells it to customers on deferred payment basis (instalments); • The agent may be a an employee on Islamic bank, a third party or the customer himself as well; • All conditions should be observed carefully in sale financing.

7. Trade based modes of Financing • There are four kinds of Trade-based modes of financing which are very common: • MURABAHAHA; • Cost+profit transaction in which both are disclosed to the buyer; • MUSAWAMAH; • A simple sale transaction in which a price is quoted to customer without any disclosure to the buyer; • SALAM; • A kind of sale in which price is paid in advance for a specific commodity to be delivered in future; • ISTISNAA'; • A sale transaction for assets that require manufacturing.

8. Trade based modes of financing • The customer expresses its wish to buy a certain thing from the bank and the bank buys it from market and sells it on instalments; • All modes follow laws and rules of Islamic Sale contract with little or no modifications; • Each mode has separate set of additional rules which needs to be followed strictly; • Any error may lead to make the transaction a void sale; • Credit Risk is lower in this kind of financing therefore Islamic Banks prefers it; • The rate once fixed in these modes could not be changed; • The concept of credit sale applies here in these modes; • Islamic banks earn money through cash purchase and credit sale; • Profit is difference between cash purchase and credit sale;

9. Trade based modes of financing • Sometimes it is argued that the time has effects on calculation of profit in case of credit sale; • We will analyze this question in following slides;

10. Price difference in Credit and Cash sale • A common question to Islamic banks: Why the price is high in case of credit sale? This excess is as good as charging of interest; • But the question is too simple to reply; • The main concept is that: is there any room for time in pricing? • Meaning can a seller consider 'time' as one of the decisive factor for pricing a commodity or asset? • The answer is yes, the is one of the main factors that play role in determining the price; • The difference of price between whole sale and retail is due to volume which is turnover of X (quantity) in a given time;

11. Price difference in Credit and Cash sale • The fast moving or perishable items are not charged high profit and return; • Slow moving and storable items are charged higher profits and return; • The reason is 'TIME'; • So the time is not something that should always be neglected in pricing or determining the value; • The generic vale of interest is its linkage with time and not with real assets and commodity; • If the time increases the value will follow suite.

12. Fixation of return/profit in trade-based modes • Non-fixation of price in a Sale transaction means no precise determination of price which is an essential element of Islamic Sale Contract; • So non-fixation in sale is not allowed; • While fixation in partnership is as good as considering something unconfirmed as confirmed which is no doubt injustice with one of the pertners; • So non-fixation here is the acceptable way.

13. Fixinf of return/profit in trade-based modes • A repeated question is that the return/profit is fixed in trade-based modes of financing while Islam prohibits fixinf of profit; • So what about famous Islamic concept of non-fixation of the profit rate? • The actual reason of prohibition is not FIXATION or NON-FIXATION; • In fact the element of GHARAR is not acceptable in financial transaction; • Gharar sometime appears in fixation and sometime in non-fixation.

14. Murabahah and Musawamah

15. Murabahah – definition and concept • Murabahah is one of the kinds of sales; • It comes under trade-based modes of financing; • Murabahah means selling a commodity or asset on “disclosure of cost and profit” basis, which means the seller discloses the cost and the added profit to buyer; • So the distinguishing feature of Murabahah from ordinary sale is that the seller is bound to discloses the cost and profit both to the buyer. • If he does not disclose the cost the sale will not be a Murabahah sale;

16. Murabahah – definition and concept • The seller (bank) sells a specific commodity or asset as per the laws and rules of Islamic sale (pertaining to Price, Subject Matter, Wordings and Contractors); • The cost and profit are disclosed to the buyer; • The buyer shows his agreement with the price for that commodity /asset; • Lastly the buyer takes delivery of the asset (possession, physical or constructive) and the sale is concluded; • The payment of price should be according to the rules and laws set for Islamic sale and purchase; • As per the rules set for sale and purchase either the price or the delivery of the sold goods (not both) could be deferred;

17. Murabahah – definition and concept • As any other sale the payment of Price in Murabahah could be in three ways: • Spot payment (Al-Bai' ul Muajjal - immediate delivery and payment); • Deferred for a specific future date (Al-Bai' ul Muwajjal - full payment at a future date); • Deferred for a period of time (Al-bai' ul Muwajjal - sale on instalment basis – payment in tranches, similar to purchase on instalments);

18. Murabahah – definition and concept • As we have discussed Islamic bank is one of the players in financial markets; • Therefore product of Murabahah used in Islamic Banking as a mode of finance is slightly different from a simple Murabahah used in normal trade. • Banking Murabahah is a contract wherein Islamic Bank purchases a commodity or an asset from a third party (supplier/ vendor); • This purchase happens upon request of the customer; • After purchase of the required asset Islamic bank sells the same to the customer usually against a deferred payment [Bai Muajjal] (sale on instalments); • The whole process is called “Murabahah to the Purchase Orderer”; • It is a bunch of contracts completed in steps and ultimately suffices the financial needs of the customer.

19. Murabahah – definition and concept • Some important features of the Murabahah are: • As Banking Murabahah is a kind of sale, there must be a seller (bank) and a buyer (customer) and something that could be bought and sold; • In such transactions the Bank is the seller, the customer is buyer and a commodity/goods are exchanged between them; • In case there is nothing that could be sold and purchased Murrabahah is not possible; • WC finance /Overheads financing etc. etc. are not possible under Murabahah since there is no sale and purchase. • Because it is a sale from bank to customer the Bank is required to purchase the commodity directly or directly from the market/seller before selling it to the customer;

20. Process flow

21. BANK CLIENT AGREEMENT TO MURABAHAH Murabahah – step by step • Step # 1: • Client and Bank sign an agreement to enter into Murabahah.

22. BANK AGREEMENT TO MURABAHAH CLIENT AGENCY AGREEMENT Murabahah – step by step • Step # 2: • Client appointed as agent to purchase goods on behalf of Bank;

23. PAYMENT OF PRICE OF GOODS TO THE SUPPLIER OR AGENT (COUSTOMER OR THIRD PARTY) Murabahah – step by step • Step # 3: • Bank gives money to directly to supplier or to the client for purchase of goods;Client appointed as agent to purchase goods on behalf of Bank; BANK AGREEMENT TO MURABAHAH CLIENT AGENCY AGREEMENT SUPPLIER

24. PAYMENT OF PRICE IN AN AGREED PERIOD OF TIME AND INSTALMENTS BANK CLIENT Murabahah – step by step • Step # 3: • Client pays agreed price to bank according to an agreed schedule. Usually on a deferred payment basis (Bai Muwajjal) in tranches;

25. Application

26. Murabahah – Application • Murabahah can be used to finance the real purchase needs of customer; • It could be used for assets which are acceptable to Shari’ah and has a tangible form. • Therefore, Murabahah can be used to finance the purchase of: • Raw Material; • Equipment; • Consumer Goods; • Personal loans; • Credit cards.

27. Musawamah • Musawamah is also one kind of sale; • Musawamah is also one kind of sale; • This is a simple sale we do in our daily routine life; • The difference is that the quoted price does not require any break-up of cost and profit; • All other details are same as for Murabahah; • The process flow is also same and the payment method may also be of same nature.

28. Questions