Introduction to Modes of Islamic Finance

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Introduction to different modes of investment and finance used by Islamic Banks

Islam does not deny that capital, as a factor of production, deserves to be rewarded. Islam allows the owners of capital a share in a surplus which is uncertain. To put it differently, investors in the Islamic order have no right to demand a fixed rate of return. No one is entitled to any addition to the principal sum if he does not share in the risks involved. The owner of capital (rabbul-mal) may ‘invest’ by allowing an entrepreneur with ideas and expertise to use the capital for productive purposes and he may share the profits, if any, with the entrepreneur borrower (mudarib); losses, if any, however, will be borne wholly by the rabbulmal. This mode of financing, termed mudaraba in the Islamic literature, was in practice even in the pre Qur’anic days and, according to jurists, it was approved by the Prophet.

Another legitimate mode of financing recognized in Islam is one based on equity participation (musharaka); in which the partners use their capital jointly to generate a surplus. Profits or losses will be shared between the partners according to some agreed formula depending on the equity ratio.

  • Mudarbah

Mudarabah is a partnership between two parties, i.e., the provider of the fund and the entrepreneur. The provider of the fund, provides the capital while the entrepreneur provides the expertise in running the business and managing the fund. Profits from the partnership are shared at a predefined profitsharing ratio. An important point here is that in the event of loss, the losses will be borne solely by the provider of fund. Despite not having to bare any losses, the entrepreneur will not be paid for his expertise.

  • Shirkah

Shirkah is a business partnership where two or more parties pool their financial resources and expertise. The profit ratio is also predetermined. Losses are shared in accordance with the financial resource provided for the project.

  • Murabah

Murabahah is a contracting scheme in which the bank acts as a partner who provides the financing for the purchase of commodities, goods or project, in return for a share of the profits realised from the partnership. However, in the event of losses, the bank may or may not share the loss, depending on the terms and conditions of the agreement. The profit and loss sharing ratio is predetermined in the agreement.

  • Musharakah

Musyarakah is a business partnership where the partners may contribute financial resources or expertise or both. Profit and loss are shared by both parties and are predetermined. Like other businesses, Islamic businesses too seek profit. However, this profit must come from halal means and also be free from others’ exploitation. Over and above these requirements pertaining to the reaping of profits, the distribution of profits is also guided by Islamic lore, which gives it a socio-economic slant.

Mudarabaand musharaka constitute, at least in principle if not in practice, the twin pillars of Islamic banking. The musharaka principle is invoked in the equity structure of Islamic banks and is similar to the modern concepts of partnership and joint stock ownership. In so far as the depositors are concerned, an Islamic bank acts as a mudarib which manages the funds of the depositors to generate profits subject to the rules of mudaraba as outlined above. The bank may in turn use the depositors’ funds on a mudaraba basis in addition to other lawful modes of financing. In other words, the bank operates a two-tier mudaraba system in which it acts both as the mudarib on the saving side of the equation and as the rabbulmal on the investment portfolio side. The bank may also enter into musharaka contracts with the users of the funds, sharing profits and losses, as mentioned above.

At the deposit end of the scale, Islamic banks normally operate three broad categories of account, mainly current, savings, and investment accounts. The current account, as in the case of conventional banks, gives no return to the depositors. It is essentially a safekeeping (alwadiah) arrangement between the depositors and the bank, which allows the depositors to withdraw their money at any time and permits the bank to use the depositors’ money. As in the case of conventional banks, cheque books are issued to the current ac count deposit holders and the Islamic banks provide the broad range of payment facilities clearing mechanisms, bank drafts, bills of exchange, travellers cheques, etc. (but not yet, it seems, credit cards or bank cards). More often than not, no service charges are made by the banks in this regard.

The savings account is also operated on an al-wadiah basis, but the bank may at its absolute discretion pay the depositors a positive return periodically, depending on its own profitability. Such payment is considered lawful in Islam since it is not a condition for lending by the depositors to the bank, nor is it predetermined. The savings account holders are issued with savings books and are allowed to withdraw their money as and when they please.

The investment account is based on the mudaraba principle, and the deposits are term deposits which cannot be withdrawn before maturity. The profit-sharing ratio varies from bank to bank and from time to time depending on supply and demand conditions > . In theory, the rate of return could be positive or negative, but in practice the returns have always been positive and quite comparable to rates conventional banks offer on their term deposits

At the investment portfolio end of the scale, Islamic banks employ a variety of instruments. The mudaraba and musharaka modes, referred to earlier, are supposedly the main conduits for the outflow of funds from the banks. In practice, however, Islamic banks have shown a strong preference for other modes which are less risky. The most commonly used mode of financing seems to be the ‘mark-up’ device which is termed murabaha. In a murabaha transaction, the bank finances the purchase of a good or asset by buying it on behalf of its client and adding a mark-up before reselling it to the client on a ‘cost-plus’ basis. It may appear at first glance that the mark-up is just another term for interest as charged by conventional banks, interest thus being admitted through the back door. What makes the murabaha transaction Islamically legitimate is that the bank first acquires the asset and in the process it assumes certain risks between purchase and resale. The bank takes responsibility for the good before it is safely delivered to the client. The services rendered by the Islamic bank are therefore regarded as quite different from those of a conventional bank which simply lends money to the client to buy the good.

Islamic banks have also been resorting to purchase and resale of properties on a deferred payment basis, which is termed bai’ muajjal. It is considered lawful in fiqh (jurisprudence) to charge a higher price for a good if payments are to be made at a later date. According to fiqh, this does not amount to charging interest, since it is not a lending transaction but a trading one.

Leasing or ijara is also frequently practised by Islamic banks. Under this mode, the banks would buy the equipment or machinery and lease it out to their clients who may opt to buy the items eventually, in which case the monthly payments will consist of two components, i.e., rental for the use of the equipment and instalment towards the purchase price.

Reference must also be made to pre-paid purchase of goods, which is termed bai’salam, as a means used by Islamic banks to finance production. Here the price is paid at the time of the contract but the delivery would take place at a future date. This mode enables an entrepreneur to sell his output to the bank at a price determined in advance. Islamic banks, in keeping with modern times, have extended this facility to manufactures as well.

It is clear from the above sketch that Islamic banking goes beyond the pure financing activities of conventional banks. Islamic banks engage in equity financing and trade financing. By its very nature, Islamic banking is a risky business compared with conventional banking, for risk-sharing forms the very basis of all Islamic financial transactions. To minimize risks, however, Islamic banks have taken pains to distribute the eggs over many baskets and have established reserve funds out of past profits which they can fall back on in the event of any major loss.


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