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Articles & News
Islamic
Funding Structures And Financing Vehicles
Islamic banks around the world have devised many creative
financial products based on the risk-sharing, profit-sharing
principles of Islamic banking. For day to day banking
activities, a number of financial instruments have been
developed that satisfy the Islamic doctrine and provide
acceptable financial returns for investors. Broadly speaking,
the areas in which Islamic banks are most active are in trade
and commodity finance property and leasing. Some of the basic
financial techniques of Islamic banking are the following:
Murabaha: This is the sale of a commodity at a price which
includes a stated profit known to both the vendor and the
purchaser. This can be called a cost plus profit contract. The
price is usually paid back by the buyer in deferred payments.
Under Murabaha, the Islamic bank purchases, in its own name,
goods that an importer or a buyer wants, and then sells them to
him at an agreed mark-up. This technique is usually used for
financing trade, but because the bank takes title to the goods,
and is therefore engaged in buying and selling, its profit
derives from a real service that entails a certain risk, and is
thus seen as legitimate. Simply advancing the money to the
client at a fixed interest rate would not be legitimate. It is
important to note that only a legitimate profit in addition to
the actual price is considered lawful under Islamic law. Any
excessive addition on account of deferred payments will be
disallowed as it would amount to a payment based on the value of
money over time i.e. interest.
Mudaraba: This implies a contract between two parties whereby
one party, the rabb al-mal (beneficial owner or the sleeping
partner), entrusts money to the other party called the mudarib
(managing trustee or the labour partner). The mudarib is to
utilise it in an agreed manner and then returns to the rabb
al-mal the principal and the pre-agreed share of the profit. He
keeps for himself what remains of such profits. The following
characteristics of mudaraba are of significance: The division of
profits between the two parties must necessarily be on a
proportional basis and cannot be a lump-sum or guaranteed
return.
The investor is not liable for losses beyond the capital he has
contributed.
The mudarib does not share in the losses except for the loss of
his time and efforts.
Briefly, an Islamic bank lends money to a client - to finance a
factory, for example - in return for which the bank will get a
specified percentage of the factory's net profits every year for
a designated period. This share of the profits provides for
repayment of the principal and a profit for the bank to pass on
to its depositors. Should the factory lose money, the bank, its
depositors and the borrower all jointly absorb the losses,
thereby putting into practice the pivotal Islamic principle that
the providers and users of capital should share risks and
rewards.
Musharaka: This is a partnership, normally of limited duration,
formed to carry out a specific project. It is therefore similar
to a western-style joint venture, and is also regarded by some
as the purest form of Islamic financial instrument, since it
conforms to the underlying partnership principles of sharing in,
and benefiting from, risk. Participation in a musharaka can
either be in a new project, or by providing additional funds for
an existing one. Profits are divided on a pre-determined basis,
and any losses shared in proportion to the capital contribution.
In this case, the bank enters into a partnership with a client
in which both share the equity capital- and perhaps even the
management - of a project or deal, and both share in the profits
or losses according to their equity shareholding.
Ijara Wa Iktina: Equivalent to the leasing and installment-loan,
hire-purchase, practices that put millions of drivers on the
road each year. These techniques as applied by Islamic banks
include the requirement that the leased items be used
productively and in ways permitted by Islamic law.
Muqarada: This technique allows a bank to float what are
effectively Islamic bonds to finance a specific project.
Investors who buy muqaradah bonds take a share of the profits of
the project being financed, but also share the risk of
unexpectedly low profits, or even losses. They have no say in
the management of the project, but act as non-voting
shareholders.
Salam: A buyer pays in advance for a specified quantity and
quality of a commodity, deliverable on a specific date, at an
agreed price. This financing technique, similar to a futures or
forward-purchase contract, is particularly applicable to
seasonal agricultural purchases, but it can also be used to buy
other goods in cases where the seller needs working capital
before he can deliver.
Besides their range of equity, trade financing and lending
operations, Islamic banks world-wide also offer a full spectrum
of fee-paid retail services that do not involve interest
payments, including checking accounts, spot foreign exchange
transactions, fund transfers, letters of credit, travellers'
cheques, safe-deposit boxes, securities safekeeping investment
management and advice, and other normal services of modern
banking.
Almost every Islamic bank has a committee of religious advisers
whose opinion is sought on the acceptability of new instruments
and who have to provide a religious audit of the bank's end of
year accounts.
The concepts of equity and morality are at the root of Islamic
banking. In Islam moral and equitable values form an integral
part of the rules of law governing contractual and financial
relations to such an extent that the relationship which exists
between equity, law and religion is an organic rather than
supplementary relationship. The importance of Islamic banking
has increased dramatically over the past 10 years. The main
difference between Western and Islamic-style banking is the
concentration on people and their businesses rather than on
accounts- it is a much more 'grass roots' banking according to
one expert.
Source: This article was published in the 10th issue of Nida'ul
Islam magazine, November-December 1995
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