Islamic Banking Chapter 4: Sources and Uses of Funds

• Chapter 4 discusses financial instruments of Islamic banking and finance
• This chapter provides insights into the sources and uses of funds
• This chapter gives an understanding of different contracts in Islamic finance.

Sources and Uses of Funds by Islamic Banks

• Sources and application (uses) of funds is the record of the cash inflows and outflows in an Islamic bank over a period of time

Sources of Funds

• There are two major sources of funds in Islamic banks: transaction deposits and investment deposits
• Transaction deposits are risk-free funds that do not yield a return, based on the wadi'ah concept
• Investment deposits are profit-making but carry the risk of capital loss, depending on the bank's investments
• Sources in Islamic banks can be classified into three accounts: current, savings, and investment accounts
• Current Accounts: Opened by individuals, companies and firms by depositing cash, cheques and/or bills - concept of wadi'ah
• Saving Account: funds deposited in saving account yield some returns depending on bank financial results - based on wadi'ah, mudarabah and musharakah concepts
• Investment Account: The most important source of funds for Islamic banks - the customer and the bank enter into a joint-venture agreement - based on mudarabah concept

Application of Funds

• Islamic banks apply funds to raise profit
• Common channels for the outflow of funds include musharakah, mudarabah, murabahah, ijarah, Istisna', bay salam, and bay mu'ajjal

Types of Contracts in Islamic Banks

• Exchange-based contracts used as financial instruments include murabahah, Istisna', Salam, bay Dayn, Tawriq, Sarf, Tawarruq and bay Inah.
• Exchange-based contracts are widely used in both Islamic banking and Islamic capital market transactions.
• Service-based contracts structured as instruments include ijarah, ijarah muntahia bi al-tamlik, ijarah thumma al-bay, ujrah, and ju'alah
• Service-based contracts relate to the right to use an asset or services rendered with a fee or commission
• Partnership contracts, including mudarabah, musharakah, and musharakah mutanaqisah, are vital in Islamic finance
• Muslim scholars encourage partnership contracts because of their equity-like nature
• Auxiliary contracts in Islamic finance are integral to transactions in modern financial instruments
• Auxiliary contracts: wakalah, ibra', wa'ad, tabarru', hibah, wadi'ah, and waqf

Concept of Exchange-Based Contract

• Exchange-based contracts in Islamic law have been viable debt financing instruments
• Examples: Murabahah, Istisna', Salam, Bay Dayn, Tawriq, Sarf, Tawarruq, and Bay Īnah

Classifications of Islamic Commercial Contracts

• Types of Contracts: Sale-Based, Partnership-Based, Lease-Based, Fee-Based and Others

Murabahah (Mark-up)

• Murabahah: cost-plus financing is a contract where a sale is made at a specified profit margin
• Murabahah is derived from the root word ribh which means profit, gain or a legal addition
• It forms a mutual contract where two parties agree to the mark-up

Istisna’ (Manufacturing Contract)

• Istisna' is a manufacturing contract of a made-to-order asset based on a deferred delivery
• Istisna' is a transaction on a commodity before it is produced
• Legally, the manufacturer must produce items at set times, according to specifications.
• The obligation on the manufacturer produce the commodity for the buyer at an agreed time with certain specifications is a moral one.

The Suitability of Istisna'

• Most suited for project finance, construction, and the manufacture and design of machinery for specific purposes

Salam (Forward Sale)

• Salam: Advance payment is for goods to be delivered later.
• The commodity does not require the commodity to exist when concluding the contract
• The delivery of the commodity is deferred
• Salam helps farmers since they are paid in advance before a harvest

Bay Dayn (Sale of Debt)

• Bay al-dayn sells and purchases debt involving a quality debt
• Muslim jurists are not unanimous on the permissibility of Bay Dayn

Bay Dayn Position of the Four Major Muslim Schools

• Shafi'i School: Sale of debt is allowed to a third party if the debt was initially guaranteed and was sold in exchange for goods to be delivered immediately
• Hanafi School: Sale of debt not allowed in Islamic commercial transactions
• Maliki School: Sale of debt allowed subject to conditions
• Hanbali School: divides the sale of debt into two - confirmed debts can be sold on the spot - unconfirmed debts are not tradable

Bay al-Inah (Sale with immediate repurchase)

• Bay’ al-Inah is where a commodity is sold on a cash basis and the seller immediately repurchases the same commodity on a deferred payment basis at a higher price.
• It is prominent in real estate and house financing situations
• Bay al-inah is controversial in the global Islamic finance industry

Bay al-Inah (Sale with Immediate Repurchase) Views on Validity by schools of law

• The Shafi'i School considers Bay al-Inah contracts are permissible in Islamic law
• The Maliki, Hanafi, and Hanbali Schools Bay al-inah is not permissible because the motive of the parties is illegal
• Most jurists prohibit bay al-inah because they believe it is tainted with elements of interest

Tawriq (Securitization)

• Tawriq's a process where an asset is converted into cash and issued as tradable certificates of investments which are tradable in the secondary market
• Tawriq resembles "securitization," especially in Islamic Commercial Jurisprudence.
• Issuance of Sukuk or Sanadat forms the "end-product" of Tawriq.

Parties to Tawriq (Securitization) or Sukuk

• Most important parties involved in this Securitization are Originator/Issuer of Sukuk, Special Purpose Vehicle (SPV), Investment Banks and Subscribers or Investors Entities.

Example of Securitization (sukuk)

• An example of a sukuk was a $100 million security used to finance the construction and delivery of cooling plants in Abu Dhabi
• This sukuk had an istisna'a and ijara structure and was issued by the Tabreed Financing Corporation in March 2004
• Tabreed created an SPV, which sold certificates of sukuk bonds.
• With the proceeds of this sale it bought some partially completed central cooling plants
• The SPV leased the trust assets to the Tabreed
• Tabreed made rental payments to the SPV
• Which it then passed on to sukuk holders.
• When the sukuk matured the trust assets were bought back from the SPV and the sukuk holders got their principal back.

Sarf (Sale of Currency)

• Bay' al-sarf involves a foreign exchange contract that features the exchanging of currencies in equal or unequal amounts
• The delivery of currencies has to be made in full at the time of concluding the contract
• The contract of exchange must take place at the same sitting where the contract is drawn up

Validity of Foreign Exchange Contract in Islamic Law

• Trade currency is permissible in Islamic law, though there is a limitation: when exchanging different currencies, it must be done hand-to-hand in one sitting
• If you are exchanging the currency, you must exchange equal amounts, and the exchange must take place at the same sitting

Tawarruq (Cash Financing or Reverse Murabahah)

• This is a hybrid sale contract where a customer approaches a financial institution to purchase a commodity with payment arranged in instalments and sells the commodity to a third party for cash
• Permissibility of Tawarruq is based on: The general principles of a typical contract of sale - absence of any interest
• Permissibility of Tawarruq is subject to: person in real need of money, contract being free of riba and alternative available and customer must possess the commodity fully

The service-based contracts include:

• Ijarah
• Ijarah muntahia bi al-tamlik
• Ijarah thumma al-bay
• Ujrah (fees)
• Ju'alah (commission)

Ijarah (Leasing)

• Ijarah: Mechanism involving the rental of an asset or hire purchase where a form of rental fee is paid for a agreed period of time
• The term has been applied differently in Islamic jurisprudence

Modern application of ijarah are:

• Ijarah muntahia bi al-tamlik - leasing ending with ownership
• Al-ijarah thumma al-bay' - a contract of lease ending with the sale

Ijarah Muntahia Bi al-tamlik (Financial Lease)

• It is a lease contract which concludes in a transfer of ownership on the lessee
• Ijarah means lease
• Tamlik denotes ownership

Ijarah thumma al-bay (Leasing and Subsequent Purchase)

• This is simply two contracts carried out one after the other
• One contract is the standard Ijarah
• The other contract is the standard purchase

Ujrah (Fees)

• Ujrah charges for the use of another person's property or payment for service with a contract
• Most financial institutions charge service fees for customers through the ujrah scheme
• Ujrah used by banks for Shariah-compliant credit card schemes

Ju'alah (Commission or Reward)

• Ju'alah is a one-sided contract where reward/commission is given for accomplishment of a task
• Legality: The Jur'an and Sunnah establish ju'alah's legality.
• Takaful contracts: Takaful contracts incorporate ju'alah

Partnership Contracts in Islamic Finance Concept of Equity-Based Contract

• The equity-based contracts generally involve some sort of partnership
• Partnership contracts which have financial instruments are Mudarabah, Musharakah, and Musharakah mutanaqisah

Mudarabah (Trust Financing)

• Mudarabah is where one party provides the funds and the other party assumes the role of the entrepreneur managing these funds through effective management
• Profit Sharing: As per the mutually agreed percentage between parties involved
• Rab al-mal is the sleeping partner
• Mudarib assumes the role of effective management

Legality & Termination

• The Qur’an and Sunnah establish the legality
• Contract Termination: Either party can terminate the agreement, given a notice.

In Islamic banking and finance, Mudarabah is applied in

• Venture capital
• Project financing
• Unit trust, GIA and SIA -
• Legality & Termination In Islamic banking and finance, Mudarabah is applied in Modern application of Mudarabah

Musharakah (Partnership Contract)

• Musharakah is Arabic term for partnership or sharing
• Is is a a form of shirkat al-amwal where all partners invest capital into the joint-venture
• Musharakah emphasizes practical participation of parties in the partnership business
• Musharakah is a form of partnership between two or more parties based on mutual trust

Musharakah (Legality & Terms)

• The investors can use a profit of what actually occurred as a measurement of success when it comes to financial results of joint venture
• At initiation of the contract, The proportion/estimation of profit due to each partner is to be agreed upon and should be pre-agreed as well
• If any losses are accumulated they’ll be based on each contributor to the initial capital investment (losses are based on the capital initially contributed by counterparties of venture)
• Sharia banks look for the musharaka, as its most viable Islamic banking, in today’s markets.

Modern application of musharakah

• Musharakah could be used effectively for Small and medium enterprises and Islamic Capital Markets
• For small and medium enterprise or SME to be applicable and efficient
• For Primary Islamic Capital Market where certificates are issued

Modern application of musharakah

• Legality & Terms in a joint venture when using musharaka, the above are legally binding by Sharia law based upon the words of Muhammad (PBUH), practices by companions and Predecessor

Differences between Musharakah and Mudarabah Contracts

• Financing to the business based on the rights of counterparties to participate in the business during any processes. The profit and losses when sharing profits is critical to understand for these reasons for both.

Musharakah Mutanaqisah (Diminishing Partnership)

• Musharakah Mutanaqisah is long-term financing
• Bank's ownership decreases gradually due to customer's sale of shares
• Musharakah Mutanaqisah: chain of three contracts
• Contract one is joint ownership
• Contract two: A contract of lease that takes place between the financier and client
• Contract three. Where the client starts to finalize another agreement with the financing partner

Supporting contracts that involve money or pledge of good

• Rahn (Collateral/Pledge): A collateral, pledge or mortgage offered as security for a debt that allows the creditor to take away the debt from such security if there is any default - legality of rahn (mortgage) contract is in the Qur'an and Sunnah
• Kafalah (Guarantee): Binding promise made to be responsible to debt defaults - the concept is in practice since the time of the Prophet

Types of Kafalah

• kafalah bi al-nafs - physical guarantee
• kafalah bi al-mal - financial guarantee

Modern Application of Kafalah

• The Kafalah is a very common practice with modern finance to secure transactions in multiple systems

• Documentation using letter of credits which is very useful in global trade

• Credit Card transactions which include high interest and risk

• Supporting the major contract of the finance world: including mudarabah contract the murabahah and ijarah that go hand and hand with the salam isna and that of musharakah contract

• Wakalah (Agency): The Agent will be on behalf of 2-individuals that will involve a process where power will be switched between both depending on the reason, however both do involve with the practice that all be involved within a Wakalah

Modern Application of Wakalah Wakalah is useful in several global modern practices.

• Modern Islamic banking, finance and takaful

• Corporate Wakalah

• Wakalah model of waqf

• Wadi'ah (Safekeeping)

• Entrusts precious property or money to a person or entity for care

• Agreed upon with most Muslim jurists in legality

• Used in both current/saving accounts and savings accounts

Concept of Unilateral Supporting Contract

• Contracts made unilaterally are done without the usual offer/acceptance which usually happen at the session which can include - Waqf donation - Ibra that foregoes a right - Hibah - gift - Wa’ad promise - Tabarru

• Waqf (Endowment)

• A charitable donation for the benefit of the society and is continued permanently

• Ibra'(Forgoing of Right)

• A complete financial ownership that can also be partially obtained, used by: - When debtor is unable to redeem the debt When the customer makes an early settlement of a debt as means to encourage such practices Hibah (Gift)

• the donation of an item with an agreed upon request to benefit either recipient in part or whole without monetary of personal gain

• In similar structure will be applied when the process that will be requested from the bank of Shariah for help is need that will involve other transactions so that to benefit the whole structure.

• Wa'ad (Promise): An agreement is between each side to proceed in a nonrestrictive procedure.

• Muwa'adah includes that all parties continue forward, this may be optional and be at will or preplanned.

• Divergent Opinions of the Muslim Jurists on the Binding Nature of Wa'ad - Fulfilling recommended - Fulfilling obligatory

• Tabarru' (Donation) a gift without expectations in return.

• This includes not taking it back.

• It is considered an important aspect within takaful as well

• A waqf donation given that is being overseen by a sharia-compliant financial group to benefit the entity