Types of Contract in Islamic Finance

Types of Contracts

• Islamic finance contracts can be divided into two main categories: debt-based and equity-based.
• Debt-based contracts result in a debt being repaid, such as Murabaha and Salam transactions.
• Equity-based contracts are based on an underlying asset or enterprise, such as Musharaka, Mudaraba, and Ijara.
• Other types of contracts include Wa'd (promise) or Arboon (down payment), which are not specifically based on debt or equity.

Islamic Financial Intermediation

• In conventional banking, the bank acts as a financial intermediary, accepting deposits from clients and granting loans to others at a higher interest rate.
• The bank generates profits from commissions and the 'spread' (difference between interest rates paid to depositors and interest charged to borrowers).
• In Islamic finance, the transformation of deposits into loans does not justify the spread, as it constitutes a pure return on money, which is prohibited (Riba).
• A return on capital is justified only when the capital has taken the form of a real (non-monetary) asset, Usufruct, or service.
• In Islamic finance, profits must be linked directly with economic activity, thus keeping debt under control and directing money capital to the most productive uses.
• The financial intermediary role of an Islamic financial institution includes identifying projects in which it can invest the customer's funds.
• The contract between the customers and the bank is a type of partnership (Mudaraba) contract, where the bank is the Mudarib (business manager) and its customers are the Rab al Mal (investors).
• The bank's prospective income is tied to the underlying transaction and takes the form of a share of the profit or loss rather than a spread.
• Islamic deposit accounts have equity-like characteristics, with investors' capital ultimately at risk, even if the bank remains solvent.