Types of Contract in Islamic Finance

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10 Questions

What type of financial transaction does Islam justify a return on capital for?

Real (non-monetary) asset transactions

In Islamic finance, what is the role of an Islamic financial institution as a Mudarib?

Business manager

What distinguishes the relationship between a conventional bank and its depositors from that of an Islamic bank and its 'investment depositors'?

Profits sharing and potential loss of capital

What form does the Islamic bank's prospective income take in relation to the underlying transaction?

Share of profit or loss

Why does an Islamic deposit account have equity-like characteristics?

As it involves sharing profits and potential loss of capital

What distinguishes debt-based contracts from equity-based contracts in Islamic finance?

Debt-based contracts involve repaying a debt, while equity-based contracts are based on an underlying asset or enterprise.

What is the primary way conventional banks generate profits?

By engaging in maturity transformation

Which financial concept refers to the difference between the interest paid to depositors and the interest charged to borrowers?

'Spread'

What is the purpose of Wa'd in Islamic financial services?

To secure a promise for future transactions

In Islamic finance, what type of transaction involves an underlying asset or enterprise?

Mudaraba

Study Notes

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.

Explore the differences between debt-based contracts and equity-based contracts in Islamic finance. Learn about Murabaha, Salam transactions, and other types of contracts based on underlying assets or enterprises.

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