Islamic modes of financing
Islamic modes of financing
• Mudaraba: Mudaraba refers to a contract
between at least two parties in which the bank as
the investor supplies the entire capital of the
business. Hence, a relationship is formed in
which banks act as the supplier of capital. The
entrepreneur acts as the manager of capital only.
When the venture ends, the manager of capital
i.e. the entrepreneur pays the entire capital back
to the bank, along with an agreed proportion of
profit. If there is any loss, it is borne by the bank.
Islamic modes of financing
Steps of Mudaraba
• Establishing a Mudaraba Project
• Result of Mudaraba
• Payment of Mudaraba Capital
• Distribution of wealth resulting from
Mudarabah
Islamic modes of financing
• Musharaka: The word Musharaka stands for a
partnership that shares both profit and loss.
Such joint venture way of financing is
designed to limited production or commercial
activities of long duration. Under Musharaka,
the bank and the customer jointly contribute
capital as well managerial expertise and other
essential services at agreed proportions. Profit
or losses are shared according to the contract
agreed upon.
Islamic modes of financing
• Steps of Musharaka:
• Participation in Capital
• Results of the Project
• The distribution of the wealth accrued from
the Projects
Islamic modes of financing
• Diminishing Musharaka
Diminishing Musharaka is a form of declining
partnership between IFI and client generally
used to finance real estates. When a
customer requests to IFI for financing to
purchase an asset IFI participates in the
ownership of asset by contributing required
finance. Certain portion (e.g.20%) must be
contributed by customer. mortgages.
Islamic modes of financing
• Diminishing Musharaka
Total equity of bank is divided into units of smaller
amounts which are purchased by client in
installments. Under this mode of financing one of
the partners (client) promises to buy the equity
share of the other partner (IFI) gradually until the
title to the equity is completely transferred to
him. Buying and selling of equity units must
be independent of partnership contract and
must not be stipulated in partnership contract.
Islamic modes of financing
• Diminishing Musharaka
Generally IFI rent out his share to client and
earns rentals. Any profit accruing on property
is distributed among the co owners according
to agreed ratio however losses must be
shared in proportion of equity (. Diminishing
Musharaka is used for house financing by IFIs
and has replaced successfully conventional
mortgages.
Islamic modes of financing
• Steps of Musharaka:
• Participation in Capital
• Results of the Project
• The distribution of the wealth accrued
from the Projects
• The bank sells its Share in Capital
Islamic modes of financing cont..
• Bai-Murabaha: The word ‘Murabaha’ means a
cost-plus profit/mark-up contract. In this system
of financing the bank agrees to purchase for a
client. The client will then repay the bank within
a stated time period at an agreed upon profit
margin. The mark-up price that the bank and the
buyer agree to is mainly based on the market
price of the commodity. Thus, under Bai-
Murabaha mode of financing, the bank earns a
profit without bearing any risk.
Islamic modes of financing
• Cont…
• Amount of installment or price of the asset cannot be
(stipulated) increased or decreased in case of default
or early payment. In order to create pressure on client
for prompt payment a penalty is imposed upon
customer as agreed in Murabaha contract. Amount of
penalty for default in prompt payment recovered
cannot be included in income of IFI in any case and
must be spent for charity . Murabaha has successfully
replaced the overdraft and short term loans facility
under conventional banking.
Islamic modes of financing cont..
• Steps of Bai-Murabaha:
• Proposal stage
• Signing a promise to purchase
• The first sale contract
• The signing of Murabaha Sale Contract
• Delivery and Receipt of the Commodity
Islamic modes of financing
• Bai-Muajjal: Bai-Muajjal refers to a contract
resembling credit sale. Under this type of contract, the
seller sells certain specific goods to the buyer at an
agreed fixed price payable at a certain fixed future
date in lump sum or in fixed installments. The sold
goods must be allowed under both Shariah and the
law of the country. Under this type of financing,
Islamic banks buy goods for those who need them and
then, receive a fixed payment for the goods at a later
date.
• The difference between Murabaha and Bai Muajjal
lies in disclosure of cost. Under Bai Muajjal cost may
or may not be disclosed. All other features are same as
discussed in Murabaha.
Islamic modes of financing
• Bai-Salam: Bai-Salam means a sale in which an
advance payment is made for a later delivery.
Usually the seller is an individual or business and
the buyer is the bank. Bai-Salam benefits both
the banks and seller. The banks locks in the price
at which the commodities will be purchased and
upon delivery can profit for selling the
commodities. On the other hand, by receiving
advance payments for commodities, the seller
can use the money for meeting various financing
needs, particularly any working capital
requirements.
Islamic modes of financing
• Cont..
Practically it is used in financing of agricultural
needs of farmers. Farmers sell their crops prior to
harvesting to IFIs in order to get money to
purchase seeds and fertilizers. Generally spot
price agreed is lesser than future the actual date
of delivery, hence IFIs are making profit. As a
matter of practice IFIs are entering into a parallel
Salam contract with third party to sell the
proceeds once taken over
Islamic modes of financing
• Steps of Bai-Salam:
• Advance payment
• Production/Manufacturing
• Delivery and receipt of the commodity on the
specific due date
Islamic modes of financing
• Ijarah: Ijara is a rental contract whereby IFI leases an asset
for a specific rent and period to the client. Ownership risks
of the asset are born by IFI while expenses relating to
use the asset are the responsibility of client. The
difference between Ijara and sale is that ownership in
Ijara remains with lesser while in case of sales it is
transferred to purchaser. Ending Ijara in sale of asset is
allowed by IFA through a separate contract at
completion of term of lease. Contract can be executed
prior to purchase and possession of asset. Consumables
cannot be leased out. Right of lessee to use the asset is
restricted to lease agreement or/and as per normal course
of business. Lessee is liable for any harm to the asset
caused by any misuse or negligence on his part. At the
completion of Ijara term either asset is returned to IFI or
purchased by client (Sharia standard 9). Ijara has
replaced successfully the facility of leasing under
conventional financial system.
Islamic modes of financing
• Qard: Qard refers to interest-free loan
provided by Islamic banks to its clients.
According to various authors ‘the main aim of
this loan is to help needy people in a society in
order to, make them self-sufficient and to
raise their income and standards of living.
