islamic finance structures-explained

8/2/2019 Islamic Finance Structures-Explained

1/94

1

Islamic Financial Instruments

Najmul HassanGeneral Manager,

Corporate Banking & Business Development


2/94

2

Islamic Shariah is the set of rules &regulations which are to be followed byIslamic Banks.

Scholars study these laws and guide thebank on how to apply them on day today transactions.

Islamic Finance


3/94

3

BASIC RULES OF SALE


4/94

4

Since Murabaha is a sale transaction, rulesof Shariah regarding sale need to beunderstood.

Sale is defined in Shariah as

Exchange of a thing of value, by anotherthing of value, with mutual consent

Rules of Sale


5/94

5

But Allah has permitted trade [2:275], But take witnesses whenever you make a

commercial contract [2:282], But let there be among you traffic and

trade by mutual good will [4:29], It is no crime for you to seek the bounty

of your Lord [2:198].

Legitimacy of sale


6/94

6

Rule 1The subject of sale must exist at the time of sale

Rule 2The subject of sale must be in the ownership ofseller at the time of sale. Hence, what is notowned by the seller cannot be sold.

Rules of Sale


7/94

7

Rule 3The subject of sale must be in the physical orconstructive ownership of seller at the time ofsale.

Constructive Possession means where thebuyer has not taken physical delivery of goods,

but the goods are under his control. And allrights and liabilities of the goods have passed tohim,i.e. the goods are at his risk.

Rules of Sale


8/94

8

Rules of Sale

Rule 4The sale must be instant and absolute. Thus asale attributed to a future date or a salecontingent on a future event is void.


9/94

9

Rule 5

The subject of sale should be an object of value.A thing having no value according to the usage oftrade cannot be sold.

Rule 6The subject of sale should not be a thing used for

a Haram purpose, e.g. pork, wine etc. Thesubject should be Maal-e-mutaqawwam

Rules of Sale


10/94

10

Rule 7

The subject of sale should be specifically knownand identified to the buyer. The subject of salemust be identified by pointing out or by detailed

specification which can distinguish it from otherthings not sold.

Rule 8The delivery of the sold commodity to the buyershould be certain and should not depend on acontingency or chance.

Rules of Sale


11/94

11

Rule 9

The certainty of price is a necessary condition forthe validity of sale.

Rule 10

The sale must be unconditional. A conditionalsale is invalid, unless the condition is recognized

as a usual practice of trade

Rules of Sale


12/94

12

MURABAHA


13/94

13

Murabaha is a particular kind of sale andnot a financing in its origin.

Where the transaction is done on a costplus profitbasis i.e. the seller discloses thecost to the buyer and adds a certain profit

to it to arrive at the final selling price.

Murabaha


14/94

14

The distinguishing feature of Murabahafrom ordinary sale is:

- The seller discloses the cost to thebuyer.

- And a known profit is added.

Murabaha


15/94

15

Payment of Murabaha price may be:

1) At spot2) In installments3) In lump sum after a certain time

Hence, Murabaha does not necessarilyimply the concept of deferred payment.

Murabaha


16/94

16

TYPES OF MURABAHA

1) Direct where the financier himselfpurchases directly from the market or

3rd party.

2) Indirect where the financier appointsthe customer as an Agent to makepurchases from the market beforebuying it from the bank.

Murabaha


17/94

17

The Holy Quran says And Allah has permitted trade(2:275)

It is further mentionedBut let there be among youtraffic and trade by mutual goodwill (4:29)

According to Imam Shafi in Al-Umm: If an individualshows another a good and says: buy this, and I willgive you this much profit in it; and then the second

man buys it then the purchase is valid. If the first partysaid: I will give you this much profit in it , but I retainan option, then he may conclude the sale or leaveit.(See Financial Transactions in Islamic Jurisprudence

Vol1 Pg 361)

Sharia Source


18/94

18

As for making the promise to purchase the item oncethe bank acquires it binding on the ultimate buyer, wemay take a ruling by Ibn Shabramah from the Malikischool that any promise that does not result inpermitting that which is forbidden or forbidding thatwhich is permitted is binding.The Malikis use this principle to make the promisebinding, especially if the promise leads another entityto undertake a financial obligation.

Sharia Source


19/94

19

In the first Conference in Dubai (1979), it was ruledthat: This type of promise is legally binding on bothparties based on the Maliki ruling, and religiouslybinding on both parties for all the other schools. In thisregard, what is religiously binding can be made legallybinding if this is beneficial and can be regulated legally.

Sharia Source


20/94

20

The second Conference in Kuwait (1983) ruled thus:The conference determines that the mutual promisesinvolved in murabaha sales to the one who orders theinitial purchase is permitted after the bank owns andgains possession of the sold object, and then sells it tothe one who ordered its purchase with the promisedprofit margin.This sale is valid as long as the bank is exposed to therisk of destruction of the goods prior to delivering it to

the final buyer, as well as the obligation to accept thereturn of the goods if a concealed defect was found. .

Sharia Source


21/94

21

Cost-plus, sale is a legally permissible contract bythe testimony of the majority of jurists andcompanions of the Prophet (pbuh).

This type of sale satisfies all the legal requirementsfor sale, and it provides a valuable service ineconomic markets since it allows thoseknowledgeable of market conditions to make a profitand those without such knowledge to obtain thegoods at a good price.

It was narrated that Ibn Masud (RA) ruled thatthere was no harm in declared lump-sum orpercentage profit margins.

Sharia Source


22/94

22

The conditions ofmurabaha are as follows: Knowledge of the initial price: The second buyer

must know the price at which the seller obtained theobject of sale, since knowledge of the price is afundamental condition for the validity of sale.

Knowledge of the profit margin: Since the profitmargin is a component of the price at which thesecond buyer obtains the goods, knowledge of thatmargin is essential for knowledge of the price, which

is in turn a condition of validity for the sale.

Sharia Source


23/94

23

The present day Murabaha transactions are

being practiced under the guidelines given

by Accounting & Auditing

Organization of Islamic FinancialInstitutions (AAOIFI) and Islamic Fiqh

Academy which have representation of

scholars of all Islamic Fiqhs.

Murabaha


24/94

24

Basic rules for Murabaha financing:

Asset to be sold must exist.

Sale price should be determined.

Sale must be unconditional.

Assets to be sold:a) Cannot be used for un-Islamic purposes.b) Should be in ownership of the seller at the time

of sale; physical or constructive.

Murabaha


25/94

25

Basic rules for Murabaha financing:

Re-negotiation of price after concluding thetransaction and roll over of Murabaha are not

permitted.

Discounting of Murabaha instrument is notpermitted.

Murabaha


26/94

26

Step by step Murabaha financing

(under Agency arrangement)


27/94

27

1.Client and bank sign an agreement to enterinto Murabaha (MMFA).

Agreement toMurabaha

Bank Client

Murabaha


28/94

28

2. Client appointed as Agent to purchasegoods on banks behalf

Agency

Agreement


Bank Client

Murabaha


29/94

29

3. Bank gives money to Agent/supplier forpurchase of goods.

Disbursement to the agent or supplier

Agency

Agreement

Supplier


Bank Client

Murabaha


30/94

30

4. The agent takes possession of goods on banksbehalf.

Transfer of RiskDeliveryof goods

Vendor

Bank Agent

Murabaha


31/94

31

5(a). Client makes an offer to purchase thegoods from bank through a declaration.

Offer topurchase

Bank Client

Murabaha


32/94

32

5(b). Bank accepts the offer and sale isconcluded.

Murabaha Agreement+

Transfer of Title

Bank Client

Murabaha


33/94

33

6. Client pays agreed price to bank according toan agreed schedule. Usually on a deferredpayment basis (Bai Muajjal)

Payment of Price

Bank Client

Murabaha


34/94

34

MURABAHA DOCUMENTATION


35/94

35

There are a number of documents involved in aMurabaha financing transaction. The mostessential of these documents are:

Master Murabaha Financing Agreement Agency Agreement

Order Form / Draw Down Notice

Declaration

Purchase Evidences

Demand Promissory Note

Payment Schedule

Murabaha Documentation


36/94

36

Master Murabaha Financing Agreement (MMFA)

Its an agreement between the client and theBank whereby the client agrees to purchasegoods from the Bank from time to time as per

terms and conditions of this agreement. This is an over all facility agreement under

which various Sub-Murabahas may be executedfrom time to time.

Hence it needs to be signed once, i.e. at thetime the facility is sanctioned.



37/94

37

Agency Agreement

Through this agreement, the Bank appointscustomer its agent to select and procure specifiedgoods for the Bank.

This agreement needs to be signed once,between the client and the bank to cover thespecified agency period.The disbursement offunds is done under this agreement.

The customer should define a comprehensive listof assets and commodities that he may procureduring the course of business from time to time.



38/94

38

Order Form

This document is executed at the time of eachsub-Murabaha request i.e. each time whenthe customer requires funds for the purchaseof assets.

Through this document customer requests thebank to purchase the assets from the supplierand undertakes that it will purchase theassets from the bank once the bank acquires

them from the market.

The customer also undertakes to compensatefor the actual loss the bank may suffer in casehe fails to purchase the assets from the bank.



39/94

39

Declaration

This is the most important part of the Murabahaprocess.

Declaration is to be signed by the customerimmediately after the purchase of goods asBanks agent but before the actual consumption.

This document establishes the actual saletransaction, i.e. transfer of ownership of goodsfrom the Bank to the customer

At this stage the specific details of the assetsmust be known i.e. quantity, quality, cost etc.



40/94

40

Declaration

Purchase Evidences in the form of bills, saleinvoice, sales tax invoice must be furnishedalong with the Declaration, specifying the fulldetails of the goods purchased.

The cost of goods must be inclusive of all costincluding sales tax, transportation and handlingetc.

Proper timing of declaration is extremely

important especially in cases of perishable orimmediately consumable commodities.

Murabaha price (Cost of Goods + Profit) shouldbe determined at this stage and stated clearly in

the Declaration.



41/94

41

Payment Schedule

The Payment Schedule specifies the amount thatthe Client will make from time to time or at oncetowards the payment of Murabaha price.

This shall be implemented after the execution ofDeclaration.

The dates mentioned in the schedulecorresponds to the day when the payment

becomes due on the client.



42/94

42

Practical Issues in Murabaha


43/94

43

1.Timing of Declaration

A Murabaha financing arrangement consists ofa series of documents to be executed at variousstages, the sequence and timing of which isextremely important.

Through declaration, the client and the bankexecute an important step of a valid Murabahasale i.e. Offer & Acceptance

Declaration is to be signed by the customer

when it has purchased and taken possession ofthe goods as the Banks agent.

Declaration must be signed while the goods arestill in existence and have not been used in the

production process or sold to some other entity.

Issues in Murabaha


44/94

44

2. Rollover in Murabaha

Rollover in Murabaha is not possible since each

Murabaha transaction is for the purchase of aparticular asset. A new Murabaha can only beexecuted for the purchase of new assets.

It is advisable that there must be a gap of 1-2

days between maturity of the previous Murabahaand disbursement of the new one.

Issues in Murabaha


45/94

45

3. Rebate on early payments

This is normally prohibited by Shariah Board

since it can make the Murabaha transactionsimilar to conventional debt.

Issues in Murabaha


46/94

46

4. Penalty on late payments

As soon as the Murabaha is executed (declarationsigned) the Murabaha price becomes a receivable

(Dayn) for the Bank. As per the rules of Islamic fiqh any amount charged

over and above thedaynamount will be Riba.

Hence bank cannot charge any late payment

charges.

The bank may, however, ask the customer to pay aforced charity in case of overdues so as to create adisincentive for him to delay the payment

Issues in Murabaha


47/94

47

5. Subject matter of Murabaha

Murabaha cannot be done in all commodities, e.g.Murabaha can not be done in currencies.

Murabaha cannot be used for paying utility bills,wages, overhead expenses, etc.

As per general rules of sale subject matter mustbe:- In existence- Having intrinsic utility

- Usable for a Halal purpose (buyer must intendto use it for the same purpose)- Capable of ownership/delivery- Specified and quantified at the time of sale- Must be in Banks ownership/possession at the

time of sale

Issues in Murabaha


48/94

48

6. Purchase Evidence

In order to ensure that the customer actuallypurchased the assets as claimed, thecustomer is required to submit asset purchaseevidence along with declaration.

The purchase evidence must confirm that theasset purchase took place after the agencyagreement.

Asset purchase may be in the form ofInvoices, delivery orders, truck receipts etc.

Issues in Murabaha


49/94

49

6. Purchase Evidence..(Contd) In some cases, however, it may be too

burdensome for the client to submit all theinvoices as the number of invoices may run into

hundreds.

For example, cotton purchases are generally insmall quantities from various sources andhence for each Sub-Murabaha there may be too

many invoices to submit. It is suggested tofurnish samples of invoices along with summaryof all purchases.

Issues in Murabaha


50/94

50

7. Direct Payment in Murabaha

Currently in many cases the disbursement ismade to the customer as an agent.

In order to ensure transparency of theMurabaha it is better that the bank disbursesthe funds directly to the supplier.

Issues in Murabaha


51/94

51

7. Direct Payment in Murabaha..(Contd)

Direct payment can be made in the followingways:

- The bank can pay the supplier directly viacash, cheque, pay-order etc.

- The bank may credit the Murabaha funds inthe customers account and only allow him to

issue pay orders/demand drafts from hisaccount in favor of the suppliers.

Issues in Murabaha


52/94

52

Purchase of raw material; for meeting working

capital needs of trade and industry.

Medium to long term requirements for purchase

of land, building and equipment.

Trade finance products including imports,

exports and alternative to bill purchase.

Applications of Murabaha


53/94

53

IJARAH


54/94

54

Ijarah is a term of Islamic Fiqh Literally, it means To give something on

rent

The termIjarahis used in two situations:

1. It means To employ the services of a

person on wagese.g. Ahires a porter at

the airport to carry his luggage

2. Another type of Ijarah relates to payingrent for use of an asset or property defined

asLANDin Islamic Economics

Ijarah


55/94

55

Leases, like sales, are among the contractsthat are explicitly discussed in Islamic Law

Leases differ from sales due to the time

limitation involved in leases, in contrast to

sales where no time limit is allowed.

The proof from the Sunnah is derived from the

Hadith:Pay the hired worker his wages before

his sweat dries off.

Ijarah: Sharia Source


56/94

56

Narrated by Ahmad, Abu Dawud, and Al-Nasaiwith the wording: The farmers during the

time of the Prophet (pbuh) used to pay rent

for the land in water and seeds. He (pbuh)

forbade them from doing that, and orderedthem to use gold and silver (money) to pay

the rent

It is impermissible to charge a rental for gold

or silver coins, or for any consumable good

measurable by weight or volume.

Ijarah: Sharia Source


57/94

57

Ijarah is an Islamic alternative of Leasing.

Leasing backed by an acceptable contract is an

acceptable transaction under Shariah.

The question of whether or not the transaction

of leasing is Shariah compliant depends on the

terms and conditions of the contract.

Several characteristics of conventionalagreements may not conform to Shariah thus

making the transaction un-Islamic and thereby

invoking a prohibition.

Ijarah as a mode of financing


58/94

58

Risk and rewards of ownership lies with the

owner i.e. any loss to the asset beyond the

control of the lessee should be borne by the

Lessor.

Late payment penalty cannot be charged to the

income of the Lessor.

Lease and Sale agreement should be separate

and non contingent.

Key Differences


59/94

Difference b/w Conventional Lease &Ijarah


60/94

60

Difference b/w Conventional Lease & Ijarah1. The Lessor cannot increase the rent

unilaterally

2. Expenses to be borne by the parties:

Lessor- expenses relating to the corpusof the asset i.e. insurance, accidentalrepairs etc. will be borne by the lessor

Lessee- actual operating/overheadexpenses related to running the asset willbe borne by the lessee

Ijarah


61/94

61

Difference b/w Conventional Lease & Ijarah

3. Two contracts into one contract is notpermissible in Shariah therefore, the bankcannot have the agreement of hire andpurchase into one agreement, only the bank

can undertake/promise to purchase theleased asset

4. Under conventional Lease, the Leaserental starts from the date of payment by

Lessor.Under Shariah, the correct way tocharge rent is after delivery of the asset tothe Lessee. Because rent is charged for useof the asset

Ijarah


62/94

62

Process of Ijarah

Ij h


63/94

63

CUSTOMER

MECHANICS

ISLAMIC BANK

The Bank makes payment to the vendor

The Bank purchases the item required forleasing and receives title of ownership from thevendor

The customer approaches the Bank with therequest for financing and enters into a promiseto lease agreement.

VENDOR . .Agreement-1

Ijarah

Ij h d f fi i


64/94

64

CUSTOMER

MECHANICS

ISLAMIC BANK

The customer makes periodic payments as percontract

The Bank leases the asset to the customer afterexecution of lease agreement.

VENDOR

Title transfers to the customer

. .Agreement-2


T f Ij h


65/94

65

1. Direct where the bank purchases an asset

from a 3rd party and leases the same to the

customer.

2. Sale & Leaseback where the bank

purchases an asset already owned by the

customer and leases back to the same person.

This is permissible with certain conditions.

Types of Ijarah


66/94

Rules of Ijarah

R l f Ij h


67/94

67

Ownership of the leased asset remains with the

Lessor during the term of Ijarah.

Since ownership of the leased asset remains with

the Lessor, all rights and liabilities relating toownership are borne by the Lessor.

The period of Lease must be determined in clear

terms.

The Lessee is responsible for damage to the asset

caused by fraud or negligence.

Rules of Ijarah

R l f Ij h


68/94

68

Any damage to the asset not caused by the

Lessees neglect, is to be borne by the Lessor.

Normal maintenance is Lessees responsibility

Lease rentals for the entire lease period must befixed;

a) Different amounts of rents can be fixed for

different periods, but they must be known.

b) The rent may be tied to a known benchmark,

acceptable to both the parties.

Rules of Ijarah

R l f Ij h


69/94

69

The Lease period will start when the asset has

been delivered to the Lessee

- in a usable condition

- whether or not the Lessee has started using it

Insurance is a cost related to ownership of the

assets, and therefore should be borne by the

Lessor

Rules of Ijarah


70/94

Ijarah Documentation



71/94

71

Undertaking to Ijarah

Ijarah Agreement

Description of the Ijarah Asset

Schedule of of Ijarah Rentals

Receipt of Asset

Demand Promissory Note

Undertaking to Purchase Ijarah Asset

Sale Deed


Applications of Ijarah


72/94

72

For long and medium term fixed assetfinancing

BMR

Retail products

Applications of Ijarah



73/94

73

Auto Finance Car Ijarah

First Islamic Car Financing Scheme

Free from Interest/Riba

It is not a Hire-Purchase agreement

Product Features

For all Locally manufactured new cars

Term 3, 4 and 5 years

No upfront Insurance Payment

No advance Rental



74/94

74

Diminishing Musharakah

Musharakah


75/94

75

Musharakah is a form of partnership (Shirkat)

between two or more parties whereby eachparty contributes to the capital of the partnershipin equal or varying proportions either to establisha new venture or share in an existing one.

There are two types of Shirkah:

1. Shirkat-ul-Milk

2. Shirkat-ul-Aqd

Musharakah

Musharakah


76/94

76

1. Shirkat-ul-Milk

Joint ownership of two or more persons in a

particular property.

2. Shirkat-ul-Aqd

A partnership affected by mutual contract. It canalso be translated as a joint commercial

enterprise.

Musharakah



77/94

77

In Diminishing Musharakah the bank and the client

participate either in joint ownership of

a property or an equipment,

or in a joint commercial enterprise

The share of the bank is divided into a number ofunits

The client purchases these units one by one

periodically until he is the sole owner of theproperty.

DiminishingMusharakah



78/94

78

Most commonly, Diminishing Musharakah is used

in cases of Shirkat-ul-Milk

This concept is based on Declining ownership ofthe financier

Three components involved :

1. Joint ownership of the Bank and the customer

2. Customer as a lessee uses the share of the

bank

3. Redemption of the share of the Bank by the

customer




79/94

79

Concept of Musha

Musha means undivided ownership of the asset

Lease of Musha

It is allowed to lease Musha to other joint owner.



80/94

80

Shariah Principles

Shariah Principles


81/94

81

To create joint ownership in property is calledShirkat-ul-Milk and is expressly allowed by allschools of Islamic Jurisprudence.

All Muslim Jurists agree on the permissibilityof the Financier leasing his share in propertyto client and charging him rent i.e. thepermissibility of leasing ones share to hispartner.

Promise of client to purchase units of share offinancier is also allowed.

Shariah Principles

Shariah Principles


82/94

82

The Transactions cannot be combined in asingle agreement and they have to beexecuted independently. This is because it isa well settled rule of Islamic Jurisprudence

that one transaction cannot be made acondition for another.

Instead of making the transactions a pre-condition for one another there can be one-

sided promises from one party to another

Shariah Principles


83/94

85

Basic Structure

Diminishing Musharaka


84/94

86

CUSTOMER

The Bank enters into a Musharaka (Joint Ownership)agreement with the customer and both of them pay theirrespective shares to the seller of the asset.

Customer pays rent for the use of banks share in theproperty

The customer approaches the Bank with the request for

Project financing

MBL JointOwnershipMusharaka

Rent




85/94

87

CUSTOMER

The Bank enters into a Musharaka (Joint Ownership)agreement with the customer and both of them pay theirrespective shares to the seller of the asset.

Ownership of the asset is gradually transferred to the customerupon payment of asset price.

Customer pays rent for the use of banks share in theproperty

The customer approaches the Bank with the request for

Project financing

MBL JointOwnershipMusharaka

Gradual Transfer of Ownership



86/94

88

Legal Documentation

Legal Documentation


87/94

89

1. Musharakah Agreement

Purpose: This is the main agreement that establishes the Banks

share in the Musharakah Property.

Components:

- Both parties share

- Musharakah Property detail

2. Payment Agreement (Rent Agreement)

Purpose: This agreement is signed after Main Musharakah

Agreement. Bank gives its share to the customer via this

agreement.

Components:

- Rent Schedule

- Formula of calculation

Legal Documentation

Legal Documentation


88/94

90

3. Undertaking to Purchase Musharakah Units

Purpose: This is an undertaking by the customer to purchase

Banks Musharakah units.

Components:

- Normal Sale Price

- Additional Unit Purchase Price

4. Undertaking to Sell Musharakah Units

Purpose: This is an undertaking by the Bank to sell its

Musharakah units from time to time.

Components:

- Normal Sale Price

- Additional Unit Purchase Price

Legal Documentation


89/94

91

APPLICATION

Application


90/94

92

Application

Diminishing Musharakah is commonly used for the

purpose of financing of fixed assets by various

Islamic banks.

House financing Car Financing

Plant and machinery financing

Factory/Building financing

Agriculture land financing

All other fixed Assets

Application


91/94

93

First complete Islamic Home Finance

facility in Pakistan!

Halal, Quick, Affordable & Hassle free

A Comprehensive solution with:

Easy Buyer - Buying a home is Easy & Halal

Easy Builder -Building a home is Easy & Halal

Easy Renovate - Renovating a home is Easy &Halal

Easy Replacement - Replacing your existingmortgage is Easy & Halal

EasyHome - Islamic Housing Finance

Application


92/94

94

The Way Forward

The Way Forward


93/94

95

Islamic banking is a viable alternative however it is

still in the development stage and has to go a longway

It needs to be supported in its mission to eliminateRiba from our business.

Islamic options were unavailable in the past. Its notthe case anymore. The onus is on us now.

Positive criticism is always welcome but one shouldnot be judgmental before having any knowledge.

Ulema, bankers and professionals need to coordinate

more frequently to help R&D.

e ay o a d


94/94

Jazak Allah

&

Thank you

islamic finance structures-explained

Documents