Islamic banks commercial transactions
Islamic banking has the same purpose as conventional banking except that it operates in accordance with the rules of Shari’ah. The basic principle of Islamic banking is the sharing of profit and loss and the prohibition of Riba.
The main implication of the Shariah rules is that Islamic banking is restricted to Islamically acceptable deals, which exclude those involving alcohol, pork, gambling, etc. Thus, ethical investing is the only acceptable form of investment. In addition, financial transactions are structured to reallocate risk-sharing and profits by using the concepts such as Murabaha (cost plus), Musharakah (joint venture), Mudarabah (profit sharing), Wadiah (safekeeping), and Ijarah (leasing).
Therefore, in an Islamic loan transaction, instead of loaning the buyer money to purchase the item, an Islamic bank might buy the item itself from the seller, and re-sell it to the buyer at a profit, while allowing the buyer to pay the bank in installments. However, the fact that this profit cannot be made explicit and therefore there are no additional penalties for late payment, Islamic banks use the concept of Murabaha to protect itself against default, by asking for strict collateral. The goods or land is registered to the name of the buyer from the start of the transaction.
Another approach applied by Islamic banks is Musharaka where they lend their money to companies by issuing loans in a way that the bank's profit on the loan is equal to a certain percentage of the company's profits. Once the principal amount of the loan is completely repaid, the profit sharing arrangement is concluded. Further, Mudarabah is venture capital funding of an entrepreneur who provides labor while financing is provided by the bank so that both profit and risk are shared. In this transaction, an owner entrusts funds to a trustee, who returns the principal and a share of profits after using the funds for a specified purpose. Such participatory transactions between capital and labor reflect the Islamic view that the borrower must not bear all the risk/cost of a failure, resulting in a balanced distribution of income. In the case of Musharakah, the joint venture which allows partners to share losses based on the proportion of their capital contributions; And in Ijarah, the transaction allows a bank to purchase equipment or machinery and lease it to clients who may ultimately take absolute ownership;
Furthermore, Exchange transactions can be for immediate or deferred exchange. Yet, it is recommended that future contracts be evidenced in writing. Spot transactions need not be evidenced in writing but witnesses are recommended. And the item for sale should be under ownership of the seller and in his physical or constructive possession at the time of contracting the sale. However, Islamic banks may agree to sell defined goods to the customers which they have not yet purchased provided that it does not involve Gharar. Therefore, in Salam and Istisna’a transactions, where a price is paid at the time the contract is formulated, but delivery takes place at a future date, goods must be defined, quantified and available in the market at the agreed time of delivery.
The main implication of the Shariah rules is that Islamic banking is restricted to Islamically acceptable deals, which exclude those involving alcohol, pork, gambling, etc. Thus, ethical investing is the only acceptable form of investment. In addition, financial transactions are structured to reallocate risk-sharing and profits by using the concepts such as Murabaha (cost plus), Musharakah (joint venture), Mudarabah (profit sharing), Wadiah (safekeeping), and Ijarah (leasing).
Therefore, in an Islamic loan transaction, instead of loaning the buyer money to purchase the item, an Islamic bank might buy the item itself from the seller, and re-sell it to the buyer at a profit, while allowing the buyer to pay the bank in installments. However, the fact that this profit cannot be made explicit and therefore there are no additional penalties for late payment, Islamic banks use the concept of Murabaha to protect itself against default, by asking for strict collateral. The goods or land is registered to the name of the buyer from the start of the transaction.
Another approach applied by Islamic banks is Musharaka where they lend their money to companies by issuing loans in a way that the bank's profit on the loan is equal to a certain percentage of the company's profits. Once the principal amount of the loan is completely repaid, the profit sharing arrangement is concluded. Further, Mudarabah is venture capital funding of an entrepreneur who provides labor while financing is provided by the bank so that both profit and risk are shared. In this transaction, an owner entrusts funds to a trustee, who returns the principal and a share of profits after using the funds for a specified purpose. Such participatory transactions between capital and labor reflect the Islamic view that the borrower must not bear all the risk/cost of a failure, resulting in a balanced distribution of income. In the case of Musharakah, the joint venture which allows partners to share losses based on the proportion of their capital contributions; And in Ijarah, the transaction allows a bank to purchase equipment or machinery and lease it to clients who may ultimately take absolute ownership;
Furthermore, Exchange transactions can be for immediate or deferred exchange. Yet, it is recommended that future contracts be evidenced in writing. Spot transactions need not be evidenced in writing but witnesses are recommended. And the item for sale should be under ownership of the seller and in his physical or constructive possession at the time of contracting the sale. However, Islamic banks may agree to sell defined goods to the customers which they have not yet purchased provided that it does not involve Gharar. Therefore, in Salam and Istisna’a transactions, where a price is paid at the time the contract is formulated, but delivery takes place at a future date, goods must be defined, quantified and available in the market at the agreed time of delivery.
Modes of investment and finance used by Islamic Banks
In recent times, Islamic financing services have increased phenomenally around the world. Islamic banks offer now, to their clients, different modes to investment their money and finance their projects. These modes include solutions for short, medium, and long-term project-financing and investments.
Profit-and-loss-sharing is the most common mode proposed by Islamic banks for import financing, pre-shipment export financing, working capital financing and financing of all single transactions. This mode could also be used in the case of socio-economic projects such as infrastructure projects. PLS instruments include Mudaraba, an equity participation contract under which one of the parties participates with capital and the other with know-how. If the project ends in profit they share the profit in a pre-arranged proportion and if it results in loss the entire loss is borne by the financier, and the entrepreneur gains no benefit out of his effort, which was his part of the investment. PLS instruments also include Musharaka, an equity participation contract under which a bank and its client contribute jointly to finance a project. Ownership is distributed according to each party's share in the financing.
Besides, Islamic banks propose non-PLS modes of investment that include Shari'ah acceptable forms of trade and leasing. Murabaha, salam and Istinasa are the most known Trade-based techniques. Murabaha is a purchase and resale contract in which an asset is purchased by the bank for its customer, with the resale price determined based on cost plus profit mark-up. As opposite to Murabaha, Salam is a purchase contract with deferred delivery of goods. While, Istisna is a medium-term contract, whereby the manufacturer, or the seller, agrees to provide the buyer with described goods after they have been manufactured within a certain time and for an agreed price.
Under, leasing-related financing, Islamic banks agree to purchase and maintain the assets and afterwards dispose of them according to Shari’ah rules. Ijara, for example, is a leasing contract whereby a party leases an asset for a specified rent and term. The bank bears all risks associated with ownership.
Finally, Islamic banks could use other schemes of financing such as the investment deposit scheme that provides investors with an Islamic alternative to making short-term investments by participating in the financing activities of the Bank. Under this scheme, the Bank accepts deposits from both individual and institutional investors for use in its Import Trade Financing Operations.
Profit-and-loss-sharing is the most common mode proposed by Islamic banks for import financing, pre-shipment export financing, working capital financing and financing of all single transactions. This mode could also be used in the case of socio-economic projects such as infrastructure projects. PLS instruments include Mudaraba, an equity participation contract under which one of the parties participates with capital and the other with know-how. If the project ends in profit they share the profit in a pre-arranged proportion and if it results in loss the entire loss is borne by the financier, and the entrepreneur gains no benefit out of his effort, which was his part of the investment. PLS instruments also include Musharaka, an equity participation contract under which a bank and its client contribute jointly to finance a project. Ownership is distributed according to each party's share in the financing.
Besides, Islamic banks propose non-PLS modes of investment that include Shari'ah acceptable forms of trade and leasing. Murabaha, salam and Istinasa are the most known Trade-based techniques. Murabaha is a purchase and resale contract in which an asset is purchased by the bank for its customer, with the resale price determined based on cost plus profit mark-up. As opposite to Murabaha, Salam is a purchase contract with deferred delivery of goods. While, Istisna is a medium-term contract, whereby the manufacturer, or the seller, agrees to provide the buyer with described goods after they have been manufactured within a certain time and for an agreed price.
Under, leasing-related financing, Islamic banks agree to purchase and maintain the assets and afterwards dispose of them according to Shari’ah rules. Ijara, for example, is a leasing contract whereby a party leases an asset for a specified rent and term. The bank bears all risks associated with ownership.
Finally, Islamic banks could use other schemes of financing such as the investment deposit scheme that provides investors with an Islamic alternative to making short-term investments by participating in the financing activities of the Bank. Under this scheme, the Bank accepts deposits from both individual and institutional investors for use in its Import Trade Financing Operations.
