Modes of financing
Islamic banks use a number of non-interest-based financing modes. The use of a particular mode is dependent on the nature, purpose and size of transactions. In selecting the mode, it is very much the know-how and knowledge of the Islamic banker which comes into play. These modes could be classified as debt type instruments, quasi - debt type Instruments, profit and loss sharing instruments or hybrid instruments.
Debt type instruments include Murabaha, Musawamah, Salam, Istisna’a, Tawarruq and Qard Hasan. Murabaha is a particular kind of sale, where the seller expressly mentions the cost he has incurred on the commodities to be sold and sells it to another person by adding some profit or mark-up thereon which is known to the buyer. It is one of the most popular modes used by banks in Islamic countries to promote Riba-free transactions. Typically Murabaha is used by Islamic banks for consumer financing for purchase of household goods, project financing, contract financing, working capital financing, asset financing, import financing and commodity financing. It offers the advantage that it is easy to use and also facilitates charging higher prices on deferred payment terms. Under Murabaha, the Islamic bank purchases, in its own name, goods from a third party that are required by their clients, and then re-sells the goods to their clients, on spot or deferred payment, with an pre-determined mark-up. The ownership of the goods being sold to a client at a mark-up price on deferred payment terms remains with the bank. The profit is derived from a service that entails the bank being exposed to some risk while holding title to the goods between the purchase and resale. By paying a higher price to the Islamic bank, spot or on deferred payment, the client is effectively obtaining interest-free financing. If the client fails to make a deferred payment on time, the mark-up does not increase due to the delay, but remains as predetermined. Another kind of sale, that is similar to Murabaha, is Musawamah, in which the price of goods to be traded is negotiated between seller and buyer. Musawamah is usually used where the seller is not in a position to ascertain precisely the costs of commodities offered for sale or does not want to disclose the cost price; all other conditions relevant to Murabaha are valid for Musawamah as well. Similarly, Tawarruq may be considered as a reverse form of commodity Murabaha. It is a debt instrument where Islamic banks sell any saleable goods or assets a client on deferred payment at cost plus profit, and the customer then sells the goods or the asset on a spot basis to a third party for cash. Most of Shari’ah scholars have approved Tawarruq, because it is considered a sale transaction that also involves a third party; it is a simple way for Islamic banks to finance individuals and businesses in need of cash or liquidity without contravening the rules of the Shari’ah.
Salam is another type of debt type trading mode that allows a buyer to make payment in advance for goods to be delivered on a specified future date at an agreed price. It consists of a forward purchase of specified goods; these goods must be tangible and can be defined as to quantity, quality and workmanship. Salam may be used by Islamic banks for trade financing in pre-shipment export finance, project financing, commodity financing and agricultural financing. Istisna’a is another trading mode where specific goods or an asset is made against a purchase order for deferred delivery. Istisna’a may be used by Islamic banks in construction projects, industrial equipment, plants and machinery, ships, aircraft and various capital goods, contract financing, asset financing, and trade financing to enable a client exporter to purchase raw materials. Under this mode, the bank agrees to construct and to sell the project to be constructed at the bank’s selling price to the client and thereafter it requests a third party to construct the project; Upon completion, the contractor will handover the project to the Bank or the Bank will authorise the contractor to deliver the project directly to customer. The payment can be flexible depending on the agreement between the bank and the client. Finally, Qard Hasan is a non-interest bearing loan or benevolent loan that may not collateralized. It is repayable as and when the borrower is able to repay. Islamic banks generally provide Qard Hasan to clients who are in need or in microfinance.
On the other hand, Ijarah is quasi-debt instruments; it is one of the simplest asset-based financial instruments, under which, the Islamic bank purchases an asset or equipment at the request of a client and leases / rents it to the client a price that includes a fair return for the bank. Lease contracts can be either an operating lease, where the Islamic bank is essentially acting as warrantor of the asset leased and a financial lease, where the client deals directly with the supplier and the ownership titles remains with the bank until it is transferred to the client. The Ijarah mode may be used by Islamic banks for asset financing for businesses that do not wish to purchase equipment, it can also be used for consumer financing for household good, vehicle financing, home financing, project financing, and asset acquisition financing.
Profit-And-Loss-Sharing Instruments include Musharakah, Mudarabah and other hybrid modes. Musharakah is used by Islamic banks for structured trade financing, real estate financing, project financing, working capital financing, asset financing, pre-export shipment financing and Import financing. It is based on the concept of profit-and-loss sharing, the profit is shared in any agreed proportion the loss is shared in strict proportion to the capital contributed by each party. Diminishing Musharakah; that is used by Islamic banks for home financing, real estate financing, project financing and equity financing; provides a method through which the bank keeps on reducing its equity in an asset against periodical payments, ultimately transferring ownership of the asset to the client. The rental payments to the bank reduce with the bank’s diminishing equity in the asset until no further rental payment has to be made. Mudarabah is another participatory mode that embodies the spirit of profit-and-loss sharing partnerships; whereby one party provides the capital while another party provides the labour and skills to manage the venture. Profits are shared between the parties according to a pre-agreed ratio; while losses are borne by the capital provider only. This mode may be used by Islamic banks for project financing, working capital financing, asset backed financing, asset acquisition financing and import financing. There are also projects which call for the use of a combination of modes. This is allowed by Shari’ah scholars based on the general principle of necessity provided that the combination does not contradict an explicit Text, does not attempt to circumvent a prohibition, does involve contradictory conditions and does not involve contingent contracts.
Debt type instruments include Murabaha, Musawamah, Salam, Istisna’a, Tawarruq and Qard Hasan. Murabaha is a particular kind of sale, where the seller expressly mentions the cost he has incurred on the commodities to be sold and sells it to another person by adding some profit or mark-up thereon which is known to the buyer. It is one of the most popular modes used by banks in Islamic countries to promote Riba-free transactions. Typically Murabaha is used by Islamic banks for consumer financing for purchase of household goods, project financing, contract financing, working capital financing, asset financing, import financing and commodity financing. It offers the advantage that it is easy to use and also facilitates charging higher prices on deferred payment terms. Under Murabaha, the Islamic bank purchases, in its own name, goods from a third party that are required by their clients, and then re-sells the goods to their clients, on spot or deferred payment, with an pre-determined mark-up. The ownership of the goods being sold to a client at a mark-up price on deferred payment terms remains with the bank. The profit is derived from a service that entails the bank being exposed to some risk while holding title to the goods between the purchase and resale. By paying a higher price to the Islamic bank, spot or on deferred payment, the client is effectively obtaining interest-free financing. If the client fails to make a deferred payment on time, the mark-up does not increase due to the delay, but remains as predetermined. Another kind of sale, that is similar to Murabaha, is Musawamah, in which the price of goods to be traded is negotiated between seller and buyer. Musawamah is usually used where the seller is not in a position to ascertain precisely the costs of commodities offered for sale or does not want to disclose the cost price; all other conditions relevant to Murabaha are valid for Musawamah as well. Similarly, Tawarruq may be considered as a reverse form of commodity Murabaha. It is a debt instrument where Islamic banks sell any saleable goods or assets a client on deferred payment at cost plus profit, and the customer then sells the goods or the asset on a spot basis to a third party for cash. Most of Shari’ah scholars have approved Tawarruq, because it is considered a sale transaction that also involves a third party; it is a simple way for Islamic banks to finance individuals and businesses in need of cash or liquidity without contravening the rules of the Shari’ah.
Salam is another type of debt type trading mode that allows a buyer to make payment in advance for goods to be delivered on a specified future date at an agreed price. It consists of a forward purchase of specified goods; these goods must be tangible and can be defined as to quantity, quality and workmanship. Salam may be used by Islamic banks for trade financing in pre-shipment export finance, project financing, commodity financing and agricultural financing. Istisna’a is another trading mode where specific goods or an asset is made against a purchase order for deferred delivery. Istisna’a may be used by Islamic banks in construction projects, industrial equipment, plants and machinery, ships, aircraft and various capital goods, contract financing, asset financing, and trade financing to enable a client exporter to purchase raw materials. Under this mode, the bank agrees to construct and to sell the project to be constructed at the bank’s selling price to the client and thereafter it requests a third party to construct the project; Upon completion, the contractor will handover the project to the Bank or the Bank will authorise the contractor to deliver the project directly to customer. The payment can be flexible depending on the agreement between the bank and the client. Finally, Qard Hasan is a non-interest bearing loan or benevolent loan that may not collateralized. It is repayable as and when the borrower is able to repay. Islamic banks generally provide Qard Hasan to clients who are in need or in microfinance.
On the other hand, Ijarah is quasi-debt instruments; it is one of the simplest asset-based financial instruments, under which, the Islamic bank purchases an asset or equipment at the request of a client and leases / rents it to the client a price that includes a fair return for the bank. Lease contracts can be either an operating lease, where the Islamic bank is essentially acting as warrantor of the asset leased and a financial lease, where the client deals directly with the supplier and the ownership titles remains with the bank until it is transferred to the client. The Ijarah mode may be used by Islamic banks for asset financing for businesses that do not wish to purchase equipment, it can also be used for consumer financing for household good, vehicle financing, home financing, project financing, and asset acquisition financing.
Profit-And-Loss-Sharing Instruments include Musharakah, Mudarabah and other hybrid modes. Musharakah is used by Islamic banks for structured trade financing, real estate financing, project financing, working capital financing, asset financing, pre-export shipment financing and Import financing. It is based on the concept of profit-and-loss sharing, the profit is shared in any agreed proportion the loss is shared in strict proportion to the capital contributed by each party. Diminishing Musharakah; that is used by Islamic banks for home financing, real estate financing, project financing and equity financing; provides a method through which the bank keeps on reducing its equity in an asset against periodical payments, ultimately transferring ownership of the asset to the client. The rental payments to the bank reduce with the bank’s diminishing equity in the asset until no further rental payment has to be made. Mudarabah is another participatory mode that embodies the spirit of profit-and-loss sharing partnerships; whereby one party provides the capital while another party provides the labour and skills to manage the venture. Profits are shared between the parties according to a pre-agreed ratio; while losses are borne by the capital provider only. This mode may be used by Islamic banks for project financing, working capital financing, asset backed financing, asset acquisition financing and import financing. There are also projects which call for the use of a combination of modes. This is allowed by Shari’ah scholars based on the general principle of necessity provided that the combination does not contradict an explicit Text, does not attempt to circumvent a prohibition, does involve contradictory conditions and does not involve contingent contracts.
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.
