Islamic Finance – Principles

Principles of Islamic FinanceHhadith – Sahih Muslim:

…gold for gold, silver for silver, dates for dates,wheat for wheat, salt for salt, barley for barley,….like for like, equal for equal, hand to hand, ….

Two permissions follow two prohibitions:

1. Sales within single type, unequal exchange, with or without delay: Riba al fadl. Money should be used as medium of exchange

2. Exchange among listed goods, with or without equality, but with delay: Riba al nasia [wheat and rice so that wheat now and rice later OR gold now or silver late]. Goods can be sold on credit for gold and silver.

CREDIT SALE IS ALLOWED IF GOODS EXCHANGE WITH MONEY

Theory & Practice of MurabahahMurabahah – Concept and Historical perspective• Introduced as new form of sale in second half of first

Hijrah century as a sale with necessary condition of a profit margin agreed by both the seller and purchaser [Al Mutta, Imam Malik] and without the order of purchaser [cost includes direct expenses]

• Modifications were made by Imam Shafi’, including an order of the purchaser, who could subsequently exercise the option not to purchase the same, and also included credit transaction

• Therefore, he clearly bifurcated two sale transactions, one from supplier (or vendor) to the seller and other from seller to the purchaser

Theory & Practice of MurabahahMurabahah – Concept and Historical perspective• The contemporary banking also takes into account the cash and

credit prices different from each other, as justified by Usmani• The banks are also required to fulfill regulatory compliance

relating to credit transactions, maximum exposure to risk, classification of credit transactions, international supervision, etc.

• In addition, the banks are also emphasized to follow the Shariah, and accounting standards issued by AAOIFI relating to Murabaha transactions. In Pakistan, the Islamic Financial Accounting Standard-1 issued by ICAP vide SECP Notification dated 24th August, 2005 is also required to be followed.

• Since the operation of Murabaha transaction resembles Riba based practice of lending, the preconditions prescribed by Shariah advisors are to be met in letter and spirit

100% 75% OB

50%

75%25%

50%

100%25%OA

M

R

N

A’s Capital

B’s Capital

A’s Share of Profit B’s Share of Profit

90%10%

MUSHARAKAH P&L DISTRIBUTION

Bank arranges pool of funds

Islamic Modes – Agricultural Financing

ISLAMIC BANK

Special Purpose

Mudarabah

IN

VE

ST

OR

SInvestment

Units purchased

6 m

onth

s W

hole

sale

Pur

chas

es

Retail Sales Lined up

Profits Accrued

Financing of crop productionLiquidity requirements (hiring of tractor & implements,

sowing, purchase of water, hiring of labour for preparation of land and harvesting, marketing)

Input requirements (seed, fertilizer, pesticides)

Islamic Modes – Agricultural Financing

Liquidity

Hiring for land prep.

Inputs in kind

Sale of fertilizers, seed, pesticides

Liquidity

Hiring for Harvest +

Marketing Exp.

SALAM

SALAM

MURAB

Liquidity

Hiring for land prep.

Inputs in kind

Delivery

Payment

Delivery

Islamic Modes/Instruments - Sale Contracts:

Parallel Salam: Procedural Details:

The disposal of commodity at the end of Bank can be through:

– Parallel Salam:Bank may sell commodity, before the date of delivery, to some other

purchaser for the date of original delivery. The period in second contract will be shorter than the original contract, but price higher than the original contract.

– Unilateral Promise: Promise of purchase can be obtained from third party for delivery on the date of original contract. Price in this promise is set higher than parallel salam because the promisor has to pay nothing.

Islamic Modes/Instruments - Sale Contracts:Risks involved in Salam Transaction:

Risks MitigantsCounterparty delivery risk•Client defaults after receiving price

•There could be dispute in quality, quantity, time of delivery, etc. in case of commodity

•Defective goods could be supplied

•Goods may be delivered late

Commodity price risk•The market price at delivery time could be lower than the price expected at the time of contract

•Liquidate security & purchase same goods from market

•MoU should clearly specify to avoid any dispute

•Collateral or security can be obtained

•Penalty clause – charity

•Parallel salam or promise to purchase

Islamic Modes/Instruments - Sale Contracts:Risks involved in Salam Transaction:

Risks MitigantsCommodity marketing risk•Bank is not able to market the goods timely resulting into blocking of funds

Asset holding risk

•Bank bears holding cost till disposal of commodity

Early termination chances•Clint refuse to supply the goods

Parallel Salam•Original seller might not supply goods in time. The buyer in parallel salam may sue the bank.

•Select appropriate commodities for salam, take promise with Hamish Jiddiyah or appoint client as agent

•Cost can be recovered in parallel transaction

•Salam is a binding contract. Penalty clause can be inserted – charity

•Bank may purchase the similar asset from market. But no such loss can be recovered from original seller

Principles of Islamic Finance

1. Prohibition of Riba: Prohibition in Shariah:

B. Ahadith

Riba al fadl: [Traditions]

1. ….exchange of radi with burny dates…..

2. Gold for gold, silver…..,……, like for like, equal for equal, and hand to hand. If the commodities differ, you may sell as you wish, provided the exchange is hand to hand.

1. When illa is different, shortfall/excess and delay both are permissible

2. When commodities of exchange are similar, excess and delay both are prohibited

3. When commodities are heterogenous but illa is the same, then excess/deficiency is allowed but delay not allowed

Principles of Islamic Finance

REFERENCE SLIDES FOR PARTICIPANTS FROM BANKS

Work on Murabahah

Practice of MurabahahPricing of Murabahah [Example]:

• Purchase of poultry feed stock• Murabahah Facility: 180 Days• Payment: Six monthly installments• Rate of Profit: Six months KIBOR+2% • Murabahah transaction: Rs. 500,000• Securities: Pledge of feed stock,

equitable mortgage, lien on deposit, post dated

cheques, etc.

Practice of MurabahahPricing of Murabahah [Example]:

Particulars Amount (Rs.)

Cost of goods Rs. 500,000

Rate of Profit Kibor + 2% (Floor 11.5%)

Six monthly KIBOR 10% p.a.

Freight & insurance 5% of cost

Total cost 500000 x 5% 500000 + 25000 =525000

Risk premium 2%

Profit 10%+2%+2% = 14% p.a. 525000 x 14% x 180/365 = 36247

Murabahah Price 525000+36247= 561247

Amount of Installment

561247/6 = 93541 Cost = 87500

Profit= 6041

Training Workshop – Islamic Microfinance Accounting of Murabahah [Example]:

Advance Payment

Advance Payment (Against Murabahah purchases)

F&I charges

To Pay order

(Payment made in advance for purchase of goods)

500000

25000

525000

Arrival of Goods

Murabahah purchases A/C

To Advance Payment (Against Murabahah purchases)

(Goods received on account of purchases)

500000

500000

Training Workshop – Islamic Microfinance Accounting of Murabahah [Example]:

Murabahah Contract/Sale

Murabahah Facility A/C

Murabahah Profit Receivable A/C

To Murabahah Sale A/C

(To amount of goods sold)

5250000

36247

561247

Recovery of Murabahah Price

Client’s A/C

To Murabahah Facility A/C

To Murabahah Profit Receivable A/C

(Payment received on maturity by debiting client’s A/C on 1st installment)

93541

87500

6041

Training Workshop – Islamic Microfinance Accounting of Murabahah [Example]:

Recovery of Murabahah Price

Client’s A/C

To Murabahah Facility A/C

To Murabahah Profit Receivable A/C

(Payment received on maturity – 2nd installment)

93541

87500

6041

Client’s A/C

To Murabahah Facility A/C

To Murabahah Profit Receivable A/C

(Payment received on maturity – 3rd installment)

93541

87500

6041

Client’s A/C

To Murabahah Facility A/C

To Murabahah Profit Receivable A/C

(Payment received on maturity – 4th installment)

93541

87500

6041

Client’s A/C

To Murabahah Facility A/C

To Murabahah Profit Receivable A/C

(Payment received on maturity – 5th installment)

93541

87500

6041

Client’s A/C

To Murabahah Facility A/C

To Murabahah Profit Receivable A/C

(Payment received on maturity – 6th installment)

93541

87500

6041

Training Workshop – Islamic Microfinance Accounting of Murabahah

[Example]:

Profit and Loss Account Statement

Murabahah Sales

Less COGS

Purchases

F&I

Profit

561247

500000

25000 525000

36247

Sale Defined:

Exchange of a thing of value with another thing of value with mutual consent OR the sale of a commodity in exchange of cash.

Elements of a valid sale:• Contract ( Aqd )• Subject matter ( Mabe’e)• Price ( Thaman )• Possession or delivery ( Qabza )