Islamic banks cannot charge interest on lending, therefore, they have to find other ways of financing entrepreneurs who are not ‘borrowers’ as the case with traditional banks but basically stand as partners to the bank. Hence Islamic banks use the term ‘investments’ to denote their ‘borrowing’ activities. These are done in basically Islamic investment instruments which fall in two groups:
- Sharing money with the investor (participating financing and thereby sharing in the profits or losses). This includes the contracts of Musharaka and Murabaha.
- Acting as intermediaries through a variety of sales and rental contracts. Islamic banks acquire or ‘own’ the goods they acquire on behalf of would-be partners before re-selling them or renting (at a higher margin).
A. Participating finance:
- Mudaraba (‘Agency’ Partnership): In this type of contract, the bank supplies “Full Financing” to an agent-manager (Mudarib) for trading or industrial purposes and the agent would contribute only his work and experience. In consideration the partner gets an agreed percentage of the profit actually realised. This form of contract reflects di- rectly how Islamic concepts value labour or pure human endeavour. In case no profit is realised or a loss occurs from normal business causes or natural causes, the Bank (Rab al- Mal, or capital supplier) bears all the loss and the ‘Mudarib’ (Manager) receives no reward for his efforts. This modality has been used by Islamic banks to finance all types of trade.
- Musharaka (Participation): This differs from Mudaraba in a small way. The bank provides less than 100% finance. The bank and the would-be customer agree to join a temporary partnership (not quite different from the joint venture concept) and both contribute financially to carry out a certain operation within an agreed period of time. In case of an industrial concern, for instance, both parties contribute to the financing of the operation including capital assets, technical and managerial expertise, working capital etc. in varying degrees, and agree to divide the profits actually realised in proportions agreed upon in advance. Loss is borne by both parties strictly in proportion to their respective contributions. There is no fixed percentage for profit sharing and each case is dealt with on its own merits.
- Decreasing participation: In medium and long-term operations, a ‘self-liquidating’ form of partnership can be agreed upon; whereby the ownership of the whole project or operation, would be transferred to the partner (customer) after an agreed period during which the bank would have retrieved its principal and would have shared in the profits and losses realised during that period. These forms of participation with customers adds a heavier burden on the Islamic bank. The bank does not only have to investigate and select the customer, but also has to study the project, supervise implementation and (if need arises) intervene in the actual administration or execution to ensure anticipated results, Islamic banking in short is a very involved type of banking. It is costly in the microsense, but it is also rewarding to the bank and to the society. There are other modalities pertaining to agriculture, namely Muzara’a and Musaquat. These use a water, crop or landsharing varieties of Musharaka. Only the land-sharing formula has been used by Islamic banks. The bank provides the financing.
B. Sales and rental contracts:
- Murabaha (Sale for mark-up): This is the case where a partner approaches the Islamic bank requesting a certain item (be it a commodity or machinery or raw materials) be bought and/or acquired for him for a specific price. He would indicate in advance his agreement to re-purchase this item from the bank at a profit to be agreed upon with the bank, in advance. So the profit element is pre-determined. Although the profit element is known, which makes it look like interest; it is not so:
- Actual trading must occur and the bank has to do this.
- The bank cannot automatically claim deferred payment if payment was not on time in the same way although it can claim compensation in certain cases.
- Ba'ye Muajjal (Deferred sale): This modality obliges the bank to acquire goods which it sells directly or through a subsidiary trading company to its customers.
- Salam: This modality is used by Islamic banks in the field of agricultural financing. It has significant implications for agriculture as it can be used to substitute the present system for advance financing of agricultural commodities or pre-export finance.
In the case of Salam the produce is delivered at a future date for a price paid in advance. Its main conditions as agreed upon by the majority of Muslim jurists are:
The agreed price for the produce to be delivered should be paid immediately at the time of contract, cash and in full (i.e. total risk is borne by the financier and not as in some rural credit systems where the price paid is low and payments are staggered throughout the season, thus ensuring the financier of a large margin of profit to hedge against failure of delivery). Wihtout this condition the jurists agree that the Salam contract is null and void.
Delivery of the goods must be postponed for a definite fixed time (i.e. the Sale contract should not be used to acquire immediately the goods, or it will only be a trick to discount the price).
The goods to be delivered against the Salam contract should be of a type that is commonly available at the time fixed for delivery i.e. the contract should not specify delivery of goods from a certain plot or location. This is to ensure the financier aginst unnecessary risk and to enable the farmer to deliver produce which he may obtain from another source if need be. However the contract must specify clearly the kind, description and quality of goods to be delivered.
- Ijara (Leasing): This is not dissimilar ot the western concept of leasing. Islamic banks use it to finance capital stock to industry. They get a fixed or variable income in rental (the repayment instalments).
- Ijara - wa-Iktina: Lease ending in the partner acquiring the machinery is a derivative of this formula.
- Istisna’a: It is a form of turnkey contract where the bank undertakes directly or by deputising the client or through a third party to finance the erection of and commissioning of factories or producing concerns or the certain umber of units of a certain product at a fixed cost — including the banks profit.
- Beneficial loans: Some Islamic banks used this formula to finance exports — mainly of livestock. This activity i.e. livestock was thought to be a very risky and also a very intricate operation which can hardly be monitored.
Banks extend the loan in local currency and get paid the exact amount loaned by the client in foreign currency (export proceeds) which they utilise for profitable import activities. This modality has been partially utilised in conjunction with other modalities to finance part of the working capital for industries. Banks get no direct reward from it but it is done when it is foreseen to enhance the overall profit of the ongoing operation (netting the bank a bigger amount of profit at the end of the day). Al-Baraka Intemation Bank (AIBL) is now using the interest free loan to finance a joint company in the UK. The bank gets its profit from the realised profit.
Source: Islamic Banking, Abdur Rahim Hamdi. Republished with permission.