Istisna as a mode of finance
Istisna is a contract on which Shari’ah scholars significant Ijtihad over the centuries and particularly during the Ottaman rule. Al-Majjallah, which was the Ottaman’s code based on the Hanafi school included a reformed form of Istisna. Hanafi Scholars made an important departure from the original Istisna form by permitting price to be paid not up-front, as in Salam but to be deferred. Some scholars even permitted seller to buy from the open market and need not himself be a manufacturer. It is because of these two points, Istisna is, now, attracting the attention of Islamic bankers.
Banks are no manufacturing agents. They are financial intermediaries. Istisna can be made a financial model, where banks play the role of credit providers. Thrg… Istisna and parallel Istisna, banks can sell, on deferred payment, manufactured goods, machinery, real estate, bridges...etc., and buy or contract to construct on cash basis. The difference between these two prices is what the bank will make as return on investment for the bank. The contract between the bank and the client will include technical specification of the manufactured good or the building to be constructed. These same specifications can be in the contract between the bank and the manufacturer or the contractor. The role of the bank, is therefore, financial intermediation, albeit on the basis of sale and not lending.
Apart from the credit risk of the client of, the bank, in Istisna, will be carrying a performance risk. Since bank client has no recourse on nor any contractual relationship with the actual manufacturer or contractor, the bank will always be liable for any failure. This risk, however, can be reduced by taking performance bond from the manufacturer or contractor. Furthermore, the contract to manufacture or construct will be based on the same blue prints and specifications provided by the client. The latter can also provide information concerning the best source of supply or the reliable contractors. The bank will have no incentive to select a contractor or a manufacturer other than the one recommended by the client. Client can even participate in negotiation, without involvement in decision making in the contract between the bank and the manufacturer or contractor. Furthermore, many scholars permitted the bank, once the goods are delivered, to be only a guarantor of the manufacturer or contractor. Hence, client can have a direct contract to them while bank bears the risks only if they fail to honor their commitment Viz. the client.
The price of the goods or the assets to be constructed will become a debt obligations on the client. Bank can therefore, request any guarantees equal or in excess of this amount in a fashion similar to conventional banking. Further, the bank can request performance bonds or L/G from contractors, and warranties after delivery. In all cases the two contracts (bank / client, and bank / contractor or manufacturer) should always be separate.
Constructing of an Istisna transaction
The deal usually starts with the client approaching the bank to finance, say, a new building. Rather than extending a loan, the bank may use Istisna to put together an interest-free transaction. The client will be asked to present the bank his ready made blue prints and plans and government required permits. He will also advice on contractor of his preference for possible consideration by the bank. After concluding a credit evaluation of the client, the bank will then get an offer from contractor (preferably the one recommended by the client) which is usually valid for one or two months. During this time the bank will sign a contract with the client, where the latter is actually buying, on deferred payment, the building which is to be constructed by the bank. The bank will then sign a contract with the contractor to construct that building using the exact the same specifications and contract conditions agreed upon with the client. Payment by the bank to the contractor will be in cash, while bank receives the sale price from the client with a mark-up through installments. This is clearly, a financial intermediation which exactly what bank should be engaged in. Bank profits are actually the difference between the cash payments made to the contractor and the deferred payment made by the client, profit can be calculated in any way, as long as it is known as an amount to the client at the time of contracting, it is not variable, and will not increase if installments are not paid in time.
Mudarabah is a participatory mode of finance. It consists of two parties, one providing the finance, called “Rub-ul-mal” and other providing labor or management called “Mudareb”. They join together in a project to generate profit which will be shared by them. Mudarabah is a principal-agent type of arrangement. The early writers in Islamic banking through Mudarabah should be the predominant mode of finance in Islamic banking. This is because they thought a banking system based on Mudarabah will produce a more equitable distribution of income and wealth in the society. Since it provides opportunities for entrepreneurs who, while they have innovative ability and managerial skills to create wealth. They can’t prec… finance from banks because bank lending requires collateral which they lack. Clearly, this is a major advantage over conventional banking.
It is not difficult, however, to see that Islamic banking developed a way from Mudarabah. Mudaraba, as a principal-agent type of arrangement suffers from a high degree of moral hazard and adverse selection. Early attempts by Islamic banks to apply mudarabah is creating bank's assets failed, because of the lack of good conduct on the part of the bank client. While the original model of Islamic banking is based on two-tier Mudarabah, the bank receives deposits in its investment accounts on the basis of that contract and finance on the same basis. In the first, bank is a Mudareb (agent) and in the second it is a Rub-ul-mal (primary of capital). Mudarah required the basis of the liability-side of all Islamic banks. It is obvious that the degree of moral hazard and adverse selection in the mudarabah contract in much less that the assets side. The reason being that banks will pay a high price if they believe in less than the highest level integrity, notwithstanding the supervision of the regulatory agencies and central bank.
Source: An Introduction To Islamic Banking, Shaykh Dr Mohamed Ali Elgari. Republished with permission.