Principles of Islamic Banking: Riba, Gharar, Istisna, Musharakah, Murabaha, Mudarabah, Ijara

1. بسم الله الرحمن الرحيم The Principles of Islamic Banking

2. Islamic Banking (IB)Definition:Islamic banking can be defined as: a form of modern banking based on Islamic legal concepts using risk- sharing as its main method excluding financing based on fixed pre- determined return.

3. Principles that underlie the methodology of Islamic banking: 1 - Prohibition of Riba 2 - Prohibition of Gharar

4. Riba is understandable given that the payment and receipt of interest are central to all conventional banking. • Riba literally means increase,addition,expansion or growth. It is a typical increase or growth , which has been prohibited by Islam. • Riba technically refers to the premium that must be paid by the borrower to he lender along with the principle amount as a condition for the loan or for an extension in its maturity. in this case Riba obviously means interest. • Islam made a clear distinction between trade and Riba. Trading is encouraged but Riba is prohibited.

5. Gharar Gharar is a type of exchange in which one or both parties stand to be deceived through ignorance of an essential element of the exchange • - Ignorance of the goods or price, • or false description of the goods. • - selling of goods that the seller is not in a position to deliver. The element of speculation inherent in derivatives trading means that such transactions fall into the category of Gharar and are therefore prohibited.

6. T Istisna Definition: Istisna is an agreement meeting the Client's need for an item, equipment, building, or project, which needs to be constructed, manufactured, fabricated, or assembled. Istisna Manufacturing good House under construction Securitization

7. Musharakah Definition: A Musharakah is a joint venture where by all partners (BANK /CLIENT) participate in providing the financial resources for the business. the Client to start and/or operate a business or industry, or undertake any other type of business venture. The bank and the Client agree to manage the business enterprise according to the terms of the agreement.

8. Basic Principles Of Musharakah: • Financing through Musharakah means participation in the business. • An investor/financier must share the loss incurred by the business to the extent of his financing. • The partners are at liberty to determine, with mutual consent, the Ratio of profit allocated to each one of them, which may differ from the ratio of investment. • The loss suffered by each partner must be exactly in the proportion of his investment.

9. Murabaha Definition: Murabaha is a sale contract between the Bank as seller of goods and Client as purchaser, based on the disclosure of initial price to client. Bank purchases Goods on spot at the request of the Client, and then sells same to him on credit at a mutually agreed marked-up price.

10. The Principles of Islamic Banking Any Murabaha transaction will typically involve a number of steps, which are broadly as follows: • The purchaser/ client submits an order to the bank to purchase the • goods they require. 2. The bank agrees to finance the purchase of proposed goods. 3. The bank prepares and sends an offer to the purchaser /client. 4. The purchaser accepts the offer, which binds it contractually to purchase the goods.

11. 5. the bank pays the supplier and purchases the goods using spot payment. 6. The purchaser, acting for himself, enters into a contract to buy the goods from the bank. 7. the purchaser purchases the goods from the bank for immediate delivery with deferred payment.

12. Mudarabah Definition: Mudarabah is a mode of financing in which the bank provides the needed finance, while the Client provides the professional, managerial, and technical know-how for starting and/or operating a business enterprise or project. The profit is shared in a pre-agreed ratio.

13. Characteristics that distinguish Mudarabah from Musharakah : a. The investment in a Mudarabah is provided by one partner only, whereas in a Musharakah it is supplied by all the partners. b. In a Mudarabah the management of the investment is the sole responsibility of the mudarib, while in a Musharakah the partners all participate in the management of the business. c. The loss in a Mudarabah is carried by the Rab'ul Mal alone, as the Mudarib has nothing to lose. In a Musharakah the proportion of loss is determined by the size of the investment .

14. d. A Mudarabah is a limited liability investment, whereas a Musharakah is not. e. The assets acquired by a mudarib for the rab'ul mal are the sole possession of the latter, and the former can only profit by shrewd disposal of the assets . In a Musharakah the assets acquired are the joint possessions of all the partners in the deal. Structuring investment funds Mudarabah uses in Islamic Banking Structuring investment portfolios Raising funds from clients Finance Clients

15. Ijara Under the terms of an Ijara transaction the investor, or lessor, would purchase equipment from a manufacturer and lease it on to the company, or lessee, for an Agreed period of time. During this pre-determined period, the title to the underlying assets will remain in the hands of the lessor, whereas the actual possession and usage of the asset would be for the benefit of the lessee.

16. Ijara Financing Offer & Acceptance Lessee Lessor Ijara (Lease) Rental Payments Leased Asset

17. Over the life of the asset, the lessee will pay pre-agreed rentals to the lessor at a frequency mutually agreed upon by the two parties. During the life of the asset the risk of ownership remains with the lessor, while the lessee is responsible for use of the asset.

18. Important differences between a conventional lease and Ijara : • In a conventional lease arrangement penalties will be incurred for late payment of an installment, which are stated as a percentage of the total. As this equates to an interest payment, it is prohibited under Shariah. • Under shari'ah, original agreements can not be altered to reflect rescheduling. This can be done only in cases of mutual agreement to cancel the old agreement and to draw up a new one. • Under conventional lease contract the lessee is responsible to insure the leased asset, where in an Islamic lease contract, the lessor holds the responsibility of paying the insurance since he owns the leased asset.

19. Salam Salam is a sale whereby the seller undertakes to supply some specific goods to the Buyer at a future date in exchange for an advanced price fully paid on the spot. The permissibility of Salam was an exception to the general rule that prohibits forward sales. For that, it was subjected to some strict conditions.

20. These conditions are as follows: • The payment of the price by the buyer should be at the time of effecting the sale. 2. Such sale is permissible only in the commodities whose quality and quantity can be specified exactly. For example, precious stones cannot be sold on the basis of Salam, because every piece of precious stone is normally different from the other. 3. It cannot be effected on a commodity whose supply is not certain. For example, if the seller undertakes to supply rice or wheat of a particular field, or the fruit of a particular tree, the Salam will not be valid.

21. 4. The quality and quantity of the commodity sought to be sold by Salam must be fully specified. The exact date and place of delivery must be specified in the contract 5. It is not permissible for the buyer of a Salam commodity to sell it before receiving it because that is similar to the prohibited sale of debts before holding.

22. Usage of Salam: Salam sale has been found suitable for the finance of agricultural operations. It is also used to finance commercial and industrial activities, especially phases prior to production and export of commodities and that is by purchasing them on Salam and marketing them at a profit.

23. Istisna’a Istisna’a is the second kind of sale where a commodity is transacted before it comes into existence. It entails ordering a manufacturer to manufacture specific goods for the purchaser. If the manufacturer undertakes to manufacture the goods for him, the transaction of Istisna’a comes into existence. It is necessary for the validity of Istisna’a that: • The price is fixed with the consent of both parties. B. The specification of the commodity intended to be manufactured is fully settled between them.

24. The contract of Istisna’a creates a moral obligation on the manufacturer to manufacture the goods, but before he starts the work ,any one of the parties may cancel the contract after giving notice to the other. • However, after the manufacturer has started the work, the contract cannot be cancelled unilaterally. • In Istisna’a, the party placing the order has the right to retract if the commodity does not conform to the specification demanded. • In Istisna’a the price could be in advance or in installments or deferred but the time of payment should be fixed.

25. Istisna’a Financing Manufacturer Bank Client

26. Usage Of Istisna: • Istisna can be used for providing the facility of financing in certain transactions, especially in the housing finance. • It is not necessary that the financier himself constructs the house. He can enter into a parallel contract of Istisna with a third party, or may hire the services of a contractor. In order to secure the payments of installments, the bank , as a security, may keep the title deeds of the house or land, or any other property , until the client pays the last installment. • The instrument of Istisna may also be used for project financing on similar lines.

27. TAWAROQ Tawaroq is a financial product to satisfy customer cash needs compliant with Shariah rules. Under such program the bank purchases certain goods on spot basis either from local or international markets and sells them to customers on credit. The customer in his turn resells the goods to a third party to obtain cash.