COMPILED BY HAMDAN HJ IDRIS, BSc Econs, MBA (Islamic Banking & Finance)

IB1005DEPOSITS AND FINANCING PRACTICES OF ISLAMIC FINANCIAL INSTITUTIONS CHAPTER 8 : INTEREST-FREE PERSONAL FINANCING COMPILED BY HAMDAN HJ IDRIS, BSc Econs, MBA (Islamic Banking & Finance) Certified Professional Trainer (MIM) Industry Expert INCEIF PRESENTED BY HJ MAHMUD HJ BUNTAT, MBA (AUOL, UK), DBM (Swansea Inst., UK), CIL (UIA) Part-time Lecturer (INCEIF) Former Head of Islamic Banking Division, OCBC Bank (Malaysia) Bhd

Chapter 8 : Interest-free Personal Financing In this chapter, the concept of Islamic loan is first examined. Then, it looks at existing personal financing facilities offered by many Islamic banks such as bay al-‘inah,tawarruq and ar-rahn personal financing.

Qardu Hassan In Islam, qardhu hasan or benevolent loan is not a loan for commercial use. It is strictly a loan for personal use. Qard means loan while hasan implies good or benevolent.

A qardhu hasan loan, therefore, expresses the spirit of cooperation (ta’awun) and brotherhood (ukuwah) between debtors and creditors. • This is because the creditor expects nothing in return for the use of the loan • All he needs is the repayment of the loan in full. • The debtor holds obligation to return the principle loan. • The debtor can also place a collateral (rahn) to support the loan.

When there exists severe reminders against loan defaulters, Prophet Muhammad S.A.W. encouraged borrowers to pay more than the principal loan. • The addition sum, however, are not contractually mentioned in the loan agreement

Narrated Jabir bin 'Abdullah: Iwent to the Prophet S.A.W. while he was in the mosque. After the Prophet S.A.W. told me to pray two Raka'at, he repayed me the debt he owed me and gave me an extra amount. • On another occasion, the Prophet s.a.w. says, ”the best amongst you is he who repays his debts in the most handsome manner’’ (al-Bukhari). • The extra payment was not made contractually binding but released according to the paying capacity of the borrowing party and most important his willingness to give more.

In a society that upholds sadeqah as a virtue and • noble action, a debtor is expected to give the • creditor a hibah for the following reasons:- 1. The debtor is thankful for the loan given by the public. 2. The debtor is concern that inflation may cut real value of principle loan. 3. The debtor understands that the creditor suffers loss of opportunity to earn alternative income if monies are invested elsewhere. 4. The debtor is an individual with imanand taqwa.

Bay al-‘inah is a sale with a repurchase or buy-back agreement between two parties, • Usually, bay al-‘inah is applied to provide cash advances to customers. It is deemed valid by some jurists since the cash advances were made possible by virtue of a sale agreement and not a loan. • In this manner, bay’ al-‘inah is sometimes viewed as a legal device (hilah) to circumvent the prohibition of riba. BAY AL-’INAH

Tawaruq is a three party contract whose objective is to provide cash advances to the customer (mutawariqq) while providing profits to the financier, usually an Islamic bank. • It is a sale and resale contract involving a third party. It is used by some Middle-east Islamic banks. TAWARUQQ

The transactions are explain as follows:- • Mr. Ismail is looking for $50,000 cash to pay off his debt. He saw an on-line advertisement of al-Safa bank offering the tawarruq facilities. He sent the application documents to the bank for approval processing. Let’s assume that his application has been successful with full amount at 10 per cent profit rate per annum payable in 3 years.

To expedite the transaction, al-Safa Bank sells Asset Y to Mr. Ismail for ($50,000 + [0.1 x $50,000 x 3] = $65,000 with payment on deferred basis. Mr. Ismail pays the bank $65,000/36 a month for 36 months. This is the murabaha contract. We call it the asset purchase agreement (APA) between Mr. Ismail and the bank.

To acquire the $50,000 cash, Mr. Ismail has to sell Asset Y to company ABC. Usually the company ABC has business relation with al-Safa Bank where the former will buy Asset Y from al-Safa Bank’s tawarruq customers. • Here, company ABC pays Mr. Ismail $50,000 in cash in return for Asset Y. This is the asset sale agreement (ASA) between Mr. Ismail and company ABC (i.e the third party).

The above structure is known as tawaruq munazzam (ie organized tawarruq). This form of tawaruqq is found unlawful by the Fiqh Academy of Mecca. It says that tawaruqq is only permissible when the third party is independent from the 1st party (ie the bank). This is important to avoid any form of guarantees that Mr. Ismail can sell Asset Y for $50,000. • In trading, price is set by market forces, Tawarruq munazzam shows that there is some form of price rigging to secure the $50,000 sale price.

What then is Islam’s alternative to interest-based pawnbroking? Islamic law offers a commercial contract known as Ar-Rahn Scheme (Islamic Pawn Broking). • A customer can place an amount of gold with the bank for safe-keeping (wadiah yad dhamanah) and receive an interest free margin of advance (qardul hassan) with the gold being held as collateral (ar-Rahn) for a tenor of up to 6 months, with 2-month extensions thereafter. (AL-RAHN)PAWN-BROKING BUSINESS

WORKFLOW OF AL-RAHN Borrower Qardhu Hassan $4,000 Pledge Pledge Rahn $5,000 $4,000 Islamic Pawn-Broking (Lender) Al-Wadiah Amanah Custodial Fee ($4,000/$100) x 2% x 5 = $40

A pawn-broking operation is relatively straight forward:- The borrower simply needs to place a pledge or security for the amount of debt needed. For example, the pledged asset is a gold ring valued at $2,000.

Should the customer not redeem the facility on maturity including the fees (ujrah) charged for safe-keeping, then the gold will be retained by the bank. • Thus, for gold valued at RM2,000 the margin of advance is RM1,000 and the relevant fees are 50 cents per RM100 in the value of the gold – this RM 2,000 / 100 x 0.5 = RM10 per month.

Given that interest (riba) is not implicated in the rahnpawn-broking business, how would a company running an Islamic pawn business (murtahin) make money? • The answer is simple. Profits take the form of storage fees charged on the pledged property. There is a standard formula how these fees are determined. For example, in the case of a pledge valued at $1,000, the pledger (rahin) is required to pay a storage fee, say a percentage of the total value of the pledge.

According to Bank Rakyat, a pledge valued at less than $1,000 will cost the rahin (1,000/100) x 40 sen or $4 a month. Normally, only about half of the pledge value is given to the rahin as an interest-free loan. Thus, a $500 loan payable in 6 months will incur a storage cost of $4 x 6 = $24.

On failure to pay the loan after a prolonged reminder, the operator holds the right to put the collateral on auction.. The rahn company will claim loan plus storage fees due to them. The surplus therein will be returned back to the rahin. • In case he cannot be located, the proceeds will be forwarded to the bait-ul-mal from which the rahin is entitled to make future claims. • At the end of the term, the rahin will pay the murtahin $524. The rahin can ask for periodic loan extension provided he pays an additional storage fee.

In case he cannot be located, the proceeds will be forwarded to the bait-ul-mal from which the rahin is entitled to make future claims. • In fact, al-rahn can be a better alternative to finance stocks purchases compared to credit cards and share-financing loans. At least the money an individual obtains via al-rahn is backed by productive assets.

The pawnee (murtahin) is not entitled to use the collateral (rahn), for his right is only in the possession of the pledge and not in its use. If the company uses the pledge for its own benefit without informing the debtor and then incurs a loss, it takes full liability for the loss incurred.

Share margin Financing-i is an alternative to conventional Share Trading Financing based on Murabahah. • Under this contract, IFI agrees to finance the customer’s share trading activities in approved Shariah counters listed in Bursa Malaysia SHARE PURCHASE FINANCING

Murahbaha share purchase involves a fixed return, whereby the shares are acquired by the bank and re-sold to the customer for deferred credit price. • Additionally, stocks deemed Shariah compliant involve a qualitative and quantitative analysis, which necessitate financial screening.

For share margin financing, the Selling Price rate is capped at the murabahah profit rate, so that customers avoid fluctuating rates over period of the financing. • The financing tenure is typically between 1 and 5 years, with a minimum of RM 50,000.

Have a good day  May God bless you Thank you and Wassalam

COMPILED BY HAMDAN HJ IDRIS, BSc Econs, MBA (Islamic Banking & Finance)