Introduction to Islamic Banking & Finance Abdulazeem Abozaid
Basis of IBF • Islamic Finance is based on principles that are derived from the Quran and Sunna of the Prophet peace be upon him. • The basic principle in Islamic Law is permissibility. Under this principle all commercial and financial transactions are permissible except those that contain prohibited elements.
How does Islamic Finance differ from conventional finance ? Islamic Modes of Finance & Investment are committed to all Sharia Prohibited Practices • Prohibited Practices • Riba ( Interest ) • Sale of Debt • Ghabn (Fraud) • Gharar (Uncertainty) • Dealing in unlawful properties
What is Riba? • Literally: Increase. • Technically: stipulated increase over the loan which a debtor agrees to pay to his creditor in relation to time. Rationale: • Money does not have an intrinsic value. It is a measuring tool, a store of value unit and a medium of exchange, not a commodity that could be bought or sold • Lending = renting money
Sale ofDebt Sale of debt occurs in: • Discounting commercial papers • Dealing in bonds • Sale of Sukuk, shares or fund units when they do not represent tangible assets, usufructs or services
Uncertainty (Gharar) Gharar: Uncertainty/Ambiguity in a contract Examples of Gharar: • Selling unknown goods - The contents of a sealed box are sold; presumably, the box contains a collection of goods, without specifying the quantity of each. - Buying an a commodity for unknown price; what’s in one’s wallet/pocket. • Gambling The gambler is ignorant of the result of the gamble; the outcome depends on chance and not efforts. Rationale: Uncertainty is likely to lead to dispute between contracting parties.
GHABN • Deception that leads the seller to underestimate or the buyer to overestimate the price of the good. • It can be divided into two kinds: • Slight or minor Ghabn (الغبن اليسير). It is tolerated in contracts. • Large, excessive, or major Ghabn (الغبن الفاحش). Not tolerated. • Examples: • Selling at higher than the market value by means of cheating • Bidding a price without intending purchase, just to increase the price payable by the actual purchaser (Najash). • Covering defects and selling as defect free.
Dealing in Unlawful Properties • Liquor • Intoxicants • Lawful properties but used for unlawful purposes
DIFFERENT PRICING FOR CASH AND CREDIT SALES • Price in deferred sale is higher than spot sale. • The bank purchases goods on cash and sells them on credit. The forward price depends on the repayment period. The longer is the maturity, the higher the price. • Such price difference, being dependent upon repayment time, is it similar to the interest charged on conventional loans?
Why price should be higher with spot than deferred payment? • In fact, price difference is similar to the difference between the price of the same commodity under present and future delivery. • Price difference is due to the degree of urgency of benefiting from the direct use of real commodities. • Similarly, prices charged with deferred payment should justifiably be higher than with spot payment. The difference is not Riba.
Cont’d • The misconception stems from misunderstanding of the prohibition of Riba • Modern capitalist theory does not differentiate money and physical commodity • Both are seen as factors of production, money is a form of commodity
Cont’d In Islam, money is differentiated from commodities Money has no intrinsic utility. It cannot be utilized directly . As a means of exchange, money can only be used to: Acquire goods and services. Store some wealth, As a unit of account to measure the monetary value of things.
Cont’d Commodities, on the other hand, have intrinsic utility and can be utilized directly. Because money has no intrinsic utility, present money does not command a higher value than future money when money is exchanged for money. Present money cannot therefore be sold for a higher quantity of future money, as both have no value of their own. Conclusion: Sharia acknowledges time value of money in sale contract, not in loan contracts since money cannot be treated as commodity.
Classification of Islamic Banking Products: Deposit (Wadi’a) products: • Current account; based on Loan • Saving account; based on Mudaraba • Time deposit; based on Mudaraba/wakala (agency in investment)
Financing Products Sale-based financing contracts: • Murabaha • Forward Sale • Salam • Istisna • Ijara Financing Equity-based financing contracts: • Mudaraba • Musharaka Fee based Financing • Wakala
Buy-Back Sale (Einah) • Einah refers to selling a commodity on a deferred basis then buying it bank on a spot basis at a lower price. • Obviously, it is meant for extending interest-based debt. • This legal trick cannot be condoned by Shariah. • Some applications: • Personal Financing • Overdraft Facility • IPDS: ‘Islamic’ Private Debt Securities
IN COLLUSION WITH SUPPLIER EINA SALE EINA SALE INDIVIDUAL IMMEDIATELY AFTER PURCHASEGOODS, DEFERRED PAYMENT WANTS CASH SELL FOR IMMEDIATE CASH SAME SUPPLIER 19
IPDS: Creation of debt (dayn) via Einah Sell Asset X for $100m Investor (Financier) Issuer Cash payment $100m Sell Asset X for $120m Deferred payments $120m Securities issued against the debt and made negotiable
Tawarruq • Tawarruq refers to purchasing a commodity from one party on credit then selling it immediately to another for cash. • Tawarruq shares the same objective of Eina as both are meant for obtaining cash. • Some applications: • Personal & Corporate Financing • Overdraft Facility
BANK SELL ON MURABAHA BUY METAL PROMISE TO BUY AGENCY AGREEMENT SELL METAL FOR IMMEDIATE CASH INSTITUTIONAL TAWARRUQ التورق المؤسسي CUSTOMER COLLUSION WITH BANK NEEDS CASH LME
Sale of Debt (Bay’ al-Dayn) • Although sale of debt is prohibited in the Shariah, it has been unlawfully practiced in Islamic finance, like in: • ‘Islamic’ factoring • ‘Islamic’ accepted bills • ‘Islamic’ Debt Securities • With these arrangements, the underlying consideration is the permissibility of the sale of debt, by the creditor, at a discount • Based it on the assumption that Debt arising from sale of commoditiesis different from debt arising from a money loan.
The Criterion of the Non-Shari’ah Compliant Transaction • When a financing mode is structured in such a way that secures a guaranteed profit to the financier without taking any risks. Or, when the financier acts in reality as a creditor who provides money without being involved in the investment process; i.e. when the substance is interest-bearing debt. • This will render the transaction impermissible regardless of its legal form, e.g. sale, lease… . • Some banks’ Sharia boards attempt to validate transactions based on their legal forms.
PAYMENT SERVICES PROFIT SHARE CUSTOMERS WAKALA FEES checks CASH AS QARD HASSAN CASH AS MUDARABA OR WAKALA debit cards INVESTMENT DEPOSITS UNRESTRICTED ATM Money transfer ISLAMIC BANKS DEMAND DEPOSITS RESTRICTED
A SHARE IN PROFITS FINANCE ISLAMIC BANK A SHARE IN MANAGEMENT EXTINGUISH gradually EQUITY FINANCE, MUSHARAKA DIMINISHING FUND USER
ISLAMIC BANK UNRESTRICTED MONITORING RESTRICTED MUDARABA + - DO NOT’S DO’S FUND USER TRANSPARENCY
DEFERRED PAYMENT LUMP-SUM OR INSTALLMENTS Buyer Promise to Buy SPOT DELIVERY Murabahah contract SPOT PAYMENT ISLAMIC BANK Sale Contract SPOT DELIVERY MURABAHA SUPPLIER
DEFERRED PAYMENT SALE DEFERRED PAYMENT: LUMP-SUM OR INSTALLMENTS Buyer DEFERRED-PAYMENT SALE CONTRACT SPOT DELIVERY OWNS COMMODITIES ISLAMIC BANK
CUSTOMER MANUFACTURER PAYMENTS IN STAGES DELIVERY OF ASSET REQUIRES AN ASSET WITH CERTAIN SPECIFICATIONS COMMISSION TO MANUFACTURE PARALLEL ISTISNA ASSET DELIVERY INSTALLMENTS ISTISNA’ COMMISSION TO MANUFACTURE ISTISNA’ REQUIRES AN ASSET WITH THE SAME SPECIFICATIONS BANK
FORWARD LEASE TITLE TRANSFER: Conditional promise to gift or sell at token price CUSTOMER RENTAL PAYMENTS = USUFRUCT AND PART OF ASSET VALUE ASSET PRICE REAL ESTATE OWNER DELIVERY, LEASE STARTS PROMISE TO LEASE USUFRUCT IJARAH FINANCING DELIVERY PURCHASE BANK
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