Applied Islamic Banking

By:
Prof. Dr. Mohd. Ma’sum Billah
masum@applied-islamicfinance.com
masum2001@yahoo.com
+6019-3699542

A project financing is a financing of a particular economic unit in which a lender is satisfied to look initially to the cash flows and earnings of that economic unit as the source of funds from which a loan will be repaid and to the assets of the economic unit as collateral for the loan. The ultimate goal in project financing is to arrange a borrowing for a project which will benefit the sponsor and at the same time be completely non-recourse to the sponsor, in no way affecting its credit standing or balance sheet. This can be accomplished by using the credit of a third party to support the transaction.

In doing business, a businessman can harm others if he behaves in an immoral way, but if he behave morally he can do well. Islamic finance is almost the same as conventional finance except that Islamic finance is governed by the sharia thus subject to a code of conduct. The need of an Islamic financing rose from the need of doing lawful business. Some people have money but they do not have skills in management, farming, or doing business. Other people have skills but lack money to undertake business. This created a need to develop a system which can help everyone. Muslims scholars came up with many financial instruments that can be used to undertake Islamic projects financing. For the purpose of this assignment we focus on few instruments .Islamic project Islamic finance consists of two elements:

The organization includes the sponsors, issuer, investors and, the trustee and the structuring (instruments) includes debt, leasing, equity and hybrid. There are several alternatives to interest-based financing. First, there are the participatory modes such as partnership. Second there the sale-based modes and third, there are the rent –based modes. For example we have mudharaba which is a case where one partner (called rabbul mal or owner of capital) provides capital while the other (called mudarib or entrepreneur) provides his effort to expertise. Musharakah is when both parties contribute to capital. The quantum of effort put in by either partner is not critical in this regard. Istisna is a contract to purchase now, for a definite price, something that may be manufactured or constructed later according to agreed specifications. istisna is a special type of sale contract.

Sharikah literally means Sharing and participation. It also means a property that belongs to several co owners in such a way that each one has ownership of every smallest part of it in proportion to the share allocated to him. In Hadith qudsi it is stated that Allah (SWT) is the third of the two partners as long as they do not betray each other, if they betray each other Allah (swt) withdraws his blessings from the partnership. In business and trade it means a joint enterprise in which all the partners share the profit or loss of the joint venture. It is an ideal alternative for the interest-based financing with far reaching effects on both production and distribution. In the modern capitalist economy, interest is the sole instrument indiscriminately used in financing of every type. Since Islam has prohibited interest, this instrument cannot be used for providing funds of any kind. Therefore, 'Musharakah' can play a vital role in an economy based on Islamic principles.

The proportion of profit to be distributed between the partners must be agreed upon at the time of affecting the contract. If no such proportion has been determined, the contract is not valid in Shari‘ah. The ratio of profit for each partner must be determined in proportion to the actual profit accrued to the business, and not in proportion to the capital invested by him. It is not allowed to fix a lump sum amount for any one of the partners, or any rate of profit tied up with his investment.
In the case of loss, all the Muslim jurists are unanimous on the point that each partner shall suffer the loss exactly according to the ratio of his investment. Therefore, if a partner has invested 40% of the capital, he must suffer 40% of the loss, not more, not less, and any condition to the contrary shall render the contract invalid. There is a complete consensus of jurists on this principle.
Most of the Muslim jurists are of the opinion that the capital invested by each partner must be in liquid form. It means that the contract of musharakah can be based only on money, and not on commodities. In other words, the share capital of a joint venture must be in monetary form. No part of it can be contributed in kind. However, there are different views in this respect.

Two partners, the bank and the customer may sign a Musharakah contract to finance certain investment activity (project). Each partner will contribute in the capital of this activity with a certain share. The profit will be distributed between them on the agreement. As soon as the activity starts and profit are realized, one of the partner (the bank may withdraw gradually from the project by selling part of its share to its partners (the customers). The share of the bank in the profits shall also diminish with the same proportion by which its share in the capital is reduced, while the share of the buyer in both the project and the profits will increase at the same time. This type of partnership may also be called Decreasing Musharakah- where the bank encourages the other partner and provides him with an option to gradually buy the banks share. Another way is whereby a financier and his client participate either in the joint ownership of a property or an equipment, or in a joint commercial enterprise. The share of the financier is further divided into a number of units and it is understood that the client will purchase the units of the share of the financier one by one periodically, thus increasing his own share till all the units of the financier are purchased by him so as to make him the sole owner of the property, or the commercial enterprise, as the case may be. The guidelines to be followed are:

The entrepreneur has the option to purchase. However he cannot be forced to buy the shares.
The prices for which the share is purchased are negotiable. It should be based on the market price, which may be more or less or the same with the nominal price.
The bank may benefit from this type of Musharakah by making profit and the Entrepreneur acquires a productive enterprise.
Examples of Diminishing Musharakah are given below.

1. It has been used mostly in house financing. The client wants to purchase a house for which he does not have adequate funds. He approaches the financier who agrees to participate with him in purchasing the required house. 20% of the price is paid by the client and 80% of the price by the financier. Thus the financier owns 80% of the house while the client owns 20%. After purchasing the property jointly, the client uses the house for his residential requirement and pays rent to the financier for using his share in the property. At the same time the share of financier is further divided in eight equal units, each unit representing 10% ownership of the house. The client promises to the financier that he will purchase one unit after three months. Accordingly, after the first term of three months he purchases one unit of the share of the financier by paying 1/10th of the price of the house. It reduces the share of the financier from 80% to 70%. Hence, the rent payable to the financier is also reduced to that extent. At the end of the second term, he purchases another unit increasing his share in the property to 40% and reducing the share of the financier to 60% and consequentially reducing the rent to that proportion. This process goes on in the same fashion until after the end of two years, the client purchases the whole share of the financier reducing the share of the financier to 'zero' and increasing his own share to 100%.
This arrangement allows the financier to claim rent according to his proportion of ownership in the property and at the same time allows him periodical return of a part of his principal through purchases of the units of his share.

2. 'A' wishes to start the business of ready-made garments but lacks the required funds for that business. 'B' agrees to participate with him for a specified period, say two years. 40% of the investment is contributed by 'A' and 60% by 'B'. Both start the business on the basis of Musharakah. The proportion of profit allocated for each one of them is expressly agreed upon. But at the same time 'B's share in the business is divided to six equal units and 'A' keeps purchasing these units on gradual basis until after the end of two years 'B' comes out of the business, leaving its exclusive ownership to 'A'. Apart from periodical profits earned by 'B', he gains the price of the units of his share which, in practical terms, tend to repay to him the original amount .invested by him.

3. 'A' wants to purchase a taxi to use it for offering transport services to passengers and to earn income through fares recovered from them, but he is short of funds. 'B' agrees to participate in the purchase of the taxi, therefore, both of them purchase a taxi jointly. 80% of the price is paid by 'B' and 20% is paid by 'A'. After the taxi is purchased, it is employed to provide transport to the passengers whereby the net income of Rs. 1000/- is earned on daily basis. Since 'B' has 80% share in the taxi it is agreed that 80% of the fare will be given to him and the rest of 20% will be retained by 'A' who has a 20% share in the taxi. It means that Rs. 800/- is earned by 'B' and Rs. 200/- by 'A' on daily basis. At the same time the share of 'B' is further divided into eight units. After three months 'A' purchases one unit from the share of 'B'. Consequently the share of 'B' is reduced to 70% and share of 'A' is increased to 30% meaning thereby that as from that date 'A' will be entitled to Rs. 300/- from the daily income of the taxi and 'B' will earn Rs. 700/-. This process will go on until after the expiry of two years, the whole taxi will be owned by 'A' and 'B' will take back his original investment along with income distributed to him as aforesaid.
From the Shari‘ah point of view this arrangement is composed of different transactions which come to play their role at different stages. Therefore, each one of the three forms of diminishing Musharakah is discussed below in the light of the Islamic principles In the First example of Diminshing Musharakah, 'Shirkat-al-Milk' (joint ownership) can come into existence in different ways including joint purchase by the parties. This has been expressly allowed by all schools of Islamic jurisprudence. Therefore no objection can be raised against creating this joint ownership. The second part of the arrangement is that the financier leases his share in the house to his client and charges rent from him. This arrangement is also above board because there is no difference of opinion among the Muslim jurists in the permissibility of leasing one's undivided share in a property to his partner. If the undivided share is leased out to a third party its permissibility is a point of difference between the Muslim jurists. The third step in the arrangement is that the client purchases different units of the undivided share of the financier. This transaction is also allowed. If the undivided share relates to both land and building, the sale of both is allowed according to all the Islamic schools. Similarly if the undivided share of the building is intended to be sold to the partner, it is also allowed unanimously by all the Muslim jurists. However, there is a difference of opinion if it is sold to the third party. In the second example of Diminishing Musharakah which involves trade. The arrangement is simply a Musharakah whereby two partners invest different amounts of capital in a joint enterprise, Purchase of different units of the share of the financier by the client. This may be in the form of a separate and independent promise by the client. The requirements of Shari‘ah regarding this promise are the same as explained in the case of House financing with one very important difference. Here the price of units of the financier cannot be fixed in the promise to purchase, because if the price is fixed before hand at the time of entering into Musharakah, it will practically mean that the client has ensured the principal invested by the financier with or without profit, which is strictly prohibited in the case of Musharakah. Therefore, there are two options for the financier about fixing the price of his units to be purchased by the client. One option is that he agrees to sell the units on the basis of valuation of the business at the time of the purchase of each unit. If the value of the business has increased, the price will be higher and if it has decreased the price will be less. Such valuation may be carried out in accordance with the recognized principles through the experts, whose identity may be agreed upon between the parties when the promise is signed. The second option is that the financier allows the client to sell these units to any body else at whatever price he can, but at the same time he offers a specific price to the client, meaning thereby that if he finds a purchaser of that unit at a higher price, he may sell it to him, but if he wants to sell it to the financier, the latter will be agreeable to purchase it at the price fixed by him before hand.

When funds are required for the working capital of a running business, the instrument of Musharakah may be used in the following manner: The capital of the running business may be evaluated. The value of the business can be treated as the investment of the person who seeks finance. While the amount given by a bank can be treated as its part of the investment. Both parties agree on a certain percentage of the profit. On the expiry of the specified term, all liquid and non liquid assets of the business are again evaluated, and the profit may be distributed on the basis of this evaluation.

Mudarabah is a type of contract where one of the parties provides capital and the other expertise, labour, and entrepreneurial skill to conduct a particular business where both parties would share profit .mudharabah enables both parties to make profit. According to the majority of the fiqh schools, the contract of mudharabah has three pillars. They are the parties that consist of the owner of the capital (sahib al mal) and the manager of the fund (mudharib or aamil), the subject matter of the contract which include the capital, the efforts, and the profit, and the expression which is made of the offer and acceptance.

The parties should have the competence to become agents. The manager while investing the capital of the sahib al mal represents him.

The capital should be in currencies that are commonly in circulation it is not allowed for the sahib al-mal to contribute in the form of goods or other immovable properties. The majority of the fiqh schools argue that it may lead to uncertainty as to the real amount of capital and the profit. This is because the price of the goods may fluctuate. The amount of the capital should be known. It is important as it may lead to a clear distinction between the capital and the profit.

The capital should be present. It is, for instance, not allowed for a creditor to enter into a mudharabah with his debtor.

The capital should be clearly mentioned, this is to separate it from the profit which will be made later. The capital should come to the complete possession of the mudharib.

The division of the profit should be clearly defined on the basis of the proportionality.

The bank gives the funds to the modarabah and the bank client provides the effort. He uses the fund to undertake an economic activity. When the business grows, it generates profit. The bank client pays back the principal plus the share in profits to the bank and for him he takes the share in profits, there is no wage.

It is not allowed that a mudharib should take his share of the profit without informing the owner of the capital. Any such division should be done in the presence of both parties. Distribution of the profit in mudarabah can only take place after the losses have been written off and the capital of the sahib al mal has been fully restored. Any distribution of profit before mudharabah comes to an end is considered as an advance taken from the profit. If the payment of zakat is not stipulated in a condition such payment is to be charged on the owner of the capital.

The mudharib is a trustee. If the property or cash is destroyed or lost in his hand, he is not held responsible unless negligence or a willful act is proven. His statement accompanied by oath should accept.

The mudharabah cannot claim any periodical salary or a fee for the work done by him for the mudharabah. The maintenance expenses of a mudharib are on him. He cannot take from the money invested for mudharabah.

The mudharabah is terminated when it is cancelled or when a mudharib is prevented from using the fund, or when he is dismissed. mudharabah is terminated when one of the parties loses his capacity or when a mudharib fails in his duties, and his failure is willful, intentional and out of his negligence.

Istina is a contract with a manufacturer who provides both raw materials and labor to manufacture a specifically defined product for a determined price and deliver it at a specific time .istisna is distinguished from the ordinary contract of sale by the fact that the former involves labor while the latter does not .istisna is distinguished from ijara by the fact that in the former the manufacturer undertakes to make the required goods with his own material. If the customer provides material, and the manufacturer contributes his labour and skill, the transaction falls under ijarah.

The item to be manufactured should be described precisely. The nature, type, quality, quantity, and all other descriptions of the item to be manufactured should be known.

Istisna is valid in respect of those goods that are customarily sold based on a prior order. In other words the item is such that requires time to be made and the common practice of the society acknowledges this.

Date of delivery of the manufactured asset should be specified in the contract. The manufacturing process on the commodity should be mentioned in the contract.

Istisna contract is a binding contract for both the parties (the manufacturer and the buyer).this means that any party cannot cancel the contract unilaterally and is obliged to fulfill its obligation at all times.

An Islamic bank instead of giving loan to the customer buys the commodity from the manufacturer and sells it to the customer. The bank may enter into istisna contract with a manufactures for the production of certain specifically prescribed commodity for which it has got an order. After the bank receives the commodity, it can sell them based on murabahah, and BBA .it is also possible for the bank to enter into istisna contract with a buyer, and then enter into a parallel istisna contract with the manufacturer. The payment in the both istisna contracts can be immediate or deferred. Any disagreements that may arise between the parties are settled under each contract separately.

The suitability of istisna for financial intermediation is based on the fiqh permissibility for the contractor in istisna to subcontract. Thus a financial institution may undertake the construction of a facility for a deferred price, and subcontract the actual construction to a specialized firm.

Let’ say the public authority first defines the specifications of a fixed investment project it wants to establish, and the number of years it requires to repay the price. Bids are invited on that basis from investors/contractors who would undertake to construct the required facilities and sell them to the public authority for a price to be paid in installments.

When the facilities are building and the istisna contract consummated, the full ownership of the facilities is immediately transferred to the public authority, against the deferred sale-price that would normally cover not only the construction cost but also a profit. That profit could legitimately include the cost of tying funds for the duration of the repayment period. Legitimately that is, from the shariah point of view. The investors could take upon themselves the legal responsibility of getting the facilities constructed, and sub-contract the work to manufacturers/contractors with the consent of public authority.

Islamic Project Financing as conveyed in our paper portrays the best source of financing since it’s abstain from from Riba and conforms to the principles of Shariah and most of all provides a source of Financing our business activities. There are many tools which could be used in Islamic Financing like Musharakah (Decreasing), Mudharabah and Istisnaa, and others, all of which could be very useful for entrepreneurs. The Islamic banks play vital role in ensuring the well being of Islamic Financial Systems as well and great effort have been put by scholars and concerned Government to contribute much in the success of the System.