Modes of Islamic Finance Assignment

University of Punjab
Gujranwala Campus
Financial Institutions
Assignment
Submitted to: Sir Sajid Nazir
Submitted by: Group 2 Sohaib Asif (BB08102) Ali Sajid (BB08119) Arslan Javed (BB08138)
Introduction
Prohibition of interest is ordained in Islam in all forms and intent. This Prohibition is strict, absolute and unambiguous. The Holy Qur'an in verse 278 of Surah Al- Baqarah states: "O ye who believe! Fear Allah and give up what remains of your demand for riba, if ye are indeed believers." and verse 2: 279 says "If you do it not, take notice of war from Allah and His Messenger. But if ye turn back, ye shall have your capital sums. Deal not unjustly and you shall not be dealt with unjustly." It therefore, follows that interest is prohibited as it leads to injustices (zulm) and Islam is against all forms of injustices and exploitations and pleads an economic system, which aims at securing extensive socio-economic justice. The Islamic law of prohibition of riba, which includes interest, was originally not based on economic theory but on Divine Authority which considers the charging of interest as an act of injustice. There could be no denying of the fact that under the interest-based system of banking or in a system not strictly based on the principles and spirit of Shariah, depositors as well as borrowers are exploited in one form or the other. It is however, significant to note that, as in the case of conventional banking, the depositors are being exploited most under the system and practices enforced by banks and financial institutions operating world-wide under the banner of Islamic banking. Islamic banking made its debut over a quarter a century ago. At present 200 Islamic banks and financial institutions, operating in 27 Muslim and 16 non-Muslim countries, are managing a portfolio of about $200 billion. It is now the time to pose the following questions: i. Whether banks operating under the banner of Islamic banking have succeeded in the elimination of injustices of the interest-based system as ordained by Holy Qur'an (2:279)? ii. Whether banks operating under the banner of Islamic banking have contributed to the attainment of socio-economic justice in line with the objectives of Islamic economic system? iii. Whether banks operating under the banner of Islamic banking are, for all practical purposes, not following the bench marks of interest-based system under Murabaha, Bai-Mu'ajjal or the like modes of financing? iv. Whether the net result in modes referred to at (iii) above really differs much from the interestbased loaning? v. Whether by adopting the modes referred to at (iii) above, banks assume any responsibility for the operational losses of the party availing finances from them? vi. Whether sharing in the operational losses are not the essence of Islamic system of banking?
vii. Whether large scale financing on a perpetual basis, on modes approved for "Sale transactions", can continue to be made for an indefinite period by Islamic banks which are not trading houses but are financial institutions? While attempting to firm up views in respect of above questions, it must be kept in view that Islamisation of banking system is a part of overall Islamic value system and is not merely refraining from interest-based transactions. The objective of Islamic banking system is to make a positive contribution to the fulfillment of socioeconomic objectives of the society in all spheres, including trade, industry & agriculture etc.
Mudarabah (Passive Partnership)

This is a contract between two parties: a capital owner (rabb-al-ml) and an investment manager (mudrib). Profit is distributed between the two parties in accordance with the ratio that they agree upon at the time of the contract. Financial loss is borne by the capital owner; the loss to the manager being the opportunity cost of his own labor, which failed to generate any income for him.
Musharakah (Active Partnership)

A musharakah contract is similar to that of the mudarabah, with the difference that in the case of musharakah both partners participate in the management and provision of capital and also share in the profit and loss. Profits are distributed between partners in accordance with agreed ratios, but the loss must be distributed in proportion to the share of each in the total capital.
Diminishing Partnership
This is a contract between a financier (the bank) and a beneficiary in which the two agree to enter into a partnership to own an asset, as described above, but on the condition that the financier will gradually sell his share to the beneficiary at an agreed price and in accordance with an agreed schedule.
Murabahah (Sales Contract at a Profit Markup)

Under this contract, the client orders an Islamic bank to purchase for him a certain commodity at a specific cash price, promising to purchase such commodity from the bank once it has been bought, but at a deferred price, which includes an agreed upon profit margin called markup in favor of the bank.
Ijarah (Leasing)
The subject matter in a leasing contract is the usufruct generated over time by an asset, such as machinery, airplanes, ships or trains. This usufruct is sold to the lessee at a predetermined price. The lessor retains the ownership of the asset with all the rights as well as the responsibilities that go with ownership.
A Lease Ending in the Purchase of the Leased Asset

Leasing that ends in the purchase of the leased asset is a financing contract which is intended to transfer ownership of the leased asset to the lessee at the end of the lease agreement. This transfer of ownership is made through a new contract, in which the leased asset is either given to the lessee as a gift or is sold to him at a nominal price at the end of the lease agreement. According to a decision of the OIC Fiqh Academy, this second transfer-of-ownership contract should be signed only after termination of the lease term, on the basis of an advance promise to affect such a transfer of ownership to the lessee. Rent installments are calculated in such a manner as to include, in reality, recovery of the cost of the asset plus the desired profit margin.
Istisna
Al-Istisn is a contract in which a party orders another to manufacture and provide a commodity, the description of which, delivery date, price and payment date are all set in the contract. According to a decision of the OIC Fiqh Academy, this type of contract is of a binding nature, and the payment of price could be deferred.
Salam
Salam is a sales contract in which the price is paid in advance at the time of contracting, against delivery of the purchased goods/services at a specified future date. Not every commodity is suitable for a salam contract. It is usually applied only to fungible commodities.
Classification and Utilization of Islamic Modes of Financing:

Islamic banks utilize Islamic modes of financing on two sides: 1. The side of liabilities or resource mobilization 2. The side of assets or resource utilization. On the resource mobilization side, the mudrabah mode, either general or restricted to a certain business line, is the mode most frequently used. The bank and the investment deposit holders share the realized profit in accordance with the ratios agreed upon between the parties at the time of contracting. The deposits in the current account are treated as if they are loans from the clients to the bank and therefore, bear no yield to the account holders. However, being loans to the bank, their principal is guaranteed by the bank. Islamic banks have achieved significant success in attracting resources on the basis of the mudrabah contract. When utilizing these resources for income generation, Islamic banks use both fixed return modes such as murbahah and leasing and variable return modes such as mudrabah and mushrakah. While, on the liabilities side, Islamic banks have made significant progress in using profit sharing, this is not the case on the assets side. The share of profit-sharing modes in the total financing provided by Islamic banks is very small. Most of the financing is provided on a murbahah basis

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University of Punjab

Submitted to: Sir Sajid Nazir

Mudarabah (Passive Partnership)

Musharakah (Active Partnership)

Murabahah (Sales Contract at a Profit Markup)

A Lease Ending in the Purchase of the Leased Asset

Classification and Utilization of Islamic Modes of Financing:

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