Monday, September 1, 2008

Islamic Banking Concepts

Wadiah
Islamic banks in Malaysia mostly use Wadiah concept to accept deposits from customers. Under this Islamic scheme of savings and current account, depositors will enjoy interest free safekeeping services of their money, as well as a share of any profit that the bank makes by utilising the deposits.

Banks typically use an Islamic banking principle that is known as "Wadiah Yad Dhamanah" which means guaranteed custody or savings with guarantee. This scheme ensures that Islamic financial institutions acquire deposits under Islamic banking principles. The core of this arrangement is that the bank has the authority to use deposits and give a guarantee to return it to depositors when demanded. The depositors are not entitled to any share of the profits but the bank may provide returns periodically to the depositors as a token of appreciation. The portion of profit to be shared with depositors is at the absolute discretion of the bank. This reward is the alternative to the interest income that depositors would otherwise receive from a conventional bank.

Mudharabah (profit sharing)
An Mudharabah transaction is derived from a partnership based on risk and profit sharing. This partnership is a collaboration between an investor (Rabbul Mal) and an entrepreneur (Mudharib) under which the former provides funds to the latter for the purpose of investment and profit sharing. This is how it works in practice - the customer (which is the investor) will deposit an amount of money with the bank (which acts as the entrepreneur).

This investment is utilised as business capital by the bank. In this contract, the customer (investor) has no authority to interfere in the management of its investment. On the other hand, the bank will have the right to manage the investments as it thinks fit by placing it into businesses that are permissible in Islam, and which it thinks are profitable.

Depending on the tenure of the investment, the customer will be offered a pre-agreed profit sharing ratio which will form the basis of the agreement made between the customer and the bank. On the date that the investments mature, the bank will distribute a share of accumulated profits into the customer’s investment account.

Bai Bithaman Ajil (BBA) or Al-Bai Bithaman Ajil (deferred payment sale)
Bai Bithaman Ajil is a common mode of Islamic financing used for property, vehicle, as well as financing of other consumer goods. Technically, this financing facility is based on the activities of buying and selling. The property that the customer wishes to purchase for example, are bought by the bank and sold to the customer at an agreed to price, once the bank and customer determine the tenure and the manner of the instalments. The price at which the bank sells the property will include the actual cost of the property, and will also incorporate the bank's profit margin. There is no interest charged and the extra price compensates the bank for its profit. Instalments remain fixed over the period of the contract and no adjustment is made if the prevailing interest rates fluctuate. The fixed monthly instalments are determined by the selling price, repayment period and the percentage margin of financing. The profit earned by the bank is legitimate from the Shariah point of view since the transaction is based on a sale contract rather than a loan contract.

Bai Inah or Bai’ al-Inah (sell and buy back)
This refers to the selling of an asset by the bank to the customer through deferred payment.

Bai Inah comprises two agreements (akad). In the first agreement, the bank sells an identified asset to the customer at an agreed price. The customer can complete the purchase of bank's asset via fixed monthly instalments on agreed tenure. While for the second agreement, the bank re-purchases the same asset from the customer at a lower price. Upon completion of the second transaction, the bank will pay the lump sum amount as per agreed by both parties in the agreement.

The difference in the price is therefore the bank's maximum profit, which is determined in advance.

Ijarah (leasing)
Ijarah in Arabic means to give something on rent, which resembles leasing as it is practised in today’s commercial world. As in a normal lease transaction, a lessor who owns the leased asset will lease it to the lessee in exchange for rental. The unique feature offered by this financial instrument is that the asset remains the property of the bank and can be put on rent every time the lease period terminates. Ijarah is suitable for high-cost assets with a long life span. Both contracting parties benefit where the lessee will get the full benefit of using the lease asset within the specified period (for as long as he adheres to the lease terms and conditions) without incurring a large capital expenditure. On the other hand, the bank receives the rent as return and also retains the asset. At the end of the lease period, the leased asset will be returned to the lessor.

There are some other variants of leasing which incorporate the transfer or option to transfer ownership of the leased asset from the lessor to the lessee at the end of the lease period. These include:

Ijarah Thumma Bai or al-Ijarah Thumma al-Bai’ (AITAB) - Lease Agreement Incorporating Sale of Leased Asset at the end of the lease tenure. Refers to an Ijarah (leasing/renting) contract to be followed by Bai' (purchase) contract. Under the first contract, the hirer leases the goods from the owner at an agreed rental over a specified period. Upon expiry of the leasing period, the hirer enters into a second contract to purchase the goods from the owner at an agreed price.

Ijarah Muntahiya Bil Tamlik - Lease Agreement with option to Own Leased Asset at the end of the lease tenure

Ijarah Wal Iktina - Lease Agreement with option to Acquire Leased Asset at the end of the lease tenure

Istisna' (project financing)
Istisna' is by definition an order sale used mainly in financing assets that are under construction, i.e., where a commodity is transacted before it comes into existence.

For instance, one can order a manufacturer to make a specific commodity for the purchaser. If the manufacturer undertakes to make the goods for the customer with material from the manufacturer, the transaction is known as istisna. The price of the commodity to be manufactured must be agreed by both parties.

Istisna is a contract of exchange with deferred delivery, applied to specified made-to-order items. Istisna is suitable for high-technology industries such as the automotive, shipbuilding and construction industries. This agreement allows the Bank to disburse payments according to the stage of completion. As a financier, the Bank rarely orders the asset for its own use.
Once completed, the asset will be handed over to the customer through a leasing arrangement (Ijarah), a deferred sale arrangement (Bai Bithaman Ajil), a cost plus arrangement (Murabaha) or a profit sharing arrangement (Mudharabah or Musyarakah).

Kafalah (guarantee)
Islamic banks use Kafalah to issue Bank and Shipping guarantees. Kafalah is a contract made between the Bank and another party whereby the Bank agrees to discharge the liability of a third party in the case of default by the third party. As a surety, the third party will give the bank some form of collateral and pay a small fee for the services.

Under the Kafalah Shipping Guarantee, the Bank gives a surety to the owner of the shipping vessel, to discharge goods to the importer pending receipt of the original bill of lading.

For the Kafalah Bank Guarantee, the bank guarantees the company's standing to facilitate any business endeavours that may require such guarantees.

Musyarakah Financing (joint venture)
Musyarakah a profit and loss sharing partnership. In a Musyarakah financing arrangement, the Bank and the Customer will both contribute their capital as well as expertise in a project. Profit and loss will be shared between partners according to some agreed formula depending on the equity ratio, normally based on the capital contribution. However, it is permissible to have profit sharing not according to the proportion of shares (ownership) but liability is limited to contribution of their shareholders. Investors cannot be held liable for more than the amount of capital they have invested.

Mudharabah Financing
As in Musyarakah financing, Mudharabah financing is a form of partnership where the Bank will provide the capital and the customer will provide the expertise. Both will agree on a profit sharing ratio. The customer will be solely responsible for running the business, project or contract without interference from the Bank. All forms of capital loss, if any, will be borne by the Bank and all forms labour loss, if any, will be borne by the customer.

Murabahah Financing (cost plus)
Murabahah financing arrangement is a trust sale financing arrangement. In this financing arrangement, the customer will first identify the goods to be financed. The bank will then secure the goods, add the mark up profit, deliver the goods and collect the payment from the customer - usually in deferred terms. In a Murabahah transaction, the cost price paid by the Bank must be transparent to the customer. Murabahah is widely used in short-term Islamic Trade Finance arrangements.

Under murabahah, the bank purchases, in its own name, goods that an importer or a buyer wants, and then sells them to the customer at an agreed profit. The bank takes title of the goods, and is therefore engaged in buying and selling. Its profit is derived from a real service that entails a certain risk, and is thus seen as legitimate.

Murabahah is one of the most widely used modes of short-term financing and follows a lump sum repayment schedule. It is suitable for purchase of commodities by customers operating in industry or trade. It enables customers to buy finished goods, raw materials, machines or equipment through the bank which may not be otherwise available directly to them due to their credit worthiness.

Wakalah (nominating another person to act)
Wakalah means agency, or the delegating of a duty to another party for specific purposes and under specific conditions. Under this concept, the bank acts as an agent in completing a particular financial transaction. As the agent, the Bank will be paid a certain amount of fee for the services it provides.

Bai’ al-Dayn (debt trading)
Refers to the buying and selling in the secondary markets of debt certificates, securities, trade documents and papers which are Shariah compliance. Only documents evidencing real debts arising from bona fide merchant transactions can be traded.

Qard (interest-free loan)
A loan extended on a goodwill basis and the borrower is only required to repay the principal amount borrowed. However, he may pay an extra amount at his absolute discretion, as a token of appreciation.

Bai’ Salam (future delivery)
Refers to an agreement whereby payment is made in advance for delivery of specified goods in the future.

Bai’ Istijrar (supply contract)
Refers to an agreement between the client and the supplier, whereby the supplier agrees to supply a particular product on an on going basis, for example monthly, at an agreed price and on the basis of an agreed mode of payment.

Rahnu (collateralised borrowing)
Refers to an arrangement whereby a valuable asset is placed as collateral for debt or right of claim. The collateral may be disposed in the event of default.

Hiwalah (remittance)
Refers to a transfer of funds/debt from the depositor's/debtor's account to the receiver's/ creditor's account whereby a commission may be charged for such service.

Sarf (foreign exchange)
Refers to the buying and selling of foreign currencies.

Ujr (fee)
Refers to commissions or fees charged for services.

Hibah (gift)
Refers to gifts award voluntarily in return for any transactions given or provided.

Tawarruq
Tawarruq refers to a transaction in which a financial institution sells a commodity to a customer on deferred payment at cost plus profit, and the customer then sells the commodity on a spot basis to a third party for cash. With tawarruq, customers can raise loan financing through buying instalments in a local commodity, owned by the Bank. The applicant then authorises the bank to sell his share in this commodity, on his behalf, to a third party for cash and then deposits the proceeds into his bank account.

Urbun
Earnest money held after a contract is established as collateral to guarantee contract performance

Riba’
The excess paid or received over and above the principal in a loan contract.

Ibra'
Rebate given by the Islamic banking institution for the unearned profits, in the event of early redemption of financing. The rebate will be in the form of a reduction in the balance outstanding of the selling price.

Qardhul Hassan
Benevolent loan

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