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Investment is the action of deploying funds with the intention and expectation that they will earn a positive return for the owner (Brokington 1986, p.68). Funds may be invested in either real assets or financial assets. When resources are used for purchasing fixed and current assets in a production process or for a trading purpose, then it can be termed as real investment. The establishment of a factory or the purchase of raw materials and machinery for production purposes are examples in point. On the other hand, the purchase of a legal right to receive income in the form of capital gains or dividends would be indicative of financial investments. Specific examples of financial investments are: deposits of money in a bank account, the purchase of Mudaraba Savings Bonds or stock in a company. Ultimately, the savings of investors in financial assets are invested by the respective company into real assets in the form of the expansion of plant and equipment. Since Islam condemns hoarding savings and a 2.5 percent annual tax (Zakat) is imposed on savings, the owner of excess savings, if he is unable to invest in real assets, has no option but to invest his savings in financial assets.
When money is deposited with an Islamic Bank, the bank, in turn, makes investments in different forms approved by the Islamic Shariah with the intent to earn a profit. Not only a bank, but also an individual or organization can use Islamic modes of investment to earn profits for wealth maximization. Some popular modes of Islamic Investment are discussed below. A comparison is also attempted between the Islamic Modes of Finance and these of conventional banks. A. ISLAMIC MODES FINANCE At the beginning it is better to give a clear definition of "Islamic Modes of Finance". The word "Modes" literally means "methods", or in other words, it refers to systematic and detailed rules, stipulations and steps to be followed for accomplishing a specific thing. The thing that needs to be accomplished in this context is, however, the subject matter of each of the said modes, i.e. any of the different types of investment activities (trade, leasing, real estate, manufacturing, agriculture, agriculture production etc., or, using Shariah expressions Murabaha, Mudaraba, Musharaka, Ijarah, Istisna, etc.). The word "Finance" in one of its different meanings refers to the supply of money capital or credit, provided by either a person (household), or an organization (private or public - financial or non financial). The word "Islamic" is inserted in the above expression to restrict the type of rules that can govern different modes of finance to the Shariah rules. A complete definition for the term "Islamic Modes of Finance"' may be given as follows:
"The systematic and detailed Shariah rules that govern the contractual relationship of an investment activity that can be applied for attracting money capital" (Fahmy & Sarkar). 1. BAI-MURABAHA 1.1 Meaning of Murabaha The terms "Bai-Murabaha" have been derived from Arabic words Bai and Ribhun. The word 'Bai' means purchase and sale and the word 'Ribhun' means an agreed upon profit. "Bai-Murabaha" means sale for an agreed upon profit. Bai-Murabaha may be defined as a contract between a buyer and a seller under which the seller sells certain specific goods permissible under Islamic Shariah and the Law of the land to the buyer at a cost plus an agreed upon profit payable today or on some date in the future in lump-sum or by installments. The profit may be either a fixed sum or based on a percentage of the price of the goods. 1.2 Types of MurabahaIn respect of dealing parties Bai-Murabaha may be of two types (IBBL 1986, pp.1-2): - Ordinary Bai-Murabaha, and - Bai-Murabaha order on and Promise. Ordinary Bai-Murabaha is a direct transaction between a buyer and a seller. Here, the seller is an ordinary trader who purchases goods from the market in the hope of selling these goods to another party for a profit. In this case, the seller undertakes the entire risk of his capital investment in the goods purchased. Whether or not he earns a profit depends on his ability to find a buyer for the merchandise he has acquired.
Bai-Murabaha order on and Promise involves three parties - the buyer, the seller and the bank. Under this arrangement, the bank acts as an intermediary trader between the buyer and the seller. In other words, upon receipt of an order and agreement to purchase a certain product from the buyer, the bank will purchase the product from the seller to fulfill the order.
However, it should be noted here that the Islamic Bank acts as a financier in this transaction. This is the case, not in the sense that the bank finances the purchase of goods by the consumers; rather it is a financier by deferring payment to the seller of the product. Thus, there is a chance that this transaction could resemble nothing more than a loan for which interest (Riba) is earned, which is contrary to Islamic beliefs.
Therefore, to avoid this potential misuse of the Bai-Murabaha relationship, the bank should purchase the goods on behalf of the bank from the seller and sell the goods to the buyer, receiving payment on behalf of the bank as well. In this way, the profits generated by the transaction to each of the parties involved cannot be misconstrued as interest or (Riba) profits. There are some important features of Bai-Murabaha as given below. 1.3 Important Features of Murabaha
These features make Bai-Murabaha distinctive from all other modes of Islamic Investment. There are certain steps to accomplish a deal of Bai-Murabaha as shown below (ABIIB 1995, p.12). 1.4 Steps of Bai-Murabaha First Step: The client submits a proposal regarding his requirements of the bank. The client sends a proposal with the specifications of the commodity to be acquired from the bank. The proposal also indicates details regarding the date, time and place of delivery as well as price and form of payment information. The bank responds by sending a counter proposal either accepting the buyer's price or stipulating a different price.
Second Step: The client promises to buy the commodity from the bank on a Bai-Murabaha basis, for the stipulated price. The bank accepts the order and establishes the terms and conditions of the transaction.
Third Step: The bank informs the client (ultimate buyer) of its approval of the agreement to purchase. The bank may pay for the goods immediately or in accordance with the agreement.
The seller expresses its approval to the sale and sends the invoice(s).
Fourth Step: The two parties (the bank and the client) sign the Bai-Murabaha Sale contract according to the agreement to purchase.
Fifth Step: The Bank authorizes the client or its nominee to receive the commodity
The seller sends the commodity to the place of delivery agreed upon. The client undertakes the receipt of the commodity in its capacity as legal representative and notifies the bank of the execution of the proxy. The Bai-Murabaha has some legal rules. These rules are mentioned below (Ibid, pp.14-16). 1.5 Rules of Bai-Murabaha
The areas of application of Bai-Murabaha are discussed below. 1.6 Application of Bai-Murabaha Murabaha is the most frequently used form of finance in Islamic banking throughout the world. It is suitable for financing the different investment activities of customers with regard to the manufacturing of finished goods, procurement of raw materials, machinery, and other required plant and equipment purchases. 2. MUSHARAKA (PARTNERSHIP) 2.1 Meaning of Musharaka The word Musharaka is derived from the Arabic word Sharikah meaning partnership. Islamic jurists point out that the legality and permissibility of Musharaka is based on the injunctions of the Qura'n, Sunnah, and Ijma (consensus) of the scholars. It may be noted that Islamic banks are inclined to use various forms of Shariakt-al-Inan because of its built-in flexibility. At an Islamic bank, a typical Musharaka transaction may be conducted in the following manner.
One, two or more entrepreneurs approach an Islamic bank to request the financing required for a project. The bank, along with other partners, provides the necessary capital for the project. All partners, including the bank, have the right to participate in the project. They can also waive this right. The profits are to be distributed according to an agreed ratio, which need not be the same as the capital proportion. However, losses are shared in exactly the same proportion in which the different partners have provided the finance for the project (Hussain 1986, p.61). 2.2 Types of Musharaka Musharaka may take two forms: i) Permanent Musharaka and ii) Diminishing Musharaka. These are discussed below (ABIIB 1995). Permanent Musharaka In this case, the bank participates in the equity of a company and receives an annual share of the profits on a pre-rate basis. The period of termination of the contract is not specified. This financing technique is also referred to as continued Musharaka.
The contributions of the partners under this mode may be equal or unequal percentages of capital for the purpose of establishing a new income-generating project or to participate in an existing one. In this arrangement, each participant owns a permanent share in the capital structure and receives his share of the profits accordingly. This type of a partnership is intended to continue until the company is dissolved. However, one can exit the partnership by selling his share of the capital to another investor.
Permanent Musharaka is used by Islamic Banks in many income generating projects. They can provide financing to their customers, in exchange for ownership and profit sharing in the proportion agreed upon by both parties. In addition, the bank may leave the responsibility of management to the customer-partner and retain the right of supervision and follow up.
The three steps to establishing Permanent Musharaka are discussed below.
One - Partnership in Capital: The bank tenders part of the capital required in its capacity as a partner and authorizes the customer/partner to manage the project. The Partner tenders part of the capital required for the project and is entrusted with what he holds from the bank funds.
Two - Results of the Projects: The intent of the project is growth. However, the project may be profitable or it may loss money.
Three - The Distribution of wealth accrued from the Project: In the event a loss is incurred, each partner bears part of the loss proportionate to his share in capital. In the event the venture is profitable, earnings are divided between the two parties (the bank and the partner) in accordance with the agreement. The following is a discussion of those legal rules that apply to the Musharaka relationship: Rules for Permanent Musharaka
Application of Permanent Musharaka
Permanent Musharaka is helpful in providing financing for large investments in modern economic activities. Islamic banks can engage in Musharaka partnerships for new or established companies and activities. Islamic banks may become active partners in determining the methods of production cost control, marketing, and other day-to-day operations of a company to ensure the objectives of the company are met. On the other hand, they can also choose to either directly supervise or simply follow up on the overall activities of the firm. As part of the agreement, Islamic banks will share in both profits and losses with its partners or clients in operations of the business.
Diminishing Musharaka
Diminishing or Digressive Musharaka is a special form of Musharaka, which ultimately culminates in the ownership of the asset or the project by the client. It operates in the following manner.
The Bank participates as a financial partner, in full or in part, in a project with a given income forecast. An agreement is signed by the partner and the bank, which stipulates each party's share of the profits. However, the agreement also provides payment of a portion of the net income of the project as repayment of the principal financed by the bank. The partner is entitled to keep the rest. In this way, the bank's share of the equity is progressively reduced and the partner eventually becomes the full owner.
When the bank enters into a Diminishing Musharaka its intention is not to stay in the partnership until the company is dissolved. In this type of partnership, the bank agrees to accept payment on an installment basis or in one lump sum, an amount necessary to buy the bank's partnership interest. In this way, as the bank receives payments over and above it's share in partnership profits, it's partnership interest reduces until it is completely bought out of the partnership.
After the discharge, the bank withdraws it claims from the firm and it becomes the property of the partner. The decreasing partnership arrangement is an Islamic bank innovation. It differs from the permanent partnership only in continuity. It appears that there are four steps of the diminishing partnership. Those are mentioned below. Steps of Diminishing Musharaka
This process continues until the bank has been fully compensated for it's capital share of the business. In this way the bank has its principal returned plus the profit earned during the partnership and vice versa.
In the first Conference of the Islamic Banks in Dubai, the conferees studied the topic of partnership ending with ownership (decreasing partnership) and they decided that this type of business relationship may take one of the following forms.
The First Form: In this form, the bank agrees with the customer on the share of capital and the conditions of partnership. The Conference decided that the bank should sell its shares to the customer after the completion of the partnership. Furthermore, they determined that the selling of the banks interest to the partner should be done under an independent contract.
The Second Form: In this form, the bank participates in financing all or part of the capital requirements in exchange for sharing in the prospective earnings. In addition, the bank gains the right to retain the remainder of the income for the purpose of applying it towards the capital provided by the bank.
The Third Form: In this form, the bank and partner's ownership is determined by stocks comprising the total value of the asset (real estate). Each partner, (the bank and the customer) gets its proportionate share of the earnings accrued from the real property. On an annual basis , the partner may purchase a prescribed number of the bank's shares until such time that the partner becomes the sole owner of the real property. There are some legal rules for diminishing Musharaka as given below.
Rules for Diminishing Musharaka
In addition to all the legal rules that apply to the permanent partnership which also apply to the decreasing partnership, the following rules also must be observed.
Application of Diminishing Musharaka
The decreasing Musharaka is suitable for the financing of industrial businesses that have regular income. It can be considered to be the appropriate mode to finance collective investment. In this arrangement, the bank earns periodic profits throughout the year and it encourages the partner to participate in the joint investment. In addition it fosters individual ownership by allowing the partner to gradually buy the bank's ownership interest. In terms of society as a whole it corrects the course of the economy by developing a mode of positive partnership instead of the negative relationship of indebtedness. In addition, it assists in the equitable distribution of societies wealth. 2.3 Concluding Remark
Financing through a Musharaka partnership is investment-based. The capital provider has full control in the management of the business. In addition, he shares proportionately in both the profits and losses of the business. Therefore, the rate of return is uncertain and can be either positive or negative. The cost of capital is also uncertain and there exists perfect correlation between the relationship of cost of capital and rate of return on capital.
3. MUDARABA
3.1 Definition of Mudaraba
The term Mudaraba refers to a contract between two parties in which one party supplies capital to the other party for the purpose of engaging in a business activity with the understanding that any profits will be shared in a mutually agreed upon. Losses, on the other hand, are the sole responsibility of the provider of the capital. Mudaraba is also known a Qirad and Muqaradah (Shirazi 1990, p.31).
Mudaraba is a contract of those who have capital with those who have expertise, where the first party provides capital and the other party provides the expertise with the purpose of earning Halal (lawful) profit which will be shared in a mutually agreed upon proportion. This type of business venture serves the interest of the capital owner and the Mudarib (agent).
The capital owner may not have the ability or the experience to run a profitable business. On the other hand, the agent (the Mudarib) may not have adequate capital to invest in a business or project. Therefore, by entering into a contract of Mudaraba each party compliments one another, allowing a business venture to be financed. The following are the steps of the Mudaraba contrac (ABIIB, p.53).
3.2 Steps of Mudaraba
The bank provides the capital as a capital owner. The Mudarib provides the effort and expertise for the investment of capital in exchange for a share in profit that is agreed upon by both parties.
3.3 Rules of Mudaraba
There are some legal rules that govern the business relationship Mudaraba which are as follows.
3.4 Concluding Remark
It is an investment-based form of financing. The provider of capital in Mudaraba has no role in the management of the capital. However, he has to bear the risk of capital loss as well as the opportunity cost of capital for the entire period of the contract. The rate of return is quite uncertain and the cost of capital is also uncertain. Hence, there is a perfect correlation between cost of capital and rare of return on capital.
4. BAI-SALAM
4.1 Meaning of Bai-Salam
Bai-Salam is a term used to define a sale in which the buyer makes advance payment, but the delivery is delayed until some time in the future. Usually the seller is an individual or business and the buyer is the bank.
The Bai-Salam sales serve the interests of both parties (Ibid).
4.2 Steps of Bai-Salam
There are some rules for Bai-Salam as given below.
4.3 Rules of Bai-Salam
Typical Bai-Salam transactions are discussed below:
4.4 Application of Bai-Salam
Salam sales are frequently used to finance the agricultural industry. Banks advance cash to farmers today for delivery of the crop during the harvest season. Thus banks provide farmers with the capital necessary to finance the cost of producing a crop.
Salam sale are also used to finance commercial and industrial activities. Once again the bank advances cash to businesses necessary to finance the cost of production, operations and expenses in exchange for future delivery of the end product. In the meantime, the bank is able to market the product to other customers at lucrative prices. In addition, the Salam sale is used by banks to finance craftsmen and small producers, by supplying them with the capital necessary to finance the inputs to production in exchange for the future delivery of products at some future date.
Thus as has been demonstrated, the Salam sale is useful in providing financing for a variety of clients, including farmers, industrialists, contractors and traders. The proceeds in a Salam sale may be used to cover the finance of operation costs and capital costs.
4.5 Concluding Remark
The Bai Salam agreement is a combination of debt and trading. The capital provider has no control over the management of capital provided. However the capital provider takes all of the risk as profits cannot be determined until the commodity is delivered and the final sale price is determined. In addition the capital provider incurs the opportunity cost associated with the capital outlay. Like the other three previously discussed modes of finance there is no certain rate of return. In addition the cost of capital is uncertain ex-ante. Also, there is no correlation in the relationship of cost of capital and rate of return on capital.
5. ISTISNA'A SALE
5.1 Definition of Istisna'a Sale
The Istisna'a sale is a contract in which the price is paid in advance at the time of the contract and the object of sale is manufactured and delivered later (IDB 1992, p.28). The majority of the jurists consider Istisna'a as one of the divisions of Salam, Therefore, it is subsumed under the definition of Salam. But the Hanafie school of Jurisprudence classifies Istisna'a as an independent and distinct contract. The jurists of the Hanafie school have given various definitions to Istisna'a some of which are: "That it is a contract with a manufacturer to make something" and "It is a contract on a commodity on liability with the provision of work". The Purchaser is called 'Mustasnia' contractor and the seller is called 'Sania' maker or manufacturer and the thing is called 'Masnooa', manufactured, built, made (ABIIB). Islamic banks can utilize Istisna'a in two ways.
Each transaction is deemed a separate contract with payment being made in cash either immediately or on a deferred basis. Any disagreements that may arise are settled under each contract separately according to the provisions therein. The steps of the Istisna'a sale and the parallel Istisna'a have been discussed below.
5.2 Steps of Istisna'a Sale
Istisna'a Sale Contract: The Buyer expresses his desire to buy a commodity and brings a request to purchase the commodity to the bank. The method of payment, whether cash or deferred is set forth in the agreement. The bank agrees to deliver the commodity to the buyer at some agreed upon time in the future.
The Parallel Istisna'a Contract: In order that the bank is able to deliver said commodity in the Istisna'a agreement, the bank enters into a parallel Istisna'a agreement with a third party to either manufacture or otherwise deliver-said commodity. Obviously, the bank stipulates a price that is lower than that agreed to in the original agreement and requires delivery on or before the date stipulated in the original contract.
The seller, in the parallel agreement, agrees to manufacture the specific commodity and to deliver it on the due date agreed upon.
Delivery and Receipt of the Commodity: The seller in the parallel Istisna'a agreement, delivers the commodity to the bank on the agreed upon date. The bank, in turn, delivers the product to the buyer of the original Istisna'a contract, in accordance with the original agreement. In this way, all parties fulfill their obligations to the contract.
5.3 Rules of Istisna'a Sale
5.4 Application of Istisna'a Sale
The Istisna'a contract allows Islamic banks to finance the public needs and the vital interests of the society to develop the Islamic economy in accordance with Islamic teachings. For example Istisna'a contracts are used to finance high technology industries such as the aviation, locomotive and ship building industries. In addition, this type of business transaction is also used in the production of large machinery and equipment manufactured in factories and workshops. Finally, the Istisna'a contract is also applied in the construction industry such as apartment buildings, hospitals, schools, and universities to whatever that makes the network for modern life. One final note, the Istisna'a contract is best used in those transactions in which the product being purchased can easily be measured in terms of the specified criteria of the contract.
6. QARD HASAN (Benevolent loans)
Qard Hasan is a contract in which one of the parties (the lender) places into the ownership of the other party (the borrower) a definite parcel of his property, in exchange nothing more than the eventual return of something in the same value of the property loaned.
Ausaf Ahmad (1998, p.49) mentioned that since interest on all kinds of loans is prohibited in Islam, a loan that is to be given in accordance with the Islamic principle, has to be, by definition, a benevolent loan (Qard Hasan) i.e. a loan without interest. It has to be granted on the grounds of compassion, i.e. to remove the financial distress caused by the absence of sufficient money in the face of dire need. Since banks are profit driven organizations, it would seem that there is not much opportunity for the application of this technique. However, Islamic banks also play a socially useful role. Hence they make provisions to provide Qard Hasan besides engaging in income generating activities.
There may be slight variations among different Islamic banks in the use of this technique. The Faisal Islamic Bank of Egypt provides interest-free benevolent loans to the holders of investment and current accounts, in accordance with the conditions set forth by its board of directors. The bank also grants benevolent loans to other individuals under conditions decreed by its Board. On the other hand, the Jordan Islamic Bank Law authorizes it to give "benevolent loans (Qard Hasan) for productive purposes in various fields to enable the beneficiaries to start independent lives or to raise their incomes and standard of living (Ibid, pp.49-50). Iranian banks are required to set aside a portion of their resources out of which interest free loans (Qard Hasan) can be given to small producers, entrepreneurs and farmers who are not able to secure financing for investment or working capital from other alternative sources, and needy customers. It should also be noted that Iranian banks are permitted to charge a minimum service fee to cover the cost of administering these funds.
Finally, in Pakistan, Qard Hasan is part of the bank's normal financing activities. Qard Hasan loans are granted compassionate basis and no service charges are imposed on the borrower. While these loans are considered loans of compassion, they are expected to be repaid when it is possible for the borrower to do so. Furthermore in Pakistan, Qard Hasan operations are concentrated in the head office of each bank. Branch offices are not permitted to extend these loans.
7. BAI-MUAJJAL (Deferred Sale)
7.1 Meaning of Bai-Muajjal
The terms "Bai" and "Muajjal" are derived from the Arabic words 'Bai' and 'Ajal'. The word 'Bai' means purchase and sale and the word 'Ajal' means a fixed time or a fixed period. "Bai-Muajjal" is a sale for which payment is made at a future fixed date or within a fixed period. In short, it is a sale on credit.
The Bai-Muajjal may be defined as a contract between a buyer and a seller under which the seller sells certain specific goods, permissible under Shariah and law of the country, to the buyer at an agreed fixed price payable at a certain fixed future date in lump sum or in fixed installments.
There are some important features of Bai-Muajjal as given below (ABIIB).
7.2 Important Features of Bai-Muajjal
7.3 Some Observations
This type of financing by the bank is considered to be more risky than the other Islamic modes of investment previously discussed. Therefore, the application/proposal for Bai-Muajjal investment must be reviewed very carefully to ensure the client can ultimately make payment. . The following steps may be taken to ensure the Bai-Muajjal Investment is a good proposition for the bank:
It should be remembered that if the Bai-Muajjal investment is not secured by first class collateral securities, it becomes more risky than investments under other modes of Islamic banking.
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