An overview of Islamic Finance Products by Azrina Mohd Isa
The main principles of Islamic finance are the prohibition of riba (usury), application of al-bay (trade and commerce), avoidance of gharar (ambiguities) in contractual agreements, prohibition of maisir (gambling) and prohibition from conducting business involving prohibited commodities such as pork, liquor, illicit sex and pornography.
Based on these principles, Islamic finance products are developed as an alternative to conventional banking products. In the practice of modern Islamic finance, Islamic finance products can be classified based on the following principles, namely sale-based principle, profit-sharing principle, lease-based principle, benevolent-loan principle, fee-based principle and supporting principle.
1. SALE-BASED PRINCIPLE
Some of the most common modern Islamic finance product which are categorized as sale-based principle are Murabahah, Bai Bithaman Ajil ("BBA"), Bai Al-Salam, Bai Al-Istisna, Bai Al-Inah and Bai Al-Dayn.
Murabahah and BBA
Murabahah and BBA are the two most practised sale contracts in Islamic finance in Malaysia.
Murabahah is a contract of sale and purchase transaction for the financing of an asset whereby the cost and profit margin (mark-up) are made known to and agreed upon by all parties involved at the commencement of the contract.
The pre-condition of a valid Murabahah is that the seller must disclose to the buyer the actual cost price of the asset that is intended to be sold to the customer. The failure to do so may render the contract null and void. The purchase price can be paid by way of a bullet payment or deferred lump-sum or an installment basis.
The deferred payment basis is the criterion that makes Murabahah appear similar to BBA as BBA involves the provision of finance for the purchase of an asset on deferred payment basis. The difference between the two is that in BBA, disclosure of the cost price is not a condition.
In Malaysia, the Murabahah contract is usually used for short term financing in which the payment period is usually up to 5 years, whilst BBA is used for long term financing. Hence BBA is commonly seen in purchase of property or in Islamic Private Debt Securities (BAIDS) which involve longer tenures of financing.
There are some differing views among the Shariah scholars with regard to the validity of BBA. However as far as Malaysia is concerned, the Shariah scholars are of the view that it is valid. This view is fortified by the Court of Appeal’s recent decision in Arab Malaysian Finance Berhad & Ors v Taman Ihsan Jaya & Ors.
Bai Al-Salam and Bai Al-Istisna
Unlike Murabahah and BBA where the subject matter of the contract is usually in existence at the time of contract, Bai Al-Salam and Bai Al-Istisna contracts enable an asset which is not in existence at the time of contract (for example, equipment which has yet to be manufactured or cotton which has yet to be produced) to be financed. Both types of contracts are the exceptions to the general rule to one of the vital pillars of Shariah contract that the subject matter of a contract must exist at the time of contract.
Bai Al-Salam is a sale whereby the seller undertakes to supply some specific goods to the buyer at a future date in exchange for an advanced payment of the price in full at spot. Bai Al-Istisna is a contract whereby a party undertakes to produce and sell a specific product to be made according to agreed-upon specifications at a pre-determined price.
The notable differences between the two concepts are that first, in Salam the price must be paid in advance in full while it is not necessary for Istisna. Secondly, in Salam, the contract cannot be unilaterally terminated whilst in Istisna, the contract can be cancelled so long as the manufacturer has not commenced work.
Bai Al-Inah works in a diametrically opposite manner from a BBA contract. It is a contract where the seller sells his assets to the buyer at an agreed selling price to be paid by the buyer at a later date. Thereafter, the buyer immediately sells back the assets to the seller at a cash price lower than the agreed selling price. The difference between the spot and deferred prices is the profit due to the seller.
Some Shariah scholars do not accept Bai Al-Inah on the basis that it is a backdoor towards riba (usury). However Bai Al-Inah is widely used by Islamic banks in Malaysia especially for personal financing and capital markets.
Bai Al-Dayn is generally known as a sale of debt. Shariah scholars differ in their views as to its permissibility as it involves gharar (uncertainty) and riba (usury).
The scholars who uphold its validity maintain that a sale of debt is permitted so long as the debt is a confirmed debt and that the buyer must pay the price of the debt on a spot basis. As regards sale of debt to a third party, some jurists maintain that it is allowed provided that the element of uncertainty and the regulation regarding the sale of ribawi items with another is observed.
Bai Al-Dayn is widely used in the modern Islamic finance for the sale and purchase of trade documents such as bills of exchange and banker’s acceptance. In the capital market, Bai Al-dayn is used in the secondary market to trade securities that have been issued based on Murabahah, BBA or Istisna.
2. PROFIT-SHARING PRINCIPLE
There are two types of contracts based on the profit-sharing principle. They are Musyarakah and Mudharabah.
Musyarakah is a contract between partners on both capital and profit. The proportion of profit must be agreed upon at the time of effecting the contract. Otherwise the Musyarakah is not valid.
Losses in Musyarakah are shared according to contribution of capital by the partners. It is perceived that the sharing of losses does not appeal to the financial intermediaries to offer this product to the market. However several banks have of late offered Musyarakah Mutanaqisah (diminishing Musyarakah) for purchase of property as an alternative to BBA.
Mudharabah is a partnership in which one party provides the capital and the other provides the labour or skill. The capital provider is known as Rab Al-Mal while the partner who provides skill is known as the Mudarib.
The notable difference between Musyarakah and Mudharabah is that in the former losses are shared whilst in the latter losses are borne solely by the capital provider. Mudharabah is commonly used in products such as General Investment Accounts and Specific Investment Accounts which are akin to fixed deposit in conventional banking.
3. LEASE-BASED PRINCIPLE
Ijara is a contract which works on a lease-based principle. Ijara means to give something on rent. Ijara can operate on the operating lease mechanism or the financial lease mechanism. The notable difference between the two is that in an operating lease, the asset is returned to the owner at the end of the lease term whereas in a financial lease, the asset is transferred to the lessee at the end of the lease term.
Ijara in the financial lease mode is a common method of financing the purchase of equipment and motor vehicles. The term used is al-ijara thumma al-bay’ or al-ijara al-muntahiyah bi al-tamlik which means lease with an option to purchase.
Ijara is also widely used as the underlying contract for issuance of sukuk as the structure is not as complex as sukuk musyarakah or sukuk mudharabah.
4. BENEVOLENT-LOAN PRINCIPLE
The only loan that is recognized in Shariah is the benevolent loan. Also known as Qard Hassan, the vital condition in the granting of such loan is that the banks are prohibited from charging profit. Hence the amount repaid by the borrower is the exact amount that was granted on loan. This product is rarely offered in the market.
5. FEE-BASED PRINCIPLE
There are 2 types of contract that contributes income to Islamic banks through charging of fees. They are contract of Wakalah and Kafalah. These contracts are usually ancillary to the main transaction such as BBA and Mudharabah.
Wakalah in essence means agency. A contract of agency can be free-of-charge or with compensation. Islamic banks usually adopt the second option. For instance in a Letter of Credit granted to customer, Islamic banks generate income by imposing certain fees over the granted facility. This fee is taken as the bank acts as the agent of the customer in the trade transaction.
Kafalah in Islamic finance is a contract of financial guarantee whereby a pledge is given to a creditor by the guarantor that the debtor will pay his debt, fine or any other personal liability.
Kafalah is widely used in modern Islamic finance to secure payment from the borrower that has been granted financing under the Murabahah, Ijara, Salam, Istisna, Musyarakah or Mudharabah principles or letters of credit and documentary credits.
6. SUPPORTING PRINCIPLE
These contracts are named as supporting contracts because more often than not, these contracts serve the purpose of strengthening the application of other Islamic commercial law contracts. They are Hawalah, Rahn and Wadiah.
Hawalah is a contract of assignment or transfer of debt from the liability of the original debtor to the liability of another person. It is a requirement that the transfer of debt is effected immediately upon the conclusion of the contract and is not suspended for a period of time. Hawalah operates to release the original debtor from the debt.
A contract of Rahn is another security contract in Shariah. Rahn is defined as the holding an item as collateral for a pecuniary obligation. Rahn differs from Kafalah in that a Kafalah contract is similar to a personal guarantee in civil law while a Rahn contract ensures payment of debt through the holding of pledged property which can be sold to make good an outstanding debt.
Wadiah is a safekeeping contract based on the principle of trust. Modern Islamic banks practice Wadiah in their savings and current account whereby an agreement is signed between the customer and the bank which allows the bank to make use of this fund and to mix the fund with those of the other customers of the bank.
The concept is known as Wadiah yad al-dhamanah (guaranteed safe-custody) where the bank will make use of the fund and be liable to refund to the customer at any time the customer so desires. Any profit generated by the bank is recognized as the bank’s profit. It may however, give the profit away to the customer as hibah (gift) but this gift is solely based on the bank’s discretion and cannot be agreed upfront.
Islamic law offers a wide range of contracts that can be utilized for Islamic finance transactions. The increasing complexity of modern financial transactions will lead to greater innovation in the development of new financing products based on the existing Shariah contracts. These innovations should be encouraged so long as no Shariah principle is violated.
AZRINA MOHD ISA (