Islamic debt financingis contrasted to conventional debt financing (structured upon interest-basedlending).
The Islamic debt financing is structured through contracts ofexchange such as sale and purchase contracts or `uqud al-mu’awadat’.There needs an underlying asset which is made the subject matter of the contractin Islamic financing. The Islamicfinancing principles that are used in Islamic debt instruments include bai` bithaman ajil (deferred-payment sale), istisna` (manufacturingsale), murabahah (tradewith mark up or cost-plus sale), ijarah (lease financing), bai`al-salam (advance purchase), bai`al-‘inah(sale with immediate repurchase) and bai’ al-tawarruq(monetisation/ cash financing/ cash procurement). Islamic equityfinancing represents a component of the overall capital market activity and structuredthrough contracts of participation/ partnership or ‘uqud al-isytirak’. Thetwo Islamic financing principles that are used in equity financing instruments aremudharabah (profit-sharing) and musharakah (profit and losssharing). The explanation foreach of the Islamic financing principles are as follows: Islamic Debt Financing (a) Murabahah (Tradewith mark up or cost-plus sale) Murabahah is atype of contract that refers to sale and purchase transaction for the purposeof funding an asset whereby the cost and profit margin (mark-up) are made knownand agreed by all parties involved. The settlement for the purchase can besettled either on a deferred lump sum basis or on an instalment basis asspecify in the contract. In order to murabahah contract to be valid, thereare several conditions that must be followed which are the cost price andmark-up (profit) must be disclosed to the contracting parties, the originalprice should be of fungible things, the contract should not lead to riba andinitial contract must be valid.
Motor vehicle financing is an example ofadopting murabahah contract. The areseveral Quran verses that supported the legality of murabahah principle and one of it is “And Allah (s.w.t.) has permitted trade and prohibited usury” 2:282). (b) Bai` bithaman ajil, BBA (Deferred-paymentsale) BBA is a type of contractthat refers to sale and purchase of assets on a deferred payment and instalmentbasis with pre-agreed payment period. A main characteristic of the contract isthat ownership of the asset unambiguously remains with the bank until all ofthe payments have been made.
BBA has similar features as murabahah interm of the financier undertaking to buy the asset required for resale to theclient at a higher price as agreed to by the parties involved. The differencewith murabahah is that BBA is used for long term financing andthe seller is not required to disclose the profit margin which is included inthe selling price. (c ) Istisna` (Manufacturingsale) An Istisna’ derived from the Arabic verb “istasna’a” that meansrequire other person / party to manufacture an asset. Thus, the istisna’ can be referred to acontractual agreement with a manufacturer to produce items with specifieddescriptions at a determined price and manufactured from his own materials withhis own effort. If the materials needed are provided by mustasni’ (the person who requests the construction of that item),the agreement is considered as ijarah.The items in the istisna’ contractmust be something that the people are familiar with in order to contract it onthe basis of the istisna’ contract. The legality of the Istisna’ principle established fromdifferent legal sources such as the Sunnah, Ijma’, qiyas and istihsan.
According to Ahmad Hanbal (1998), MusnadAhmad, Musnad Anas Ibn Malik, Hadith No. 12012, J.4.
Beirut : Alam Al-Kutub,Nafi’ reported that Abdullah ibn ‘Umar has reported to him that the Prophet(p.b.u.h.) requested the manufacturing of a ring for him. (d) Ijarah(Lease financing) An Ijarah is a type of contract that have been designed for funding anasset / equipment. It is a manfaah (benefit) or the right to use theasset / equipment.
The lessor leases out an asset / equipment to the client atan agreed rental fee for a pre-determined period pursuant to the contract (aqad).The main characteristic of ijarah is that ownership of the asset /equipment remains with the bank or is gradually transferred to the entrepreneuras the lease payments are made. Different forms of leasing are permissible,including leases where a portion of the instalment payment goes toward thefinal purchase at the end of the leasing period whereby the ownership of theasset / equipment will be transferred to the lessee through a sale and purchaseagreement. It is considered as hire-purchase that is shariah compliance andalso known as ijarah thumma bai` or ijarah wa iqtina’ or ijarahmuntahiyah bi tamlik. In ijarah bi tamlik orijarah wa iqtina` (lease financing toward eventual ownership) financing,the bank buys an asset / equipment and leases it to the entrepreneur, whoeventually opts to buy it at a previously agreed-upon price. Ijarah thumma bai`(lease to purchase) is a contract which starts with an Ijarah contract for thepurpose of renting out a lessor’s asset to a lessee.
Consequently, at the endof the lease period, the lessee will purchase the asset at an agreed price fromthe lessor by executing a purchase agreement. The legality of Ijarah also canbe proof in Quran, Sunnah and Ijma’. One of the related Quran verse is, “And if they suckle your (offspring), givethem their recompense” Quran 65:6. (e) Bai` al-salam (Advancepurchase) Bai’ al-salam is a typeof contract whereby the payment is made in cash at the point of contract butthe delivery of asset purchased will be deferred to a pre-determined date.
Thelegality of Salam principles can beproof in Quran, Sunnah and Ijma’. One of the related Quran verse is, Allah (s.w.t.) says “O ye who believe! Whenye deal with each other, in transactions involving future obligations in afixed period of time, reduce them to writing, let a scribe write downfaithfully as between the parties” Quran 2:28. In addition, Shariahscholars have permitted parallel salam or back to back salam contracts,whereby the investor will play a dual role.
On one hand the investor is theseller in one salam purchase agreement and on the other hand he becomesa customer by entering into a separate independent salam agreement inorder to acquire salam goods of a similar specification. The most importantthing in the parallel salam is to distinguish the contracts as two separatedeals of salam. (f) Bai’ al-Tawarruq(Monetisation/ Cash Financing/ Cash Procurement) Bai’ al-tawarruq can be referred as buying acommodity with deferred payment and selling it to a person other than the buyerfor a lower price with immediate payment.
The majority of scholars and fiqhcouncils consider individual tawarruq aspermissible in principle. However, they stated additional conditions toguarantee its proper application. There are 3 types of tawarruq as listed below: · Al-Tawarruq Al-Fardi (Individual Basis)The seller owned and possessed the purchase of a commodity for a delayedpayment. Then, the buyer will resell the commodity to other than originalseller in order to obtain cash.· Al-Tawarruq Al-Munazzam (Organised Tawarruq)The seller handles the process by which cash is obtained for the mutawarriq. The seller sells thecommodity to mutawarriq for a delayedpayment.
He sells it on his behalf by taking the payment from the buyer andhandling over the cash to the mutawarriq.· Al-Tawarruq Al-Masrafi (Banking Tawarruq)The Islamic Financial Institutions (IFIs) organises the sale ofcommodity (except gold or silver) between an international commodity market andthe mutawarriq for a delayed paymenton a agreed condition. (g) Bai’ al’-inah (Sale with immediate repurchase) Bai al-inah is a typeof contract that involves the sale and buy back transaction of assets by aseller. A seller will sell the asset to a buyer on a cash basis. The sellerwill later buy back the same asset on a deferred payment basis which the priceis higher than the cash price or the price is lower than the deferred price. Thelegality of bai’ al-‘inah is relatedto the legality of stratagems (hiyal).
Islamic EquityFinancing (a) Musharakah (Profitand Loss Sharing) Musharakahderived from the word sharaka whichmeans sharing and mixing shares of 2 or more parties in order to make theminterchangeable. Thus, musharakah canbe referred to a partnership arrangement between 2 parties or more to fund abusiness venture (for instance, joint venture) whereby all parties contributecapital either in the form of cash or in kind (for instance, technical andmanagerial expertise) for the purpose of funding the business venture. Anyprofit derived from the venture will be distributed based on a pre-agreed profitsharing ratio. However, a loss will be shared on the basis of capitalcontribution. There are 2 types of musharakah which are partnership in ownership(Sharikah Al-Milk) and partnership by contract (Sharikah Al-Aqd). Musharakah principle is legallyconfirmed in the Quran, Sunnah and Ijma’.
One of the related Quran verse thatacknowledged this concept is “But if morethan two, then they shall share in one-third ….. (of the inheritance)”,al-Quran 4:12.
In addition, the Shariah scholars have developed the musharakahprinciple deeper by introducing diminishing musharakah (musharakahmutanaqisah). Under this contract, the financial institution and clientshare the ownership of the financed asset. The periodic payment of the clientcontains two parts, (i) a rental payment for the part of the property owned bythe IFIs and (ii) a buy-out of part of that ownership.
Over time, the portionof the asset owned by the client increases, until he owns the entire asset andthe contract is eventually terminated. (b) Mudharabah (Profit-sharing)Mudharabah is acontract which is made between 2 parties to fund a business venture. Theparties are a rabb al-mal (capital provider/ investor) and a mudarib (an entrepreneur who manages the project).If the business venture is profitable, the profit will be distributed based ona pre-agreed ratio. In the event of loss, it shall be borne solely by the capitalprovider, unless the loss is due to the negligence or mismanagement of themudarib in managing the venture. The most important feature of mudharabah isthat the capital provider cannot claim a fixed profit (the investor is not guaranteeda specific return). Mudharabah alsoknown as qirad and muqaradah. There are 3 pillars of mudharabah which are (i) from thecontract (sighah), (ii) the parties involve (rabb al-mal and mudarib) and (iii) the subject matter (capital,work and profit).
Same as any other Islamic principles, the validity andlegality of mudharabah concept also can be proof in the Quran, Sunnah andIjma’. One of the Sunnah stated that theact of the Prophet (p.b.u.h.
) himself who used to work as a mudarib forKhadijah. Another Sunnah also stated that Ibn ‘Abbas reported that whenever his father gave money for mudharabah,he stipulated some conditions that the mudarib will not take his money acrossthe sea, into any valley or buy any animal with a soft belly. If the mudaribdoes any of these things, the he is liable. The Prophet (p.b.u.h.
) heard ofthis practice and permitted it (Al-Bayhaqi, Al-Sunan Al-Kubra, 6/184no:11611). In addition, the Shariahscholars have developed the mudharabah principle deeper byintroducing a “two-tier mudharabah.” The first tier mudharabah iscreated when the capital provider places his capital with an Islamic financialinstitution which acts as the entrepreneur. The financial institution in turninvests the capital with another entrepreneur by means of a second-tier mudharabah.
In other words, by using this type of mudharabah, an Islamic financialinstitution can act as an intermediary between capital providers and entrepreneurs.