Islamic debt financing
is contrasted to conventional debt financing (structured upon interest-based
lending). The Islamic debt financing is structured through contracts of
exchange such as sale and purchase contracts or `uqud al-mu’awadat’.
There needs an underlying asset which is made the subject matter of the contract
in Islamic financing. The Islamic
financing principles that are used in Islamic debt instruments include bai` bithaman ajil (deferred-payment sale), istisna` (manufacturing
sale), murabahah (trade
with 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).
financing represents a component of the overall capital market activity and structured
through contracts of participation/ partnership or ‘uqud al-isytirak’. The
two Islamic financing principles that are used in equity financing instruments are
mudharabah (profit-sharing) and musharakah (profit and loss
sharing). The explanation for
each of the Islamic financing principles are as follows:
Islamic Debt Financing
(a) Murabahah (Trade
with mark up or cost-plus sale)
Murabahah is a
type of contract that refers to sale and purchase transaction for the purpose
of funding an asset whereby the cost and profit margin (mark-up) are made known
and agreed by all parties involved. The settlement for the purchase can be
settled either on a deferred lump sum basis or on an instalment basis as
specify in the contract.
In order to murabahah contract to be valid, there
are several conditions that must be followed which are the cost price and
mark-up (profit) must be disclosed to the contracting parties, the original
price should be of fungible things, the contract should not lead to riba and
initial contract must be valid. Motor vehicle financing is an example of
adopting murabahah contract. The are
several 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-payment
BBA is a type of contract
that refers to sale and purchase of assets on a deferred payment and instalment
basis with pre-agreed payment period. A main characteristic of the contract is
that ownership of the asset unambiguously remains with the bank until all of
the payments have been made. BBA has similar features as murabahah in
term of the financier undertaking to buy the asset required for resale to the
client at a higher price as agreed to by the parties involved. The difference
with murabahah is that BBA is used for long term financing and
the seller is not required to disclose the profit margin which is included in
the selling price.
(c ) Istisna` (Manufacturing
An Istisna’ derived from the Arabic verb “istasna’a” that means
require other person / party to manufacture an asset. Thus, the istisna’ can be referred to a
contractual agreement with a manufacturer to produce items with specified
descriptions at a determined price and manufactured from his own materials with
his 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’ contract
must be something that the people are familiar with in order to contract it on
the basis of the istisna’ contract.
The legality of the Istisna’ principle established from
different legal sources such as the Sunnah, Ijma’, qiyas and istihsan.
According to Ahmad Hanbal (1998), Musnad
Ahmad, 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.
An Ijarah is a type of contract that have been designed for funding an
asset / equipment. It is a manfaah (benefit) or the right to use the
asset / equipment. The lessor leases out an asset / equipment to the client at
an 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 entrepreneur
as the lease payments are made. Different forms of leasing are permissible,
including leases where a portion of the instalment payment goes toward the
final purchase at the end of the leasing period whereby the ownership of the
asset / equipment will be transferred to the lessee through a sale and purchase
agreement. It is considered as hire-purchase that is shariah compliance and
also known as ijarah thumma bai` or ijarah wa iqtina’ or ijarah
muntahiyah bi tamlik.
In ijarah bi tamlik or
ijarah wa iqtina` (lease financing toward eventual ownership) financing,
the bank buys an asset / equipment and leases it to the entrepreneur, who
eventually 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 the
purpose of renting out a lessor’s asset to a lessee. Consequently, at the end
of the lease period, the lessee will purchase the asset at an agreed price from
the lessor by executing a purchase agreement. The legality of Ijarah also can
be proof in Quran, Sunnah and Ijma’. One of the related Quran verse is, “And if they suckle your (offspring), give
them their recompense” Quran 65:6.
(e) Bai` al-salam (Advance
Bai’ al-salam is a type
of contract whereby the payment is made in cash at the point of contract but
the delivery of asset purchased will be deferred to a pre-determined date. The
legality of Salam principles can be
proof in Quran, Sunnah and Ijma’. One of the related Quran verse is, Allah (s.w.t.) says “O ye who believe! When
ye deal with each other, in transactions involving future obligations in a
fixed period of time, reduce them to writing, let a scribe write down
faithfully as between the parties” Quran 2:28.
In addition, Shariah
scholars have permitted parallel salam or back to back salam contracts,
whereby the investor will play a dual role. On one hand the investor is the
seller in one salam purchase agreement and on the other hand he becomes
a customer by entering into a separate independent salam agreement in
order to acquire salam goods of a similar specification. The most important
thing in the parallel salam is to distinguish the contracts as two separate
deals of salam.
(f) Bai’ al-Tawarruq
(Monetisation/ Cash Financing/ Cash Procurement)
Bai’ al-tawarruq can be referred as buying a
commodity with deferred payment and selling it to a person other than the buyer
for a lower price with immediate payment. The majority of scholars and fiqh
councils consider individual tawarruq as
permissible in principle. However, they stated additional conditions to
guarantee 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 delayed
payment. Then, the buyer will resell the commodity to other than original
seller 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 the
commodity to mutawarriq for a delayed
payment. He sells it on his behalf by taking the payment from the buyer and
handling over the cash to the mutawarriq.
Al-Tawarruq Al-Masrafi (Banking Tawarruq)
The Islamic Financial Institutions (IFIs) organises the sale of
commodity (except gold or silver) between an international commodity market and
the mutawarriq for a delayed payment
on a agreed condition.
(g) Bai’ al’-inah (Sale with immediate repurchase)
Bai al-inah is a type
of contract that involves the sale and buy back transaction of assets by a
seller. A seller will sell the asset to a buyer on a cash basis. The seller
will later buy back the same asset on a deferred payment basis which the price
is higher than the cash price or the price is lower than the deferred price. The
legality of bai’ al-‘inah is related
to the legality of stratagems (hiyal).
(a) Musharakah (Profit
and Loss Sharing)
derived from the word sharaka which
means sharing and mixing shares of 2 or more parties in order to make them
interchangeable. Thus, musharakah can
be referred to a partnership arrangement between 2 parties or more to fund a
business venture (for instance, joint venture) whereby all parties contribute
capital either in the form of cash or in kind (for instance, technical and
managerial expertise) for the purpose of funding the business venture. Any
profit derived from the venture will be distributed based on a pre-agreed profit
sharing ratio. However, a loss will be shared on the basis of capital
There are 2 types of musharakah which are partnership in ownership
(Sharikah Al-Milk) and partnership by contract (Sharikah Al-Aqd). Musharakah principle is legally
confirmed in the Quran, Sunnah and Ijma’. One of the related Quran verse that
acknowledged this concept is “But if more
than two, then they shall share in one-third ….. (of the inheritance)”,
In addition, the Shariah scholars have developed the musharakah
principle deeper by introducing diminishing musharakah (musharakah
mutanaqisah). Under this contract, the financial institution and client
share the ownership of the financed asset. The periodic payment of the client
contains two parts, (i) a rental payment for the part of the property owned by
the IFIs and (ii) a buy-out of part of that ownership. Over time, the portion
of the asset owned by the client increases, until he owns the entire asset and
the contract is eventually terminated.
(b) Mudharabah (Profit-sharing)
Mudharabah is a
contract which is made between 2 parties to fund a business venture. The
parties 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 on
a pre-agreed ratio. In the event of loss, it shall be borne solely by the capital
provider, unless the loss is due to the negligence or mismanagement of the
mudarib in managing the venture. The most important feature of mudharabah is
that the capital provider cannot claim a fixed profit (the investor is not guaranteed
a specific return).
known as qirad and muqaradah. There are 3 pillars of mudharabah which are (i) from the
contract (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 and
legality of mudharabah concept also can be proof in the Quran, Sunnah and
Ijma’. One of the Sunnah stated that the
act of the Prophet (p.b.u.h.) himself who used to work as a mudarib for
Khadijah. 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 across
the sea, into any valley or buy any animal with a soft belly. If the mudarib
does any of these things, the he is liable. The Prophet (p.b.u.h.) heard of
this practice and permitted it (Al-Bayhaqi, Al-Sunan Al-Kubra, 6/184
In addition, the Shariah
scholars have developed the mudharabah principle deeper by
introducing a “two-tier mudharabah.” The first tier mudharabah is
created when the capital provider places his capital with an Islamic financial
institution which acts as the entrepreneur. The financial institution in turn
invests the capital with another entrepreneur by means of a second-tier mudharabah.
In other words, by using this type of mudharabah, an Islamic financial
institution can act as an intermediary between capital providers and entrepreneurs.