Instruments of Islamic Finance In Islamic finance

Instruments of Islamic Finance In Islamic finance

PLS Financing Products PLS financing
is closest to the spirit of Islamic finance. Compared with non-PLS financing, its core principles of equity and participation, as well as its strong link to real economic activities, help promote a more equitable distribution of income, leading to a more efficient allocation of resources. There are two types of PLS financing: musharakah and mudârabah.

Musharakah       is a profit-and-loss sharing partnership and the most authentic form of Islamic financing.6 It is a contract of joint partnership where two or more partners provide capital to finance a project or own real estate or movable assets, either on a permanent or diminishing basis.7 Partners in musharakah have a right to take part in management; they seem to bear the greatest risk among all Islamic financing modes with the potential for earning the highest reward. However, whereas profits are distributed according to pre-agreed ratios, losses are shared in proportion to capital contribution.

Mudârabah is a profit-sharing and loss-bearing contract where one party supplies funding (financier as principal) and the other provides effort and management expertise (mudarib or entrepreneur as agent) with a view to generating a profit. The share in profits is determined by mutual agreement but losses, if any, are borne entirely by the financier, unless they result from the mudarib’s negligence, misconduct, or breach of contract terms.

Mudârabah     
is sometimes referred to as a sleeping partnership because the mudarib runs the business and the financier cannot interfere in management, though conditions may be specified to ensure better management of capital. Islamic banks mainly make use of mudârabah financing to raise funds; mudârabah contracts are also used for the management of mutual funds.



Non-PLS Financing Products  


Non-PLS contracts are most common in practice. They are generally used to finance consumer and corporate credit, as well as asset rental and manufacturing. Non-PLS financing instruments include murâbaḥah, ijārah, salam, and istisna

 Murâbaḥah       is a popular Shari’ah-compliant sale transaction mostly used in trade and asset financing.9 The bank purchases the goods and delivers them to the customer, deferring payment to a date agreed by the two parties. The expected return on murâbaḥah is usually aligned with interest payments on conventional loans, creating a similarity between murâbaḥah sales and asset-backed loans. However, murâbaḥah is a deferred payment sale transaction where the intention is to facilitate the acquisition of goods and not to exchange money for more money (or monetary equivalents) over a period of time. Unlike conventional loans, after the murâbaḥah contract is signed, the amount being financed cannot be increased in case of late payment or default, nor can a penalty be imposed, unless the buyer has deliberately refused to make a payment. Also, the seller has to assume any liability from delivering defective goods. Murâbaḥah transactions are widely used to finance international trade, as well as for interbank financing and liquidity management through a multistep transaction known as tawarruq, often using commodities traded on the London Metal Exchange (LME).10 However, in some jurisdictions, tawarruq transactions are not considered compliant with Shari’ah principles.

 Ijārah          is a contract of sale of the right to use an asset for a period of time. It is essentially a lease contract, whereby the leaser must own the leased asset for the entire lease period. Since ownership remains with the leaser, the asset can be repossessed in case of nonpayment by the lessee. However, the leaser is also responsible for asset maintenance, unless damage to the leased asset results from lessee negligence. This element of risk is required for making ijārah payments permissible. A variety of ijārah takes a hire-purchase form, whereby there is a promise by the leaser to sell the asset to the lessee at the end of the lease agreement, with the price of the residual asset being predetermined.

Salam           is a form of forward agreement where delivery occurs at a future date in exchange for spot payment.13 Such transactions were originally allowed to meet the financing needs of small farmers as they were unable to yield adequate returns until several periods after the initial investment. A vital condition for the validity of a salam is payment of the price in full at the time of initiating the contract, or else the outcome is a debt-against-debt sale, which is strictly prohibited under Shari’ah. The subject matter, price, quantity, and date and place of delivery should be precisely specified in the contract. In the event that the seller can neither produce the goods nor obtain them elsewhere, the buyer can either take back the paid prices with no increase, or wait until the goods become available. Should one of the parties fail to fulfill their contract, the bank will get back its initial investment, but will have to accept the lost profit. To reduce exposure to credit risk, the bank may ask for a financial guarantee, mortgage, advance payment, or third-party guarantee.

Istisna        is a contract in which a commodity can be transacted before it comes into existence. The unique feature of istisna’ (or manufacturing) is that nothing is exchanged on the spot or at the time of contracting. It is perhaps the only forward contract where the obligations of both parties are in the future. In theory, the istisna’ contract could be directly between the end user and the manufacturer, but it is typically a three-party contract, with the bank acting as intermediary. Under the first istisna’ contract, the bank agrees to receive payments from the client on a longer-term schedule, whereas under the second contract, the bank (as a buyer) makes progress installment payments to the producer over a shorter period of time.